Labor and Finance

1. Labor and Finance Marco Pagano Università di Napoli Federico II, CSEF, EIEF and CEPR Conference on “Labor, Law, Politics and Finance” organized by the Korea Money and Finance Association Seoul, 20 June 2008

2. Plan of the lecture • Effects of financial markets on labor: • Boosting economic activity  employment and wage growth • Reallocation of resources  employment and wage risk • Private arrangements to limit employment and wage risk / enhance workers’ loyalty: • Formal contracts • Implicit contracts • “Dark side” of implicit contracts in widely held firms • Role of regulation and the economic environment: • Shareholder protection • Employment protection and trade union laws • Takeover regulation • Technological innovation, international financial integration

3. I. Effects of finance on labor • Financial development  growth of output and productivity, firm entry. Prima facie beneficial for employment and wages. Supported by a vast literature that uses • cross-country data (e.g., Demirguc-Kunt and Levine, 2001), • industry-level data (e.g., Rajan and Zingales, 1998), • firm-level data (e.g., Galindo, Schiantarelli and Weiss). • Reallocation of resources from ailing industries/firms to promising ones  finance seen as inflicting employment losses and wage cuts: • Hostile takeovers in the U.S. during the 1980s • Private equity leveraged buyouts (LBOs) in the last decade

4. Employment effects of hostile takeovers Michael Douglas as “Gordon Gekko” in Wall Street • In 1981 Frank Lorenzo took over Continental Airlines, and in 1983 forced it into bankruptcy after fruitless negotiations with unions, breaching contracts and imposing new terms. • In 1986, he acquired Eastern Airlines, divested non-strategic assets and, after a fight with unions, liquidated its assets in 1991. • In 1986, Charles Icahn took over TWA and in 1988 broke the union by hiring non-union workers: the takeover premium was about ½ the PV of the wage losses to members of the TWA unions (Shleifer and Summers, 1988).

5. Public perception of private equity LBOs • In April 2005, the Chairman of the German Social Democratic Party, Franz Müntefering, likened private equity firms to “swarms of locusts that fall on companies, stripping them bare before moving on”, claiming that “some financial investors don't waste any thoughts on the people whose jobs they destroy”. • In March 2007 John Evans, secretary of the Trade Union Advisory Committee referred to private equity as “a cancer eating away at the job-creation system”

6. But evidence is less damning • Rosett (1990): union wage changes in the 6 years after the takeover can account for 1 to 2 percent of such premium, and for 5 percent over 18 years. For hostile takeovers, he estimates that “unions actually gain 3% over 6 years and 10% over 18 years, of what target shareholders gain.” • Davis et al. (2008): private equity intervenes in ailing firms and shrink their less efficient operations. But it also tends to expand them in new directions in the first 2 years after the LBO: greenfield job creation is 15% for target firms and 9% for control firms, and acquisition and divesture activity is also significantly greater. Conclusion: “private equity acts as catalyst for creative destruction”.

7. The case of Grohe • Grohe is a bathroom equipment company that Franz Müntefering took as main example for his “locust” metaphor: it was taken over by private equity group TPG, and was expected to fire more than half of its German-based workforce. • However, David Haines, the CEO chosen by TPG, renewed Grohe’s product lines, by investing substantially in R&D, restored its profitability and growth, and eventually cutting only 743 of the initially envisaged 3,000 jobs. • Ironically, the current German finance ministry cites Grohe as an example of how private equity can successfully restructure companies and put them on a path to growth.

8. II. Employment risk and firm-level relationships • Firms may buffer employment risk by developing long-term relationships. Efficiency gains from 2 sources: • Risk-sharing: firms can diversify shocks better than workers • Loyalty-building: enhance firm-specific human capital investment • This can be done via employment contracts. But specifying all possible contingencies may be too complex/costly. • Alternative: “implicit contracts” (Baily, 1974). But these pose an enforcement problem. How to sanction contract breach? • Front-end loading – but not feasible if both parties may breach. • Reputation – but what if firm is taken over by a raider? (Shleifer and Summers, 1988)

9. Implicit contracts in family firms • Reputation can support implicit contracts in family firms: • family’s “name” is on the line. • If the family’s stake is large enough, control is unassailable. By definition true if the firm is not publicly listed. • Sraer and Thesmar’s (2007) study on French family firms: • not only the founder but also his heirs pay lower wages to employees; • heir-managed firms shelter employees from industry-level sales shocks; • heir-managed firms are not damaged by such arrangement: their profitability exceeds that of comparable non-family firms.

10. Implicit contracts in widely held companies • With dispersed ownership, the firm is a coalition of shareholders and management, riddled by corporate governance problems. • Pagano and Volpin (2005): if governance problems are acute, managers have an incentive to forge a generous implicit contract with the employees at the expense of shareholders: • With long-term contracts, employees become “shark repellents”: the inability to renegotiate wages makes the firm unattractive to raiders. • Well-paid employees will also act as “white squires”: they will fight hostile takeovers by lobbying against the raider. • If employees also own shares in the company (ESOPs), they will vote against the takeover.

11. Evidence on ESOPs • Chaplinsky and Niehaus (1994), Beatty (1995) and Rauh (2006): ESOPs reduce the likelihood of takeover attempts. • Kim and Ouimet (2008): • ESOPs increase firm value if they are small (less than 5% of outstanding shares), but leave firm value unaffected when the ESOP is larger, where the productivity gains induced by ESOPs are offset by increases in worker compensation, because employees can affect the firm’s policy. • Large ESOPs prevail in states with laws that make them an effective anti-takeover deterrent, and there compensation increases following the adoption of ESOPs.

12. III. Role of regulation • Regulation also affects: • the establishment and survival of long-term employment relationships; • their tendency to induce collusion betweens managers and workers. • Various aspects of regulations are relevant: • shareholder protection; • employment protection and union empowerment; • takeover regulation.

13. Shareholder protection • Poor legal shareholder protection allows managers to extract large private benefits of control at the expense of non-controlling shareholders. • Hence, managers will be keener to enlist workers in defense of such benefits. • This is consistent with evidence by Atanassov and Kim (2007) who study 9,923 firms in 41 countries in 1993-2004. They find that in weak investor protection countries: • poorly performing firms are less likely to replace top managers; • they are less likely undertake mass layoffs of employees.

14. Employment protection • Pagano and Volpin (2005): the stronger is legal protection against changes of employment contracts, the greater is the incumbent managers’ ability to use long-term wage contracts as a “shark repellent” against raiders. • Atanassov and Kim (2007): top managers are less likely to be replaced as union power increases, in low investor protection countries – consistently with the idea that these are the countries where private benefits should be largest and therefore managers should be more eager to entrench themselves. • Also consistent with OECD evidence: frequency of hostile takeovers is inversely related with high employment protection (see figure).

15. Employment protection and takeover activity in the OECD

16. Takeover regulation • The law itself can offer protection to managers by enhancing their ability to fend off hostile takeovers: for instance, by allowing them to include poison pills, staggered boards, and other anti-takeover provision in their company’s statute. • This is consistent with evidence that ESOPs tend to substitute for other anti-takeover schemes by Chaplinsky and Niehaus (1994). • Rauh (2006) finds that after Delaware validated the use of poison pills together with staggered boards in the mid-1990s, companies incorporated in Delaware saw a fall in employee ownership between 0.3 and 1 percentage points of the company’s value.

17. Political economy of regulation • Regulations that promote manager-worker alliances – such as poor shareholder protection, strict employment protection and pro-union regulation – can persist only if a political majority supports them. • Naturally, this majority will tend to include the same people who benefit from these regulations. • Hellwig (2000): “Incumbent managers who try to buttress their positions will regularly find allies in the political system” against outside shareholders. • This leads us to Perotti’s theme: the political economy of regulation!

18. Technological change • When technological innovation improves firms’ growth opportunities: • the efficient re-allocation of capital becomes more important than in a more stable environment, • the need to raise fresh external capital makes the inefficiencies caused by manager-worker collusion more damaging. • Then regulation and social norms may change so as to favor outside shareholders and break down stable employment relationships. • When instead technology is mature and stable, the incentive and risk-sharing benefits of long-term relationships may be more important than their costs.

19. Globalization • When obstacles on international capital flows are removed, firms can invest in countries where labor costs and employment protection are lower, directly or by acquiring local companies. • To take advantage of low labor costs or good investment opportunities, they tend to breach local pre-existing implicit contracts, shedding excess labor and/or slashing wages. • Multinationals can also be tougher negotiators with unions: being internationally mobile and less subject to local political and media pressure, they are more likely to leave the bargaining table and shut down local operations than the typical domestic company.

20. Globalization (2) • Foreign ownership of firms tends to lower the union wage premium. • Using matched employer-employee data for Denmark, Braun (2008) reports that, while domestically-owned unionized firms pay 2 to 4% higher wages than non-unionized ones, foreign firms pay no such wage premium. • This, together with their greater tendency to rely on large employment cuts to improve profitability, helps to explain the frequent resistance of trade unions to foreign ownership.

21. Globalization (3) • Example from Korea: • In May 2001 GM bid for Daewoo Motor, on the condition that it layoff 5,000 employees. This led to mass nationwide strikes and labor unrest until April 2002, when an agreement was reached. • Now acquisitions of European companies by Asian ones: • Jaguar and Land Rover’s U.K. car plants by Tata; • French Arcelor steelmaking group by Mittal. • In both cases, local unions opposed these acquisitions, and workers’ unrest has mounted.

22. Labor’s “global response” • Ironically, global capital may succeed where socialism failed, pushing labor to realize Marx and Engels’ appeal: “Workers of the world, unite!” • But a global union merger would have to overcome the conflicts of interests between workers in developed and developing countries. • The U.S.-based United Steelworkers (USW) and Britain’s UNITE are about to announce a merger, “aimed at helping workers whose jobs or terms of employment are threatened by economic globalization”. • The new union would have about 3 million members in the U.K., Ireland, U.S., Canada and the Caribbean. Plans to extend it to Latin America, Eastern Europe and Asia.

23. IV. Concluding remarks • A fascinating new research area, where new insights can be obtained by joining knowledge of labor and finance. • Much work remains to be done, especially on the effects that technological innovation and globalization have both on corporate finance and labor relations. • Recent empirical work shows the fruitfulness of bringing firm-level and plant-level data to bear on these issues, but so far is limited mainly to U.S. and U.K. • Very important also for policy: this is a very controversial and politically loaded area, where policy is at risk of being ransom of slogans and catchwords.