Debt Constraints and Employment

Abstract

During the Great Recession, regions of the United States that experienced the largest declines in household debt also experienced the largest drops in consumption, employment, and wages. Employment declines were larger in the nontradable sector and for firms that were facing the worst credit conditions. Motivated by these findings, we develop a search and matching model with credit frictions that affect both consumers and firms. In the model, tighter debt constraints raise the cost of investing in new job vacancies and thus reduce worker job finding rates and employment. Two key features of our model, on-the-job human capital accumulation and consumer-side credit frictions, are critical to generating sizable drops in employment. On-the-job human capital accumulation makes the flows of benefits from posting vacancies long-lived and so greatly amplifies the sensitivity of such investments to credit frictions. Consumer-side credit frictions further magnify these effects by leading wages to fall only modestly. We show that the model reproduces well the salient cross-regional features of the U.S. data during the Great Recession. A data appendix is available at http://www.nber.org/data-appendix/w22614A popular view of the [2007][2008][2009] Great Recession in the United States is that large disruptions in the credit market played a critical role in generating the observed drop in output and employment. This view is motivated in part by the regional patterns documented in recent work by several authors. Sufi (2011, 2014) showed that regions of the Unites States with the largest declines in household debt and housing prices also experienced the largest declines in consumption and employment, especially nontradable employment. Beraja, Hurst, and Ospina (2016) showed that wages were moderately flexible in that they fell across regions almost as much as employment did. Finally, Giroud and Mueller (forthcoming) showed that employment fell the most in firms that were facing the worst credit conditions.Motivated by these facts, we investigate the interplay between credit and labor market frictions, and how this interplay may have accounted for the Great Recession, by developing a version of the Diamond-Mortensen-Pissarides (DMP, henceforth) model with risk-averse agents, borrowing constraints, and human capital accumulation.In the DMP model, hiring workers is an investment activity in that costs are paid up front, whereas benefits accrue gradually. As with any investment activity, the amount of such investments falls after a credit tightening, leading to a drop in employment. Although this force is present in any dynamic search model, the drop in employment following a tightening of credit is minuscule in the textbook version of the DMP model without human capital accumulation. This result is driven by the feature of the textbook DMP model that the flows of benefits from forming a match are very short-lived, with a (Macaulay) duration of two to three months, and is reminiscent of standard results in corporate fina...

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