The New York Times; July 1, 2013

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Will Reduced Unemployment Insurance Improve the Labor Market?

In an insightful column, “War on the Unemployed,” published July 1, 2013, Paul Krugman of the New York Times argues that the most important problem facing the U.S. economy is a shortage of demand that translates into a shortage of jobs.  For this reason, Krugman argues against cutting unemployment benefits.  Supporters of scaling back unemployment insurance argue that such a policy change will make people more anxious to search for and accept jobs.  But if the root problem is that inadequate demand is constraining the number of jobs available, pushing people to search more intensively for jobs will not improve employment. As economists would say, demand for labor is the “binding constraint” on employment in times like these, not the willingness of people to take jobs.  If stingier unemployment insurance forces someone to take a job she might have turned down with better unemployment benefits, that is just one fewer job available for someone else without any corresponding increase in the demand for labor.  The policy just hurts the already precarious situation of the unemployed without raising the total number of jobs in the economy.

This perspective is consistent with the Keynesian macroeconomic vision developed on this site.  We encourage readers to read through our Keynesian Basics pages to better understand the macroeconomic theory that supports Krugman’s argument.

Here, however, we want to highlight one particular aspect of Krugman’s column that deserves special emphasis:

[W]hat about supply and demand? Won’t making the unemployed desperate put downward pressure on wages? And won’t lower labor costs encourage job growth? No — that’s a fallacy of composition. Cutting one worker’s wage may help save his or her job by making that worker cheaper than competing workers; but cutting everyone’s wages just reduces everyone’s income — and it worsens the burden of debt, which is one of the main forces holding the economy back.

This line of argument is very important because it addresses a common misconception about unemployment.  Those with a little economics training often think of the labor market as an isolated part of the economy that can be separately analyzed with the simple supply and demand tools taught in introductory economics.  The misleading argument goes like this:  if there is unemployment in the labor market (“excess supply” of labor in econ jargon), then the price of labor (wages and salaries) needs to fall.  Lower wages will encourage firms to hire more workers until demand rises enough to absorb any excess supply.  If this argument were true, it would suggest that pushing more people to seek jobs would in fact raise total labor demand—and therefore total employment—by causing wages to fall.

As Krugman says, this logic may apply to the situation faced by an individual worker or several workers at an individual firm.  Some workers might be able to outcompete others by accepting wage cuts.  But in an economy like the contemporary American one, when there are too few jobs in the aggregate because there is not enough demand for firms to justify offering enough jobs to reach full employment, the problem of creating more jobs in the aggregate will be solved only by increasing aggregate demand for goods and services.

Paying people less will not stimulate aggregate demand.  Firms may like the fact that workers can be hired more cheaply, but they will not hire workers, even at a relatively low cost, to produce output that cannot be sold. Rather than hiring more employees because of the lower wage, firms will simply pay the same number of employees less, further hurting aggregate demand.

You will find a deeper explanation for the reasons why lower wages and prices do not cure demand problems here, including development of the idea mentioned by Krugman that falling wages raises the burden of debt, exacerbating the problem of insufficient demand.  Understanding this issue is crucial not just for analyzing policies related to unemployment insurance, but also for appreciating the logic of basic Keynesian macroeconomics.