As shown in the graph below (from http://www.calculatedriskblog.com/) after a big decline starting in April of last year, Initial Claims for Unemployment Insurance have become extremely erratic.

This week it was time for some good news as claims fell by 11,000 to 448,000, although part of that is because last week’s numbers were revised upwards by 3,000, so in some ways it is more like a decline of 8,000. The four-week moving average, which smooths out some of the week to week volatility (and which is what is shown in the graph) increased by 1,500 to 462,500.

While this week’s decline is welcome news, it is really not good enough. To really indicate the economy is on-balance creating jobs at a healthy pace, we need to see the number below 425,000, and preferably below 400,000. We are actually below that 425,000 level at 423,000 on a raw — not seasonally adjusted — basis, but there are lots of seasonal factors in the job market, and so the unseasonally adjusted numbers are really not what one should be focused on.

While the numbers have been going up and down like a yo-yo so far this year, it is also important to step back and look at the longer-term trend. The four-week average is now 164,500 below where it was a year ago, a drop of 26.2%, so we have seen significant progress.

Continuing Claims

There was also some good news on the Continuing Claims front, with a drop of 18,000 to 4.645 million on the week and down 1.564 million from a year ago. However, regular continuing claims do not even come close to telling the whole story. They are paid out of state unemployment insurance funds and end after 26 weeks. In March, over 44% of all the unemployed had been out of work for longer than that, and half had been out of work for more than 20.0 weeks.

After people have exhausted their regular benefits, they move over to extended claims, which are paid by the federal government as part of the Stimulus Package. Extended claims (combining the two largest programs) also fell last week, by 91,000, to a level of 5.403 million. Unlike regular continuing claims and initial claims, the level of people on extended claims is far above where it was last year. The current level is more than twice the 2.336 million level last year.

The extended claims are best looked at in combination with continuing claims, since that is really the total number of people getting benefits. Thus there are now 10,048 million people getting checks, down 109,000 from last week, but up 1.503 million, or 17.6% from a year ago.

Providing extended benefits when the economy is in a deep slump is good economics, and the non-partisan CBO scores it as among the most effective stimulus measures on a job saved or created per dollar spent basis. The reason is that without the extended benefit, people would have no income at all, and by the time they have been out of work for six months, they have probably already depleted most of their savings.

With no income, they have no demand. Fewer shoppers is not good for Wal-Mart (WMT) or Kroger’s (KR) nor is it good for the makers of the goods that they buy. While benefits vary somewhat by state, generally unemployment benefits are about 60% of what people were making prior to losing their jobs, up to around $400 per week. That reduction in income should provide plenty of incentive for people to want to get back to work.

However, there is some evidence that extended benefits can also create disincentives to seriously search for a job as well. With the number of job applicants many times the number of job openings in most areas, those effects right now are fairly minimal.

A recent study by the San Francisco Fed (see http://www.econbrowser.com/archives/2010/04/data_based_asse.html#more) put the effect of extended benefits as 0.4 points of the 6.0 point increase in the unemployment rate we have seen in this downturn, not counting the countervailing overall stimulus effects. They conducted the study by comparing how long people who were eligible for unemployment insurance were out of work (those who were laid off) to those who were unemployed buy not eligible for benefits (because they quit or are new to the workforce) and found very little difference between the two groups, as is shown in the second graph.

However, as the economy recovers, the stimulative benefit of extended claims will become less important, and the potential disincentives will potentially become larger. We don’t want to turn the extended benefit program into a back-door welfare system.

There will become a time when extended benefits need to be eliminated, but with the overall unemployment rate still at 9.7% and the under-employment rate at 16.9%, this is not yet the time to do so.

Extended benefits obviously have a major humanitarian benefit, but they also are an important support for the overall economy when overall aggregate demand is far below potential. Without them, it would not just be the unemployed and their families who felt the pain, but also any bank that they owed money to. Their neighbors as the unemployed person’s house went into foreclosure and further lowered the housing values on their street would also be affected, as would the big banks like Bank of America (BAC), which made and serviced the mortgage.

Since U.S. taxpayers own 80% of both Fannie Mae (FNM) and Freddie Mac (FRE), which probably own or guarantee the mortgage, they would get hurt as well. As they say in the quick oil-change commercials, pay them now or pay them later.

We probably need to keep the extended benefits going at least until the unemployment rate falls below 8.0%. However, a case could be made for a graduated schedule where the level of benefits slowly diminishes over time to minimize the disincentive effects.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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