The Employment Cost of Sovereign Default

This paper analyzes the interaction between government default decisions and labor market outcomes in an environment with persistent unemployment, endogenous wages and financial frictions. In the model, sovereign risk worsens the conditions for firms to pre-finance production and vacancies. This generates anticipation effects of default risk and a new type of endogenous domestic default cost — the employment cost of default. The model is estimated to match the Portuguese debt crisis of 2012. The qualitative and quantitative performance of the model hinges on labor market frictions responsible for the persistence and asymmetry of default costs. Quantifying the costs associated with the Portuguese debt crisis yields a 2.1% lower bound on the quarterly consumption loss. A counterfactual debt default would have resulted in persistent welfare losses and higher spreads, even in resolution of the debt crisis. Introducing labor policies affects a government’s ability to commit to debt repayment, which largely impairs cost-reducing effects.