Leverage and Bubbles: Experimental Evidence

25 Pages Posted: 7 Jan 2019 Last revised: 12 Feb 2020

See all articles by Paul Gortner

Paul Gortner

Leibniz Institute for Financial Research SAFE

Baptiste Massenot

University of Toulouse - Toulouse Business School

Date Written: February 10, 2019

Abstract

We investigate the effect of leverage on bubbles in an asset market experiment. We expect higher leverage to produce larger bubbles because (i) it creates moral hazard in a setup with limited liability and (ii) it increases aggregate liquidity. Inconsistent with the moral hazard channel, which we test by holding aggregate liquidity constant, higher leverage does not produce larger bubbles. To understand this unexpected result, we run the same experiment with a different framing: instead of repaying debt, participants can earn a bonus. This bonus treatment produces larger bubbles, suggesting that more leveraged participants trade more cautiously to avoid default. Finally, bubbles are larger and increase over time when we keep leverage constant over time by injecting liquidity in the economy. Overall, these results suggest that higher leverage inflates bubbles not because of moral hazard but because of more abundant liquidity.

JEL Classification: G28, E58

Suggested Citation

Gortner, Paul and Massenot, Baptiste, Leverage and Bubbles: Experimental Evidence (February 10, 2019). SAFE Working Paper No. 239, Available at SSRN: https://ssrn.com/abstract=3311378 or http://dx.doi.org/10.2139/ssrn.3311378

Paul Gortner

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Baptiste Massenot (Contact Author)

University of Toulouse - Toulouse Business School ( email )

20, bd Lascrosses
BP 7010
Toulouse, 31068
France

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