Marco PaganoUniversity of Naples Federico II, CSEF, EIEF and

CEPR

Giovanni PicaUniversity of Salerno and CSEF

Economic Policy, 53rd panel meeting

15 and 16 April 2011 - Magyar Nemzeti Bank

Finance and Employment

Is finance the enemy of labor?

Textbook vision of the role of finance: efficient allocation of capital optimal risk sharing

Probably most workers instead view finance as: creating employment risk via corporate restructuring,

bankruptcies, and financial crises enabling or spurring firms to maximize share value at

labor’s expenses allowing bankers to earn astronomical bonuses, etc.

The crisis has reinforced this negative vision of finance. Good time to think about this…

Outline

1. How does financial development (FD) affect employment, wage and productivity growth?

2. How does it affect the variability of employment?

3. Does it magnify the employment losses at times of banking crisis?

Toy model of labor market response to FD

For a start, consider case of identical firms 1-size continuum of firms with Cobb-Douglas

technology:

Entrepreneur has wealth A He can “steal” (at most) fraction 1 of revenues (net

of wages: no stealing from workers) Better investor protection more funding to

firms (henceforth = degree of FD) Competitive credit and labor markets

1Y K L

FD also amplifies employment response to shocks

FD raises the response of employment to changes in: growth opportunities : firms can better exploit them hire more

labor, offer higher wages

initial cash flow A: it allows firms to lever more on its cash hire more labor, offer higher wages

This result hinges on firms being finance-constrained. True with CRS: firms always want to expand

If there is an efficient scale K*, once firms are past K*:

effect of FD abates as economy grows

FD no longer affects employment response to cash-flow shocks

Evidence on finance, employment and wages

We extend the approach by Rajan and Zingales (1998): FD should matter more for industries that are more “dependent on external finance”

External dependence = reliance on external finance by U.S. listed companies in the Compustat database

Baseline specification:1970( )jc c j jc j c jcY FD ED SHARE

Data

Value added, employment and wage bill (Yj c): UNIDO

INDSTAT3 2006 database, 1970-2003 yearly data for 28 three-digit-industries

63 countries

External dependence (EDj): Rajan and Zingales (1998)

Financial development (FDc):

private credit/GDP

stock market capitalization/GDP (1980–95 averages)

Finance, employment and wages: all countries

Dependent variable: Growth of Value Added

Employment Growth Wage GrowthLabor Productivity

Growth

Industry’s share in 1970 -0.156***

(0.030)0.204***

(0.027)0.141***

(0.026)0.167***

(0.029)0.020***

(0.003)0.022***

(0.003)0.002***

(0.001)0.002***

(0.001)

External dependence stock market capitalization (80-95)

0.026*

(0.014)0.037***

(0.013)0.00004(0.004)

0.002(0.011)

External dependence claims of banks and other fin. inst. (80-95)

0.034**

(0.016)0.055***

(0.014)0.002

(0.004)0.008(0.013)

Observations 1533 1637 1447 1526 1293 1370 1428 1505

R-squared 0.32 0.33 0.42 0.39 0.72 0.68 0.29 0.30

Effect is between 0.23% and 0.83% as FD rises from 25th to 75th percentile

Finance, employment and wages: OECD

Dependent variable: Growth of Value Added

Employment Growth Wage GrowthLabor Productivity

Growth

Industry’s share in 19700.212***

(0.054)0.212***

(0.055)0.153***

(0.044)0.155***

(0.045)0.022***

(0.004)0.022***

(0.004)0.001(0.001)

0.001(0.001)

External dependence stock market capitalization (80-95)

0.022(0.018)

0.011(0.012)

0.010(0.007)

0.002(0.004)

0.021**

(0.011)

External dependence claims of banks and other fin. inst. (80-95)

0.011(0.011)

0.009(0.008)

0.012*

(0.007)

Observations 628 628 624 624 594 594 622 622

R-squared 0.48 0.48 0.55 0.55 0.70 0.70 0.34 0.34

Finance, employment and wages: non-OECD

Dependent variable: Growth of Value Added

Employment Growth Wage GrowthLabor Productivity

Growth

Industry’s share in 19700.161***

(0.032)0.213***

(0.030)0.163***

(0.033)0.185***

(0.037)0.021***

(0.003)0.023***

(0.003)0.003***

(0.001)0.003***

(0.001)

External dependence stock market capitalization (80-95)

0.037**

(0.016)0.041***

(0.015)0.003(0.004)

0.008(0.013)

External dependence claims of banks and other fin. inst. (80-95)

0.091**

(0.036)0.133***

(0.033)-0.000

(0.010)0.000(0.030)

Observations 905 1009 823 902 699 776 806 883

R-squared 0.30 0.32 0.31 0.30 0.64 0.62 0.24 0.27

Effect on employment reallocation

Extend model to 2 industries with different prospects: strong industry H with high expected profitability H

weak industry L has low expected profitability L

Labor flows freely between them: single equilibrium wage w

Now FD affects not only total employment but also its distribution between industries – in favor of industry H !

With higher FD, industry H attracts more funds than L: employment in industry H grows by more than in industry L employment in industry L may drop (if Ls is sufficiently

inelastic) sufficiently high FD will eventually “shut off” industry L

Response to growth shocks and to cash flow shocks

With greater FD, sectoral growth shocks entail more cross-industry employment reallocations

But as FD proceeds, more and more firms achieve their efficient scale and become unconstrained:

these firms stop reacting to cash flow shocks…

As FD rises, it lowers the effect of cash flow shocks on job reallocations (eventually eliminates it)

Evidence on finance and labor reallocation

Strategy: regress a measure of inter-industry reallocation on measures of

FD

FD cross-industry dispersion of stock returns: FD should amplify response of sd to growth shocks but lower it to cash flow shocks

where sd = cross-industry st. dev. deviation of Yjct

(industry j’s growth in VA, L or w) in country c and year t

( ) ( )jct ct jct ct c t jctsd Y FD sd DRI FD

Finance and reallocation: augmented specification

Dependent variable: standard deviation by year and country of

Value added growth

Value added growth

Value added growth

Employ-ment

growth

Employ-ment

growth

Employ-ment

growth

Wage growth

Wage growth

Wage growth

Private credit by deposit money banks and other financial institutions to GDP

0.097(0.064)

0.013(0.043)

0.054*

(0.029)

Stock market capitalization to GDP

0.072***

(0.025)0.053***

(0.017)0.011(0.008)

Stock market total value traded to GDP

0.089*

(0.045)0.069***

(0.024)0.029**

(0.012)

Standard deviation of continental price shocks Fin. Dev.

0.152(0.191)

0.236**

(0.118)0.383

(0.250)0.069

(0.123)0.182**

(0.074)0.247**

(0.110)0.153**

(0.073)0.063**

(0.032)0.100*

(0.054)

Observations 1281 874 893 1246 857 875 1207 824 846R-squared 0.02 0.03 0.03 0.02 0.04 0.04 0.03 0.03 0.03

Crises: the “dark side” of financial development?

FD may become a handicap in a crisis because they create “dependence”: the more financial markets are trusted in normal times, the greater the damage to output and employment when a crisis hits

Most clearly seen by looking at liquidity provision: in normal times banks allow firms to save on liquidity deploy more resources to production

But when banks are hit by a liquidity shortage, the damage can be more severe

Evidence on banking crises

Two empirical strategies:

1. Kroszner et al. (2007): re-estimate Rajan-Zingales regressions before, during and after a financial crisis:

o 1 crisis observation per country, averaging crisis episodes for countries that experience more than one crisis

2.Panel data approach similar to Braun & Larrain (2005):

Financial crisis data from Laeven and Valencia (2010): universe of banking crises (1970-2009)

0 1 1 2

3

( ) ( )

( )

jct cjt j ct c j

c j ct ct j jct

Y SHARE ED crisis FD ED

FD ED crisis

Panel data evidence on severe banking crises

Value Added growth

Employment growth

Wage growth

Value Added growth

Employment growth

Wage growth

Lagged industry's share of value added (cols 1-4) / Lagged industry's share of employment (cols 2-5) / Lagged ratio of industry's wage to average wage (cols 3-6)

-0.547***

(0.085)-0.234***

(0.053)-0.098***

(0.011)-0.660***

(0.089)-0.233***

(0.048)-0.101***

(0.011)

External dependence × Banking crisis

0.026(0.027)

0.023(0.015)

-0.001(0.012)

0.068*

(0.036)0.049**

(0.023)-0.014(0.016)

External dependence × Stock market capitalization

0.052**

(0.021)0.033**

(0.016)0.002

(0.007)

External dependence × Stock market capitalization × Banking crisis

0.024(0.069)

-0.015(0.030)

0.006(0.021)

External dependence × banks and other fin. inst. claims

0.065***

(0.019)0.046***

(0.013)0.005

(0.006)External dependence × banks and other fin. inst. claims × Banking crisis

-0.055*

(0.030)-0.050**

(0.022)0.016

(0.015)

Observations 44856 43293 42033 47431 45533 44265R-squared 0.01 0.01 0.05 0.01 0.01 0.05

Conclusions

Financial development is associated with

more employment growth, but only in non-OECD countries

less employment reallocation (cross-industry dispersion of employment growth)

but more employment reallocation in response to greater variability of shocks to growth opportunities (cross-industry dispersion of stock returns)

Some evidence of a “dark side” of financial development: during crises, employment growth drops more in financially

dependent sectors of countries with more developed financial markets