October 30, 2012 | Research Feature

Letting Go of the Best

Why are firms' most productive employees the most likely to get pink slips when a recession hits?

Who does unemployment hit the hardest during recessions? Some signs have pointed toward high-wage workers. Yet these workers also tend to be firms’ most productive employees, and why firms aren’t more reluctant to let them go has remained somewhat puzzling. New research from Professor Andreas Mueller digs deeper to not only provide strong evidence that high-wage workers are disproportionately impacted in recessions but also to explain why firms seem so overeager to shed their most productive workers.

Mueller looked at the Current Population Survey, the main labor force survey in the United States, which the Bureau of Labor Statistics uses to estimate the unemployment rate. The survey tracks unemployment and wage information, following households for more than a year, and has a high response rate. By using a complicated matching process, Mueller was able to conduct an analysis of every recession since 1962.

He finds that even controlling for education, work experience, gender, and other easily observable characteristics of the unemployed, those with high wages — beyond any other similarities they may share — tend to get disproportionately laid off in recessions. In particular, those with high residual wages — high wages relative to others with similar education and experience — are the most heavily impacted.

Mueller also analyzed the data to see whether the changes could be driven by factors not easily observed in the data. For example, might high-wage workers, once laid off, have a much harder time finding a job in a recession than low-wage workers? “It turns out it’s just as difficult for a low-wage worker to find a job in the recession as it is for a high-wage worker,” Mueller notes. “So that doesn’t explain why such a high proportion of high-wage earners are unemployed in recessions.”

An obvious candidate for what’s behind these disproportionate layoffs of high-wage workers is firm and plant death: if a plant shuts down, it sheds all workers, not just its low-skilled workers. But Mueller found that plant and firm death don’t happen that much more during recessions than they do during better times, and only explains a small part of the layoff pattern.

Among the handful of theories about what causes this pattern, Mueller found the strongest evidence points to credit constraints that emerge in recessions as the most decisive of possible factors. During recessions, firms would prefer to keep their high-wage, high-productivity workers, who will be key to the firm’s performance once the recession ends. But many firms must rely more on credit during a recession. Since borrowing costs rise in recessions while available credit contracts, these firms find themselves crunched by current costs and appear more inclined to get rid of high-wage workers despite their productivity.

Yet another theory about high-wage layoffs suggests that the bulk of high-wage workers getting laid off during recessions are those who were simply lucky at some point in their careers and were able to secure a higher wage than their productivity called for. In hard times, the theory goes, these supposedly overvalued, lower-quality workers are the first to go. In a related study Mueller and his co-authors Peter Fredriksson of Stockholm University and Björn Öckert of the Institute for Evaluation of Labour Market and Education Policy use employer employee data to track workers’ employment as they move from firm to firm and examine the composition of Swedish unemployment during recessions. The researchers matched that data with cognitive and non-cognitive ability test scores from Sweden’s compulsory military service, which allowed the researchers to see not just whether individuals are “book smart” but also to get a sense of their social and other skills.

Although Sweden’s labor market is in many ways very distinct from the United States’s, the initial results show the same patterns of unemployment among high-wage earners in recessions. And those with higher IQ tests scores, greater proven abilities, and higher non-cognitive scores do increasingly get laid off in recessions. The pool of unemployed reflects a higher share of among the highest quality workers — which controverts the idea that firms primarily shed their least talented high-wage workers when credit thins.

“One often hears anecdotes about firms’ unwillingness to hire laid-off workers — firms assume the pool of unemployed is of low quality,” Mueller says. “But if I were in HR, I would want to hire in recessions. I have a much better chance of recruiting high-ability staff.”

Andreas Mueller is assistant professor of finance and economics at Columbia Business School.

Read the Research

Andreas Mueller

"Separations, Sorting and Cyclical Unemployment"

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