Labor Market Liquidity

Labor market liquidity (flows to and from employment) have decreased sharply in the US in the last decades while the unemployment rate has remained constant; and across developed economies, there are also huge differences in flows. This poses very different risk profiles for workers: low labor market liquidity makes employment more attractive (higher job security) and unemployment less so (lower reemployment security). In this paper we ask which regime offers better insurance and higher welfare: job security or reemployment security? Except for very high levels of labor market liquidity, we find that welfare for a given asset level is increasing in liquidity for both the unemployed and employed. To avoid being borrowing constrained in an illiquid labor market, unemployed workers dissave more slowly, and the employed increase their savings, whose value is affected by equilibrium prices (wages and the interest rate). However, allowing capital markets to readjust generates higher aggregate welfare as flows decrease, completely through improved job security and asset accumulation for the low-skilled employed. The aggregate welfare gains from lower liquidity are sizable, 1.4% of consumption when comparing across countries. Optimal Unemployment Insurance (UI) is around 40% in the benchmark US economy and is increasing with lower labor market liquidity. A skill-specific optimal policy heavily favors the less wealthy low skilled but less so in a more illiquid labor market. Finally, we find lower flows decrease wealth inequality.