Recent time-series work in macroeconomics has emphasized the role of the interest rate spread between risky and safe debt in forecasting real GNP. Stock and Watson (1989) and Friedman and Kuttner (1989) demonstrate that this interest differential has greater predictive power for output than money, interest rates, or any other financial variable. Increases in the spread are associated with subsequent downturns in GNP growth. While this analysis is limited to postwar data, similar results apply

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... the prewar period.' Though the statistical relation between the spread and output appears robust, relatively little effort has been devoted to providing a sound structural interpretation of the evidence. It is clear that, under any story, movements in the spread reflect changes in "payoff" or "default" risk, broadly defined. 2 Nonetheless, the question emerges as to what are the sources of shifts in this payoff risk. In this paper, we argue that the countercyclical pattern in the spread may in part be symptomatic of a financial element in the business-cycle propagation mechanism. Our reasoning draws heavily on some recent theoretical work that links informational problems in capital markets at the micro level with fluctuations in aggregate economic activity. We also provide some