Bank Credit and Unemployment

Abstract

The worst employment slumps tend to follow the largest expansions of household debt. In this paper, we theoretically investigate an amplification mechanism by which debt on household balance sheets distorts labor market search behavior, leading to deeper employment slumps. Using a competitive search model, we find that levered households protected by limited liability engage in risk-shifting by searching for jobs with high wages but low employment probabilities. In general equilibrium, firms respond to this household preference distortion and post high wages but few vacancies. This vacancy-posting effect implies that high household debt leads to high unemployment, a result that casts light on why labor market recoveries are sluggish after financial crises. The equilibrium level of household debt is inefficiently high due to a household-debt externality — banks fail to internalize the effect that household leverage has on employment via the vacancy-posting effect. We analyze the role that a financial regulator can play in mitigating this externality. We find that loan-to-value caps for households and capital requirements for banks can elevate employment and improve efficiency, providing an alternative to monetary policy for labor market intervention.