The Employment Cost of Sovereign Default

Abstract

This paper analyzes the interaction between government default decisions and labor market outcomes in an environment with persistent unemployment and financial frictions. Sovereign risk impairs bank intermediation through balance sheet effects, worsening the conditions for firms to pre-finance wages and vacancies. This generates a new type of endogenous domestic default cost – the employment cost of default. The persistence of unemployment produces serial defaults and rationalizes high debt-toGDP ratios. In the dynamic strategic game between the government and the private sector, anticipation effects allow the study of both debt crises and outright default episodes. Introducing employment subsidies and bank regulations affect the government’s ability to commit to debt repayment.