After the credit squeeze: how labour market flexibility can strengthen firm growth and employment

How beneficial is labour market flexibility ¬– for instance, the ability to hire and fire workers – for firm growth? And how does such flexibility interact with a firm’s ability to obtain bank credit? This article provides evidence that less rigid employment protection benefits firms during times of scarce credit. We study the performance of credit constrained Spanish firms during the financial crisis of 2008-09, exploiting a firm-size-specific labour regulation that imposes more stringent employment protection on firms with more than 50 employees. We find that Spanish firms with fewer than 50 employees operating in sectors in which labour and capital are close substitutes grew faster during the financial crisis when exposed to a negative credit shock than similarly credit constrained but larger firms. This effect is more pronounced for firms that were more productive before the crisis, suggesting that flexible employment protection laws benefit otherwise healthy firms that are credit constrained, by enabling them to substitute labour for capital and continue growing. JEL Classification: G21, J80, D20