Credit frictions in the Great Recession

Capital—whether it takes the form of cash, credit, or human capital like education and job skills—is the lifeblood of an economy. When it dries up, the economy withers. The Great Recession was a tragic example of such a dysfunction: The U.S. economy collapsed when the debt instruments that underpinned the housing market unraveled. As credit markets froze, the Fed and Treasury responded by injecting liquidity into the economy. Much of the funding flowed to firms through targeted transfers, often referred to as “bailouts,” to banks, other financial institutions, and large industries such as U.S. automakers.

As we cope with another recession, sparked by a very different crisis, capital and credit are again in focus. And while lessons from the Great Recession may or may not be directly applicable, they certainly inform the discussion.

Research from the Minneapolis Fed examines credit frictions during the Great Recession and finds that government intervention might have been more effective had it been directed toward workers rather than firms. In particular, employment declines might have been less severe, “if instead of focusing on easing firms’ access to credit, the government had expended an equal amount of resources to alleviate households’ credit constraints,” write Minneapolis Fed economists Patrick Kehoe and Elena Pastorino, and their co-authors.

Their analysis incorporates two elements often ignored in research on the impact of credit constraints: job search, that is, frictional labor markets in which it takes time for firms and workers to find desirable matches and create an employment relationship, and human capital. Both are crucial features that enable the economists to better understand how tightening credit markets affect not only firms, but also the workers they employ.

Firms or families?

Whereas government asset purchases, particularly the large-scale asset purchase program pursued by the Fed, were a significant part of the government’s fiscal response to the Great Recession, a number of studies have documented that targeted transfers, not asset purchases, accounted for the majority of fiscal expenditure. These transfers sought to ease credit constraints for firms and households, thereby stimulating consumption, output, and employment.

Economists have studied the tightening of credit to firms and households, but the respective roles and relative importance of these two credit channels remain unclear. Kehoe, Pastorino, and co-authors seek to clarify the relevance of these two types of credit constraints by developing a model that explicitly isolates frictions to each of these credit channels. Specifically, to understand the employment impact of government transfers, the authors incorporate the notion of imperfect labor markets in which firms and workers need to expend resources and time to create good job match—each party “swiping” left until a firm finds the right employee, and the employee agrees.

To this framework, the economists add another key feature: human capital—that is, the know-how that workers accumulate on the job. This element is critical to understand the different impacts of a credit tightening on workers and on firms.

Difference of perspective

For firms, hiring is a relatively short-term investment decision. Namely, the immediate expense of added payroll is an investment toward additional output and profit. The value of this investment from any given worker is short-lived, though, lasting only as long as a worker is employed and producing. When credit tightens, interest rates increase and firms reduce their workforce investments accordingly by hiring fewer workers as well as through layoffs or wage cuts.

For workers, the impact of a credit tightening is much stronger because their investment in a job match has long-term value. Indeed, a worker’s investment value flows not only from wages currently earned, but also from the potential of wage increases in the current job and higher wages in any future job, thanks to the new skills gained at the current job. This human capital is long-lived, possibly lasting an entire working life, thereby generating gains that “are large and persistent,” as the economists observe. Like any long-term asset, its value is then strongly affected by changes in interest rates.

Put otherwise, for firms, a job match no longer has value once the match ends. For workers, however, the accumulated on-the-job human capital is a long-term asset, which has value long after the current match ends and, hence, is highly sensitive to credit conditions. Thus, workers have more to lose from tighter credit than do firms.

The difference between firms and workers in the time horizon of the value of a job match implies that when credit tightens, firms are keener to reduce workforce costs by lowering wages than workers are willing to accept less pay. Intuitively, when borrowing is more costly for workers, investing in a job match and receiving higher future wages becomes much less attractive to workers than being paid higher current wages. Workers are therefore less willing to accept the lower wages that firms want to pay when workers’ credit contracts than when firms’ credit contracts. As a result, employment declines more when workers’ constraints tighten than when firms’ constraints tighten.

“This differential rigidity of wages helps account for how the fall in employment after a household-side credit tightening is larger than after a firm-side credit tightening,” write the economists. Tighter credit reduces the value of a worker’s greatest asset, that is, human capital, more than it reduces a firm’s profits from not hiring (or retaining) an additional worker.

Model and reality

The model thus provides a theoretical backing for the notion that tighter constraints on household credit have a larger employment effect than tighter constraints on firm credit. The researchers then evaluate its converse. Specifically, they study the quantitative impact of easing credit constraints on firms and on workers in a model of the U.S. economy in which states are subject to a credit tightening. For each U.S. state, credit tightens to an extent comparable to the tightening that economists inferred each state experienced during the Great Recession.

The researchers find that a transfer to workers—used to relax credit constraints that impede their borrowing ability—has a far larger impact on employment than an equal transfer to firms. For example, their model implies that comparable transfers to firms and to workers in Nevada, which faced large declines in employment and consumption during the Great Recession, would have reduced employment losses by 20 percent if directed to firms, compared with a 50 percent reduction if directed to workers.

Credit where it is needed

The two major findings of this research are sides of a coin. First, tightening credit constraints on households has a much larger impact on employment than an equal tightening on firms. Second, transfers that ease credit constraints on households reduce employment declines more than do comparable transfers to firms.

Both findings hinge on the importance of human capital acquired by workers on the job. The long-term value of such capital is highly sensitive to credit constraints on households, but less so to credit constraints on firms, for which job matches have value over a shorter horizon.

The policy implications are also clear. When credit tightens in a recessionary downfall, fiscal relief is likely to be more powerful when directed toward workers rather than firms. “A government intervention that transfers income to households,” conclude the economists, “would have been more effective than an equal-sized intervention to firms at stimulating the recovery of employment in the cross-section of U.S. states.”