BIS Working Papers. No 534. Labour reallocation and productivity dynamics: financial causes, real consequences. Monetary and Economic Department

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1 BIS Working Paper No 534 Labour reallocation and productivity dynamic: financial caue, real conequence by Claudio Borio, Enie Kharroubi, Chritian Upper and Fabrizio Zampolli Monetary and Economic Department December 2015 JEL claification: E24; E51; O47 Keyword: Labour reallocation, productivity, credit boom, financial crie, hyterei

2 BIS Working Paper are written by member of the Monetary and Economic Department of the Bank for International Settlement, and from time to time by other economit, and are publihed by the Bank. The paper are on ubject of topical interet and are technical in character. The view expreed in them are thoe of their author and not necearily the view of the BIS. Thi publication i available on the BIS webite ( Bank for International Settlement All right reerved. Brief excerpt may be reproduced or tranlated provided the ource i tated. ISSN (print) ISSN (online)

3 Labour reallocation and productivity dynamic: financial caue, real conequence 1 Claudio Borio, Enie Kharroubi, Chritian Upper, Fabrizio Zampolli 2 Abtract We invetigate the link between credit boom, productivity growth, labour reallocation and financial crie in a ample of over twenty advanced economie and over forty year. We produce two key finding. Firt, credit boom tend to undermine productivity growth by inducing labour reallocation toward lower productivity growth ector. A temporarily bloated contruction ector tand out a an example. Second, the impact of reallocation that occur during a boom, and during economic expanion more generally, i much larger if a crii follow. In other word, when economic condition become more hotile, miallocation beget miallocation. Thee finding have broader implication: they hed light on the recent ecular tagnation debate; they provide an alternative interpretation of hyterei effect; they highlight the need to incorporate credit development in the meaurement of potential output; and they provide a new perpective on the medium- to long-run impact of monetary policy a well a it ability to fight pot-crii receion. Keyword: Labour reallocation, productivity, credit boom, financial crie, hyterei. JEL code: E24; E51; O47 1 The author thank Martin Brown, Andy Filardo, Paloma Garcia, Jonathan Kearn, Gianni Lombardo, Joé-Lui Peydró, Thij van Ren and eminar participant at Banque de France, Bank of Portugal, the BoC-ECB conference on "The underwhelming global pot-crii growth performance determinant, effect and policy implication", the CEPR conference on Peritent output gap: caue and policy remedie, the Univerity of St. Gallen conference on "Finance, capital reallocation and growth". The view expreed here are thoe of the author and do not necearily repreent the view of the BIS. 2 Monetary and Economic Department, Bank for International Settlement. WP534 Labour reallocation and productivity dynamic: financial caue, real conequence iii

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5 Content Abtract Introduction Labour reallocation and productivity growth: decompoition, data and a firt glance The decompoition The data A firt glance Credit boom, labour reallocation and productivity growth Relative impact on the allocation and common of productivity Decompoing the allocation Invetigating cauality Financial crie, labour reallocation and productivity growth Methodology Empirical reult Concluion Reference Annex A.1 Labour reallocation and productivity growth A.2 Decompoing the allocation WP534 Labour reallocation and productivity dynamic: financial caue, real conequence v

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7 1. Introduction By now, it i well known that credit boom can eriouly damage an economy' health. Mot of the evidence o far ha related to the boom' aftermath. Rapid credit growth ubtantially increae the rik of financial (banking) crie (eg Borio and Lowe (2002), Cecchetti et al (2009) Drehmann et al (2011), Gourincha and Obtfeld (2012), Mian and Sufi (2009)). And banking crie preceded by credit boom tend to be followed by larger output loe and hallower recoverie (Jorda et al (2013), Reinhart and Rogoff (2011)). Moreover, the impact of banking crie on output i very long-lating, if not permanent (BCBS (2010)). More recent evidence alo ugget that credit boom may damage the economy even a they occur by reducing productivity growth, regardle of whether a crii follow (Cecchetti and Kharroubi (2015)). The mechanim are not well undertood, but Cecchetti and Kharroubi conjecture that the allocation of reource play a key role. The financial ector' expanion may benefit diproportionately project with high collateral but low productivity. And financial intitution' high demand for killed labour may crowd out more productive ector. Both mechanim are in line with empirical evidence that during financial boom productivity growth fall diproportionately in manufacturing indutrie that are either R&D intenive or hold le tangible aet. In thi paper we invetigate the empirical link between credit boom, financial crie and productivity growth more cloely. We focu on labour reallocation acro ector, although within-ector effect may alo be important. Specifically, we ak two quetion. Firt, during credit boom, doe labour hift to lower productivity growth ector? And econd, doe a financial crii amplify the effect of labour reallocation that took place during the previou economic expanion? The anwer to both of thee quetion i a clear ye. At leat, thi i the concluion baed on a ample of 21 advanced economie over the period 1969 to the preent. Credit boom ap productivity growth through labour reallocation 1 Graph 1 Percentage point Annual cot during credit boom......and over a five-year window pot-crii Productivity lo due to labour reallocation 2 Productivity lo due to other reaon Etimate calculated over the period for 21 advanced economie, auming a five-year credit boom followed by a financial crii. 2 Annual impact on productivity growth of labour hift into le productive ector during a five-year credit boom. 3 Annual impact in the abence of labour reallocation during the boom. Source: Author calculation. WP534 Labour reallocation and productivity dynamic: financial caue, real conequence 1

8 Graph 1 ummarie our key finding. To help fix idea, it how the impact on productivity of a ynthetic credit boom-cum-financial crii epiode pecifically, the impact of an aumed 5-year credit boom that i followed by a financial crii, and conidering a 5-year pot-crii window. 3 Three point tand out. Firt, credit boom tend to undermine productivity growth a they occur. For a typical credit boom, a lo of jut over a quarter of a percentage point per year i a kind of lower bound. Second, a large part of thi, lightly le than two third, reflect the hift of labour to lower productivity growth ector thi i the only tatitically ignificant. Think, for intance, of hift into a temporarily bloated contruction ector. The remainder i the impact on productivity that i common acro ector, uch a the hared of aggregate capital accumulation and of total factor productivity (TFP). Third, the ubequent impact of labour reallocation that occur during a boom i much larger if a crii follow. The average lo per year in the five year after a crii i more than twice that during a boom, around half a percentage point per year. Put differently, the reallocation cat a long hadow. Taking the 10-year epiode a a whole, the cumulative impact amount to a lo of ome 4 percentage point. Regardle of the pecific figure, the impact i clearly izeable. The finding are robut to alternative definition of credit boom, to the incluion of control variable and to technique to identify the direction of cauality. While our reult are quite general, it i eay to identify obviou recent example of thee mechanim at work. The credit boom in Spain and Ireland in the decade to 2007 coincided with the rapid growth of employment in contruction and real etate ervice at the expene of the more productive manufacturing ector. Once the boom turned to but and the financial crii truck, the economie went through a painful rebalancing phae, a reource had to hift back under advere condition not leat a broken financial ytem that did not facilitate, indeed may well have hindered, the proce. In thi ene, the reallocation of reource during the boom were clearly miallocation (we will ue the term interchangeably in what follow). Technically, we proceed in two tage. Firt, we build on Olley and Pake (1996) in decompoing aggregate labour productivity growth into a common and an allocation purely an identity. 4 The common reflect the unweighted average of productivity growth acro all indutrie in the economy. The allocation meaure the impact of labour reallocation acro indutrie. 5 For intance, a hift of labour from low to high productivity indutrie will lead to a poitive allocation. Becaue of data limitation, and in order to capture 3 We conider a one tandard deviation increae in private credit to GDP growth and derive the implied lowdown in labour productivity a well a in the correponding common and allocation uing Table 3 etimate. Then, uing Table 10 etimate, we ue the implied change in labour productivity growth to compute the percentage deviation in labour productivity that the economy would face five year after a financial crii. 4 Bartelman et al. (2013) provide a tudy of the determinant of cro-country difference in productivity uing the Olley and Pake (1996) decompoition. 5 Strictly peaking, a will be clear in ection 2, the allocation i the covariance acro ector between the growth rate of the ectoral employment hare and the growth rate of ectoral productivity. Hence, in theory, it meaure both the impact of labour reallocation acro ector and that of change in productivity growth acro ector. In practice, however, the data how that change in the allocation are eentially driven by change in the ditribution of labour acro ector. That i why we ue thi hortcut, tating that the allocation meaure the impact of labour reallocation acro indutrie. 2 WP534 Labour reallocation and productivity dynamic: financial caue, real conequence

9 a many credit boom epiode a poible, we focu on the one-digit indutry level. Admittedly, thi i a relatively coare claification for intance, the entire manufacturing ector i lumped together and bank are merged with other financial ervice. Armed with thee decompoition, we ue a erie of panel technique to diect the impact of credit boom on productivity growth. We firt explore the impact of credit boom on the productivity a the boom proceed. We then examine the impact of the variou productivity during pre-receion economic expanion on the ubequent path of productivity, depending on whether crie occur. We naturally control for variou other factor, including the independent impact of a crii. Thi paper build on two different trand of the literature on the effect of reource reallocation. The firt quantifie job reallocation and explore their caue and conequence. Davi and Haltiwanger (1992) etimate that roughly 20% of US manufacturing job are created or detroyed per year. Campbell and Kuttner (1996) find that reallocation hock account for roughly half of the variance in total employment growth. A large literature examine the relationhip between reallocation and the buine cycle to teae out cauality (ee for intance Baily et al (2001) or Foter et al (2014)). More recently, a growing number of tudie have begun to conider the effect of credit boom on uch reallocation. Acharya et al (2010) delve into the effect of US cro-tate banking deregulation on the allocation of output and employment acro ector at the tate level. Gorton and Ordoñez (2014) find that credit boom can have negative implication for aggregate TFP: in their model thi reult from agent not producing information about the quality of collateral during the boom. A econd trand of the literature deal more generally with the macroeconomic implication of microeconomic ditortion. In their eminal paper, Hieh and Klenow (2009) etimate the diperion of productivity within individual indutrie uing firmlevel data. They argue that thi diperion i indicative of reource miallocation, which in turn act a a drag on aggregate productivity. Hieh and Klenow' approach ha been extended in variou direction, but the focu ha generally been on miallocation within particular indutrie. Their reult may therefore provide a lower bound of the effect of miallocation, although meaurement error and other factor could work in the oppoite direction (ee Retuccia and Rogeron (2013), who alo urvey the ubequent literature). Our approach differ from model in the Hieh and Klenow tradition in at leat two repect. We meaure reallocation acro ector, not within individual indutrie. And we directly relate it contribution to productivity growth to one potential driver, namely rapid credit growth. The paper mot cloely related to our are Dia et al (2015) and Gopinath et al (2015). Dia et al (2015) extend Hieh and Klenow' approach to include intermediate input in order to meaure intra-indutry miallocation in Portugal. They find that uch miallocation almot doubled between 1996 and 2007, a period of rapid capital inflow. Gopinath et al (2015) find that flow of capital into Spain, triggered by low interet rate in the wake of European monetary unification, diproportionately benefited firm that had not been finance-contrained hitherto. The author interpret the reulting higher diperion of the marginal product of capital a pointing to reource miallocation. WP534 Labour reallocation and productivity dynamic: financial caue, real conequence 3

10 Our paper i organied a follow. Section 2 preent the decompoition of labour productivity growth into it common and allocation, decribe the data, and cat a firt glance at the behaviour of the two. The detail of the derivation are relegated to Annex 1. Section 3 explore how credit boom affect productivity growth by influencing it variou a the boom occur, at increaing degree of granularity. Section 4 examine the implication of labour reallocation for the ubequent productivity path, paying pecial attention to how the occurrence of financial crie affect the link. The concluion raie ome broader quetion and implication of the analyi. 2. Labour reallocation and productivity growth: decompoition, data and a firt glance 2.1 The decompoition We begin by defining the concept of labour reallocation we will be uing throughout the paper (Annex). We rely on a imple decompoition of aggregate labour productivity growth. Thi i purely an identity. Denoting y( y ) aggregate output (ector output) and ll ( ) aggregate employment (ector employment), the growth rate of labour productivity can be written a y/ l l / l y / l l / l y / l 1 1 % 1 cov ; 1 % y/ l l / l % y / l l / l y / l common allocation where an upper bar denote an unweighted average acro ector and y / y i the ratio of ector output to average output acro ector. The firt term of the right-hand ide in expreion (1) i the common of real labour productivity growth (henceforth, ( com )). It i the product of the average growth rate in ector-level employment hare and the ize-weighted average growth rate of productivity acro ector. The econd term of the right-hand ide in expreion (1) i the allocation (henceforth, ( alloc )). It repreent the covariance acro ector between the growth rate of ector-level employment hare and the ectorlevel ize-weighted labour productivity growth. For a given ditribution of ector ize, thi term meaure whether labour i reallocated toward high or low productivity growth ector. To illutrate thi decompoition, we conider a hypothetical economy made up of two ector, A and B, of equal output and employment ize and three different cenario (Table 1). All three cenario aume that aggregate employment i contant, that productivity grow by 10 per-cent in ector B and that it drop by 10 per-cent in ector A. They differ only with repect to the aumed ectoral employment growth rate: in cenario 1, employment i contant in both ector A and B; in cenario 2, employment grow by 10 per-cent in ector B, where productivity growth i poitive, but drop by 10 per-cent in ector A, where it i negative; finally, in cenario 3, the oppoite i true: employment grow by 10 per-cent in ector A.but drop by 10 per-cent in ector B. (1) 4 WP534 Labour reallocation and productivity dynamic: financial caue, real conequence

11 A imple example of productivity growth decompoition Table 1 Employment growth Productivity growth Aggregate Productivity growth Emp./Prod. growth correlation Sector A B A B A and B Scenario Scenario Scenario The cenario have different implication for productivity growth. In cenario 1, employment i contant in both ector, o aggregate productivity growth i jut the imple average of productivity growth acro ector, which i zero. By contrat, in cenario 2, employment grow in the ector enjoying a productivity gain and drop in the ector facing a productivity lo. Thu, aggregate productivity i higher. Finally, in cenario 3, the oppoite hold: employment grow in the ector uffering a productivity lo and drop in the ector facing a productivity gain. Thi reult in negative aggregate productivity growth. In thee three cenario, by contruction, the common a defined in decompoition (1) i equal to zero, ince both average employment growth and average productivity growth acro ector are zero. Therefore, aggregate productivity growth i equal to the allocation. Thi, in turn, i imply equal to the correlation acro ector between employment and productivity growth, conitent with decompoition (1). We now turn to quantifying each of the term in decompoition (1) baed on available data. 2.2 The data We rely on three different ource of indutry-level data: the OECD-STAN databae, the EU-KLEMS databae and the GGDC 10-ector databae. Thee three dataet provide information on value added and employment at the ector level following the ISIC 3 rev.1 claification at the 1-digit level. Overall, we conider 9 different ector: Agriculture (A and B), Mining (C), Manufacturing (D), Utilitie (E), Contruction (F), Trade ervice (G and H), Tranport ervice (I), Finance, Inurance and Real Etate ervice (J and K) and Government and Peronal ervice (L to Q). To build our dataet, we require for each data point that indutry-level output and employment um up to the economy-wide aggregate. Thi limit the number of countrie and year that can WP534 Labour reallocation and productivity dynamic: financial caue, real conequence 5

12 be included in the analyi. 6 We end up with an unbalanced ample covering 21 countrie tarting in 1979 and ending in Following the previou notation, uing decompoition (1), aggregate real labour productivity growth in country i between year t and year t n can be written a y / l / l it, n it, n y it, it, com alloc (2) itt,, n itt,, n On the right-hand ide, ( com ) repreent the common of productivity growth and ( alloc ) repreent the allocation a defined in decompoition (1). To compute the variou growth meaure we conider nonoverlapping period of either three or five year. Thi i becaue reallocation mut urely take coniderable time, epecially acro indutrie a widely defined a thoe conidered here. 8 Shorter period, of, ay, one or two year, could mak the "true" extent of the reallocation. Uing 5-year window yield 120 obervation and 3-year window 182 obervation. 2.3 A firt glance Table 2 provide ummary tatitic pooling all the data for aggregate real labour productivity growth, ie the left-hand ide in expreion (1), and for it common and allocation, ie repectively, the firt and econd term on the right-hand ide in expreion (1). The firt three column of Table 2 provide ummary tatitic uing 5-year window and the lat three uing 3-year window. Over a 5-year interval, real labour productivity grow on average by 8.6 percent, ie 1.6 percent per year. On average, the common repreent around 5.4 percentage point (or jut under two-third) and the allocation the remaining 3.2 percentage point. The figure baed on 3-year window are imilar: aggregate real labour productivity grow on average by 1.7 percent per year, with the common repreenting two-third of the total. 6 In thi paper we focu on net change in ector-level employment, without eparating employment detruction from employment creation. Another difference from the literature i that we focu on employment or peron employed a oppoed to job. A a reult, we are probably underetimating the extent of labour reallocation in the economy. For example, Davi and Haltiwanger (1992) etimate that each year around 20 percent of job are either created or detroyed in US manufacturing. By contrat, our net employment change barely repreent a few percentage point of total employment in our ample. 7 The countrie included in the ample are Autralia, Autria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Korea, the Netherland, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom and the United State. The tart and end date (1979 and 2009) were choen mainly becaue of contraint on indutry data availability. 8 Blanchard and Katz (1992) conider the effect of tate-pecific hock to labour demand acro US tate. According to their etimate, it can take up to 7 year for their effect on tate unemployment and participation to diappear. More recently, baed on longitudinal data, Walker (2013) etimate the tranitional cot aociated with reallocating worker from newly regulated indutrie to other ector in the wake of new environmental regulation. Hi reult ugget that thee cot are ignificant: the average worker in a regulated ector experienced a total earning lo equivalent to 20% of pre-regulatory earning, with almot all of the etimated earning loe driven by worker who eparate from their firm. 6 WP534 Labour reallocation and productivity dynamic: financial caue, real conequence

13 Summary Statitic Table 2 Productivity growth Allocation 5-year growth Common Productivity growth Allocation 3-year growth Common Average Median Standard deviation Standard deviation (within) Obervation Source: Author calculation. The volatility (tandard deviation) of the allocation account for 45 to 55% of the volatility of aggregate productivity growth, depending on the window length. The common i roughly a volatile a aggregate productivity growth, implying a negative covariance with the allocation. Thi mean that change in the common are ytematically aociated with oppoite, but maller, change in the allocation. For example, an economy-wide hock that raie productivity growth uniformly acro all ector tend to be partly offet by labour reallocation toward thoe with lower productivity growth. Table 3 provide the correlation matrix for aggregate productivity growth and the two, focuing on within-country correlation. Correlation in the upper left matrix are computed uing 5-year window; thoe in the lower right matrix uing 3-year one. Correlation Matrix Table 3 Productivity growth Allocation Common Productivity growth Allocation Common 5-year growth rate 3-year growth rate Source: Author calculation. Productivity growth 1 Allocation 0.248*** 1 5-year growth Common 0.871*** 0.260*** 1 Productivity growth 1 Allocation 0.222*** 1 3-year growth Common 0.865*** 0.298*** 1 The matrix how that labour reallocation toward high productivity ector tend to boot aggregate productivity growth. Aggregate productivity and it allocation co-move poitively within countrie and the relationhip i tatitically ignificant. WP534 Labour reallocation and productivity dynamic: financial caue, real conequence 7

14 3. Credit boom, labour reallocation and productivity growth 3.1 Relative impact on the allocation and common of productivity What i the impact of credit boom on the two of productivity growth a the credit boom occur? Simply put, we find that credit boom depre productivity growth and that their impact work through the allocation the only one for which a tatitically ignificant link i apparent. Thi reult urvive increaingly demanding tet. The baic reult emerge already quite clearly in imple bivariate tet. Financial boom and productivity growth Computed over five-year window and taken a deviation from country and period mean Graph 2 Credit boom and the allocation Credit boom and the common Private credit to GDP growth Allocation contribution to productivity growth Private credit to GDP growth Common contribution to productivity growth The left-hand panel plot the growth rate in private credit to GDP againt the allocation of labour productivity growth, both variable being taken a deviation from country and period mean. The right-hand panel plot the growth rate in private credit to GDP againt the common of labour productivity growth, both variable being taken a deviation of from country and period mean. The ample include 21 economie (Autralia, Autria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Korea, the Netherland, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom and the United State) and ix period of five year ( ; ; ; ; ; ) Source: Author calculation. Graph 2 plot the allocation (left panel) and the common (right panel), repectively, againt the growth in credit to the private ector to GDP (hown on the x-axe) our benchmark meaure of credit expanion, the latter being drawn from the BIS databae on credit to the non-financial private ector. We ue 5- year window and focu on deviation from country and time average. The graph trace a negative and tatitically ignificant relationhip between credit growth and the allocation. By contrat, no uch relationhip emerge with the common. To tet whether thee bilateral correlation urvive a more rigorou econometric analyi, we etimate the following three regreion: 8 WP534 Labour reallocation and productivity dynamic: financial caue, real conequence

15 y / l l f x it, n it, n it, n it, n y i t i, t l i, t yit, / lit, lit, fit, alloc com itt,, n itt,, n l f x it, n it, n a ai, at, a it, al, a it, lit, fit, l f x it, n it, n c ci, ct, c it, cl, c it, lit, fit, (3) yit, n / lit, n Here, tand for the growth rate of labour productivity in country i yit, / lit, between year t and t n alloc, and,, itt n and com itt,, n for the allocation and the common, repectively. The independent variable include a et of country and time dummie i; t a well a a vector of (pre-determined) control variable x it,. 9 The growth rate of employment in country i between year t and t n i lit, n fit, n denoted and i the variable meauring the intenity of the credit boom lit, fit, in country i between year t and t n. 10 Finally, are reidual. We etimate regreion (3) uing the two different window-length, 3 and 5 year, and two different meaure of credit boom, namely the rate of growth in the private credit-to-gdp ratio (our benchmark meaure) and the deviation of the ame ratio from it long-term trend (the credit gap ). 11 The vector x of control include the following variable: (i) the ratio of credit to GDP; (ii) government ize, meaured a the ratio of government conumption to GDP; (iii) CPI inflation; (iv) openne to trade, meaured a the ratio of import plu export to GDP; (v) a dummy for the occurrence of a financial crii; and (vi) the log of the initial level of output per worker. Thee data are all drawn from the OECD Economic Outlook databae, except the data on financial crie, which are drawn from Laeven and Valencia (2012). The choice of control variable deerve ome explanation. Credit in relation to GDP can help avoid confuing the effect of credit level and growth. If, ay, the growth rate in the credit-to-gdp ratio i lower when the credit-to-gdp ratio i higher, then a negative correlation between our meaure of credit boom and productivity growth could imply reflect the poitive effect of a higher credit-to-gdp ratio. We include government expenditure becaue credit boom boot tax revenue, allowing the government to increae it pending and employment. Since, by contruction, the government ector exhibit low productivity growth, the negative correlation identified above might jut be capturing change in it ize. The addition of inflation 9 Note that including country fixed effect enure we focu on within-country credit boom while including time fixed effect enure we focu on country-pecific credit boom and filter out global one. 10 Aggregate employment growth control for the cyclical poition of the economy. When the economy expand, productivity growth may fall imply becaue the marginal worker i le productive. During thoe expanion, credit may alo increae fater. Thu, controlling for the cyclical poition enure that the credit variable doe not puriouly capture thi effect. 11 Data on the credit gap are from Borio et al (2009). Moreover, for the ake of brevity, we only report etimation uing five-year window. Etimation uing three-year window are available upon requet. WP534 Labour reallocation and productivity dynamic: financial caue, real conequence 9

16 reflect the well-known view that inflation can lead to miallocation by introducing noie in the ignal agent receive about relative price (Luca (1975)). If credit boom coincide with higher inflation then we may jut be picking up thi effect. Trade openne hould be expected to boot productivity gain acro ector, including through reallocation toward ector enjoying ome comparative advantage. A already dicued, financial crie, which tend to be preceded by credit boom, are alo known to generate output loe: the previou reult may imply reflect their cot. Finally, the initial level of productivity i intended to capture the famou catchup effect, ie the tendency for productivity growth to converge acro countrie. Credit boom, productivity growth and it Table 4 Growth in private credit to GDP Average private credit to GDP gap (i.a) (ii.a) (iii.a) (i.b) (ii.b) (iii.b) Productivity growth 0.077** (0.0370) Employment growth 0.372*** (0.0796) Dummy for financial crii (0.0118) Initial private credit to GDP Government conumption to GDP Openne to trade CPI inflation Initial GDP per peron employed (log of) (0.0347) 0.674* (0.344) (0.0732) (0.165) 0.271*** (0.0443) Common (0.0399) 0.514*** (0.0931) (0.0142) (0.0415) 0.705* (0.412) 0.154* (0.0795) (0.219) 0.222*** (0.0607) Allocation 0.045*** (0.0170) 0.142** (0.0575) ( ) (0.0216) (0.224) (0.0466) 0.199* (0.108) (0.0407) Productivity growth *** (0.0131) 0.409*** (0.0665) (0.0209) (0.0488) (0.338) (0.0551) (0.0741) 0.270*** (0.0251) Common (0.0549) 0.529*** (0.0935) (0.0145) (0.0396) (0.412) 0.158** (0.0777) (0.216) 0.222*** (0.0618) Obervation Allocation * (0.0228) 0.120** (0.0579) ( ) (0.0187) (0.223) (0.0475) 0.237** (0.116) (0.0411) R-quared Note: Thi table report the etimated coefficient for independent variable reported in the firt column, the dependent variable being aggregate productivity growth (column (i.a) & (i.b)), the allocation (column (ii.a) & (ii.b)), the common (column (iii.a) & (iii.b)). Growth rate and average are computed uing 5-year window. Etimation period: All etimation include country and time fixed effect. Robut tandard error are in parenthee. Statitical ignificance at the 1%/5%/10% level repectively i indicated with ***/**/*. The regreion reult uing the growth rate in private credit to GDP a a meaure of credit boom fully confirm the preliminary bivariate tet (Table 4). Baed on 5-year window, private credit to GDP growth i negatively correlated with aggregate productivity growth, and the reult appear to be entirely driven by a trong and highly tatitically ignificant relationhip with the allocation (column 10 WP534 Labour reallocation and productivity dynamic: financial caue, real conequence

17 (iii.a)): there i no ignificant relationhip between credit growth and the common. 12 Turning to the control variable, ome intereting pattern emerge. There i little evidence of a financial deepening effect: the level of private credit to GDP doe not eem to account for either aggregate productivity growth or it two. On average, employment growth tend to coincide with lower aggregate productivity growth even a it goe hand-in-hand with productivity-enhancing reallocation: the common dominate. And we can dicard the view that labour reallocation are driven by change in government expenditure. Government conumption doe appear to dampen productivity growth, although the relationhip i only weakly tatitically ignificant, but no link i apparent with the allocation. 13 The role of CPI inflation i conitent with prior: inflation correlate negatively and ignificantly with the allocation of productivity growth, although there i no tatitically ignificant relationhip with productivity growth a a whole. Alo a expected, openne to trade doe co-vary poitively with the common of productivity growth, even if, a in the cae of inflation, there i no tatitically ignificant link with labour productivity growth a a whole. Finally, financial crie do not appear to affect productivity growth or any of it in a tatitically ignificant way. 14 The regreion alo hed light on the o-called catch-up effect. They indicate that the effect reflect almot excluively the operation of the common, ince the correlation between the initial productivity level and the allocation i not tatitically ignificant. Thi implie that the allocation i relatively more important in economie with higher productivity, becaue overall productivity growth will generally be lower there. If o, credit boom are likely to be more cotly in advanced economie. The concluion are very imilar if we ue the credit gap a a proxy for credit boom, with ome qualification. In particular, in thi cae, the correlation with the allocation i till apparent, but i tatitically weaker. Thi difference probably reflect meaurement error: given the low-moving trend, for current purpoe the credit gap i a noiier meaure of credit boom, particularly over hort window. 3.2 Decompoing the allocation The previou reult highlight how labour reallocation during credit boom dampen productivity growth, but, trictly peaking, they are ilent about the nature of the reallocation. Specifically, when the allocation decline over time, i thi 12 Reult uing a 3-year window are very imilar, except that now there i ome evidence of a tatitically ignificant link alo with the common, albeit only at the 10% level. Poibly, over the horter window, credit boom boot demand acro all ector, leading to a generalied increae in employment which lead to a productivity lowdown. But a the credit boom proceed, the incidence acro ector become more differentiated o that the average effect fade out while labour reallocation keep taking place. 13 Thi hypothei can be formally teted by computing productivity growth and it, excluding the government ector. 14 Thi lat reult may ound urpriing but it i important to remember that the regreion control for the poition of the economy in the buine cycle. In other word, the depreing effect of financial crie on productivity growth i already captured through the employment growth variable. WP534 Labour reallocation and productivity dynamic: financial caue, real conequence 11

18 becaue, for a given ditribution of ectoral productivity growth, employment grow more rapidly in low productivity growth ector ( employment-driven )? Or i it becaue, for a given ditribution of ectoral employment growth, productivity low down in ector with rapidly expanding employment ( productivity-driven )? Put differently, do change over time in the allocation reflect change in the ditribution of labour acro ector (a our ue of the term "labour reallocation" ugget) or change in the ditribution of productivity gain acro ector? To iolate thee channel we carry out a variance decompoition exercie on the allocation itelf (Annex 1). We then run the ame regreion (3) uing each of the variance decompoition a a dependent variable. Decompoing the effect of credit boom on the allocation Table 5 Private credit to GDP growth Average private credit to GDP gap (i.a) (ii.a) (iii.a) (iv.a) (i.b) (ii.b) (iii.b) (iv.b) Allocation ProductivityEmploymen -driven t-driven *** (0.0170) Employment growth 0.142** (0.0575) Dummy for financial crii (0.0071) Initial private credit to GDP Government conumption to GDP Openne to trade CPI inflation Initial GDP per peron employed (log of) (0.0216) (0.224) (0.0466) 0.199* (0.108) (0.0407) (0.0073) ** (0.0188) (0.0023) *** (0.0064) (0.0891) (0.0161) 0.162*** (0.0491) *** (0.0158) *** (0.0155) 0.190*** (0.0536) * (0.0068) (0.0210) (0.211) (0.0460) (0.0843) 0.113*** (0.0341) Jointly driven (0.0055) 6.52e 05 (0.0134) (0.0014) (0.0047) (0.0585) (0.0092) (0.0375) (0.0122) Allocation ProductivityEmploymen -driven t-driven * (0.0228) 0.120** (0.0579) ( ) (0.0187) (0.223) (0.0475) 0.237** (0.116) (0.0411) (0.0079) *** (0.0180) ( ) *** (0.0055) (0.0868) (0.0159) 0.155*** (0.0505) *** (0.0154) ** (0.0210) 0.171*** (0.0543) ( ) (0.0171) (0.209) (0.0475) (0.0901) 0.113*** (0.0364) Jointly driven (0.0067) (0.0135) ( ) (0.0045) (0.0572) (0.0089) (0.0401) (0.0122) Obervation R-quared Note: Thi table report the etimated coefficient for independent variable reported in the firt column, the dependent variable being the allocation (column (i.a) & (i.b)), the allocation due to productivity hock (column (ii.a) & (ii.b)), the allocation due to employment hock (column (iii.a) & (iii.b)) or the allocation due to both productivity and employment hock (column (iv.a) & (iv.b)). Thee three lat variable are computed baed on decompoition (16) while the allocation i computed uing decompoition (1). Growth rate and average are computed uing 5-year window. Etimation period: All etimation include country and time fixed effect. Robut tandard error are in parenthee. Statitical ignificance at the 1%/5%/10% level repectively i indicated with ***/**/*. The decompoition indeed confirm that the decline in the allocation during credit boom overwhelmingly reflect hift in employment toward low productivity growth ector (Table 5). Specifically, the negative correlation between credit to GDP growth and the allocation i explained almot excluively by change in indutry-level employment growth rather than change in izeweighted productivity growth acro ector: only the employment effect i 12 WP534 Labour reallocation and productivity dynamic: financial caue, real conequence

19 tatitically ignificant. In other word, credit boom do not appear to affect the ectoral ditribution of productivity gain, turning potentially high productivity growth ector into low productivity growth one. Rather, they induce labour hift into lower productivity growth ector. Productivity in indutrie with rapid long-run productivity growth doe not grow any more lowly during credit boom, but thee indutrie attract relatively fewer worker. Table 5 how that more than 90% of the effect of credit boom reflect thee hift in employment hare. Switching to the credit to GDP gap provide very imilar reult. The negative correlation between credit boom and the allocation remain largely unchanged, and till pertain to change in the ectoral ditribution of employment creation. The relative ize of the effect i alo very imilar. Are any pecific ector driving the reult? To examine thi, we proceed in two tep. Firt, intead of making ue of the full et of ector, we withdraw one of them at a time and conider the hypothetical economy made up of the correpondingly maller et of ector. Second, we re-compute decompoition (1) for that economy and run the previou et of regreion to check whether credit boom till correlate negatively with the allocation. The relationhip between credit boom and the allocation of productivity growth for different ector excluion Table 6 Sector withdrawn None AGRICULTURE MINING MANUFACTURING UTILITIES (i) (ii) (i) (ii) (i) (ii) (i) (ii) (i) (ii) *** *** *** *** *** ** * *** ** (0.0178) (0.0170) (0.0199) (0.0152) (0.0154) (0.0127) (0.0181) (0.0251) (0.0162) (0.0207) Sector withdrawn CONSTRUCTION TRADE TRANSPORT FINANCE OTHER SERVICES (i) (ii) (i) (ii) (i) (ii) (i) (ii) (i) (ii) ** *** *** ** ** *** *** * ** (0.0208) (0.0204) (0.0197) (0.0190) (0.0198) (0.0192) (0.0198) (0.0168) (0.0241) (0.0201) Note: Thi table report the etimated coefficient and tandard error for credit to GDP growth, the dependent variable being the allocation of productivity growth. The dependent variable for each regreion (i) & (ii) located in the ame column i computed excluding the ector referred to in the row Sector withdrawn. Etimation (i) include country and time fixed effect; etimation (ii) include the full et of control ued in pecification (3) in addition to country and time fixed effect. Etimation period: Robut tandard error are in parenthee. Statitical ignificance at the 1%/5%/10% level repectively i indicated with ***/**/*. The reult ugget that manufacturing and contruction are the two ector primarily reponible for the lowdown (Table 6). When either ector i withdrawn, the negative correlation goe away or at leat weaken compared with the benchmark cae. Interetingly, removing the financial ector doe not affect our reult. Combining thi reult with the previou one, the concluion i clear. Aggregate productivity low down during credit boom primarily becaue employment expand more rapidly in the contruction ector, which tructurally feature low productivity growth. And employment expand more lowly or contract in manufacturing, which i tructurally a high productivity growth ector. WP534 Labour reallocation and productivity dynamic: financial caue, real conequence 13

20 3.3 Invetigating cauality A a lat robutne check, we invetigate whether the evidence produced o far i imply a correlation or repreent cauality. But before we turn to the etimation deigned to addre thi iue, it i worth noting that, in fact, the evidence o far doe point to cauality running from credit boom to productivity growth rather than the other way round. Intuitively, revere cauality doe not look plauible. It would imply that productivity lowdown induce either financial intermediarie to upply more credit or firm and houehold to demand more of it. True, in the very hort term one could imagine, ay, houehold borrowing more to hield their conumption in the face of an unexpected lowdown in productivity and hence income. But uch an effect hould wah out over the relatively long window we are conidering. Moreover, credit tend to be pro-cyclical. And ince we control for cyclical condition through employment growth, the repone of credit to the real economy i already largely filtered out. Finally, it i hard to ee why credit would ytematically react to productivity lowdown driven by labour reallocation but not to thoe driven by the common. A firt tatitical afeguard againt revere cauality i that in regreion (3) all right-hand-ide variable are pre-determined with repect to the dependent variable, ie are meaured at the beginning of the period. The exception are employment and credit growth, which are both meaured over the ame period. 15 Still, in order to lay to ret any reidual doubt about the direction of cauality even for thee two variable, we intrument them. We do o with beginning-of-period value for the nominal long-term interet rate, the trade balance-to-gdp ratio, the current account balance-to-gdp ratio a well a the level and change in the financial liberaliation index contructed by Abiad et al (2008). Table 7 provide the etimation reult uing thi intrumental variable (IV) technique. Credit to GDP growth i the proxy for credit boom in the firt four column, and the average credit to GDP deviation from trend in the lat four. A in previou table, the common and the allocation um up to productivity growth and the dependent variable in etimation (iv.a) and (iv.b) i the part of the allocation driven by change in the ectoral ditribution of employment, following the variance decompoition preented in ection 3.2. Etimation reult confirm our previou finding. Indeed, the reult become even tarker. The etimated coefficient become larger in abolute value, uggeting that the OLS etimate may underetimate the effect of credit boom on productivity growth. For example, according to the OLS etimate, a 10 percentage point increae in private credit to GDP growth over 5 year reduce productivity growth by 0.8 percentage point over the ame period. But according to the IV etimate, the lowdown in productivity i cloer to 1.4 percentage point over five year, which amount to dampening productivity growth by percentage point per year. In addition, conitent with the OLS reult, the IV etimate confirm that roughly 60% of the effect of credit boom on productivity reflect labour reallocation acro 15 In addition, the financial crii dummy i meaured over the ame period a productivity growth. However, thi variable prove in practice to have very little influence on the empirical reult. We therefore take it out from the IV etimation to enure all right-hand-ide variable, except thoe we intrument, are pre-determined. 14 WP534 Labour reallocation and productivity dynamic: financial caue, real conequence

21 ector. In other word, labour reallocation i quantitatively the main channel through which credit boom affect productivity. Moreover, thee reult hold pretty much unaltered if credit boom are meaured with the credit gap. Intrumenting credit boom and employment growth Table 7 Private credit to GDP growth Average private credit to GDP gap (i.a) (ii.a) (iii.a) (iv.a) (i.b) (ii.b) (iii.b) (iv.b) Productivity growth 0.137*** (0.0464) Employment growth 0.681*** (0.158) Initial private credit to GDP Government conumption to GDP Openne to trade CPI inflation Initial GDP per peron employed (log of) J-tat p. value LM-tet p. value (0.0378) 0.841** (0.353) 0.177** (0.0896) 0.598*** (0.215) 0.155** (0.0668) (0.324) (0.001) Common (0.0581) 0.934*** (0.175) (0.0425) 0.737* (0.401) 0.259*** (0.0884) 0.468** (0.214) (0.0711) (0.572) (0.001) Allocation *** (0.0268) 0.253*** (0.0938) (0.0223) (0.217) * (0.0422) (0.141) 0.136*** (0.0466) (0.683) (0.001) Emp.-driven Productivity Allocation growth *** (0.0309) 0.351*** (0.0957) ** (0.0243) (0.225) ** (0.0388) (0.122) 0.164*** (0.0480) (0.913) (0.001) 0.188*** (0.0685) 0.873*** (0.187) (0.0337) 0.718* (0.386) 0.219** (0.100) 0.787*** (0.274) 0.129* (0.0735) (0.700) (0.0048) Common (0.0750) 1.012*** (0.178) * (0.0323) 0.697* (0.385) 0.276*** (0.0858) 0.556** (0.246) (0.0692) (0.715) (0.0048) Emp.-driven Allocation Allocation 0.107*** (0.0361) (0.102) (0.0177) (0.227) (0.0534) (0.161) 0.120** (0.0470) (0.863) (0.0048) 0.102*** (0.0395) 0.241** (0.0947) (0.0167) (0.217) (0.0477) (0.132) 0.148*** (0.0449) (0.996) (0.0048) Obervation R-quared Note: Thi table report the etimated coefficient for independent variable reported in the firt column from an IV regreion where the dependent variable i aggregate productivity growth (column (i.a) & (i.b)), the common (column (ii.a) & (ii.b)), the allocation (column (iii.a) & (iii.b)), the allocation due to employment hock ((column (iv.a) & (iv.b))). The common and the allocation are computed baed on decompoition (1) while the employment-driven allocation i computed uing decompoition (16). Growth rate and average are computed uing 5-year window. Employment growth and private credit to GDP growth or the average private credit to GDP gap are intrumented uing the beginning-of-period value for the long-term interet rate, the hort term-interet rate, the current account balance to GDP, the level and change in the financial liberaliation index (ee Abiad et al (2008)). Etimation period: All etimation include country and time fixed effect. Robut tandard error are in parenthee. Statitical ignificance at the 1%/5%/10% level repectively i indicated with ***/**/*. 4. Financial crie, labour reallocation and productivity growth During credit boom labour tend to be reallocated into indutrie with low productivity growth. But what happen afterward? Will miallocation perit and WP534 Labour reallocation and productivity dynamic: financial caue, real conequence 15

22 perhap beget further miallocation? Or will the effect revere? More importantly, how do thee effect depend on the ubequent occurrence of a financial crii? To addre thee quetion, and to enure that the analyi i epecially relevant for the current pot-crii period, we hift our focu omewhat from a panel of 3- or 5-year window to a cro-ection of economic downturn. We ditinguih between "normal" downturn and thoe that coincide with financial crie. Thi i important becaue the reult are likely to be different. For intance, Jorda et al (2013) find that receion aociated with financial crie are particularly deep and recoverie after downturn aociated with credit boom particularly hallow. The impact of credit boom on the miallocation of labour documented in the previou ection may provide a mechanim behind thee finding. 4.1 Methodology We tart by identifying receion, defined here a turning point in real GDP per working-age population, in our ample of 21 advanced economie. 16,17 Our panel thu include 80 turning point (Table 8). Then, building on Jorda (2005), we conider for each country-receion year pair it ;, the ubequent path of labour productivity, ie yit, h/ lit, h; h 0, where y it, h and l it, h repectively denote GDP and the number of peron employed in country i, h year after the tart of the year-t receion. Our dependent variable will thu be the percentage change in labour productivity relative to the tart of the receion conidering time horizon h running from 1 to 8 year, ie y y / l it, h it, h / l it, it, ; h 0,1,...,7,8. Two point concerning the ample contruction are worth mentioning. Firt, ince receion are relatively rare event, we lengthen the ample by beginning in 1969, rather than in 1979 a done previouly, in order maximie the number of receion. Importantly, tarting in 1979 doe not change our finding, but it doe ignificantly reduce the ample ize, from 80 down to 59 epiode (the reult are available on requet). 18 Second, ince our indutry data top in 2009, we rely on macroeconomic data to compute aggregate productivity. Critically, thi allow u to include in the ample the mot recent receion, in particular thoe that hit in Thi alo mean that etimation for the 7- and 8-year horizon which ue productivity figure for 2015 and 2016 partly rely on forecat of real GDP and employment. 16 We focu on real GDP per working-age population to filter for output fluctuation related to change in demographic. 17 We impoe two retriction to identify receion date. Firt, we require turning point in real GDP per working-age population to be local peak, ie that the growth rate prior to the receion date be poitive and the growth rate following the receion date be negative. Second, we exclude double dip, ie we require real GDP to working-age population for a given turning point to be higher than real GDP to working-age population at the previou turning point and lower than at the following turning point. 18 We could not have done a comprehenive analyi in the firt part tarting in 1969 becaue indutrylevel data are not available for a number of countrie in the ample. Fortunately, however, they are available for all thoe that did experience a receion between 1969 and WP534 Labour reallocation and productivity dynamic: financial caue, real conequence