Econ 101: Unemployment Insurance Promotes Unemployment

Sen. Jim Bunning’s filibuster of a bill that included an extension of the ability to file for federal unemployment benefits attracted a good deal of negative attention from the news media. CNN’s Ali Velshi tweeted that Bunning was an “embarrassment 2 the Senate, 2 Washington, & 2 politics.”

Bunning wanted the Senate to stick with its recently-passed pay-go rule that requires any bill that spends money to either raise taxes or to find reductions in spending. Since the extension to file would cost the federal government $10 billion, Bunning wanted to find a way to pay for it.

The media made him appear a Scrooge who would cast thousands, if not millions, of Americans to the wolves when their benefits expired. But rarely, do journalists investigate the economic effects of unemployment benefits (Velshi was an exception the week following his tweet).

From Adam Smith on, economists have based their theories on the basic concept that people respond to incentives. If you reduce the cost of something people will choose more of it. If you increase the costs, people will choose less of it. There is little debate in the profession about the truth of this hypothesis.

So if we apply this to unemployment, it ought to be clear that if we reduce the cost of becoming or remaining unemployed, then we will have greater unemployment. This is not rocket science by any means. Suppose that unemployment benefits were $6000 per week and lasted indefinitely. Is there little doubt that most of us would choose unemployment? 

Normal unemployment benefits last for 26 weeks and are provided to persons actively seeking work who are out of work due to circumstances beyond their control – basically they were laid off rather than having quit. The cost is shared between the states and federal government. Employers pay a tax per worker to both the federal and state government to fund the program.

In June of 2008, Congress enacted the Emergency Unemployment Compensation Act of 2008. It has been extended and expanded several times since then. The current extension of unemployment benefits allows unemployed persons to collect reduced benefits for up to another 34 weeks in every state, and an additional 19 weeks in states with high unemployment rates. The cost of the extended benefits is borne fully by the federal government.

One reason we have had such a “jobless recovery” is due to the reduction in the cost of remaining unemployed due to the expansion of unemployment benefits. All that is at question is the amount of additional unemployment.  

The efficiency of the market system in producing wealth for the masses occurs in good part because the price system, including that of labor services, and the profit system move resources swiftly from industries where consumer demand is falling or where resource costs are rising into areas where consumer demand in increasing or resource costs are falling. By lengthening the time of unemployment, this process of “creative destruction,” as Joseph Schumpeter called it, is deterred. Labor remains in the unproductive position of unemployment longer than would otherwise be the case and will delay moving into new industries where their labor resources are valued enough for them to gain employment.

Another problem with unemployment insurance is that it increases the cost of hiring workers. Because employers must pay a tax per employee to fund the program, they will hire fewer workers than otherwise, making it harder for workers to find jobs. Again, there is not a question about whether this will increase unemployment, only how much unemployment will increase.

Now there are advantages to having unemployment benefits. The primary one is that by lengthening the time one has to search for a new position, the probability of obtaining the highest valued position is increased. Economists distinguish between reasons for unemployment, and recognize that there is an optimal length of job search which is greater than zero. However, we would expect in a free society that people will responsible for their own actions and thus will save during their period of employment as insurance against a period of unemployment.

A difficulty in insuring oneself against a period of unemployment is that unemployment insurance faces the standard moral hazard problem – once we are insured against an event we take fewer precautions to avoid the event. Government unemployment insurance attempts to avoid this problem by only providing benefits to those who are unemployed through no fault of their own.

However, it may be hard to distinguish between getting fired and quitting in some cases and once unemployed we certainly have the incentive to remain unemployed when receiving benefits of up to $387 per week as under the current law. For this reason, it is difficult if not impossible to find private insurance against loss of income from unemployment.

As a society we may wish to provide unemployment insurance, and we may wish to provide extended benefits as Congress has repeatedly done in the recent recession. However, when making such a decision we should take into consideration the fact that by doing so unemployment rates will be higher and our economy will be less efficient and dynamic than it would otherwise be.

Gary Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College and a Business & Media Institute adviser.

Correction: This story was changed to correct an editing error in reference to extensions in the bill. The Business & Media Institute regrets the error.