Financial Aspects of Business Cycles: An Analysis of Balance Sheet Adjustment of U.S. Financial Enterprises over the Twentieth Century

Abstract

This paper formulates and tests a model that describes the asset and financing adjustments of U.S. non-financial enterprises over the twentieth century. Asset adjustments change the expected income and operating risk of firms while financing adjustments change the financial risk. To protect debt and equity investors from a conflict of interest problem, an up-front contract develops an assignment rule for managing the firm's balance sheet whereby managers make investment decisions that conform to the risk aversion of their stockholders and financing decisions that offset changes in operating risk resulting from the investment decisions. This contract induced assignment rule resolves the conflict of interest problem between bondholders and stockholders and coalesces their welfare over the business cycle. Empirical evidence fails to reject the predictions of the model.