There has been much debate recently about the extension of unemployment benefits. In particular, this debate has focused on Speaker of the House Nancy Pelosi’s claim that unemployment benefits are a source of stimulus for the economy. Much of the discourse has centered on the magnitude of the disincentives to work caused by the increased benefits. However, this recent discourse is a distraction from a much more fruitful discussion about the effects of unemployment compensation on output. Rather than arguing about the magnitude of the disincentives to work, the central proposition in question concerns the determinants of consumption.
The idea that unemployment benefits might stimulate the economy is based on the Keynesian consumption function under which consumption is determined by current income. Following a negative economic shock, output and employment fall. As a result of the decline in employment and therefore current income, consumption falls as well, which further reduces output. Under such a scenario, unemployment compensation serves to increase current income and thus current consumption.
An alternative to the Keynesian consumption function is Milton Friedman’s Permanent Income Hypothesis (PIH). Under the permanent income hypothesis, individuals make consumption decisions based on their expectations of permanent income rather than current income. In other words, the future path of consumption is determined by the expectations of future income. Transitory fluctuations in income do not affect the consumption path.
Consider an unemployed worker under the PIH. The worker loses his job and his current income declines. His consumption path, however, will only be affected to the extent that he believes that the reduction in current income represents a permanent change. If the change is expected to be permanent, he revises his future consumption path downward and lowers his reservation wage. If the change is expected to be transitory, he does not change his consumption path. As time goes by, the worker continues to update his expectations.
Now consider unemployment compensation under this scenario. When the unemployed worker receives these benefits, his current income receipts increase. However, the unemployment compensation is only transitory and does not affect the worker’s permanent income and therefore does not influence the future consumption path of the worker.
The distinction between alternative theories of consumption has important implications for whether or not unemployment benefits stimulate the economy. The Keynesian consumption function, for example, supports Nancy Pelosi’s claim that increasing unemployment benefits lead to increases in consumption and output. However, the PIH casts doubt on this proposition. The question is therefore largely empirical.
A careful reading of the empirical literature suggests that the PIH performs better than the Keynesian consumption function. For example, a series of research over the last decade or so by John Seater at North Carolina State University and his various co-authors has produced a great deal of support for the PIH using microeconomic data (see here, here, and here). In fact, nearly all of the evidence against the PIH is based on macroeconomic data, which Seater finds to be the result of misspecification or problems with using aggregate data. It is also important to note that DeJuan and Seater’s Journal of Monetary Economics article finds little evidence of liquidity-contrained consumers or the so-called “rule of thumb” consumers, which are often suggested as reasons why the PIH might not hold.
Taken together with the theoretical propositions stated above, the empirical evidence would seem to cast doubt on the efficacy of unemployment benefits in providing stimulus to the economy. Advocates of further extensions to unemployment benefits can continue to argue that such extensions are beneficial by smoothing income receipts for the jobless in this lengthy recession or other similar arguments. However, it would be incorrect to say that we should expect unemployment benefits to provide stimulus to the economy.