Sovereign Default and Labor Market Dynamics

Abstract

This paper investigates the interaction between labor market dynamics and sovereign debt risk. Countercyclical default risk and the limited ability to borrow during recessions renders the government a procyclical fiscal policy. The anticipation of higher tax rates in downturns discourages agents' participation in the labor market and creates prolonged unemployment. The slack labor market, in turn, aggravates the default risk and strengthens the fiscal procyclicality. Moreover, under the discretionary policy, a government does not internalize the dynamic-scratching effect of raising tax rates on employment, so it suffers a low level of job creation and high default incentives. In this environment, imposing commitment measures on tax rates such as fiscal covenant can stimulate job creation, improve debt sustainability, and lead to a significant welfare gain.