The Elephant in the Room: The Impact of Labor Obligations on Credit Markets

We study the impact of labor market frictions on credit risk. Our central finding is that labor market variables are the first-order effect in driving both of the aggregate time series and the cross sectional variations of credit risk. Recent studies have highlighted a link between credit risk and macroeconomic/firm-level variables such as investment growth, financial leverage, volatility, etc. We show that labor market variables (wage growth or labor share) can forecast the aggregate credit spread as well as or better than alternative predictors. Furthermore, firm-level labor expense growth rates and labor share can predict Moody-KMV expected default frequency (EDF) in the cross-section across a wide range of countries. A model with wage rigidity and endogenous long-term defaultable debt can explain these links as well as produce large credit spreads despite realistically low default probabilities (credit spread puzzle). This is because pre-committed payments to labor make other committed payments (such as debt) riskier; for this reason variables related to pre-committed labor payments have explanatory power for credit risk.