Open Access Publications from the University of California

## Essays on Finance, Labor, and Group Inequality

• Author(s): Avenancio-Leon, Carlos
• Advisor(s): Manso, Gustavo;
• Palmer, Christopher
• et al.
No data is associated with this publication.
Abstract

This dissertation consists of two chapters centered on the interplay between financial markets and labor market institutions, and that emphasize how this interplay affects group inequality (i.e., inequality with respect to race, gender, socioeconomic status, etc.). Two main themes are recurrent in this work: (i) that firms' and lenders' distress risks spillover to workers and households; and (ii) that, conversely, frictions or interventions in the labor market create financial distortions. Taken together, these two ideas imply that the relationship between financial and labor markets can generate instability, as their reciprocal feedback tends to generate responses that are either cyclical or that amplify existing market frictions. Furthermore, by focusing on interventions in either labor or financial markets, this dissertation speaks to the distributional implications of this type of instability. In each of the chapters, we first rely on careful institutional analysis of the labor and financial forces at play (and their connection to macro labor and financial markets), and then proceed to use reduced form methods to assess the substantive economic questions of interest arising from those settings.

In the first chapter, Incarceration and Access to Credit," we evaluate the effects that carceral institutions have on access to credit, how incarceration obscures the information lenders use to screen borrowers, and how lack of access to credit impacts recidivism. When individuals are incarcerated, they lose their jobs and their ability to repay debts is impaired while in prison. These effects directly impact their ability to get credit. In addition to that, however, it creates an information problem for lenders, as they are unable to recover the true default probability of a formerly incarcerated loan applicant. Lenders can partially correct for information distortions if they are aware of an applicant's criminal record, but this correction would be incomplete: Lenders cannot recover distortions due to heterogeneity in the effects of incarceration, neither can they completely correct on average as they cannot distinguish among different types of sentence.

The case of incarceration highlights how a labor market institution can amplify information asymmetries problems present in the allocation of credit. But it also highlights a feedback effect: the interplay between the credit market and labor market amplifies a failure of the criminal justice institution to reduce crime, namely that incarceration increases individuals' likelihood of recidivism. We show that when individuals are unable to access durable goods or smooth consumption due to credit frictions they are more likely to engage in criminal activity. But this effect is even stronger when the lack of access to credit stems from incarceration itself.

In the second chapter, How Corporate Debt Perpetuates Labor Market Disparities?," we take a new approach to address an old but important question: what drives the large magnitude of fluctuations in employment? Previous work has focused on explaining wage rigidities by exploring variations in the wage determination process, by studying labor institutions, or by studying cultural norms. We study, instead, the role corporate debt plays in determining equilibrium wages and unemployment. The idea is simple: a worker's wage reflects the job security of her employment match \textit{vis- Essays on Finance, Labor, and Group Inequality a-vis} how valuable the outside option of being unemployed or working for another firm is. When aggregate financial leverage increases, it affects both components in conflicting directions: (1) unemployment risk goes up and, consequently, the firm must increase wages to keep the worker; and (2) the value of the outside option goes down, driving wages downwards, as unemployment risk increases for other firms as well. When economic conditions are poor (i.e., low labor market tightness), the outside option of the worker is weak, which means that wages are mostly determined by the value of employment. In this case, increases in aggregate financial leverage resulting in higher unemployment risk decrease the future value of employment and since there is no offsetting effect through the outside option, wages must go up--- and so will unemployment. In constrast, when economic conditions are good (high labor market tightness), the outside option of the worker is high. This means that when aggregate financial leverage increases, any increase in wages resulting from higher unemployment risk will be offset by decreases in the outside option of the worker since unemployment risk is affecting other firms as well. Wages will go down--- and so will unemployment. The three take-aways on the dynamics of capital structure, wages, and unemployment are these: (1) leverage dampens fluctuations in wages (wages go up when economic conditions are poor, and vice versa); (2) leverage amplifies unemployment fluctuations (unemployment goes up, when it is already high, and vice versa); and (3) labor market tightness predicts changes in leverage.Since the trade-off between compensation for unemployment risk and a weaker outside option arises from a general equilibrium framework, this paper can reconcile seemingly conflicting evidence in Corporate Finance. In an influential paper, Matsa (2010) finds that collective bargaining agreements lead to higher financial leverage. The finding, which has been documented in several other settings as well, has been interpreted as evidence of strategic use of corporate debt as a bargaining tool. However, Graham and Harvey (2002) provide survey evidence that CFOs give very little weight to bargaining with workers when making capital structure decisions. Our work reconciles both findings. Policies that affect the outside option of the worker will have an impact on capital structure. As we discussed, a higher outside option means that increases in the aggregate financial leverage will decrease wages leading to higher financial leverage in equilibrium. Leverage does affect bargaining with workers but it does not need to operate in a strategic manner. The fact that stronger outside options lead to higher levels of financial leverage and that capital structure amplifies fluctuations in unemployment has important redistributive implications. When increases in the cost of labor are a result of employment regulations, the outside option of the worker increases and in equilibrium firms issue more debt, mitigate the regulatory costs, and weaken the regulation's intended objectives by increasing unemployment risk. Consistent with this, we find that firms increased corporate debt following the passage of anti-discrimination regulation during the Civil Rights Movement. We document that increases in corporate debt disproportionately exposed minority workers to higher levels of unemployment risk."/> a-vis} how valuable the outside option of being unemployed or working for another firm is. When aggregate financial leverage increases, it affects both components in conflicting directions: (1) unemployment risk goes up and, consequently, the firm must increase wages to keep the worker; and (2) the value of the outside option goes down, driving wages downwards, as unemployment risk increases for other firms as well. When economic conditions are poor (i.e., low labor market tightness), the outside option of the worker is weak, which means that wages are mostly determined by the value of employment. In this case, increases in aggregate financial leverage resulting in higher unemployment risk decrease the future value of employment and since there is no offsetting effect through the outside option, wages must go up--- and so will unemployment. In constrast, when economic conditions are good (high labor market tightness), the outside option of the worker is high. This means that when aggregate financial leverage increases, any increase in wages resulting from higher unemployment risk will be offset by decreases in the outside option of the worker since unemployment risk is affecting other firms as well. Wages will go down--- and so will unemployment. The three take-aways on the dynamics of capital structure, wages, and unemployment are these: (1) leverage dampens fluctuations in wages (wages go up when economic conditions are poor, and vice versa); (2) leverage amplifies unemployment fluctuations (unemployment goes up, when it is already high, and vice versa); and (3) labor market tightness predicts changes in leverage.Since the trade-off between compensation for unemployment risk and a weaker outside option arises from a general equilibrium framework, this paper can reconcile seemingly conflicting evidence in Corporate Finance. In an influential paper, Matsa (2010) finds that collective bargaining agreements lead to higher financial leverage. The finding, which has been documented in several other settings as well, has been interpreted as evidence of strategic use of corporate debt as a bargaining tool. However, Graham and Harvey (2002) provide survey evidence that CFOs give very little weight to bargaining with workers when making capital structure decisions. Our work reconciles both findings. Policies that affect the outside option of the worker will have an impact on capital structure. As we discussed, a higher outside option means that increases in the aggregate financial leverage will decrease wages leading to higher financial leverage in equilibrium. Leverage does affect bargaining with workers but it does not need to operate in a strategic manner. The fact that stronger outside options lead to higher levels of financial leverage and that capital structure amplifies fluctuations in unemployment has important redistributive implications. When increases in the cost of labor are a result of employment regulations, the outside option of the worker increases and in equilibrium firms issue more debt, mitigate the regulatory costs, and weaken the regulation's intended objectives by increasing unemployment risk. Consistent with this, we find that firms increased corporate debt following the passage of anti-discrimination regulation during the Civil Rights Movement. We document that increases in corporate debt disproportionately exposed minority workers to higher levels of unemployment risk."/> a-vis} how valuable the outside option of being unemployed or working for another firm is. When aggregate financial leverage increases, it affects both components in conflicting directions: (1) unemployment risk goes up and, consequently, the firm must increase wages to keep the worker; and (2) the value of the outside option goes down, driving wages downwards, as unemployment risk increases for other firms as well. When economic conditions are poor (i.e., low labor market tightness), the outside option of the worker is weak, which means that wages are mostly determined by the value of employment. In this case, increases in aggregate financial leverage resulting in higher unemployment risk decrease the future value of employment and since there is no offsetting effect through the outside option, wages must go up--- and so will unemployment. In constrast, when economic conditions are good (high labor market tightness), the outside option of the worker is high. This means that when aggregate financial leverage increases, any increase in wages resulting from higher unemployment risk will be offset by decreases in the outside option of the worker since unemployment risk is affecting other firms as well. Wages will go down--- and so will unemployment. The three take-aways on the dynamics of capital structure, wages, and unemployment are these: (1) leverage dampens fluctuations in wages (wages go up when economic conditions are poor, and vice versa); (2) leverage amplifies unemployment fluctuations (unemployment goes up, when it is already high, and vice versa); and (3) labor market tightness predicts changes in leverage.Since the trade-off between compensation for unemployment risk and a weaker outside option arises from a general equilibrium framework, this paper can reconcile seemingly conflicting evidence in Corporate Finance. In an influential paper, Matsa (2010) finds that collective bargaining agreements lead to higher financial leverage. The finding, which has been documented in several other settings as well, has been interpreted as evidence of strategic use of corporate debt as a bargaining tool. However, Graham and Harvey (2002) provide survey evidence that CFOs give very little weight to bargaining with workers when making capital structure decisions. Our work reconciles both findings. Policies that affect the outside option of the worker will have an impact on capital structure. As we discussed, a higher outside option means that increases in the aggregate financial leverage will decrease wages leading to higher financial leverage in equilibrium. Leverage does affect bargaining with workers but it does not need to operate in a strategic manner. The fact that stronger outside options lead to higher levels of financial leverage and that capital structure amplifies fluctuations in unemployment has important redistributive implications. When increases in the cost of labor are a result of employment regulations, the outside option of the worker increases and in equilibrium firms issue more debt, mitigate the regulatory costs, and weaken the regulation's intended objectives by increasing unemployment risk. Consistent with this, we find that firms increased corporate debt following the passage of anti-discrimination regulation during the Civil Rights Movement. We document that increases in corporate debt disproportionately exposed minority workers to higher levels of unemployment risk."/> a-vis} how valuable the outside option of being unemployed or working for another firm is. When aggregate financial leverage increases, it affects both components in conflicting directions: (1) unemployment risk goes up and, consequently, the firm must increase wages to keep the worker; and (2) the value of the outside option goes down, driving wages downwards, as unemployment risk increases for other firms as well.

When economic conditions are poor (i.e., low labor market tightness), the outside option of the worker is weak, which means that wages are mostly determined by the value of employment. In this case, increases in aggregate financial leverage resulting in higher unemployment risk decrease the future value of employment and since there is no offsetting effect through the outside option, wages must go up--- and so will unemployment. In constrast, when economic conditions are good (high labor market tightness), the outside option of the worker is high. This means that when aggregate financial leverage increases, any increase in wages resulting from higher unemployment risk will be offset by decreases in the outside option of the worker since unemployment risk is affecting other firms as well. Wages will go down--- and so will unemployment. The three take-aways on the dynamics of capital structure, wages, and unemployment are these: (1) leverage dampens fluctuations in wages (wages go up when economic conditions are poor, and vice versa); (2) leverage amplifies unemployment fluctuations (unemployment goes up, when it is already high, and vice versa); and (3) labor market tightness predicts changes in leverage.

Since the trade-off between compensation for unemployment risk and a weaker outside option arises from a general equilibrium framework, this paper can reconcile seemingly conflicting evidence in Corporate Finance. In an influential paper, Matsa (2010) finds that collective bargaining agreements lead to higher financial leverage. The finding, which has been documented in several other settings as well, has been interpreted as evidence of strategic use of corporate debt as a bargaining tool. However, Graham and Harvey (2002) provide survey evidence that CFOs give very little weight to bargaining with workers when making capital structure decisions. Our work reconciles both findings. Policies that affect the outside option of the worker will have an impact on capital structure. As we discussed, a higher outside option means that increases in the aggregate financial leverage will decrease wages leading to higher financial leverage in equilibrium. Leverage does affect bargaining with workers but it does not need to operate in a strategic manner.

The fact that stronger outside options lead to higher levels of financial leverage and that capital structure amplifies fluctuations in unemployment has important redistributive implications. When increases in the cost of labor are a result of employment regulations, the outside option of the worker increases and in equilibrium firms issue more debt, mitigate the regulatory costs, and weaken the regulation's intended objectives by increasing unemployment risk. Consistent with this, we find that firms increased corporate debt following the passage of anti-discrimination regulation during the Civil Rights Movement. We document that increases in corporate debt disproportionately exposed minority workers to higher levels of unemployment risk.