Credit Cycles, Expectations and Corporate Investment
Author(s):
Huseyin Gulen (Purdue University)
Mihai Ion (University of Arizona)
Candace Jens (Whitman School, Syracuse University)
Stefano Rossi (Bocconi University)
Journal:
Review of Financial Studies (2024)
Summary:
We examine earnings forecasts from equity analysts and show that periods of time during which forecasts are predictably erroneous front-run declines in firm investment and debt issuance.
Research Questions:
Can we tie a firm-level measure of over-optimism about firm fundamentals to subsequent firm investment and debt issuance and provide empirical support for the theories in Minsky (1957, 1977)?
What We know:
Minsky (1957, 1977) theorizes that recessions are caused by overinvestment by firms and overextension of credit by lenders. During bull markets, runs of good news regarding firm fundamentals result in overly-optimistic firm managers and investors. Excessive optimism drives an excessive decrease in the cost of capital, inducing managers to borrow and invest too much and increasing the overall fragility of the economic system. As the fragility of the system increases, any disappointing news can trigger abrupt reversals in credit and investment and bring about a recessionary period. According to Minsky (1957, 1977), large investment and debt issuance by firms during booms sows the seeds of subsequent downturn.
Novel Findings:
We examine earnings forecasts from equity analysts and show that predictable errors in these forecasts predict cycles in aggregate firm investment and debt issuance. These predictable errors are a measure of over-optimism about firm fundamentals as Minsky (1957, 1977) describes, so these results provide direct empirical support for the theories in Minsky (1957, 1977). We also examine the investment and debt issuance of financially constrained and unconstrained firms and show no differences between cycles in these firms. The similarity of cycles between financially constrained and unconstrained firms demonstrates over-optimism on the part of both firm managers and investors, which is key to Minsky’s theory. Finally, we show that firms for which there are the largest predictable forecast errors, on average, show the greatest subsequent reversal in investment and debt issuance. These findings allow us to demonstrate, at the firm level, a connection between over-optimism and subsequent declines in firm investment and debt issuance, as Minsky (1957, 1977) predicts.
Implications for Policy:
An important question in discussions of monetary policy is whether unstable capital markets have the potential to self-stabilize or whether monetary authorities need to take corrective actions. Alan Greenspan and others have famously argued in favor of minimal policy interventions to allow markets to self-regulate in the face of booming capital markets. This view is clearly correct whenever an excess demand for financing by over-optimistic managers is met with an increase in the cost of capital brought about by rational capital suppliers. This view is also correct whenever excessively low credit spreads are exploited by rational managers who issue debt and use the proceeds to buy back shares, restoring stability in capital markets while doing so.
Our results imply that buoyant capital markets often go hand-in-hand with over-extrapolation by managers who respond to low credit spreads with excessive debt issuance and excessive real investment. Thus, financial market booms plant the seeds for their own demise, bringing about subsequent reversals and further instability down the road. Not only does over-extrapolation blur the traditional forces of supply and demand, but it also obfuscates the workings of otherwise rational arbitrage. Our results suggest that the presence of financially unconstrained firms that overwhelmingly keep issuing securities and investing in the face of low spreads and unclear investment opportunities represents a clear sign of over-heating in capital markets. Such over-heating may warrant close scrutiny by monetary authorities, with a view of considering undertaking corrective actions.
More broadly, our results indicate the need to incorporate biased beliefs in a realistic theory of business cycles. Two facts point us in this direction, namely, the strong empirical role of irrational expectations, both in the aggregate and in the cross section, and the fact that financial frictions do not have additional explanatory power once irrational expectations are considered. These pieces of evidence indicate that a realistic theory of belief formation should be a key ingredient of a realistic theory of business cycles.
Full Citation:
Gulen, Huseyin, Mihai Ion, Candace E. Jens, and Stefano Rossi, 2024. Credit Cycles, Expectations, and Corporate Investment. Review of Financial Studies, forthcoming.
Abstract:
We provide a systematic empirical assessment of the Minsky (1957) hypothesis that business fluctuations stem from irrational swings in expectations. Using predictable firm-level forecast errors, we build an aggregate index of irrational expectations and use it to provide three sets of results. First, we show that our index predicts aggregate credit cycles. Next, we show that these predictable credit cycles drive cycles in firm-level debt issuance and investment and similar cycles between financially constrained and unconstrained firms, as Minsky (1957, 1977) predicts. Finally, we show more pronounced cycles in firm-level financing and investment for firms with ex ante more optimistic expectations.