Total Factor Productivity and Labor Reallocation: The Case of the Korean 1997 Crisis

In recent research on financial crises, large exogenous shocks to total factor productivity (TFP) are used as the driving force accounting for large output falls. TFP fell 3% after the Korean 1997 financial crisis. We find evidence that the large fall in TFP is mostly due to a sectoral reallocation of labor from the more productive manufacturing and construction sectors to the less productive wholesale trade sector, the public sector and agriculture. We construct a two-sector model that accounts for the labor reallocation. The model has a consumption sector and an investment sector. Firms face sector-specific working capital constraints, which we calibrate with data from financial statements. The rise in interest rates makes inputs more costly. The model accounts for 42% of the TFP fall. The model also accounts for 53% of the fall in GDP. It is broadly consistent with the post-crisis behavior of the Korean economy.