The Right Protection from Shocks

When it comes to labor markets, the policy response to the pandemic crisis has been unprecedented in scale, yet markedly divergent in nature on the two sides of the Atlantic. The US relied extensively on unemployment insurance, insuring workers against the cost of job loss. European countries, instead, prioritized preserving existing employment through short-time work. These polar strategies led to 12 percent of the US working-age population being on unemployment insurance in April 2020, and 16 percent of the European labor force being put on short-time work at the same moment in time, despite both having operational schemes working both ways. When facing large economic shocks, should governments insure workers or guarantee jobs?

Short-time employment is a subsidy for reducing the hours of work in firms during temporary shocks. It enables employers to reduce employees' working hours instead of resorting to layoffs. Employees are compensated by the government for earnings lost due to hours not worked. In contrast, unemployment insurance offers temporary subsidies to laid-off workers. Thus, while both programs mitigate labor market shocks, they differ in one fundamental way: short-time work aims to preserve jobs; unemployment insurance intends to protect workers from the risks associated with job loss.

Short-time work schemes are primarily intended to minimize job reductions. From a macro standpoint, countries that made extensively used short-time work during the pandemic witnessed smaller declines in employment. The opposite is true for unemployment insurance. Although this evidence is only correlational, it echoes a growing body of research showing that short-time work indeed saved jobs during the Great Recession. In both crises, the program proved to be an expedient way of preserving employment and mitigating the social costs of layoffs, a feat that unemployment insurance alone cannot achieve.
In practice, though, short-time work and unemployment insurance cater to different types of workers. In Germany, where both schemes coexist, unemployment insurance recipients tend to be younger, have lower earnings, and are reliant on a weaker safety net than recipients of short-time work. Consequently, despite short-time work's added benefit of preserving jobs, those most in need may slip through its protective net.

Short-time work and unemployment insurance are not without costs. Both require fiscal disbursement, which grows larger as workers and firms exploit the scheme beyond what is strictly necessary. Such opportunistic behavior, known as moral hazard, ultimately determines the total fiscal cost for the government of providing a dollar in transfers going to an unemployed person versus a worker on short-time work. Evidence from Switzerland and Italy during the Great Recession suggests that the total fiscal cost of short-time work is lower than that of unemployment insurance, primarily because the former, by preserving employment, reduces resort to and cost of the latter.

Besides fiscal costs, policymakers must also consider the economic costs of social insurance. One concern that loomed large during the pandemic was that short-time work, by maintaining workers' ties to their existing employers, may have delayed their reallocation to more productive employment relationships and slowed down the recovery. Whilst evidence from the Great Recession suggests that reallocation costs were smaller than dreaded, it is hard to speculate about their scope in the pandemic.

The pandemic crisis has underscored the pivotal role of timeliness and outreach for effective government intervention. While several countries managed to successfully provide timely support through new, temporary schemes, a priority going forward is to reassess the optimal policy toolkit to address labor market shocks. What should governments do? The policy debate tends to frame short-time work and unemployment insurance as alternative, mutually exclusive strategies to respond to economic shocks. In fact, far from being substitutes, the two have high potential to be complementary. They offer protection to different types of workers, exhibit strong fiscal complementarities, and tend to perform best in response to different shocks: short-time work is an effective way to respond to temporary shocks, whereas unemployment insurance can be more efficient and economically less costly when shocks are persistent. Incorporating both programs into the policy toolkit is likely to be the most effective strategy to respond to future labor market shocks.