David R. Henderson  

Laffer on Unemployment Insurance

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Arthur Laffer, whose work I've often respected and who, I think, has been underappreciated by the economics profession, has a piece in today's Wall Street Journal on unemployment insurance (UI). It's titled, "Unemployment Benefits Aren't Stimulus." I wish I could say I like it. I don't. What's strong is part of his theoretical argument, one that many economists have made over the years. What's weak is another part of his theoretical argument and his evidence.

Strong argument:

The most obvious argument against extending or raising unemployment benefits is that it will make being unemployed either more attractive or less unattractive, and thereby lead to higher unemployment.

and later:
Employers don't usually hire people to assuage their consciences. They hire people to make after-tax profits. And if workers require more pay because of higher unemployment benefits, employers will hire fewer employees. Whether increased unemployment benefits incentivize workers to work less or disincentivize employers from hiring more workers, the effect will be the same--higher unemployment.

That's great. But check out this part of this theoretical argument:
To see this, imagine an economy that produces 100 apples. If 10 of those apples are given to the unemployed, then people who otherwise would have had those 10 apples now won't. The stimulus of 10 apples for the unemployed is exactly offset by the destimulus of 10 apples for those people from whom the 10 apples were taken.

This should be in economics textbooks as an example of begging the question. Notice that he assumes a fixed supply: 100 apples. So, of course, if he starts with that assumption, he can't allow for the conclusion that unemployment benefits could lead to, say, 101 apples. In other words, he assumes, from the start of the analysis, that unemployment insurance is not a stimulus.

I hasten to add that I don't think unemployment insurance is stimulus. But you don't prove something by assuming it from the getgo.

His weak evidence is actually a clever graph that I have never seen before. On the left-hand vertical axis is total real benefits paid per UI recipient (average payment per week times average duration of benefits.) On the right-hand axis is the unemployment rate. Of course, they track closely. He never claims explicitly that the UI benefits are what caused the unemployment, but that seems to be what he wants the reader to conclude. The obvious alternate hypothesis goes the other way: in times of high unemployment, the federal extension of UI benefits is triggered and so average benefits per recipient rise. I think he's got something with his graph. But he needs to dig further and try to get the causation right.

I'm against the extension of UI and, indeed, am more radical on this than Art Laffer. He writes:

No one opposes unemployment benefits as a transition aid for people to get back on their feet and find a new job.

I do. If unemployment insurance is such a great idea, let the free market provide it. You can argue that a private insurer would have trouble enforcing against moral hazard. And you would be right. But so does the government, which has no particular expertise at that. You could also argue that unemployment insurance would be underprovided in the free market because it carries a positive aggregate demand externality. But if you're going to have a government macroeconomic policy, the way to pump up aggregate demand, without the disincentive effects of UI, is, as Scott Sumner points out again and again, to increase the money supply.

Update: I've learned from conversations with regular readers of Econlog that many of you don't read any of the comments. For that reason, I recommend that you see my comment below in response to previous commenters.


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COMMENTS (19 to date)
David C writes:

I would disagree. One of his two strong arguments is weak too.

"And if workers require more pay because of higher unemployment benefits, employers will hire fewer employees. Whether increased unemployment benefits incentivize workers to work less or disincentivize employers from hiring more workers, the effect will be the same--higher unemployment."

If the average individual wants to maintain a lifestyle that costs $32,000 a year, then whether they're receiving $1,200 a month or $1,500 a month in unemployment benefits will have no effect on what salary they want when they get a job. They'll want to make $32,000 a year or greater. Increasing their salary from $40,000 to $45,000 will not increase their incentive to get a job again.

David R. Henderson writes:

@David C.
Wrong. Think on the margin.
David

Bob Murphy writes:

But if you're going to have a government macroeconomic policy, the way to pump up aggregate demand, without the disincentive effects of UI, is, as Scott Sumner points out again and again, to increase the money supply.

Et tu, David?

I could agree with you and Scott if you meant it like this: "If the government is going to inject heroin into everybody, the way to pump it in their arms is with clean needles."

But I don't think that's how you guys mean it. :(

Khoth writes:

I can see unemployment benefit increasing unemployment under normal circumstances. But surely now, with so many more jobseekers than jobs, having a few fewer people bothering to look for jobs will make no significant difference to the number of places that get filled?

David C writes:

I should say I don't disagree with your conclusion. The government should allow private insurance to handle unemployment insurance. And I'm not arguing that his argument is wrong from a classical economics perspective. I'm saying individuals don't think at the margin, and neither should models of individual behavior.

If an individual has a mortgage/rent payment, plus a car payment, plus insurance, plus fairly fixed electricity costs, and likely doesn't want to change their diet too much, then unemployment insurance will only delay how long they have until they need to get a job again. An extra few hundred bucks of unemployment insurance isn't going to make them desire to start eating at Denny's instead of McDonald's every morning in order to justify having to return to work. They need that money. You're arguing that people will choose to make drastic changes in their lifestyle to gain a slight benefit at the margin. That's not going to happen.

B.B. writes:

Hmmm..

Financial companies would sell unemployment insurance in good times, and pay out in bad times. Sounds like a great idea. Now who would sell such great insurance?

Maybe A.I.G. Or maybe Citicorp.

Private unemployment insurance would work in a complete Arrow-Debreu framework, but not in a more accurate description of the economy.

The ability of the federal government to create money (a la Sumner) also gives it the ability to fund unemployment compensation.

Blackadder writes:

If unemployment insurance is such a great idea, let the free market provide it.

Private attempts to provide unemployment insurance would face a severe adverse selection problem, which is probably why you don't see the market providing unemployment insurance even in places (like Singapore) where it isn't provided by the government.

David R. Henderson writes:

@Bob Murphy,
A longer discussion is needed than I have space for here. But let me change the analogy: instead of heroine, it's food. If government monopolizes food, I don't want it to reduce the quantity produced.
@Khoth,
That's an assertion on your part. There could be a million people out of the 16 million or so unemployed who are on the margin. Result if they get jobs: unemployment rate falls by about 0.6 to 0.7 percentage point.
@David C,
The "drastic change" I'm saying many people will make is to get a less-than-ideal job.
@B.B.
Government's ability to fund UI is not at issue here. I'm not arguing that government is unable to finance UI. I'm saying it shouldn't.
@Blackadder,
If private UI faces a severe adverse selection problem, as it well might (I alluded to this with my mention of moral hazard), then it won't exist. You can't wish away the problem with compulsory government provision. Instead, what government UI does is cross-subsidize, even ex ante. It's not truly insurance.

Bill writes:

In a different part of the Laffer piece, he repeats something that continues to surprise me, coming as it has from people who claim to reject the Keynesian story. To paraphrase Laffer, "Beyond the notion that in order for government to give out money, it must first take it from someone else, experience shows that the unemployment benefits (or tax rebates, etc.) will be saved and not spent, and are, therefore, not stimulative. Why make this saved vs. spent distinction? Savings are not "hoarded," i.e., placed under the mattress or buried in a coffee can in the back yard. Rather they are placed with financial institutions and become loanable funds that are then borrowed and used to buy something. A dollar doesn't care who spends it. If I receive a $1000 rebate, why is it more stimulative if I use it to purchase a big-screen TV than if I deposit it in my credit union account and it is then loaned out to someone else who uses it to buy a big-screen TV? Are financial institutions determined to carry such large quantities of excess reserves that no additional deposits to savings are being loaned, i.e., are being "hoarded" by the financial institutions?

Vinnie writes:
The obvious alternate hypothesis goes the other way: in times of high unemployment, the federal extension of UI benefits is triggered and so average benefits per recipient rise. I think he's got something with his graph. But he needs to dig further and try to get the causation right.

With one quick glance, the lead-lag relationship is painfully obvious, even to a simp like me. Unemployment rate changes; benefit level responds.

Curt writes:

Seems to me this line is also begging the question:

"If unemployment insurance is such a great idea, let the free market provide it."

Doesn't this imply that the 'free market' can or should implement all 'great ideas'? Can every great idea be structured in such a way as to present market opportunity?

David C writes:

"The 'drastic change' I'm saying many people will make is to get a less-than-ideal job."

I'm having trouble making sense of this. Once a person decides to get a job, the job they decide to get doesn't affect UI in any way. They're losing UI no matter what, so they should choose their ideal job. The best I can think of is that they're getting a job on the black market, but I don't think that's your argument. UI only drives up wages if people 1) refuse to take certain jobs, but 2) would be willing to take those jobs if wages were slightly higher. I'm disputing the second point.

Blackadder writes:

If private UI faces a severe adverse selection problem, as it well might (I alluded to this with my mention of moral hazard), then it won't exist. You can't wish away the problem with compulsory government provision. Instead, what government UI does is cross-subsidize, even ex ante. It's not truly insurance.

That's a nice semantic argument, but so what? If it turns out that government provided unemployment insurance isn't "truly insurance" but is only a functional equivalent, why should anyone care?

Mike Rappaport writes:

For those interested in this issue, see my article on private unemployment insurance, Michael B. Rappaport, The Private Provision Of Unemployment Insurance in the Wisconsin Law Review. I argue that private UI would be feasible under certain circumstances and that private insurers wanted to sell it prior to government insurance but were not permitted to do so. Most amazingly, Governor Franklin Roosevelt of New York vetoed a law that would have allowed private unemployment insurerance. Perhaps another example of government failure being the real cause of market failure.

Tracy W writes:

I'm saying individuals don't think at the margin, and neither should models of individual behavior.

If people don't think at the margin, then presumably all of us in a market society either starves to death, or spends all of our incomes buying food, no matter how large our incomes are. Actually, what we observe is people doing neither. People buy and consume some food, but they don't typically spend all their money on it (and if they do that's generally a sign they're destitute). People at some point are thinking "well, I could keep buying food, but that means I won't have any money left over for rent/electricity bill/rates", or, beyond that, "well I could keep buying food but I'd rather save up for a computer so I can read econlog". Models of individual behaviour should reflect how people actually act, not how you say they act, unless the two happen to the same.

If an individual has a mortgage/rent payment, plus a car payment, plus insurance, plus fairly fixed electricity costs, and likely doesn't want to change their diet too much, then unemployment insurance will only delay how long they have until they need to get a job again.

How about an individual who is flatting with someone who is still working and helping them out with the expenses, or they're getting some help from their parents?
There are deadbeats who will try anything to avoid working, there are cases of people with inherited wealth who work flat out, and there are people who work to support an expensive life-style and who want to keep that lifestyle going (I'm one of them, although I also suspect I would be more miserable if I didn't work as I suck at self-motivation). But there are people whose decision is more marginal. These are the people whose behaviour would be affected by a policy shift.

David C writes:

"How about an individual who is flatting with someone who is still working and helping them out with the expenses, or they're getting some help from their parents?"

Then they're even less likely to be influenced by wage increases because they're unsure of how much support they can get from other individuals, so they're even less likely to know the value of the trade-off between time and money. That's what I'm saying when I claim people don't think at the margin. Trying to determine the relative value of small changes to a large quantity of time and money is impossible. So they'll use a different set of factors to determine how much money they're willing to work for; specifically the lifestyle they're living or how much money they got in their previous job.

Seth writes:

"Private attempts to provide unemployment insurance would face a severe adverse selection problem, which is probably why you don't see the market providing unemployment insurance even in places (like Singapore) where it isn't provided by the government."

Another plausible explanation: There's no market because they self-insure.

Josh writes:

Economists who oppose these extensions are missing a very key argument that is much better than the disincentive to work.

The claim that unemployment benefits are stimulative is based on the assumption that consumption is dependent on current income receipts as in the Keynesian consumption function. In contrast, under the permanent income hypothesis, consumption is dependent on expectations of income. Thus, temporary additions to current income receipts such as tax rebates or unemployment benefits do not increase consumption.


I have written more on this here:

http://everydayecon.wordpress.com/2010/06/02/keynesians-monetarists-and-unemployment/

Tracy W writes:

Then they're even less likely to be influenced by wage increases because they're unsure of how much support they can get from other individuals, so they're even less likely to know the value of the trade-off between time and money.

I don't follow your logic here at all. How does not knowing how much support you'll get from other individuals result in you not caring about wage increases or the trade-off of time and money? I've gone independent contracting, where quite often I would wake up on Monday morning with nothing to do and by Tuesday midday be flat out. I did care about my hourly fee and I don't recall myself being any more uncertain about the value of the trade-off between time and money. Complete certainty is not necessary for making these decisions, we are in the end all uncertain about our incomes (you could be laid off from your job, the government could stop spending, the entire economy could collapse), but we do keep making decisions.

Now there may be some people who are getting both unemployment insurance and help from a third party who find the uncertainty about future help from the third party so unclear that they will try to go back to work as quickly as possible. But what matters is the person at the margin. And we do know that there are people, even in times of vanishingly low unemployment, who will live entirely off another's income if they can get away with it, I know some personally. Which means that not everyone is totally intolerant of living off a third party's support, despite the risk of that support being withdrawn. So, again, we come down to the person at the margin who is being influenced.

Trying to determine the relative value of small changes to a large quantity of time and money is impossible.

No it isn't impossible, if it was people couldn't function at all. Professionals with no fixed working hours manage to decide somehow to come into work at a certain time, even though a change of 5 minutes one way or another makes only a very small change relative to a large quantity of time and money. How do you decide whether to buy a stick of chewing gum (I assume that's small relative to your total income). How does the Government of the day decide whether to fund a new programme involving a relatively small change to total government expenses (eg a "save the Chatham Islands robin" spend?) People do this sort of thing every day, so it's clearly not impossible.

All your claims here make me wonder how you live your economic life.

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