Household Debt Overhang and Unemployment

Personal bankruptcy is pervasive in the U.S.—about one in 10 Americans will declare bankruptcy in his lifetime.1 Under the U.S. bankruptcy code, households are protected by limited liability. That is, they can discharge their debt and still keep a substantial amount of their assets. Such limited-liability protection distorts the incentives of indebted households, just as it distorts the incentives of indebted firms in corporate finance. In our forthcoming paper,  we investigate how this distortion can affect the labor market. In particular, we ask the following questions. How does limited-liability debt distort household labor supply, and how does this affect aggregate employment in equilibrium? Further, do households take on too much limited-liability debt, and should a regulator intervene to mitigate the resulting distortions?

We show that limited-liability debt on households’ balance sheets leads to a debt overhang problem that makes indebted households reluctant to work unless they are paid very high wages, because they do not capture enough of the benefits of their labor. Rather, their high debt-repayment obligation forces them to  share “too much” of the benefits from working with the banks they borrowed from.  Recognizing this, firms realize that they must pay high wages to make working attractive to households. And given this reality, they cannot afford to hire many workers. Thus, they post relatively few vacancies. This vacancy posting effect implies that high household debt leads to high unemployment. We show this as an equilibrium phenomenon with fully rational households, employers, and lenders.

We then show households take on excessive debt in equilibrium. This is due to a household debt externality. Specifically, when a household takes debt onto its balance sheet, it decreases the likelihood that households are employed, as implied by the vacancy posting effect. Since unemployed households are likely to default on their debt, the default rate on all loans goes up, including other banks’ loans to other households. In other words, when households take on debt, they do not take into account the negative effect that their borrowing has on other agents in the economy through the labor market. Thus, there is scope for a financial regulator to intervene to mitigate this externality through regulations like caps on household leverage or equity requirements on certain types of loans.

Finally, we show that banks’ beliefs about future employment are self- fulfilling, which generates multiple equilibria. If banks believe that the rate of employment will be low, so household default risk is high, banks require high face-values of debt to offset this risk. Households thus have high debt, so employment is indeed low due to the vacancy posting effect. In contrast, if banks believe that employment will be high, so household default risk is low, banks require low face-values of debt, and employment is indeed high. Thus, there is another reason for regulatory intervention: to prevent the economy from ending up in the “bad” equilibrium with high debt and low employment.

Our model is stylized but nonetheless sheds light on two contemporary policy questions: Should household debt be limited, and should the personal bankruptcy code be more forgiving? Our model suggests that limiting household debt ex ante may be a good thing. In our model, caps on household debt can prevent the economy from ending up in the “bad” equilibrium with high debt and low employment. In contrast, making the bankruptcy code more debtor-friendly and limiting the liability of households ex post could be a bad thing. In our model, decreasing default penalties tightens households’ limited liability constraints, which can exacerbate the vacancy posting effect.

Our prediction that limited-liability household debt leads to a decrease in labor supply finds support in a number of recent empirical papers. Bernstein (2016) shows that  household financial distress causes a decline in labor supply of between 2.3 and 6.3 percent, an effect that he calculates may have accounted for over 20 percent of the decline in employment between 2008 and 2010, or almost 2 million U.S. jobs. Further, Herkenhoff (2012) finds a spike in the employment rate of households when their debt expires, suggesting that, when households discharge their debt, the household debt overhang distortion is mitigated, which increases the employment rate. Our results are also in line with Dobbie and Goldsmith-Pinkham (2015), who find that limited recourse for mortgage debt—that is, household limited liability—leads to a decrease in the employment rate.

This post comes to us from professors Jason Roderick Donaldson at Washington University in St. Louis, Giorgia Piacentino at Columbia University, and Anjan V. Thakor at Washington University in St. Louis. It is based on their recent paper, “Household Debt Overhang and Unemployment,” available here.