Financial Aspects of U.S. Business Cycles : An Analysis of Balance Sheet Adjustments of U.S. Nonfinancial Enterprises Over the Twentieth Century

This paper formulates and empirically tests a model that describes the balance sheet adjustments of debt and equity financed U.S. nonfinancial enterprises over the twentieth century. In this model 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. That assignment rule has managers making asset adjustment decisions that conform to changes in the risk aversion of their equity investors as revealed to them by changes in equity share prices. These asset adjustments by themselves and then through the production function cause business cycles. Financing adjustments are then made to insulate bondholders from changes in operating risk initiated by the investment decisions of firms. In this way the contract induced assignment rule resolves the conflict of interest problem between bondholders and stockholders and in the process coalesces their welfare over the business cycle. The model makes several important predictions about the balance sheet adjustments of firms. One prediction is that firms adjust their assets in response to changes in lagged stock prices as they proxy for changes in stockholder risk aversion. A second prediction of the model is that long-term financial leverage is countercyclical; i.e., an increase in risky capital investment that causes a cyclical expansion is financed with equity, while reductions in investment that cause a recession is supported with debt. These and other predictions of the model are not rejected by the intertemporal balance sheet data for U.S. nonfinancial enterprises over the twentieth century