Continuing in the theme of cognitive illusions, I’d like to discuss how moralistic reasoning distorts our view of macroeconomics.  Consider the following from Salon.com:

During the recent fight over extending unemployment benefits, conservatives trotted out the shibboleth that says the program fosters sloth. Sen. Judd Gregg, for instance, said added unemployment benefits mean people are “encouraged not to go look for work.” Columnist Pat Buchanan said expanding these benefits means “more people will hold off going back looking for a job.” And Fox News’ Charles Payne applauded the effort to deny future unemployment checks because he said it would compel layabouts “to get off the sofa.”

The thesis undergirding all the rhetoric was summed up by conservative commentator Ben Stein, who insisted that “the people who have been laid off and cannot find work are generally people with poor work habits and poor personalities.”

Both liberals and conservatives are engaging in moralistic thinking, and both are wrong.  They’re fighting the age-old battle over whether the unemployed are the “deserving poor” vs. the “undeserving layabouts.”  To utilitarians like me, there are no “just deserts,” just more or less utility as a result of various public policy options.

I don’t see any evidence that the unemployment problem is caused by laziness.  Or perhaps I should say that I doubt the work ethic of the recently unemployed is much different from the employed.  There are definitely people who would rather not work if they didn’t have to (like me), especially those with dangerous, dirty, or unpleasant jobs.  Or lots of exams to grade.  But people also like money, and I’d guess the vast majority of unemployed people would rather be back at work.

But the liberals are also wrong; 99 week unemployment insurance probably does modestly raise the unemployment rate.  It’s only natural that a person who loses a fairly good job would like to return to a fairly good job.  A laid off accountant would be foolish to accept a job as a maid, janitor or coal miner.

But the main point of my post is that it’s a big mistake to form opinions about the impact of macro policies on the basis of personal observation, or intuition about human nature.  And that’s because of the fallacy of composition.  If an accountant losses his UI and becomes desperate for work, that doesn’t increase his chances of getting his old accounting job back.  But if every unemployed worker loses his or her UI and becomes desperate for work, it does increase the chances of the accountant getting his job back.  The reasons are complex.

Let’s start by assuming that UI doesn’t affect NGDP, rather the path of NGDP is determined by the Fed.  Of course Krugman and Eggertsson would not agree, they’d argue that less UI would reduce NGDP.  But recent actions by the Fed indicate that they won’t let inflation fall below about 1%, and that also puts a floor on NGDP.  Every time the economy weakens, the Fed does more QE, or at least more talk about future expansionary actions.

If we hold NGDP constant, then how does eliminating UI raise RGDP?  It does so by sharply boosting the supply of labor, which depresses the equilibrium nominal (and real) wage rate.  Workers who are desperate for work now throw themselves onto the job market.  Suppose each worker becomes willing to accept a job paying 40% less than his former job.  This lowers wages at all levels, and for any given NGDP that increases employment.  It is equivalent to a rise in AD.  The accountant who suddenly becomes willing to be a bank teller, paradoxically is more likely to get his old job back, because the general expansion of the economy that results from lower wages leads to a greater need for accountants.  Of course this process wouldn’t work perfectly, but there would be some tendency for employment to increase.

So the liberals are right that the unemployed aren’t lazy, but the conservatives are right that less UI would reduce the unemployment rate.

By now you might have assumed that I am advocating cutting UI.  If so, you are again engaged in moralistic thinking, assuming that someone making a technical argument is actually making a normative argument.  I don’t have strong views on exactly where the UI cut-off should be.  In the long run I’d like to see the system reformed to include more self-insurance, but for right now you can make a respectable argument for keeping UI in place, despite the modest increase in unemployment.  It does reduce suffering in the short term, suffering caused by needlessly contractionary policies instituted by policymakers who may not even know a single unemployed person.  (Oops, now I’m being moralistic.)

One other quick example of the problems with moralistic thinking.  Liberals say cutting the estate tax favors people like Paris Hilton.  Conservatives counter with stories of family businesses that must be sold off to pay the estate tax.  If these were actually the two arguments, I’d go with the liberal view.  I’m a utilitarian who thinks a dollar is worth much more to a poor person that a rich person.  But I want to abolish the inheritance tax precisely because it’s not a tax on the rich; it’s a tax on capital, whereas we should be taxing consumption.  We need a progressive consumption tax.

Part 2:  Always avoid annoying alliteration

I just noticed that my last three posts have been entitled Disinflation denial, Avoid asymmetries, and “Misleading moralistic macro.  I apologize.

Probably.  Nevertheless it’s worth thinking about the implications of this Robert Barro piece:

To get a rough quantitative estimate of the implications for the unemployment rate, suppose that the expansion of unemployment-insurance coverage to 99 weeks had not occurred and””I assume””the share of long-term unemployment had equaled the peak value of 24.5% observed in July 1983. Then, if the number of unemployed 26 weeks or less in June 2010 had still equaled the observed value of 7.9 million, the total number of unemployed would have been 10.4 million rather than 14.6 million. If the labor force still equaled the observed value (153.7 million), the unemployment rate would have been 6.8% rather than 9.5%.

In contrast, his son Josh Barro points out that most studies suggest extended UI boosted the unemployment rate by only about 0.4% or 0.7%, and then goes on to argue that even those figures may be too high.

…The incentive effects of UI extension must also be weighed against the stimulative effects of paying UI benefits. For some reason it’s become almost taboo to note this on the Right, but UI recipients tend to be highly inclined to spend funds they receive immediately, meaning that more UI payments are likely to increase aggregate demand. UI extension also helps to avoid events like foreclosure, eviction and bankruptcy, which in addition to being personal disasters are also destructive of economic value.

I’d like to sit in on one of those family dinners!

Count me as being somewhere between the two Barros, but closer to Josh.  I think the main difference between 1983 and today is that NGDP growth was nearly three times faster in the initial recovery of 1983-84.  If that’s all I knew about this recession–nothing about the banking/housing fundamentals that triggered it, and nothing about 99 week UI extensions, I’d still predict a very slow recovery, albeit perhaps a tad faster than we are getting.  Robert Barro contrasts the slow recovery to 1983, but better comparisons might be 1992 and 2002, when unemployment actually rose for more than a year after the end of the contraction.

However, I wouldn’t go as far as Josh Barro, who concedes a small adverse effect on the economy’s supply side, but then argues that the program boosts AD.  If extended UI benefits make the labor market more rigid (which seems likely), then it may reduce the equilibrium real rate of interest.  In that case monetary policy will become effectively tighter, even if the Fed continues to target nominal rates at 0.25%.  Many economists overlook the way supply and demand shocks become entangled.  There is a reason why negative demand shocks often follow closely on the heels of negative supply shocks (1974, 2008, etc.)

And although I think it unlikely we end up never recovering, the French experience should teach us some humility.  Recall that in the 1960s most European economies had much lower unemployment than the US, typically around 2% or 3%.  By the 1980s many were stuck with rates close to 10%.  France never really recovered from the 1981 recession, with unemployment fluctuating between 7% and 11% over the past 30 years.  And in 1972 no one in Europe saw this coming.

Why did it happen?  Who knows.  Initially people came up with all sorts of explanations.  Here’s an example from a 1993 paper:

A flow model is used to identify the causes for rising unemployment in France between 1978 and 1990. Two flow equations are estimated as functions of exogenous factors such as aggregate demand, factor costs, structural shifts and long-term factors and then used in simulations for the level of unemployment. It is shown that the main reason for high unemployment in France is a slow down in the demand for labour due to high labour and energy costs in the early 1980s and to tight aggregate demand over the whole period.  Change in the labour supply have had an increasing impact in recent years.

Today it seems silly to cite AD and energy prices, but it’s hard not to sympathize with the author (Dominique Gross).  If the cause was structural (as most now believe) it begs the question of why the natural rate of unemployment suddenly rose from 2% to 9%.  And which structural problem?  For ever suspect, you can find some small European country that has that policy, and yet maintains only 5% unemployment.  Perhaps it is labor market policies interacting with differences in culture and comparative advantage.

An optimist like me would argue that we aren’t about to copy the French statist model; dramatically higher minimum wages, generous UI benefits, national health care, higher taxes, etc.  Oh wait . . .  Seriously, as bad as it looks to conservatives, there is a lot of ruin in a nation.  So I still think there is only a 10% or 20% chance we will experience French-style ” hysteresis” (which refers to a sticky unemployment rate that refuses to fall during “recoveries.”)

One thing that has always annoyed me is economists who do a lot of moral grandstanding, accusing people they disagree with of being evil.  For instance, this is how Robert Reich recently entitled his attack piece on Robert Barro:

A record number of Americans is unemployed for a record length of time. This is a national tragedy. It is to the nation’s credit that many are receiving unemployment benefits. This is good not only for them and their families but also for the economy as a whole, because it allows them to spend and thereby keep others in jobs. That a noted professor would argue against this is obscene.

Regarding obscenity, a Supreme Court justice once said “I know it when I see it.”  With all due respect to Reich, I don’t see it.  Here’s the Barro article he responds to:

The unemployment-insurance program involves a balance between compassion””providing for persons temporarily without work””and efficiency. The loss in efficiency results partly because the program subsidizes unemployment, causing insufficient job-search, job-acceptance and levels of employment. A further inefficiency concerns the distortions from the increases in taxes required to pay for the program.

In a recession, it is more likely that individual unemployment reflects weak economic conditions, rather than individual decisions to choose leisure over work. Therefore, it is reasonable during a recession to adopt a more generous unemployment-insurance program. In the past, this change entailed extensions to perhaps 39 weeks of eligibility from 26 weeks, though sometimes a bit more and typically conditioned on the employment situation in a person’s state of residence. However, we have never experienced anything close to the blanket extension of eligibility to nearly two years. We have shifted toward a welfare program that resembles those in many Western European countries.

Didn’t Reich just say Barro opposed unemployment insurance?  Not only does he favor it, but he favors extended benefits during recessions.

Perhaps he thinks it’s obscene to accuse the unemployed of being lazy.  But then I found this in Reich’s article:

In theory, Barro is correct. If people who lose their jobs receive generous unemployment benefits they might stay unemployed longer than if they got nothing.

So I guess somewhere between the 99 weeks recommended by the virtuous Robert Reich, and the 39 weeks recommended by the evil Robert Barro (and implemented by Bill Clinton), UI extension proposals become obscene.  It all reminds me of the old Winston Churchill joke:

Churchill: “Madam, would you sleep with me for five million pounds?”

Socialite: “My goodness, Mr. Churchill… Well, I suppose… we would have to discuss terms, of course…”

Churchill: “Would you sleep with me for five pounds?”

Socialite: “Mr. Churchill, what kind of woman do you think I am?!”

Churchill: “Madam, we’ve already established that. Now we are haggling about the price.”

PS.  Robert Barro is one of my favorite supply-side economists.  No one is more deserving of a Nobel Prize in Economics.  But I think he has a bit of a blind spot about AD shocks, as do many on the right.

HT: Alex Tabarrok, Mark Thoma

In the previous post I provided evidence that extended UI benefits tend to reduce aggregate supply and increase unemployment.  (BTW, the most recent three posts are best read in reverse order, this one last.)  Now I will argue that extended benefits probably trigger a more contractionary monetary policy.

Let’s assume a sort of “Bernanke put” on the price level.  More specifically, assume that if inflation threatens to fall below the 0% to 1/2% range, the Fed will pull out all the stops with some sort of unconventional easing, say QE or lower interest rates on excess reserves.  I’ll call this a “zero lower inflation bound” assumption.

The standard Keynesian argument against cutting extended UI benefits is that it would reduce inflation expectations, and hence AD would fall.  Any job-creating effects from lower wages would be swamped by the deflationary impact of falling prices.  But if the economy is at the zero lower inflation bound, then cutting UI benefits does not reduce inflation.  To better understand this counter-intuitive result, imagine an AS/AD diagram (some day I need to learn how to make graphs on a computer.)  Lower UI benefits will tend to shift the SRAS curve to the right.  Normally this would lower inflation.  But if we are already at the zero inflation bound, then the Fed will react to this policy shift by moving the AD curve to the right, in order to prevent prices from falling.  In that case we are in a classical world, where less UI and lower minimum wage rates will lower both nominal and real wage rates, and also boost employment.

You may have noticed an amusing irony in this argument.  Keynesians like Paul Krugman argue that all the laws of classical economics go out the window when nominal interest rates are at the zero lower bound.  Cutting UI doesn’t create jobs.  There is a paradox of thrift.  But if we assume that inflation is at the zero lower bound (due to the Fed’s reaction function) then much of (old) Keynesian economics goes out the window.  In one sense there is nothing new here.  The new Keynesians have long recognized that the old Keynesian model is invalid when the central bank has a symmetrical policy of inflation targeting.  Fiscal policy can’t affect inflation, and, ipso facto, it can’t affect AD.

Here I am proposing something more modest–an asymmetrical lower bound on inflation, but a central bank that is still willing to tolerate slightly higher inflation rates.  In that case fiscal stimulus can still boost NGDP, but fiscal austerity no longer contracts NGDP.  This is roughly analogous to the zero interest rate bound, where conventional monetary policy can lower NGDP, but is powerless to increase NGDP.

I still believe the symmetrical inflation target is the better policy assumption, but I think this one is also fairly plausible for small changes.  It also loosely relates to a point that Andy Harless recently made in the comment section to one of my posts.  Harless argued that the Fed may be reluctant to engage in unconventional easing out of fear that they might overshoot into high inflation.  If I’m not mistaken, implicit in that view is the idea that there is some inflation rate (perhaps 0%?) where the Fed hits the panic button and engages in more QE or lower interest on reserves.  Maybe even an explicit inflation target.  If I have interpreted Harless correctly, this would allow for a bit of the sort of asymmetry that I have assumed in this post.

PS.  I am frequently amused by how often Paul Krugman suggests that any discussion of fiscal stimulus is completely out of bounds if it doesn’t implicitly acknowledge that monetary policy is ineffective at zero nominal rates:

If you believe stimulus is a bad idea, fine; but surely the least one could have expected is that opponents would listen, even a bit, to what proponents were saying. In particular, the case for stimulus has always been highly conditional. Fiscal stimulus is what you do only if two conditions are satisfied: high unemployment, so that the proximate risk is deflation, not inflation; and monetary policy constrained by the zero lower bound.

Notice how Krugman sort of rolls his eyes in disgust at us fools who refuse to “listen” when Keynesians claim that central banks are unable to debase fiat currencies.  OK, I will try to listen more in the future.  But I don’t think Krugman is being fair when he implies that people who believe the following are ignorant of the basic tenets of macroeconomics:

But even given the Fed’s own projections, it’s not doing its job, it’s missing its targets. Yet it apparently sees no need to act.

The preceding quotation was made just a few days ago by a distinguished economist.  I don’t think it is very polite to suggest that this economist doesn’t “listen” and somehow never learned that the Fed is “constrained” once rates hit zero.  And then consider this quotation from a few days earlier:

But how, exactly, does it serve the Fed’s credibility when it fails to confront high unemployment, while consistently missing its own inflation targets? How credible is the Bank of Japan after presiding over 15 years of deflation?

Whatever is going on, the Fed needs to rethink its priorities, fast. Mr. Bernanke’s “it” isn’t a hypothetical possibility, it’s on the verge of happening. And the Fed should be doing all it can to stop it.

There is nothing objectionable about these two quotations.  At worst, you could accuse the economist who made them of being a tad inconsistent.

Seriously, I do understand how Krugman reconciles all this in his own mind.  The Fed could do a lot more, but it’s risky and they probably won’t.  Ergo, we need fiscal stimulus.  (Of course Congress won’t either, as some of us warned last year.)  But not all of us buy into his assumptions about how the Fed operates, and hence not all of us believe the rules of classical economics fly out the window once rates hit zero.  That was the point of this post—to show that you could make an equally plausible claim that the laws of Keynesian economics fly out the window when inflation falls to its lower bound.

Update, 7/20/10:  Rob Fightmaster was kind enough to send me the following graph:

I am always a bit amazed by the way anti-supply-siders interpret certain stylized facts.  They seem to start with the premise that supply-side tax effects are not important.  If you raise taxes on the rich, you get lots more revenue.  And if you lower taxes on the rich, you get lots less revenue.  I try to imagine their thought process:

Yes, the huge increase in the top MTR under Hoover and Roosevelt didn’t raise much revenue, but that was because it “just so happened” that America’s income distribution got much more equal after 1930.  No supply-side effects there.  And yes, the Reagan tax cuts on the rich were actually associated with more revenue, but that’s because it “just so happened” that the income distribution got much less equal after 1980.  And yes the Europeans don’t actually raise much more revenue than we do, despite higher tax rates, but that’s because it “just so happens” that Europeans work less.  You say they work less for tax reasons?  Don’t be silly—it “just so happens” the Germans and French have lazy, happy-go-lucky cultures.  You say the French worked as hard as Americans in the 1960s?  It “just so happens” this distinctive French culture developed only in the past few decades, when their tax rates rose far above American levels.

And then there is the debate over extended benefits for the unemployed, which at 99 weeks is far longer than under any previous recession (that I can recall–does anyone have data?)  Unemployment benefits are of course an implicit tax on labor.  If the benefits are 77% as big as the wages in the best job you can find, then they are a 77% implicit tax rate.  That makes a big difference, particularly for workers in dead-end jobs.  Matt Yglesias recently challenged right-wing economists:

That’s because Congress is unwilling to extent UI eligibility beyond 99 weeks. Which means that soon enough we should see . . . something. But what? My guess is not much. My guess is that basically nobody wants to hire the vast majority of the current long-term unemployed. So my guess is that the labor market prospects of people who’ve been unemployed for 98 weeks will look an awful lot like people who’ve been unemployed for “only” 70 weeks. I wonder what people with a more right-of-center approach would predict? Are we going to see a surge in employment among people around the 99 week mark? Will they uncover hidden secret jobs that are stashed away somewhere?

Then a commenter named “wonks anonymous” provided me with a link where Casey Mulligan discusses just such a study by Stepan Jurajda and Frederick Tannery.  They looked at the number of weeks before unemployed Pittsburghers found jobs during the period from 1980 through 1985.  They choose this period because Pittsburgh had a horrible job market, with unemployment frequently over 10% and peaking at 16%.  They found that a few weeks before unemployment benefits were about to run out, roughly 3% of unemployed workers found a job each week.  Then the number of job finders jumped to 30% during the week their unemployment benefits ran out, and stayed somewhat above normal for another 9 weeks.  That’s pretty definitive evidence that incentives matter.

Why are liberals so often wrong about the supply-side effect of taxes?  Partly because these effects go against comment sense, and partly because they seem morally distasteful.  Unemployed people really are suffering (liberals are right about that), and claims that they could get jobs if they wanted to appear to be “blaming the victim.”  I think this is wrong, and that we need to avoid letting normative considerations distort our positive analysis of cause and effect, but it isn’t easy to do.

Another problem is that people visualize a period of high unemployment as one with very few new jobs being created.  This is not true; millions of jobs are being created all the time, even during recessions.  The problem during recessions is that many more people are looking for those jobs, and hence it is much more difficult for any given individual to find a job.  But it is certainly not impossible, as we know from the jobs created and jobs lost data.  My guess is that most of those suddenly finding jobs are less skilled workers who are accepting a lower-paying job out of desperation.  The low wage job market is widely known to have lots of turnover.

To summarize, common sense suggests that Matt Yglesias and Paul Krugman are right.  And those of us with empathy for the unemployed would like them to be right.  But it “just so happens” they are wrong.  Does this mean UI is a bad idea?  As you know, I favor the Singapore approach of self-funded UI accounts.  Given that we don’t have them, and given that millions have lost their jobs due to the incompetence of America’s macroeconomists (who keep insisting that monetary policy is out of ammunition, or that there is no problem of inadequate AD), then I think you can make a good argument for providing some additional help for the unemployed.

[Update:  A commenter named “Defennder” pointed out that my statement about Singapore was completely inaccurate.  I apologize for this error, which probably appears in a few other posts.  I had recalled that the Singapore (CPF) forced savings plan could be used for health, retirement and unemployment insurance.  According to this link it can only be used for health, retirement, and buying a home.  From now on I’ll call it the UI system that Singapore should have.  The link also indicates that 96% workers in big companies (more than 25 workers) get some sort of severance package, but of course big companies can go bankrupt, and lots of workers are in smaller firms.  Severance packages are better in terms of incentives, but the coverage may be inadequate.  Singapore typically has very low unemployment rates.]

In the next post I will discuss why the extended UI benefits are worsening the recession.  Is there a way to help the unemployed without making the recession worse?  Perhaps the government might want to consider a large, one-time, lump sum payment to the unemployed, which is not in any way tied to the duration of unemployment.  I don’t know whether such an idea is feasible, but it seems better on both efficiency and humanitarian grounds than building dubious public works projects.

PS.  The preceding is not an endorsement of actual, real world, supply-side politicians.  They often do make far-fetched assertions, such as the claim that the Bush tax cuts boosted revenue.  Tax cuts usually do not boost revenue, and that isn’t even the question we should be asking.

PPS.  I don’t mean to suggest that Yglesias and I are far apart on taxes.  We both think a progressive consumption tax is optimal.