Equilibrium Default and Slow Recoveries

The 2007-2009 financial crisis generated a striking short-lived increase in the employment separation rate and a persistent decrease in its finding probability, which resulted in an increase in unemployment and a slow recovery. In this paper we propose a novel mechanism that can account for these patterns. The key innovation relies on the interaction between firms' number of workers and its willingness to default: firms with more debt per worker are less likely to repay and consequently face higher credit spreads. Therefore, at the aggregate level, credit conditions worsen with higher unemployment, which further reduces firms' incentives to hire resulting in a loop between the financial and the labor market.