Credit Cycles, Expectations, and Corporate Investment

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.