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The Anatomy of a Credit Crunch: From Labor to Capital Markets

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Financial crisis are typically associated with severe economic contractions and, in particular, lasting deteriorations in labor market conditions. Both the Great Depression and the 2007-9 recession are dramatic examples of such phenomena, which seems to be a more general attribute of credit-driven episodes of economic contraction (Reihnart and Rogoff, 2009). Why is this?

Despite such close connection between financial crises and sustained rises in unemployment, there is very little understanding of the mechanisms through which disruptions in credit markets transmit to labor market outcomes. In this blog post, we summarize one such mechanism, developed in Buera, Fattal-Jaef, and Shin (2014), which attempts to fill this gap developing a quantitative model with financial and labor market frictions.

The fundamental insight of the paper is that, unlike other types of macroeconomic shocks, such as aggregate productivity shocks, sudden deteriorations in credit conditions are re-allocative in nature and, therefore, entail a magnification of the number of workers flowing from one enterprise to the other. Combined with a labor market that does not match workers into jobs immediately, the enhanced “traffic” through the labor market will have to carry an increase in the unemployment rate.

A key feature of the analysis, which gives rise to the enhancement of reallocation flows, is the observations that there are many businesses that can dispense from external financing in case credit conditions tighten, and appeal to internal sources of financing. To these firms, credit crunches represent an opportunity to expand, rather than to contract, since they are insulated from credit market yet they face lower costs for their factors of productions.

Besides the labor market, the authors emphasize another important channel through which a credit crunch creates a recession. This is the resource misallocation channel. In response to a contraction in credit supply, factors of production will flow (mediated by the labor friction in the case of labor) from constrained to internally self-financed entrepreneurs. This reallocation, however, need not be efficient, since resources could be flowing out from talented but poor entrepreneurs into wealthy but untalented ones. The extent to which this happens will be determined by the realization of the idiosyncratic productivity levels of the firms, and the endogenously accumulated level of financial wealth.  As a result, the aggregate Total Factor Productivity will be hindered

The paper explores the quantitative significance of these two channels both at the macro and micro level.  From a macro point of view, it shows that engineering a credit crunch, disciplined to generate a contraction in the external finance to non-financial assets comparable to the one observed for the total non-financial sector in the US economy, the economy can enter into a recession characterized by plausible contractions in TFP and Investment, and most importantly, a sharp and persistent increase in the unemployment rate. At the micro level, the paper shows that they type of reallocation that happens across firms in the model is qualitatively consistent to what is observed in the US data. Young and small entrepreneurs, which are the most affected by the credit crunch, show a substantial decrease in the growth rate of their net employment levels, while it is the old and large business that are relatively expanding. This pattern is consistent with age-size dynamics during the business cycle documented in Fort, Haltiwanger, Jarmin, and Miranda (2011).

Besides offering a plausible mechanism for the connection between financial crises and unemployment, the paper leaves a number of open questions. Why didn't unconstrained businesses expand as sharply in the data as it was implied by the theory? In other words, why capital reallocation in the data is not as large as that implied that the simple model? Also, the model's predicted recovery for TFP is a much slower one than that observed in the data. What feature is being left out of the model to account for these events?


- Buera, Fattal-Jaef, and Shin (2014): “The Anatomy of a Credit Crunch: from Labor to Capital Markets”, forthcoming Review of Economic Dynamics

- Fort, Haltiwanger, Jarmin, and Miranda (2011): “How Firms Respond to Business Cycles: The Role of Firm Age and Firm Size”, IMF Economic Review

- Reihnart and Rogoff (2009): “The Aftermath of Financial Crises”, The American Economic Review


Roberto N. Fattal Jaef

Economist, Development Research Group

Francisco Buera

Senior Economist and Research Advisor

Yongs Shin

Associate Professor

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