Labor Market Flexibility and the Impact of a Credit Crunch

This paper explores the interaction effect between a credit crunch and a flexible labor market on the duration of a recession. In a flexible labor market, highly leveraged entrepreneurs may choose to be workers in the aftermath of a credit crunch. As a result, they lose the incentive to save for a business and fall into a credit trap, which magnifies the effect of a credit crunch on the duration of a recession. We illustrate this channel's mechanism and quantitatively evaluate its importance using a general equilibrium model. We also provide empirical support for the theoretical predictions using data from 65 countries over the period 1960-2011, which reveals that the interaction effect between a credit crunch and a flexible labor market significantly prolongs the duration of a recession. In comparison, our placebo test shows that there is no significant interaction effect between a flexible labor market and a credit boom as the credit trap channel is absent.