Credit Cycles, Expectations, and Corporate Investment

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

Keywords: Credit-market sentiment, credit cycles, corporate investment, over-extrapolation

JEL Classification: E32, E44, G02, G12, G31