Finance and labor rigidity in Portugal

How do credit shocks affect firms’ employment adjustment and exit? How does the propagation of these shocks depend on labor rigidities? Do credit shocks reinforce or hinder productivity-enhancing reallocations in the real economy?

According to the classic Schumpeterian view, shocks should bring about creative destruction and a “cleansing effect” on the real economy. However, financial frictions might attenuate or even reverse this, thus leading to “scarring”. The contribution of the paper is to exploit the exogeneity of a credit shock to Portugal to analyze these contrasting issues, and document how the responsiveness of firms to credit shocks depends on labor rigidities.

To this end, the paper combines data on Portuguese banks and firms, a matched employer-employee dataset and a bank credit registry to trace out the propagation of the interbank market dry-up that followed the failure of Lehman Brothers in 2008, through the Portuguese banking system to the corporate sector.

The paper provides novel evidence that the credit shock had significant effects on firms’ employment adjustment and exit. These findings are entirely driven by the interaction of the credit shock with labor-market rigidities, determined by incumbent workers’ wage rigidities and the exposure to a working-capital channel. Moreover, total factor productivity has not affected firms’ ability to react to the shock, thus supporting the argument that the shock did not have a cleansing effect. The credit shock also led to substantial aggregate real effects on the Portuguese economy. In fact, it explains around 29 percent of the employment losses of Portuguese firms in 2008-2013, all through their exposures to labor rigidities. A growth accounting exercise shows that all in all the shock originated around 4.3 percent of the aggregate productivity loss observed during the period.

Click here to go to the paper by Edoardo Acabbi, Ettore Panetti and Alessandro Sforza.