Credit Cycles, Expectations, and Corporate Investment

81 Pages Posted: 8 May 2019 Last revised: 18 Mar 2021

See all articles by Huseyin Gulen

Huseyin Gulen

Purdue University - Krannert School of Management

Mihai Ion

University of Arizona - Department of Finance

Stefano Rossi

Bocconi University; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

Date Written: March 10, 2021

Abstract

We provide a systematic empirical assessment of the Minsky (1977) hypothesis that business
fluctuations are due to irrational swings in expectations. We build an aggregate index of irrational
expectations using predictable firm level forecast errors and use it to provide three sets of results.
First, we show that such an index of irrational expectations drives aggregate credit cycles. Next,
we build an aggregate index of predictable credit cycles as the portion of credit cycles predicted
by irrational expectations, and we show that such index drives cycles in firm-level debt issuance
and investment. Finally, we show that after increases (re., decreases) in credit market sentiment
firm-level financing and investment cycles are more pronounced for firms with ex ante more optimistic (re., pessimistic) expectations. Financial constraints do not have additional explanatory
power for firm-level cycles in the cross section once irrational expectations are considered. We
rationalize these results within a parsimonious dynamic Q-theory model with risky debt in which
both corporate managers and credit investors hold diagnostic expectations.

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

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

Suggested Citation

Gulen, Huseyin and Ion, Mihai and Rossi, Stefano, Credit Cycles, Expectations, and Corporate Investment (March 10, 2021). Available at SSRN: https://ssrn.com/abstract=3369295 or http://dx.doi.org/10.2139/ssrn.3369295

Huseyin Gulen

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

Mihai Ion

University of Arizona - Department of Finance ( email )

McClelland Hall
P.O. Box 210108
Tucson, AZ 85721-0108
United States
5206210737 (Phone)

Stefano Rossi (Contact Author)

Bocconi University ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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