Contractual Fragility, Job Destruction, and Business Cycles

. We develop a theory of labor contracting in which negative productivity shocks lead to costly job loss, despite unlimited possibilities for renegotiating wage contracts. Such fragile contracts emerge from ...rms' tradeos between robustness of incentives in ongoing employment relationships and costly speci...c investment. In a matching market equilibrium, contractual fragility serves as a powerful mechanism for propagating underlying productivity shocks: in our benchmark calibration, i.i.d. shocks are magni...ed seven times in their eect on aggregate output, and the eect is highly persistent. We also explore novel motivations for government policies that strengthen employment relationships. 1. Introduction Popular discussion of recessions emphasizes the high costs borne by workers as a consequence of increased job loss. This view of recessions has in turn been amply documented by empirical research. Blanchard and Diamond (1990), for example, ...nd that gross #ows of workers...