Is Welfare a Band-Aid for Nominal Wage Rigidity?

The minimum wage and welfare (broadly defined to include unemployment benefits and such) curiously interact.  As I’ve previously explained:

The minimum wage deprives the unfortunate workers shown in red of their ability to support themselves.  Given this involuntary unemployment, the case for welfare is suddenly easier to make.  What happens if the government in its mercy puts the unemployed on the dole?

The answer may surprise you.  The supply of labor falls to S’, of course, because free money makes workers less eager to work.  But unless welfare is ample enough to push the market-clearing wage above the legal minimum wage, welfare has no effect on the wage or quantity of hours worked!  Why not?  Because thanks to the minimum wage, jobs are rationed.  There’s still a line of eager applicants even if the marginal payoff for work declines.

With a binding minimum wage, the only clear-cut effect of welfare is to transform involuntary unemployment into voluntary unemployment.  That’s why the red line shrinks: Some – though not all – of the workers who craved a job at the minimum wage now shrug, “Eh, now that I’ve got free money, why interview?”

Diagrammatically:

Figure 3: Low-Skilled Labor Market With Minimum Wage and Welfare

That’s the simple analysis.  Suppose, however, that if involuntary unemployment gets high enough, policy-makers cut the minimum wage.  In this scenario, raising welfare makes the minimum wage less likely to fall.  As a result, the social cost of welfare is higher than it looks on the surface.  Yes, in the short-run, welfare merely “converts” involuntary unemployment to voluntary unemployment.  In the long-run, though, welfare increases overall unemployment by making the collateral damage of the minimum wage more politically palatable.

The same principles applies if employers can gradually circumvent the minimum wage by requiring employees to work faster or harder.  (Just picture labor demand rising because workers produce more per hour, and labor supply falling because workers suffer more per hour).  The higher the rate of involuntary unemployment – the fraction of workers who want a job given current market conditions – the more appealing this circumvention becomes.  When welfare converts involuntary unemployment to voluntary unemployment, it “sedates” the market’s normal urge to undo the damage of the minimum wage.

Convinced?  Now let’s generalize to a much broader problem.  Like most economists, I embrace standard New Keynesian models that blame mass unemployment on nominal wage rigidity.  Workers’ and managers’ deep distaste for hourly pay cuts functions like an economy-wide morass of job-specific minimum wage laws.  How does welfare interact with this nominal wage rigidity?

Once again, the short-run interaction is harmless.  Workers who genuinely can’t find a job because they’ve been priced out of the market receive some government money to help them make ends meet.  Welfare converts desperate involuntary unemployment into merely unhappy voluntary unemployment.

In the long-run, though, welfare makes unemployment more likely to persist.  When lots of unemployed workers are eager to work under current conditions, employers have the upper hand.  This doesn’t mean they can safely ignore workers’ distaste for nominal wage cuts.  But it does embolden employers to search for ways to cut compensation without incurring workers’ wrath.  When welfare makes unemployment more bearable, then, employers search less aggressively for ways to cut pay.  As a result, full employment takes longer to return.

The upshot: Welfare is not a harmless band-aid for nominal wage rigidity.  It’s more like scratching a mosquito bite.  In the short-run, welfare makes unemployed workers feel better.  In the long-run, though, welfare makes workers more likely to stay unemployed.  The reason isn’t that welfare makes unemployment “fun.”  The reason, instead, is that welfare retards job creation by reinforcing nominal wage rigidity.

Economists have recently been debating the effect of denying unemployment checks to the long-term unemployed.  Market-oriented economists tend to think that as soon as the checks stop coming, the unemployed get off their couches and find jobs.  Old-style Keynesians tend to think the welfare cut-off will merely impoverish the unemployed – not get them back to work.

I say both sides are wrong.  Holding wages constant, cutting unemployment benefits does nothing to make employers want to hire more people.  But cutting unemployment benefits does corrode nominal rigidity, leading – by a slow and painful path – to higher employment.  When the government cuts unemployment benefits, don’t expect a sudden return to full employment.  Instead, expect a gradual increase in job hunting, which in turn sluggishly drags wages back down to full-employment levels.

Many readers will conclude that “today is already the tomorrow which the bad economist yesterday urged us to ignore.”  If unemployment benefits had not been extended to 99 weeks in 2009, the labor market could easily already be back to normal.

The post appeared first on Econlib.