Cash Flow Constraints on Labor and Debt Contracts joint with Garth Baughma and Marco Brianti

Abstract:

In an effort to understand the interactions between labor and capital, this paper combines a standard model of labor markets, the competitive search framework, with two standard financial frictions, costly state verification and cash flow constraints. Qualitatively, the model provides a novel explanation for the priority of unpaid wages in US bankruptcy, and suggests that some estimates of the indirect costs of bankruptcy are misspecified if they ignore wages. Quantitatively, the model reasonably matches a number of moments, and provides rich predictions about the relationships between a number of variables. We conclude that the interaction between these frictions should be taken seriously and point out potential implications for studies of business cycles, fiscal analysis, labor economics, bankruptcy policy, and optimal capital structure.