Why short-term contracts are becoming increasingly common
Companies going into administration. Rising redundancies. The immediate impact of the credit crunch on employment is easy to see but what of the broader costs of doing business in these financially insecure times?
Researchers Dr Vincente Cuñat of LSE's Department of Finance and Dr Andrea Caggese of Pompeu Fabra University in Barcelona have examined just this question and found that as the credit crunch bites, companies will be much more likely to offer employees short-term contracts rather than permanent jobs.
Using detailed data on the hiring and firing practices of small and medium Italian firms the researchers were able to show the impact that poor access to credit has on hiring practices. They found that firms with poor access to credit markets tended to hire more fixed-term workers and fewer permanent workers.
Furthermore, financial difficulties tend to exacerbate inequalities that already exist between fixed-term and permanent workers. Fixed-term employees face, in general, a more volatile and unstable future, being more likely to be affected by labour adjustments than those with permanent contracts. The study finds that when firms lack access to credit or in times of economic downturn these differences are emphasized.
Financially-constrained companies arguably require greater productivity than unconstrained companies, which can be fostered more effectively with permanent contracts that promote job stability and investment in human capital. However cash-strapped companies also value the flexibility offered by fixed-term contracts and the ability to downsize at the beginning of an economic downturn without paying out firing costs. The study found that this second effect is more important in practice, leading to financially constrained firms relying more on fixed-term contracts.
'All firms face this trade-off',' comments Dr Cuñat, 'and our analysis shows that firms facing financial difficulties in accessing capital markets place a much higher value on the flexibility of the fixed term workers than firms with no financing problems. At the beginning of a downturn firms unable to access external finance can reduce employment much faster than financially unconstrained firms, both because they are forced to cut wages in order to avoid insolvency and because they employ a higher number of fixed-term workers, who can be dismissed without cost.'
The study considers a model economy which replicates the labour market conditions in Italy in the 1990-2000 period, when fixed term workers made up on average only 4 per cent of the total labour force. In this context the presence of financing constraints increases the volatility of permanent employment contracts by only 6 per cent, while it increases the volatility of fixed term contracts by as much as 35 per cent. As a consequence, the volatility of total employment increases by as much as 16 per cent.
Poor access to the credit markets is not the only burden companies face in deciding on their employment policies. Strong employment laws can also create disincentives to hire permanent staff.
Italy was the ideal country to use for this study for several reasons. 'Firstly, Italy's labour law established a very high level of labour protection', explains Dr Cuñat, 'and secondly, the Italian financial system is traditionally underdeveloped with Italian firms facing capital market imperfections that are only partially corrected by the availability of bank credit as the main source of credit.
'Our analysis shows that as financial market imperfections increase expected firing costs, so permanent contracts become implicitly more expensive and the hiring of fixed-term workers in expansion phases becomes more commonplace.'
So with a faltering global economy and an increasingly volatile workforce, how can policy makers effectively support both companies and individuals?
'This is a real step forward in understanding how financial constraints affect the real activity of firms' said the authors. 'Policies that relax financing constraints that firms face will have a positive impact on the stability of total employment and in particular on fixed term contracts. Reducing the financing constraints faced by firms would decrease job instability in general but would also help to close the gap in terms of job instability between fixed term and permanent contracts.'
Financing constraints and fixed-term employment contracts [PDF] by Dr Vincente Cuñat, Department of Finance, LSE, and Dr Andrea Caggese of Pompeu Fabra University in Barcelona was published in The Economic Journal, 118, November 2008.
For full details of Dr Vicente Cuñat's research and publications see his profile in the LSE Experts Directory: Dr Vicente Cuñat
Department of Finance