Financial Constraints in Search Equilibrium: Mortensen and Pissarides Meet Holmstrom and Tirole (2017), with TIto Boeri and Espen Moen. Forthcoming, Labour Economics

Cepr Discussion Paper Num. 10266

A key lesson from the Great Recession is that firms’ leverage and access to finance are important for hiring and firing decisions. It is now empirically established that bank lending is correlated with employment losses when credit conditions deteriorate. We provide further evidence of this and make causal inferences on the effect of leverage on job losses drawing on a new firm-level dataset that we assembled on employment and financial positions of European firms. Yet, in the Diamond Mortensen Pissarides (DMP) model there is no role for finance. All projects that display positive net present values are realized and financial markets are assumed to be perfect. What if financial markets are not perfect? Does a different access to finance influence the firm’s hiring and firing decisions? The paper uses the concept of limited pledgeability proposed by Holmstrom and Tirole to integrate financial imperfections and labor market imperfections. A negative shock wipes out the firm’s physical capital and leads to job destruction unless internal cash was accu- mulated by firms. If firms hold liquid assets they may thus protect their search capital, defined as the cost of attracting and hiring workers. The paper explores the trade-off between size and precautionary cash holdings in both partial and general equilibrium. We find that if labor market frictions disappear, so does the motive for firms to hold liquidity. This suggests a fundamental complementarity between labor market frictions and holding of liquid assets by firms.

Closing the Retirement Door and the Lump of Labor, with Tito Boeri and Espen Moen

(previously circulated as
A Clash of Generations? Increase in Retirement Age and Labor Demand for Youth, WorkInps Paper number 1)


Economists are active militants against the popular idea that the number of jobs is fixed, so that decreasing labor input across one age group- for example by easing early retirement- makes room into the labor pool for another group of workers, typically the youngsters. Standard price theory suggests that this lump of labor concept is indeed a fallacy. Even when capital is fixed in the short run, and labor supply is rigid, changes in the retirement age are totally offset by wage adjustment. Yet, under short-run wage rigidity and with labor demand determined, an unexpected locking-in of older workers, associated with a partial closing of the retirement door for older workers, may affect youth employment. On the one hand, complementarity in production across age groups makes youth labor demand increasing in the locking-in of older workers. On the other hand, scale effects driven by short run decreasing returns to scale lead to a contraction of labor. Under these conditions, the effects of closing the retirement door on youth labor demand are an empirical matter. We take Italy as a case study as a major reform took place in December 2011 increasing the retirement by up to six years for some categories of workers. We have access to a unique dataset from the Italian social security administration (INPS) identifying in each private firm the fraction of workers locked-in by the sudden increase in the retirement age, and for how long. Our results indicate that an increase in the number of locked-in workers has indeed crowded out the youth. Quantitatively, the policy change accounts approximately for 60 percent of the reduction in youth employment and for 80 percent of the increase in the number of older workers in the average firm affected by the policy change. These results survive to a variety of robustness checks, and are relevant in light of the old-in young-out dynamics observed recently in Europe.

Inside Severance Pay, (2016) with Tito Boeri and Espen Moen.  Journal of Public Economics., Volume 145, January, Pages 211-225

All OECD countries have either legally mandated severance pay or compensations imposed by industry-level bargaining in case of employer initiated job separations. According to the extensive literature on Employment Protection Legislation (EPL), such transfers are either ineffective or less efficient than unemployment benefits in providing insurance against labor market risk. In this paper we show that mandatory severance is optimal in presence of wage deferrals motivated by deterrence of opportunistic behavior of workers. Our results hold under risk neutrality and in general equilibrium. We also establish a link between optimal severance and efficiency of the legal system and we characterize the effects of shifting the burden of proof from the employer to the worker. Our model accounts for two neglected features of EPL. The first is the discretion of judges in interpreting the law, which relates not only to the decision as to whether the dismissal is deemed fair or unfair, but also to the nature, economic vs. disciplinary, of the layoff. The second feature is that compensation for dismissal is generally increasing with tenure. The model also rationalizes why severance is generally higher in  countries with less efficient judicial systems and why small firms are typically exempted from the strictest EPL provisions.

Financial Frictions, Financial Shocks, and Unemployment Volatility, (2015) with Tito Boeri and Espen Moen

Cepr Discussion Paper 10648

Financial market shocks and imperfections, alongside productivity shocks, represent both an impulse and a propagation mechanism of aggregate fluctuations. When labor and financial markets are imperfect, firms' funding and leverage respond to productivity changes. Models of business cycle with equilibrium unemployment largely ignore financial imperfections. The paper proposes and solves a tractable equilibrium unemployment model with imperfections in two markets. Labor market frictions are modeled via a traditional Diamond Mortensen Pissarides (DMP) model with wage positing. Financial market imperfections are modeled in terms of limited pledgeability, in line with the work of Holmstrom and Tirole. We show analytically that borrowing constraints increase unemployment volatility in the aftermath of productivity shocks. We calibrate the model to match key labor and financial moments of the US labor markets, and we perform two quantitative exercises. In the first exercise we ask whether the interaction between productivity shocks and borrowing constraints increase the volatility of unemployment with respect to models that focus only on the labor market imperfections. In the general specification of the model, both leverage and non pledgeable income move with the cycle. Our calibration exercise shows that the volatility of unemployment in response to productivity shock increases by as much as 50 percent with respect to a pure DMP model with wage posting. The second quantitative exercise explores the role of pure financial shocks on aggregate equilibrium. We calibrate pledgeability shocks to match the frequency of financial crisis and define financial distress as a situation in which internal liquidity completely dries up. The second exercise shows that full dry up of internal liquidity implies an increase in unemployment as large as 60 percent. These results throw new light on the aggregate impact of financial recessions. 

Dismissal Disputes and Endogenous Sorting, (2015) with Gerard Pfann

Cepr Discussion Paper, IZA Discussion Paper, CES-Ifo Discussion Paper, forthcoming.

A dismissal dispute is a difference between an employer and an employee that prevents agreement on work contract termination. Disputed employer initiated separations often lead to costly and lengthy job termination processes. Such disputes can have various forms, as emphasized by the law practice and by country specific legislation. Many relevant and important questions can be asked. How shall we model and classify disputes? How do different grounds for contract terminations sort among different types of disputes? How long and how costly are dismissal disputes? Do courts and other third party institutions respond differently to different disputes? Yet, the economics of dismissal disputes is surprisingly silent. This paper is an attempt to partly fill this gap. Theoretically, the paper proposes a simple accounting framework that is coherent with general dismissal legislation. Empirically, it has access to more than 2000 dismissal disputes that took place in the Netherlands between 2006 and 2009. The data set records dispute level information on both the employer and the employee engaged in the controversy, including firm and worker characteristics, the reason of the dispute, the process duration, the decision, and the associated costs. In addition, the paper models the trade off between a lengthy bureacratic dismissal procedure via the Public Employment Service and a costly court ruling, as typically faced by Dutch firms. The model rationalizes the sorting of disputes among the two institutions and helps understanding the longevity of the Dutch model and its political resilience. Finally, it highlights how different institutions act differently in the face of dismissal conflicts. Such a phenomenon is clearly observed in the real life data.

Graded Security From Theory Practice: with Tito Boeri and Espen Moen

Cepr Policy Insight 82

Competitive On the Job Search, (2016) with Espen Moen and Dag Einar Sommervoll. Published in the  Review of Economic Dynamics, special issue in honour of Dale Mortensen. 
Cepr Discussion Paper Num 10175. October 2014.
SSRN 250340 Available at SSRN:
The paper proposes a model of on-the-job search and industry dynamics in which search is directed. Firms permanently differ in productivity levels, their production function features constant returns to scale, and search costs are convex in search intensity. Wages are determined in a competitive manner, as firms advertise wage contracts (expected discounted incomes) so as to balance wage costs and search costs (queue length). An important assumption is that a firm is able to sort out its coordination problems with its employees in such a way that the on-the-job search behavior of workers maximizes the match surplus. Our model has several novel features. First, it is close in spirit to the competitive model, with a tractable and unique equilibrium, and is therefore useful for empirical testing. Second, the resulting equilibrium gives rise to an efficient allocation of resources. Third, the equilibrium is characterized by a job ladder, where unemployed workers apply to low-productivity firms offering low wages, and then gradually move on to more productive, higher-paying firms. Finally, the equilibrium offers different implications for the dynamics of job-to-job transitions than existing models of random search.