This is a strange argument by Krugman.

(N.B. I agree with his main assumption — we are in a demand-side recession. I also think that economists who don’t recognize the logic of the demand-side recession should re-think their position. I’m not disputing this element of Krugman’s argument.)

It needs to be recognized that there are probably equally as many conservatives (at least, people Krugman would see as conservatives) who share the same general explanation for the Great Recession as Krugman. These are economists like Scott Sumner, Steven Horwitz, George Selgin, Larry White, Milton Friedman, et cetera. However, imagine the only blog you read is Krugman’s; you would have no reason to think that conservative monetary disequilibrium economists exist.

The impression I get as a reader of Krugman’s blog post is that if you agree with the general demand-side approach, then the rest of it naturally follows. That is, anyone who believes that, to one degree or another, unemployment benefits distort working incentives must think that the recession occurred because of half of the workforce was killed off in an alien invasion (oh wait, that would actually boost the economy — I kid, I kid).

Yet, there are many economists who both endorse the demand-side cause of the recession and the notion that unemployment benefits, on some margin, distort incentives to work. Note, these economists don’t necessarily think that all unemployment benefits should be cut, or even that unemployment benefits shouldn’t be extended during downturns. Friedrich Hayek, for example, supported redistributing income to guarantee a minimum standard of living. Hayek also believed in the possibility of demand shortages. It shouldn’t be controversial, in any case, that certain unemployment/welfare policies can create disincentives to work, to whatever extent — even if you think, considering other factors, that unemployment payments, on net, create a net benefit.

All of the following beliefs are consistent with each other. Unemployment benefits reduce incentives to work. There are some people, on the margin, who therefore choose not to look for work while receiving benefits (even if it only explains a tenth, or a twentieth, of the cyclical increase in unemployment). It follows that unemployment benefits don’t help reduce unemployment, quite the opposite actually. Yet, it is still a net benefit to redistribute income to society’s poorest, because there is a moral case in support. Cyclical increases in unemployment can be lengthy, and people shouldn’t starve to death because no one can afford their labor. (And, no, it’s not obvious that private charity, in the absence of public welfare, would be sufficient.)

Krugman argues that unemployment benefits boost demand, because they “put money in the hands of people likely to spend it.” But, this doesn’t follow from the demand-shortage theory of recessions. You need to make an additional assumption: the Keynesian multiplier.

In the context of the Keynesian multiplier, increasing unemployment benefits also increases investment, because, after all, someone needs to consume what is produced. The poor generally have a higher marginal propensity to consume than the wealthy; they save a smaller fraction of their income. The marginal propensity to consume is directly related with the marginal efficiency of capital (the return on investment), meaning lower consumption correlates with lower investment. Redistributing wealth from the rich to the poor therefore stimulates aggregate demand, by increasing both consumption and investment demand. But, investment and consumption require an intertemporal tradeoff, and therefore it doesn’t make much sense that current consumption drives current investment. Entrepreneurs borrow now to satisfy future consumption. There is no Keynesian multiplier. In fact, unemployment benefits increase consumption at the expense of investment, and can therefore reduce the stream of future consumption output.

So, there is a moral case for unemployment benefits, but there is no stimulus case for them. Of course, reasonable people can disagree on how large unemployment benefits should be, and for how long they should be paid. Similarly, it is reasonable to disagree on what minimum standard of living a minimum basic income should maintain. And, it follows that reasonable people can think that real world existing welfare benefits are higher than they ought to be. Of course, reasonable people should also corroborate their views with the empirical evidence, but the evidence in this case is open to interpretation.

There is, in fact, a better way to stimulate the economy (for efficiency concerns): monetary policy. And, this is exactly what many conservatives call for, and have been consistently calling for. Scott Sumner comes to mind as someone who has persistently and consistently advocated for changes to monetary policy, specifically NGDP targeting. Krugman, of course, agrees. He wrote a well-known paper on how monetary policy (increasing inflation expectations) can solve a demand shortage, even at the zero lower bound. But, it’s funny that he doesn’t mention this when he’s talking about conservatives who reject unemployment benefits and how unemployment benefits can stimulate the economy.

Separate quibble: recessions and the capital stock

Krugman asks, “Did termites eat part of the capital stock?” He answers in the negative. He’s wrong, and he might even be contradicting himself.

To keep it simple, look at the housing market. During the housing boom, there was quick growth in the construction industry, as new houses began to built in certain parts of the country. For whatever reason, it turned out that this investment was unsustainable, because consumers’ incomes fell (their budget constraints shifted to the left) and the demand for housing fell. The capital that was used to produce this excess supply of housing was misallocated; it was consumed at a loss. The capital stock shrinks. Potential GDP falls.

Of course, shocks to the capital stock can’t explain all of the movement in cyclical unemployment. If wages were perfectly flexible, the labor market would clear and there would no involuntary unemployment (apart from that produced by supply-side frictions). Cyclical unemployment can only be explained by non-clearing labor markets. Yes, wage floors (i.e. the minimum wage) are also responsible for non-clearing labor markets, but a large fraction of the unemployed are more productive than minimum-wage earners. These people are unemployed because of a shortage of money. Thus, monetary policy.