The question of how unemployment benefits affect the unemployment rate is one where one must pay close attention to the magnitude of incentive effects as well as what direction they are.
In this case, the direction is clear from economic theory: The more generous unemployment benefits are, all other things held equal, the higher the unemployment rate. This is because greater compensation increases the “opportunity cost” of taking a new job. (Opportunity cost is the value of what you must give up when you decide to take any action.) The higher the unemployment check, the lower the additional income from taking any particular job.
Real-world data supports this implication from theory. European unemployment benefits generally are a higher proportion of earnings in the last job held and go on longer. And in the past four decades, unemployment rates in most European countries with such generous benefits usually are higher than in our country.
Hence, Sen. John Kyl, R-Ariz., hit the nail on the head in March when he said “continuing to pay people unemployment compensation is a disincentive for them to seek new work.” So did Sen. Judd Gregg, R-N.H., in May when he asserted extended benefits “keep an economy that encourages people to stay on unemployment.”
But while these two critics are correct in judging the direction of economic incentives — higher or longer benefits produce higher unemployment rates — they don’t address the magnitude of the effects.
A recent study by JP Morgan Chase estimated the unemployment rate would be 1.5 percentage points lower right now had Congress not extended the duration of unemployment benefits. Many economists find this estimate high. A study considered more reliable that was conducted by researchers at the Federal Reserve Bank of San Francisco found an effect of 0.4 percentage points.
That study suggests the tradeoff is that we could have an unemployment rate of 9.1 percent right now instead of 9.5 percent. But more than 10 million people would have had sharply lower incomes — and hence spent less on goods and services — the past two years. Different people can come to different conclusions as to whether that would have made us better or worse off as a society.
A second issue of magnitude and direction of economic effects going on is ignored — that of the motivations members of Congress face in voting for programs like extended benefits or ongoing transfers to cash-strapped state governments.
Over four decades, a group of conservative economists, especially Nobel laureate James Buchanan and Gordon Tullock from George Mason University, have applied tools of economic analysis to areas hitherto considered political science. One topic was identifying the economic incentives for members of Congress to vote the way they do.
Earlier theory assumed elected officials voted according to their personal beliefs or the perceived best interests of their constituents. The new public-choice theory assumed politicians were driven by maximizing their own well being in terms of income, power or fame. They voted for measures that made them better off rather than what made the nation or their own constituents better off.
It is historically well established that the higher the unemployment rate and the worse-off the general economy, the better an opposition party does in a national election.
Thus, public-choice theory implies it is rational right now for a Republican to try to defeat measures that would lower unemployment, spur greater output or reduce the social discontent stemming from the sick economy.
Of course, for this to be successful, such opposition to economic growth and employment could not be seen as such by the voting public. But given the complexity of ongoing economic issues and the babble of opposing positions voiced by economists and pundits, this may not be as hard as one might think.
One particular issue is that of increased federal transfers to financially strapped state and local governments. These were an important component of the Obama administration’s $787 billion stimulus package. Some versions of the bills to extend unemployment benefits have included more such payments. If not made, state and local employment, already down 95,000 since the end of 2009, will decrease much more. That, political history indicates, would improve the chances of the minority party in the fall elections.
(Minnesota state government in May was actually slightly up from December but down about 1,400 from a year earlier. Local governments are actually up by nearly 4,000 since December but vary seasonally and have been running 1,000 — 4,000 below year-earlier levels over most of the last 12 months.)
I personally don’t think many Republicans would sandbag the economy just to increase their party’s prospects in November. But just as economic theory predicts unemployment compensation should increase unemployment, it also predicts such opportunistic behavior by politicians in election years.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.