Risks to Human Capital
77 Pages Posted: 5 Sep 2019 Last revised: 9 Mar 2020
Date Written: March 8, 2020
What is the connection between financing constraints and the equity premium? To answer this question, we build a model with inalienable human capital, in which investors finance individuals who can potentially become skilled. Though investment in skill is always optimal, it does not take place in some states of the world, due to moral hazard. In other states of the world, individuals acquire skill; however outside investors and individuals inefficiently share risk. We show that this simple moral hazard problem and the resultant financing friction leads to a realistic equity premium, a low riskfree rate, and severe negative consequences for distribution of wealth and for welfare.
When investment fails to take place, the economy enters an endogenous disaster state. We show that the possibility of these disaster states distorts risk prices, even under calibrations in which they never occur in equilibrium.
Keywords: Contracting Frictions, Rare Events, Moral Hazard
JEL Classification: G12, G32
Suggested Citation: Suggested Citation