Credit contractions and unemployment

Abstract

This paper investigates the impact of private credit contractions on labor market performance. Impulse responses for total, youth, and long-term unemployment are estimated using local projections for a panel of 20 OECD countries over the period 1980–2013. The empirical findings suggest that a decline in private credit can generate sizable and statistically significant increases in all three unemployment measures. On average, credit contractions in the sample increase total unemployment rates by nearly 1 percentage point at the peak. This effect is even stronger for youth unemployment. The persistent impact on long-term unemployment emphasizes the sluggish recovery of labor markets following a credit downturn. The results also reveal that increases in joblessness depend heavily on the scale of the build-up in financial leverage prior to the onset of a contraction. Specifically, excessive credit booms tend to be followed by a significantly larger rise in unemployment in the subsequent bust phase. Moreover, credit contractions associated with rigid labor market institutions lead to disproportionately greater increases in unemployment. These findings underline the important relationship between disruptions in the credit market and unemployment fluctuations.