Firing restrictions and economic resilience: Protect and survive?

Firing restrictions are in use throughout the developed world but their role in the transmission of macroeconomic shocks into the real economy is mostly unstudied. We illustrate the theoretical role of these policies as amplifiers of macroeconomic shocks via labor-misallocation-induced output losses following an adverse shock. We use our model to derive an aggregation result which features a labor misallocation term and conduct a simulation exercise which demonstrates how misallocation can drive total factor productivity (TFP) down during recessions. We then perform a quasi-natural experiment which utilizes global credit supply shocks to study this amplifying role using a panel of 21 OECD economies. We show that strict firing restrictions are associated with a weaker initial response of the labor market, which is followed by a stronger and more persistent decline in real output as well as a slower return of real activity to pre-shock levels. The stronger output decline can be mostly explained by a stronger fall in aggregate TFP, which supports our theoretical predictions.