Collateral crises and unemployment

ABSTRACT

Inspired by the sudden devaluation of ‘safe’ assets at the dawn of crisis, I build a model that features collateralisation in the financial market, and search frictions between employers and workers in the labour market. The model identifies a collateral quality threshold, below which banks switch from unconditional lending to lending contingent on receiving good collateral. The switch explains why a small shock in the collateralised market may lead to sharp losses in job vacancies, such as that seen in the 2008 Great Recession. A trade-off is identified between the proximity and severity of a collateral crisis. Policymakers may manipulate the trade-off, but they cannot eliminate it.

KEYWORDS:

• Collateral crises
• job vacancies
• search frictions

Acknowledgements

I thank seminar participants at the 4th NZ Macroeconomic Dynamics workshop, Wellington, 18 April 2014; the 54th Annual Conference of the New Zealand Association of Economists, Wellington, 3–5 July 2013; Econometric Society Australasian Meeting Conference, Hobart, 1–4 July 2014; the Southern Workshop in Macroeconomics (SWIM), Auckland, 7–8 March 2014; and the Australian Economics PhD Conference, Australian National University, 7–9 November 2013. I also thank the editor and the anonymous referees for helpful comments.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. Note the difference between this analysis and the conventional financial accelerator channel. An increase in productivity in a financial accelerator model would reduce the leverage ratio and the external finance premium of firms, which would bring about increased employment. The argument raised here is as firms cannot quickly expand in size, one firm can only hire one worker and start one project at any time; therefore a deprivation of funds from firms leads to lower employment.

2. Notably, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 in the United States, the Banking Act of 2009 and Banking Reform Act of 2013 in the United Kingdom, the move toward a common regulatory system in the European Union, and internationally through changes in the way banks are required to finance themselves.

3. In the three decades before 2007, most crises occurred in emerging markets. They include the Latin American crises in the late 1970s--early 1980s, the Mexican crisis in 1995 and the East Asian crises in the mid- to late 1990s. However, more advanced countries experienced crises in recent decades as well, from the Nordic countries in the late 1980s, to Japan in the 1990s. The most recent crises starting with the US subprime crisis in late 2007 and then spreading to other advanced countries show (once again) that crises can affect all types of countries (Claessens and Kose, 2013).

4. See also Dang et al. (2014); Holmström (2014); Gorton (2009).

5. To fix ideas, it is useful to think of an example. Assume oil is the intrinsic value of land. Land is good if it has oil underground, which can be exchanged for C units of goods. Land is bad if it has no oil underground. Oil is nonobservable at first sight, but there is a common perception about the probability that each piece of land has oil underground. It is possible to confirm this perception by drilling the land at a cost λ units of resource.

6. Output is, by definition, the higher of the two terms, and the bank is entitled to it because production could not be carried out without the bank's contribution. The larger is the bargaining power of the bank (β), the more it can tap into output.

7. Although both a decrease in output and an increase in financing cost reduce the likelihood of crisis (and increase its magnitude), it can be shown that impact of the latter dominates when banks' bargaining power is low, and when credit market matching is more sensitive to market tightness than labour market matching.

8. Defined as the difference between the cost of funds raised externally and opportunity costs internal to the firm (Bernanke et al., 1999, p. 1345).

9. The author shows that total private sector employment in the United States declined by 30% more at small firms than large firms in the year following the Lehman bankruptcy. See also Campello, Graham, and Harvey (2010).