Labor Market Distortions under Sovereign Default Crises

Risk of sovereign debt default has frequently affected emerging market and developed economies. Such financial crisis are often accompanied with severe declines of employment that are hard to justify using a standard dynamic stochastic model. In this paper, I document that a labor wedge deteriorates substantially around swift reversals of current accounts or default episodes. I propose and evaluate two different explanations for these movements by linking the wedges to changes in labor taxes and in the cost of working capital. With these two features included, a dynamic model of equilibrium default is able to replicate the behavior of the labor wedge observed in the data around financial crisis. In the model, higher interest rates are propagated into larger costs of hiring labor through the presence of working capital. 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 a counter-cyclical tax rate policy. The model is used to shed light on the recent events of the Euro Area debt crisis and in particular of the Greek default event.