Monday, July 5, 2010

Unemployment Insurance

Krugman's column this morning gets a B. He arrives at the right conclusions (more or less), and includes some useful economics, but loses points for:
Yet the Senate went home for the holiday weekend without extending [unemployment insurance] benefits. How was that possible?

The answer is that we’re facing a coalition of the heartless, the clueless and the confused.
I prefer to be charitable. Ignorance (I guess that is the clueless and confused part) is a good explanation for a lot of behavior, and is easily cured with education.

Why is unemployment insurance (UI) provided by the government, and not by the private sector? To my knowledge, and perhaps surprisingly, economists who analyze UI systems typically don't answer this question. I think the answer is closely related to why (in my opinion) a well-designed government-run health insurance program works well. In the UI business, standard problems of moral hazard (behavior of the insured affects the chances of suffering an insured loss) and adverse selection (the insurer has a hard time differentiating bad insurance risks from good ones) are severe. The insurer of unemployment cannot observe how much effort the unemployed put into searching for work, and cannot determine whether the unemployed are excessively choosy in terms of the jobs they will accept. As well, as with private health insurance, a market in private unemployment insurance would likely degenerate, by way of the adverse selection problem, to a state of affairs where only high-risk (for unemployment) workers buy insurance policies, and the high prices of the insurance keep the low-risk workers out of the insurance pool. This argument is far from airtight, though, as we now have to ask why the private market seems to work in terms of auto insurance and homeowners' insurance, but not for health and unemployment. However, let's go on.

If we accept that the government should be providing unemployment insurance, we also have to accept that there are some frictions in loan markets that prevent unemployed people from smoothing their consumption over time in the face of unemployment shocks. Credit market frictions, or what we think of as credit market constraints, can make government tax policy matter. For example, a government transfer - unemployment insurance benefits - can increase economic welfare, in spite of the fact that the government will have to finance the transfer by increasing someone else's tax burden, either now or in the future.

Thus, we think that governments can improve welfare by providing unemployment insurance, and there can be a cyclical role for generous unemployment insurance when aggregate economic activity is low and credit market frictions are more severe. Unemployment insurance is targeted toward people who are credit constrained, and therefore arguably a more efficient policy tool than broad tax cuts. However, the government is still faced with the severe moral hazard and adverse selection problems inherent in all UI programs, and needs to design these programs so as to provide the correct incentives. It is well-known that more generous unemployment insurance increases the average unemployment rate - this is well-documented in data from Europe and Canada relative to the US, for example, and is consistent with standard search theory.

The theory of dynamic incentives, as applied to UI, in work by Shavell and Weiss, Hopenhayn and Nicolini, for example (see this paper for the references) tells us that the UI system in the US is likely far too stingy. Generally, the idea is that replacement rates (the ratio of the UI benefit to income when working) should be higher, and benefits should continue for much longer, declining over time. In normal times, UI benefits in the US conform to a replacement rate of about 50% for 26 weeks, then go to zero. In most developed countries, UI is much more generous. For example, in Canada, UI benefits continue for longer, are geared to local labor market conditions (probably a bad idea, actually), and include maternity leaves, parental leaves, compassionate leaves, and illness.

What's the conclusion for current policy in the United States? Krugman is right, in that extending UI benefits under the current conditions would be a good idea. Incentive problems matter, but theory tells us that we should cut the unemployed some slack during a downturn. For the long term, reform of UI in the United States would be useful, but as usual, that would be complicated. UI is in part governed by a framework of Federal law, but the details and funding are worked out by the States. Good luck with that.

33 comments:

  1. i believe krugman's column was specifically about the fact that UI is being held up for political reasons; in the face of that, logic is useless...im not grading him, but i think his use of the word heartless was weak; criminal would have been a better choice...

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  2. Yes, by definition anything the Congress does is political. A better way to put it might be to say that the Republican party tends to pander to ignorance. Unfortunately that can win votes.

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  3. stephen, my point was not that they were pandering, but that they were deliberately trying to crash the economy: Stabenow: “Republicans Want This Economy To Fail” - In a depressing briefing with reporters, Sen. Debbie Stabenow (D-MI) charged that Republicans basically are holding back measures to extend unemployment insurance and create jobs in a cynical ploy to help their chances in November by crashing the economy and blaming the Democrats for it.At issue is the large tax extenders/jobs bill, which has been whittled down consistently over the past few weeks, with Republicans continuing to offer a united front against the bill. Today there will be a cloture vote on the bill, and absolutely nobody believes it will pass.

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  4. One side panders to ignorance, the other exaggerates. Exaggeration may be necessary to pass legislation, but from an objective point of view, it's just exaggeration. I could be wrong, but I don't think the economy is in the fragile state that some people are claiming. The bill looks dead in the water, but without it what we will have are a large number of unemployed people who are much worse off than they need to be, and an economy that will continue to recover. Why we have such low employment and a high unemployment rate in the face of reasonably good growth in GDP is something we need to understand better.

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  5. the economy may not be fragile, but the 7 million who've been without a paycheck for more than 6 months are:
    http://research.stlouisfed.org/fred2/series/UEMP27OV?rid=50&soid=22

    ...im getting tired of the emails from friends who despite their best efforts cant find a job, have to cut off the internet service, face eviction, starve themselves so their kids can eat, or wish that if only her suicide would pay for her daughter's education....

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  6. while im here ill take a shot at this: "Why we have such low employment and a high unemployment rate in the face of reasonably good growth in GDP is something we need to understand better."

    if you type "struc" into a google search bar you get "structural unemployment" as a suggestion, and you will see there are dozens of articles about it that have been written recently; one from a few days ago that links to two others is here: http://economistsview.typepad.com/economistsview/2010/07/innovation-scaling-and-the-industrial-commons.html

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  7. I understand you concerns. Unemployment is serious business for those who experience it. I followed your link, and did not find anything I was sympathetic to. It is easy to blame foreigners for our problems and resort to protectionism to "prevent jobs from being exported." What I think we are experiencing are deep long-term structural changes within the US economy, in terms of what we produce and where it is produced. Some of those things were masked by the boom in the housing sector, and exacerbated by the subsequent housing collapse. Moving manufacturing jobs from Michigan to Alabama or moving workers from construction to health care is painful. However, there is little the government can do to change the reality of what has to happen, other than to smooth the transition with social insurance and public education.

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  8. i wasnt blaming foreigners or advocating any kind of protectionism...i just was trying to point out the problem and note that the political conniving to cut off that "social insurance" in the face of those structural changes to the global employment situation borders on criminal...changing UI policy to something that might work better as you suggested should take a backseat to immediately dealing with the human crisis at hand...

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  9. I disagree with your comment that: "as with private health insurance, a market in private unemployment insurance would likely degenerate, by way of the adverse selection problem..." The private health insurance market has plenty of problems, but the perceived problem that higher-risk individuals may have higher demand for insurance is constantly overstated. Insurance of all kinds can work perfectly well with some level of adverse selection – see http://www.guythomas.org.uk/pdf/LC2A.pdf . I’d say the main difficulty with private insurance against unemployment is that the individual risks are not uncorrelated.

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  10. Slightly off-topic: why does the private market seem to work well for auto insurance?

    1. Every driver must have it (no adverse selection).
    2. Everybody thinks they're a good driver, until they crash (no asymmetric info).
    3. Bad drivers have lots of little crashes, not just one big one, so experience rating works well (no peso problem).
    4. If some bad drivers get priced off the road, that's a good thing, not a policy problem.

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  11. Anonymous said:

    "I’d say the main difficulty with private insurance against unemployment is that the individual risks are not uncorrelated."

    But if the problem is aggregate risk, how is the government better-equipped to bear that than the private sector?

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  12. "But if the problem is aggregate risk, how is the government better-equipped to bear that than the private sector?"

    The government has a much greater (unlimited?) capacity to absorb claims in a really bad year. Private insurers could just be wiped out - or would have to hold very large reserves against the possibility.

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  13. Bryan Caplan on adverse selection in insurance:
    http://econlog.econlib.org/archives/2009/07/adverse_hazard.html

    Casey Mulligan argues that unemployment insurance increases unemployment even during recessions:
    http://caseymulligan.blogspot.com/2010/03/do-jobless-benefits-discourage-people.html
    He suggests that other labor-market distortions are keeping unemployment high even as GDP recovers.

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  14. Re Wonks's link to Caplan's comments:
    Caplan puts it perfectly when he refers to economists evoking Moral hazard and adverse selection as "simplistic, angry mantra".

    However, he then goes on to devise an extreme example (half the population have 20 times the risk of the other half) to try to prove that insurance won't work without discriminatory pricing. In fact, with more realistic risk variations, such insurance can, and does, work perfectly well.

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  15. Nicholas Barr has a nice theory about the welfare state as a substitute for private insurance markets. One of the reasons has to do with the fact that unemployment is typically a systemic risk.

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  16. The private insurance will get some insurance markets and they will give some tips to by using this tips we have take the policy.cheap car insurance

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  17. The insurer of unemployment cannot observe how much effort the unemployed put into searching for the work, and cannot determine whether the unemployed are excessively choosy in terms of the jobs they will accept.
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  19. 1. Every driver must have it (no adverse selection).
    2. Everybody thinks they're a good driver, until they crash (no asymmetric info).
    3. Bad drivers have lots of little crashes, not just one big one, so experience rating works well (no peso problem).
    4. If some bad drivers get priced off the road, that's a good thing, not a policy problem.

    ReplyDelete
  20. "I’d say the main difficulty with private insurance against unemployment is that the individual risks are not uncorrelated."

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