Debt Default and the Insurance of Labor Income Risk

In this article, we evaluate in detail the role of debt forgiveness in altering the transmission of labor income risk in the absence of catastrophic out-of-pocket "expense shocks" used in the literature on consumer default. The experiments we present can be thought of as: "If we insure the out-of-pocket expenses that constitute expenditure shocks, is there still a role of debt relief as a form of insurance against 'pure labor income risk'?" We address this question by studying a range of specifications for households' attitudes toward the intra- and intertemporal properties of income risk alone. Our main finding is that, absent expense shocks, the ability to default very generally hinders the ability of households to protect themselves against labor income risk. Our findings suggest the scope of shocks that debt forgiveness is providing insurance against may be limited, perhaps principally to relatively catastrophic outcomes.