Philippe Bacchetta, Kenza Benhima and Céline Poilly, American Economic Journal: Macroeconomics, 2019, 11(3): 1–37
Céline Poilly is a professor of Economics at AMSE. She obtained her PhD from the University of Cergy-Pontoise in 2008 and was assistant professor at University of Louvain-la-Neuve in Belgium (2008-2011) and University of Lausanne in Switzerland (2011-2016). She joined AMSE in 2016. Her research interests are monetary macroeconomics and macro-econometrics.
The research program
Many firms are sitting on piles of cash. For instance, Apple Inc. registered $245 billion cash on its balance sheet, according to its first-quarter 2019 earnings report. In theory, a firm has no incentive to hold cash, as it does not provide any return. Why should a corporate firm keep cash, instead of using it to start new projects, to hire new employees? Yet in the aftermath of the US financial crisis, both a sharp decline in employment and an accumulation of cash held by firms have been observed. To what extent are corporate cash-holding decisions linked to employment decisions?
The purpose of this paper is to investigate the link between corporate cash-holding and employment decisions. Using aggregate Flow-of-Funds US data, we observe a negative correlation between corporate cash ratio – defined as the share of corporate liquidity in total assets – and number of employees. This correlation is -0.43 over the sample 1980-2015. Said differently, employment drops as corporate cash reserves grow, even more strikingly so during the 2007 financial turmoil. Using firm-level data from the Compustat database over the same period, we find that the cross-firm correlation is still negative and significant. Therefore, we conclude that employment and cash ratio move in opposite directions over time and across firms.
To understand this puzzling stylized fact, we need a theoretical model. We use a tractable model with heterogeneous firms, including both cash and employment decisions. The basic assumption is that firms need both external and internal liquid funds to finance their production. Liquidity that is external to the firm may take several forms, such as credit lines, trade credits, trade receivables to customers, or late wage payments. Internal liquidity is simply cash. Liquidity is closely related to labor because firms need liquidity to finance the wage bill, which is part of working capital. Importantly, this assumption is validated by the firm-level data. We assume that firms do not have full access to external liquidity and thus cannot borrow enough to meet all their short-term needs.
Based on this stylized model, we argue that the negative correlation between corporate cash ratio and employment can be explained by external liquidity shocks. A reduction in external liquidity generates two effects. On the one hand, lower liquidity reduces firms’ financial opportunities and depresses labor demand. On the other hand, reduced external liquidity makes the production process more cash-intensive, to ensure that wages are fully financed. Firms’ assets get tilted toward cash. Combining these two effects means that the cash ratio increases while employment declines. So a reduction in external liquidity makes production less attractive or more difficult to finance, while it also generates a need for liquidity to pay wage bills, which can be satisfied by holding more cash.
One natural question emerges here. Do external liquidity shocks contribute greatly to GDP fluctuations in the US? Mixing the empirical aggregate data and the theoretical model together, we simply build a series of external liquidity shocks. Importantly, we show that they are highly correlated with the use of short-term loans or of commercial paper, which validates their interpretation. We argue that these shocks account for 2.5 percent out of the 7 percent fall in GDP observed in the second quarter of 2009. This result sheds light on the role of a new type of financial shock – namely external liquidity shocks – on employment, especially during the global financial crisis which started in 2007.
As the theoretical model includes heterogeneous firms, we exploit this dimension to analyze whether the firm-specific component of external liquidity shocks affects employment and cash-holding decisions. We show that our model is able to generate the negative cross-firm correlation documented in the empirical analysis.
While this work offers a new explanation for the link between corporate cash-holding and employment, it does not explain the sources of external liquidity fluctuations. Therefore, it would be of interest to model mechanisms through which liquidity supply varies endogenously. Another important question, from a policy point of view, is to understand how central banks’ decisions can modify the recessionary effects of external liquidity shocks.