Consumption Smoothing and the Structure of Labor and Credit Markets

When borrowing is limited by possible insolvency, compression of labor income affords earlier consumption and higher welfare. Credit constraints also reduce the positive welfare effect of labor market turnover for workers whose labor income is temporarily low. These simple theoretical insights offer a rationale for the observed cross-country covariation of labor market regulation and consumer credit. Available evidence indicates that the same economies that feature constrained borrowing opportunities and inefficient legal systems also tend to feature regulated labor markets and compressed, persistent labor incomes. The proposed framework of analysis offers more general insights as to ways in which historically determined features and politico-economic interactions may jointly shape institutional aspects across labor and financial markets, and as to appropriate design of reform processes. ∗Bertola: Università di Torino and EUI. Koeniger: IZA, Bonn. This work is part of the Finance and Consumption in the EU Chair research program, sponsored by Findomestic Banca and CETELEM at the European University Institute. We are grateful for helpful comments and suggestions to workshop participants at Università del Piemonte Orientale (especially the discussant, Gianluca Femminis, and Daniele Checchi) and at IZA (especially the discussant, Etienne Wasmer), and to Olmo Silva.