The Possible Abrupt End of the $600 add-on to Weekly Unemployment Benefits Could Tank the Economy
In macroeconomics, as compared to fields like physics and chemistry, it is usually impossible and/or impractical to conduct controlled experiments, for the purpose of testing a hypothesis or otherwise. The Covid-19 pandemic may allow some empirical measurements of some of the basic foundations of macroeconomic theory and could also possibly allow new concepts to be considered.
One of the foundational concepts of macroeconomics is the Keynesian multiplier, which relates the impact of autonomous expenditures on aggregate expenditures. The Keynesian multiplier is the basis for fiscal policy, where government spending and tax policies are used to influence macroeconomic conditions, including aggregate demand and employment. The Covid-19 pandemic has prompted government stimulus programs that have dual objectives of alleviating the suffering associated with unemployment and increasing aggregate demand.
In prior recessions, where a political consensus that fiscal stimulus should be enacted evolved over a period of time, the stimulus typically took the form of tax cuts and public-works type spending. Likewise, monetary stimulus was also applied typically at a gradual pace. With the Covid-19 pandemic related shut-downs of economic activity, the unemployment rate went from 3.5% in February 2020 to 14.7% in April 2020. Thus, the need for immediate stimulus became apparent. This meant that the typical tools of income tax cuts and public-works type spending would have had much to slow an impact. Thus, the focus was on fiscal stimulus that could immediately alleviate the suffering associated with unemployment and boost aggregate output at the same time.
There are three categories of fiscal stimulus that can be put in place and quickly increase aggregate demand. These are direct payments, additional unemployment benefits and reducing payroll taxes. The CARES Act included direct payments to individuals and some businesses and a $600 add-on to weekly unemployment benefits. Despite being strongly advocated by President Trump, no payroll tax reductions for individuals have been enacted yet.
Each of these categories of relatively quick-acting fiscal stimulus has distinct characteristics in terms of its impact and what might be called its incidence in terms of who benefits. More importantly, there is a wide variance regarding the multiplier effect that should be associated with each.
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The CARES act provided for direct payments to only those with less than $150,000 per household ($75,000 individual) adjusted gross income as per their 2018 federal income tax return. Payments were also made to those who did not make enough to file any federal income tax return. These payments were sent out fairly quickly. One problem with these payments involved regional differences. $150,000 family income could be a bank president, living in a mansion in Alabama, while it could also be a restaurant chef married to a bartender living in a tenement in Manhattan.
The Alabama bank president could be still employed, working out of his mansion. The family consisting of the restaurant chef and bartender living in a tenement in Manhattan could have made $200,000 last year, and thus not received any direct payment, but now be unemployed because of Covid-19. Obviously, the restaurant chef and bartender household has a much higher marginal propensity to consume than the Alabama bank president, whose employment related costs, such as commuting expenses and meals away from home may now actually be lower.
The labor force can be divided into those who are unemployed and those who are employed. All of the incidence of the $600 add-on to weekly unemployment benefits goes to only those who are unemployed. All of the incidence of a reduction in payroll taxes would go to only those that are employed. The $600 add-on to weekly unemployment benefits is set to expire on July 31, 2020.
So Far Fiscal Stimulus Has Kept Retail Sales Above Prior Year Levels
In terms of supporting consumption, the fiscal stimulus was very effective. Even though the unemployment rate in June 2020 was 11.1% with 142.182 million employed, as compared to 157.148 million employed in June 2019, total retail and food services sales for June 2020 were actually up 1.1% compared to June 2019.
Adjusted for seasonal variation and for holiday and trading day differences, total retail and food services sales for June 2020 were $524.306 billion and were $518.614 billion for June 2019. The not adjusted, year-over-year increase was even larger. Not adjusted, total retail and food services sales for June 2020 were $530.442 billion and were $518.273 billion for June 2019. That was a year-over-year increase of 2.3%.
The year-over-year increase in the series: total retail sales, which excludes food services sales, were even greater. Total retail sales, seasonally adjusted for June 2020 were up 5.0% compared to June 2019. Not adjusted, total retail sales for June 2020 were $482.116 billion and were $452.242 billion June 2019. That was a year-over-year increase of 6.6%.
Approximately 20 million individuals are collecting the $600 add-on to weekly unemployment benefits per week. That is a $624 billion annual rate. That is 2.9% of the $21.54 trillion QI 2020 nominal annual rate GDP. It is likely to be over 3% of QII nominal GDP. The June 2020 CBO Monthly Budget Review release on July 8, 2020, projects federal payroll tax receipts of $996 billion for fiscal year 2020.
The Keynesian multiplier would imply that the decline in GDP as a result of stopping the $600 add-on to weekly unemployment benefits per week on July 31, 2020, should be some multiple of the $624 billion. In theory, the $624 billion annual rate taken out of the economy starting on July 31, 2020 could be offset by an equal amount of payroll tax cuts or direct payments. However, the Keynesian multiplier is a function of the marginal propensity to consume. The Keynesian multiplier formula is that the multiplier is 1/mps, where mps is the marginal propensity to save, which is equal to 1- the marginal propensity to consume.
Those unemployed have a much lower savings rate than those employed. Thus, taking a dollar away from an unemployed person should reduce net GDP, even if a dollar is simultaneously given to an employed person. In addition to the higher marginal propensity to consume of the unemployed, there is also the impact of what the unemployed are spending the extra weekly $600 on, as compared with what employed individuals would do with extra money. In particular, it is important what the unemployed will stop paying for, when the $600 per week ends.
The 2008 financial crisis demonstrates that when a substantial number of people stop paying their mortgages and other debts, there can be very serious ramifications for the financial system and thus for the entire economy. So far, the surge in the unemployment rate has not resulted in the magnitude of defaults and delinquencies by consumer borrowers that would normally be expected to accompany the present large reduction in employment.
Those who remember the film Too Big To Fail and the events it depicted, may recall the scene where Treasury Secretary Paulson is told that it would be a minimum of six weeks before the TARP program could begin buying any troubled assets, envisioned when TARP was enacted. Paulson then reluctantly agrees to a plan of direct capital injections into the banks that he had earlier flatly rejected out of hand. Paulson was aware that a sharp decline in bank capital due to the surge in defaults and delinquencies, and the write-down of the loans on the banks’ balance sheets, was an existential threat to the entire economy that had to be addressed immediately.
Banks have to write down the value of a loan that is not current, When an unemployed person fails to pay a mortgage or other consumer debt, the decline in a bank’s capital can be a multiple of the amount of the missed payment. For example, assume an unemployed person who owes $200,000 on a 3% 30-year loan is current on their $843.21 monthly payment, but is unable to make the payments when the weekly $600 ceases. The bank or other lender who owns the loan, may have to write down the value of the loan by 50%. This reduces the bank’s capital by $100,000. Banks can extend credit in amounts that are some multiple of their capital. When an unemployed person fails to pay rent and the landlord defaults on the mortgage, the impact to the lenders is similar.
This effect could give rise to a distressed credit multiplier, where the deleterious effects of the unemployed defaulting on loans and rent, due to the abrupt cessation of the weekly $600 payments, causes a far greater reduction in aggregate demand, as banks reduce the amount of credit they extend.
The original objection to the $600 weekly add-on was that many of the unemployed would be receiving more than their former salaries. When benefits such as health insurance and 401-k matching amounts are considered, the number of job losers who are actually better off may not be as much, but is still significant.
The Republicans have proposed that the extra unemployment be limited to an amount so that the unemployed person does not receive more than 70% of their previous wage. Obviously, relative to what the unemployed are receiving now, the lower wage workers would have their payments reduced the most. The problem with the 70% cap idea is that the state unemployment systems were not able to implement it. That was particularly the case for gig workers and others who were not normally covered by unemployment insurance, but who were made eligible by the CARES act. The state’s unemployment technology has probably not improved much since March. Senator Portman (R-Ohio), who has proposed a two-month extension of the weekly add-on at a lower amount, has said that some states would need at least two months to be able to base the extra payments to a worker’s former earnings.
When the July 31, 2020, $600 weekly add-on cutoff is combined with the re-imposition of some of the Covid-19 restrictions and slowing of reopenings, that is occurring in some states due to the steep rise in infections, the result may be a sharper reduction in aggregate demand than many now envision.
Conclusions and Recommendations
It is unclear as to whether the $600 will end on July 31, 2020, completely, or some extension will be enacted. Even if the same amount of money is included in a new stimulus package, but it is not targeted to the unemployed, there will be significant reductions in retail sales and significant increases in consumer loan defaults.
The possible scenarios range from an extension of the $600 weekly add-on to January 2021, as is contained in a bill passed by the House to no extension at all and no substitute. An extension as contained in the House bill would probably allow retail sales to remain at non-recessionary levels. A complete cut-off would almost certainly push the economy back into recession.
A sharp downturn in the economy due to a complete cut-off would probably push many of the companies in the sectors already weakened by Covid-19 into bankruptcy. The airlines are particularly vulnerable as I indicated in: American Airlines (AAL) May Be The First Airline Bankruptcy, But It Will Not Be The Last
Disclosure: I am/we are short AAL VIA PUTS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.