To comprehend downsizing, and how it went from a sign of failure to an indication of future success, it must first be understood why the firm's management would use the size of the labor force to manipulate the value of the firm. In the early 1990s, CEOs and executive management were being viewed more and more as servants of the shareholders. The merger wave of the 1980s taught executives that any company trading at a price-earnings multiple lower than the industry-wide multiple was considered undervalued, or a poor-performer, and ripe for a takeover, or messy shareholder law suits. CEOs used to be concerned with optimizing production and cutting costs, which they hoped would engender profits and therefore shareholder wealth. Now the focus had turned to building shareholder wealth more directly, by simply boosting the stock price, therefore doing whatever was necessary to convince the market that the stock price should rise. This could become problematic, as swings in the level of profits don't necessarily correspond to changes in the stock price from day to day or year to year. The stock price had become more and more important in the daily decisions of executives, as more and more companies were paying the bulk of executives' salaries in stock options and stock itself. Therefore, to maximize their salaries, CEOs had more of an incentive to take measures that would convince the market of the upward potential in their stock prices. Such measures could be real or artificial methods to boost firm value; all that matters is for them to be believable. In other words, it doesn't really matter if a project is profit generating; it only matters if the stock market believes the project will make money. To the extent that the investors are not stupid, and have perfect information about the project (expectations of profitability are in line with actual future profitability), there are no problems.

Afraid of losing their jobs, many CEOs looked for a quick fix to boost accounting profitability, with less regard to the long-term profitability of the strategy. For example, an executive concerned with sagging earnings in the current quarter might have had an incentive to undertake a project that would boost earnings in that quarter, but decrease expected earnings in future quarters. Such a move, even if negative in the net present value sense, could potentially have a positive impact on the stock price if the investors' probability distribution over expected future earnings (or losses) due to the strategy differed from that of the management. This situation could arise especially if the negative long-term implications were unclear to the market, or clearer to the management than to the market. This is a problem of asymmetric information between the management, which has more information pertaining to the health of the firm, and the owners.

Executives looked at the balance sheet to trim the fat, and viewed cutting labor as a necessary and relatively painless method to boost profit margins. The economy was experiencing the sort of growth that made both skilled and unskilled labor more and more superfluous. At the low end of the wage and skill scale, advanced automation in machinery and assembly were enabling workers to become more productive, and reduced the amount of workers necessary for a given level of profit. At the middle end, rapid advances in information technology reduced the need for a large layer of middle management to process and interpret data and feed it to higher management. Company Intranets and purchase systems reduced the need for middle management to compile and supervise the processing of data. To a lesser extent, many tasks not related to the core production or service of the firm were cut, and contracted out to consultants.

Additionally, trimming the payroll liability seemed an easier way to increase profits in the short term. The payroll is basically a current liability, and to the extent that workers are not engaged in long-term contracts (or to the extent that a long-term contract with a substantial number of employees is soon to expire), the firm has a certain flexibility in determining the amount of labor it uses in the short run. A move to adjust employment might be a relatively painless way to boost cash flow, when compared to selling land or equipment to obtain cash. A buyer might not be readily available, and the purchase price would not be certain.

At first, companies that were performing poorly relative to other firms in their industry divested assets to generate cash. When this did not engender results, many searched for a quick solution that would be easily perceived by the stock market, and have an immediate effect on the profit and loss statement. Substantial investment in research and development, or employee training programs are examples of strategies that would be poor choices to accomplish this goal, no matter how profitable they would seem. News of an employee training program or a complete overhaul of the firm's outdated computer inventory control system would not be exciting enough to be considered "news" that would be reportable or have a major impact, particularly if the benefits would not be realized for another year or two. Also, such a strategy would be expected by the market as something necessary to compete with other firms, and would not greatly impact the market's perception of the firm's value. Downsizings have everything a CEO could want: they are tragic and newsworthy, and they get the word out that the company is serious about its cash flow.

It remains quite difficult to lay the blame entirely on CEOs and executive management for what seem like unnecessary cutbacks on the payroll. They would not be executing such strategies if they didn't believe that the market would react positively. Forget for a moment the actual impact of a reduction in the payroll to the firm's heath-the only important factor is the impact perceived by the market. If the general consensus is that firms should be hiring workers to increase profitability (perhaps there is a scarce amount, and firms had better grab the talent now before it is gone), then there would be no incentives for CEOs to downsize-even if firing workers would help the firm's bottom line.

At first, firms that were lagging their competitors in terms of accounting earnings and price-earnings multiples decided to downsize. As these firms began to catch up to the rest of their industry in terms of profitability, firms that were performing quite well also began to turn to downsizing as a way to convince the market that they were worthy of a substantial jump in market capitalization. The first major downsizing was done by GE, now one of the Dow's best performers. During the 1980s, GE released 104,000 of its 402,000 workers in a move to stay competitive. While this number may seem misleading due to shifts between capital and labor inputs in production, as well as the wide range of businesses in which GE engages, consider Digital Equipment Corp., which cut 10% of its workforce in 1992 to remind the market, that relative to the rest of the industry, it was willing to do everything necessary to remain cost-competitive. From 1993 to 1996, there was a sentiment in the market that smaller up-start companies were going to overtake the larger, blue chip corporations, which were perceived to be bloated with superfluous workers and internal red tape. Although these rumors of diseconomies of scale were widely exaggerated, many large corporations slashed their labor force in a move to maintain an aura of competitiveness.

From 1993 to 1996, unemployment fell from 7.1% to 5.1%, and 8.6 million jobs were created, mostly in the range above the median salary in the US. In particular, in 1996, 1 million jobs were created, and on average paid more than currently existing jobs. Despite these encouraging economic statistics, corporate America was quick to remind Wall Street of how major restructurings were going to be achieved by slashing workers. Over the same period, in which unemployment fell by two whole percentage points, and close to a billion jobs were created, many major corporations announced plans to downsize. This could suggest that workers were being assigned to new sectors of the economy, and that the economy was shifting from having workers concentrated in a few large corporations to having workers dispersed throughout many small firms. A Los Angeles Times article pointed out that the paradox of falling unemployment and rising downsizings could be explained by the fact that "small, technology-savvy enterprises are replacing the behemoths of old."

One perfect example of this is Delta Airlines (which will be discussed in Chapter VII), which downsized 20% of its workers. Some of the ousted higher-level workers formed a consulting firm that performed operations analyses for airlines, including Delta. So while the downsized employees were essentially performing their old jobs for their former employer, the BLS would measure this event as job creation in one sector and job destruction in another. It's difficult to determine whether firing workers and re-hiring them as consultants actually was a wealth-creating move for Delta's shareholders. On the one hand, Delta was released from the costs of maintaining the workers (health care, pension contributions), but on the other hand, Delta was implicitly still paying for these costs in the consulting fees it remitted. Also, the consultants were not doing dedicated work for Delta any longer: their experience at Delta could be applied to a client like United, and if the consultant ever got busy, Delta would have to wait its turn behind other airlines in the queue for its former employees' services.

This phenomenon, known as "outsourcing," effects both managers and the rank-and-file workers. For example, baggage handlers for Delta who used to make $21,000 per year were fired, and re-hired by an independent contractor that Delta engaged to perform its baggage handling services at several airports. The workers took a 35% cut in pay and lost most of their benefits from this move.

In 1984, the 500 largest companies in the US employed well over 14 million people. Ten years later, in the midst of the downsizing craze, they employed less than 12 million. The largest private employer in the US went from General Motors to Manpower Inc., which is a temp agency providing labor services to various firms. The costs associated with temporary labor might be more attractive. A corporation can dispense with a temp job without all of the expenses that accompany hiring and firing permanent staff. Elaborate recruiting, benefits packages, and severance pay are no longer necessary. Temporary help and outsourcing are frequently utilized in payroll, janitorial, advertising, or distribution services. A firm would rather hire a contractor with outside experience than maintain its own in-house labor.

With the phenomenon of re-employment and outsourcing, downsizing is not expected to effect profitability at all. The same people were doing the same job at more or less the same cost. Without re-employment, salaries would be bid down as too many workers chase after too few jobs. Yet, the labor data proves that this was clearly not the case for the US economy during the downsizing craze. Therefore, examples such as Delta demonstrate that the effect of a downsizing might not be as negative for employment or as positive for firm value as would be expected. However, this does not at all indicate that downsizings do not have an impact on people's perception of the employment market. For example, a story "Delta slashes 20,000 jobs" will more likely appear in a newspaper than a piece entitled "Delta contracts with 200 consulting firms that each employ an average of 100 people." Net employment has not at all changed, but the perception of unemployment has changed, especially if only the first story is reported. The next sections explain the strategic effects of downsizing in the macro-economy.

Traditionally, changes in the payroll of a firm were a direct result of changes in the demand for that firm's products. During a boom, the firm would hire as many extra workers as possible in order to accommodate the perceived increase in demand for its products. Should a recession occur, the perceived fall in demand indicated that the firm would be selling fewer products, and should therefore produce fewer items. The need to curtail production meant that a certain percentage of the labor force would be superfluous, and would therefore need to be released. Such a labor strategy will be referred to as traditional layoffs: the precursor to modern downsizing.

Firms could also add or remove workers based on changes in the marginal productivity of capital or labor, given that demand was constant. If worker productivity increased, the firm would need a smaller headcount in order to produce the same output. Presumably, the workers would be compensated for their increased productivity, so the total wage bill of the firm would not change when a certain number of workers were fired. If the wage bill and demand do not change, then presumably profitability and cash flow will be stagnant, as will the stock price. This example is of no interest to the shareholder, who is only concerned with the total wage bill and the total output, and not how many workers are needed to arrive at that output, per se.

The downsizing observed in the 1990s has generally fit neither of these categories. The shareholders would be concerned by the traditional sort of downsizing, in which the firm lays off workers during a slump in demand for the product; this is called downsizing for survival. The downsizing of the current decade has been something altogether different, as downsizings seem entirely strategic in nature. Particularly, the massive downsizings of corporations when they are at their most profitable, and most dominant in their markets do not fit the traditional image of a layoff.

For example, most downsizings took place in late December or early January. This includes firms whose sales are seasonal with Christmas-time demand, such as Sears, and firms whose business is not, such as AT&T, Bank of America, Kimberly-Clark, RJR Nabisco, and Xerox. It seems rather suspicious that the hypothesis of demand-driven layoffs could explain why most downsizings are clustered around the end of many firms' fiscal years. This phenomenon lends itself to the strategic explanation of downsizing. Downsizing appears to be an effective technique in making the next fiscal year's earnings look better in relation to the current fiscal year by expensing millions of dollars related to severance pay in the current year. Although these expenditures will be made in the following year, they will not appear in the following year's income statement. Net income in the current accounting period will be horrendous, and net income for the following year will be impressive. The CEO can then claim that net income grew as a result of his downsizing and cost-cutting techniques, but this is really a question of the chicken and the egg.

The traditional explanation of layoffs completely fails to explain employment policy for many companies, since very few of these companies were in the financial dire straits that traditional layoffs try to correct. For example, Procter & Gamble's downsizing came as it announced a record $2.65 billion operating profit, and had the best returns on equity in its core businesses. Its stock price had doubled over the course of the year.

Generically, downsizing will be modeled as an example in which no wage bargaining will take place at all between the workers and the management. The firm can hire as many or as few workers it wants at a market wage required by the labor force. In this respect, the company is a "price taker" for labor. Abstracting away from the strategies of unions and workers, the downsizing models in this thesis will specify games between the management and the owners that determine firm value, in which one of the strategies of the management is to manipulate the level of employment. In this case, the level of employment is sort of a by-product, externality, or outcome to the result of the game, in which workers are rather powerless to determine their future employment status. Downsizing is defined in the popular press as a situation in which a firm slashes its work force tremendously (higher than 10% of active full-time employees) as a measure to improve profits, regardless of the financial position of the firm. For the purposes of this thesis, downsizing will be the case in which the firm chooses the amount of people on its payroll as the variable that maximizes the stock price. The firm is in a perfectly competitive industry, and acts as a price taker. Its choice of the level of employment determines how much it can produce and sell at the given price, and therefore, what its profits will be.

The concept of downsizing can have a longer-term and perhaps subtler effect on the labor force. Management can repeatedly threaten to wield the job-cutting axe, and to the extent that workers believe that the threat is credible, they will be less bold in asking for salary raises. Management clearly has an incentive to reduce the wage bill. As many participate in profit-sharing plans, and stock options, the lower the wage bill (for a given output and productivity level), the higher the profits. The incentive is clearly for management to portray a doom-and-gloom attitude about the state of the firm to its workers, while conveying a rosy outlook to its shareholders.

The years 1993 to 1997 provided the labor force with almost idyllic settings. Unemployment dropped significantly, and the jobs being created were at higher salaries than the average of what already existed. Yet, highly publicized downsizings instilled an almost irrational fear in the work force of impending and wide-spread layoffs. In a study by The New York Times following the AT&T downsizings, 75% of households reported a close encounter with a job layoff in the past fifteen years. One third of the respondents knew someone who had recently lost a job or had been laid off, while 10% of those surveyed claimed that a job loss had "precipitated a major crisis" in their lives. An article in The Denver Post read: "[This] is an explosive social backdrop for new massive job losses through downsizing in the developed world. In America, it is time for government to bring businesses, finance, and labor together for discussions on compensation packages to prevent workers from bearing the entire cost of downsizing while shareholders take all its profits." Such a dire account of the state of the labor market seems more applicable to the Great Depression than to a booming economy. "Nobody's safe anymore," announced Maine's Portland Press Herald. The Austin American-Statesman proclaimed "Millions run scared in today's workplace."

This relates to the issue of perceptions in the labor market. If newspapers report massive job cuts, and don't report the wide-scale hirings, perceptions of unemployment might be higher than actual unemployment. Workers might assume that the probability of their being unemployed is greater than it actually is. Blanchflower suggests that the equilibrium wage should tend to rise in this situation. Workers who perceive a high chance of being laid off should receive a wage premium for their willingness to be employed in a risky position. In the Blanchflower world, the fear of downsizing increases the aggregate corporate wage bill in the economy. For a given revenue stream, this will lower profits and shareholder value. In such a model, downsizing is a horrible strategy for the management to undertake as it increases the wage bill. The counter-argument proposed by Rosen seems to explain wage inflation in the US better than the Blanchflower model. Rosen suggests that the fear of unemployment will tend to lower the equilibrium wage, as workers are afraid to ask for raises, since they believe that there are many unemployed individuals who would be more than happy to replace them in their jobs at a lower wage. Additionally, those seeking work are willing to return to employment at below-market wages, which are still better than unemployment benefits. In the Rosen model, the perception of downsizing bids up equity values. The more that workers believe that downsizing is prevalent, the lower the wage bill for a given revenue. This tends to increase profits, and therefore the value of the company.

If anything, downsizing appears to be a nation-wide scare tactic, and one that worked for a long time. The Conference Board conducts a monthly economic survey, asking respondents to characterize the labor market six months from the survey date as "more jobs," "fewer jobs," or "no change." Despite impressive economic growth during the era of downsizing, more respondents claimed that there would be fewer jobs in the near future. Once the AT&T downsizing had captured widespread media attention, 20% of those surveyed predicted fewer jobs (up from 16% the previous month), while 11% estimated there would be more jobs (down from 14% the previous month). Such a dire change in outlook (see the "spike" in the time series at January 1996 in Figure II.1.) remains completely unjustified by the promising economic news that was released at the time.

A study by President Clinton's Council of Economic Advisors reported in late April 1996 that Americans' fears of corporate downsizings "could be overstated" given that two-thirds of jobs created since 1994 pay above-average wages. Job reductions were found to have risen slightly, but were outpaced by higher-paying "quality" jobs. As this report was released during an election year, the Dole campaign countered that it was a politicized report designed to boost Clinton's poll ratings. Still, a survey in the report revealed that a growing number of Americans feared downsizings, and cited AT&T's much-publicized decision to cut 40,000 workers. The study was conducted in April of 1996, two months after AT&T had revised that number to 18,000 workers, and actually had only fired less than 1,000 by that time.

Perhaps this widespread fear, however unjustified it is, may explain why wages have not inflated as a response to tightness in the labor market as they have historically. The standard macroeconomics states that a rise in aggregate demand will increase the demand for inputs such as labor. To induce more workers to join the labor force, wages should rise. Both the wage increases and the price hikes stemming from stronger aggregate demand are supposed to cause inflation. Yet, a rise in prices does not seem apparent as a result of the robust economy. To the extent that the economy is strong and at the same time exhibits little inflationary pressure is ideal for equity values. In the formula for the price of a share of stock, the numerator (expected future earnings) rises as firm earnings are expected to rise, and the denominator (the rate at which cash flows are discounted) falls as inflation falls. A rising numerator and falling denominator indicates, without ambiguity, a higher share price.

Perhaps sentiments in the labor market generated by downsizing are causing this phenomenon. Workers are not reacting to tight employment in the manner textbooks claim they should. The Conference Board's survey is a fairly reasonable proxy for the sentiments of workers. The null hypothesis is that expectations of the future state of the job market cannot predict the change in inflation, from month to month. This hypothesis is rejected at the 95% level of the modern US economy. Regressions demonstrate the changes in the inflation rate are negatively correlated with the percentage of workers who feel that the outlook for jobs is poorer, over the period 1980 to 1997. In other words, as the number of workers who are pessimistic about employment prospects in the economy rises, the change in the inflation rate over that period falls, all things equal. Specifically, for every one-percentage point of workers that anticipate more layoffs than hirings, the rise in inflation slows down by 1.3 basis points (standard error 0.36 basis points, regression 1). The full regression output is included in the appendix of the thesis (Chapter X). A similar result is obtained for expectations six months in advance: for every pessimistic worker out of 100, the rate of inflation falls by 0.9 basis points (standard error 0.21 basis points, regression 2).

To verify that this relationship is a result of the perceived derived demand for labor not a result of the industrial production itself, the rate of inflation was regressed on the change in the government's industrial production index, as well as the Conference Board statistics on expectations in the labor market. Industrial production was not statistically significant for the current economy, or the economy expected six months from that date, while the job data retained its statistical significance at the 95% level (regressions 3 and 4).

Geoffrey Tootell, an economist with the Boston Federal Reserve has studied this phenomenon. Tootell wanted to test if the recent downsizing craze has increased the natural rate of unemployment in the economy. He regressed perceived changes in the NAIRU on two phenomena that have been the subject of debate recently. The first are massive job cuts in the military and defense industries, and the second (and related observation) is the geographic mis-match in the economy: some regions have many job openings, and others profess tight labor markets. Supposedly, large downsizings in concentrated areas would cause great variation in regional unemployment and might increase the NAIRU. Tootell was forced to accept the hypothesis that the military downsizing had no effect on the NAIRU.

The effects of downsizing on stock value now seem more evident. The effect on un-discounted cash flow depends on perception: does the market consider the firm repositioning itself to accommodate greater market share, or does the market believe the firm is reducing capacity to brace for a downturn in demand? This effect is firm or industry-specific. Yet there exists a subtler effect of downsizing that is economy-wide, and that is the effect of downsizing on the rate that the cash flows of a share of stock are expected to generate. Anecdotal and empirical evidence suggests that fear of downsizing, whether legitimate or not, will put downward pressure on inflation (workers are less bold in asking for pay raises) and therefore the rate used to discount cash flows.

While this analysis serves to explain what impact downsizing in general will have on stock prices in general, a framework needs to be developed to account for how the downsizing of one company will alter the equity value of that particular company. The next chapter presents an event study that measures the effect upon the stock price of a downsizing announcement.