Uninsured Creative Destruction
Abstract
We propose a theory of creative destruction under incomplete markets. At its core is the observation that creative destruction shapes workers’ labor income process. When displaced workers are the economy’s savers, displacement risk moves the demand for assets and, with it, the return at which innovation is financed. In a quality-ladder model, households self-insure with a liquid bond and the stock that finances entrants. Because the stock provides worse insurance against unemployment, it pays a liquidity premium that moves firms’ discount rate and, through free entry, the pace of creative destruction. Incomplete markets can accelerate or slow creative destruction relative to complete markets, depending on whether the precautionary motive or the liquidity channel prevails. Creative destruction rises with consumption inequality, implying a trade-off between reducing inequality and sustaining growth.