Labor market distortions under sovereign debt default crises

Risk of sovereign debt default has frequently affected both emerging market and developed economies. Such financial crises are often followed by severe declines of employment that are hard to justify using standard economic models. This paper documents that labor market distortions deteriorate substantially around debt default episodes. Two different explanations for such dynamics are evaluated by linking these distortions to changes in labor taxes and costs of financing working capital. When added into a dynamic model of equilibrium default, these features are able to replicate the behavior of the observed labor distortion around a period of financial crisis and can also account for substantial declines of employment. In the model, higher interest rates are propagated into larger costs of hiring labor through the presence of working capital. Then, as an economy is hit with a stream of bad productivity shocks, the incentives to default become stronger, thus increasing the cost of debt. This reduces firm demand for labor and generates a labor wedge. A similar effect is obtained with an endogenously generated counter-cyclical income tax rate policy that also rationalizes why austerity is applied during deep recessions. The model is used to shed light on the recent events of the Euro Area debt crisis, in particular, the Greek sovereign debt default.