Implicit Contracts with Asymmetric Information and Bankruptcy: The Effect of Interest Rates on Layoffs

Abstract

This paper develops a model in which a firm writes labour contracts with workers and debt contracts with creditors. Firms have more information than do the owners of the factors of production and they are also subject to limited liability. We show that if the limited liability constraint is binding then the employment level is inefficient relative to a situation of symmetric information. The firm is then embedded into a partial equilibrium model in which the real rate of interest is exogenously determined. We show that increases in the real rate of interest increase the inefficiency of the optimal employment contract and lead to layoffs in more states of nature than would occur at lower real interest rates. Recent literature in the area of implicit contracts, has shown considerable interest in the assumption of asymmetric information (henceforth A.I.). Papers by Azariadis (1982), Green and Kahn (1982) and Grossman and Hart (1981) have all shown that A.I. will interfere with optimal risk sharing, but although these models produce non-Walrasian outcomes it is not clear that they are capable of explaining the observed variations in employment over the business cycle. In the absence of a link between the level of employment and other macroeconomic variables, these new versions of contract theory are open to the charge that they are presenting a complicated explanation of frictional unemployment. One potential link between variations in output, and variations in intertemporal prices, is suggested by models which explicitly allow for the possibility of bankruptcy. Sappington (1983) has shown that bankruptcy will generate inefficient outcomes even between risk neutral agents and Farmer (1984) has shown that if Sappington type contracts are incorporated into a macroeconomic structure then the resulting model predicts that bankruptcies will vary countercyclically over the business cycle. Although bankruptcy is important, however, it is unlikely that bankruptcies alone will account for all of the output loss during a recession. The purpose of this paper is to show that the assumptions of A.I. and limited liability will generate a model in which the employment level is inefficient and in which the magnitude of this inefficiency varies systematically with the expected real rate of interest. This model predicts that the observed increase in the incidence of layoffs during recessions is directly attributable to the effects of high interest rates on aggregate supply. Some evidence of the phenomenon to be explained is presented below.