This paper introduces a structural model of the labor market that features worker and firm heterogeneity, where workers accumulate human capital and can search on the job. We analyze the optimal provision of insurance within the firm through an optimal dynamic contract. In particular, we show that limited liability on the firm side generates downward wage rigidity. In addition, aggregate fluctuations alter the sorting between workers and firms and distort incentives to accumulate human capital. Insurance incentives and contractual rigidities are crucial in determining the pattern of job separations along the business cycle. Workers that look for employment in bad times direct their search towards less productive firms, which has lasting effects for their working career. At the same time, limits to the intensity of investment in human capital generate long term costs of business cycle fluctuations.
How do credit shocks affect labor market reallocation and firms’ exit, and how does their propagation depend on labor rigidities at the firm level? To answer these questions, we match administrative data on worker, firms, banks and credit relationships in Portugal, and conduct an event study of the interbank market freeze at the end of 2008. Consistent with other empirical literature, we provide novel evidence that the credit shock had significant effects on employment dynamics and firms’ survival. These findings are entirely driven by the interaction of the credit shock with labor market frictions, determined by rigidities in labor costs and exposure to working-capital financing, which we label “labor-as-leverage” and “labor-as-investment” financial channels. The credit shock explains about 29 percent of the employment loss among large Portuguese firms between 2008 and 2013, and contributes to productivity losses due to increased labor misallocation.