Wage rigidity and debt financing: evidence from labor contract renewal during the financial crisis

Abstract

This paper studies the differential impacts of the 2008 financial crisis on the financing policies and real activities of firms with flexible labor contracts and those with binding labor contracts. We find that flexible-contract firms significantly reduced their labor costs during the crisis, while binding-contract firms lacked such flexibility. Compared to flexible-contract firms, binding-contract firms experienced a larger drop in bond prices and were less likely to issue new bonds. Moreover, binding-contract firms reduced investments, bank borrowing and equity financing significantly more. Our analysis provides new causal evidence on how labor-market frictions affect firms’ financing in economic downturns. Valuation Insight: Flexible labor contracts allowed firms to lower labor costs during the 2008 financial crisis. These firms relative to firms with binding labor contracts issued more equity and bonds, received more bank loans and invested more during the crisis and experienced a smaller drop in their bond prices. The increased flexibility adds value because it allows higher returns in crisis times when this is valued most.