Leverage Risk and Investment: The Case of Gold Clauses in the 1930s

Abstract

We study the impact of the 1933 abrogation of gold clauses on the slow recovery of corporate investment following the Great Depression. Legal challenges to the constitutionality of abrogating gold clauses exposed many firms to the possibility of a 69% increase in required payments to bondholders. We show that public firms with higher exposure to this risk reduced their investment in 1933 and 1934. For these firms, investment recovers quickly following the Supreme Court’s 1935 decision to uphold abrogating gold clauses. In the cross-section of firms, decreases in investment over 1933 and 1934 coincide with an increase in equity payouts. Our estimates imply that the risk of higher financial leverage accounts for about one-third of the decline in aggregate divestment by public firms over 1933 and 1934. This channel complements existing explanations of the slow recovery based on bank credit supply which public firms did not rely on.

Keywords: Great Depression, investment, debt overhang, indexed bonds, leverage risk

JEL Classification: G01, G32, G33, G35, N12, E50, E22