Tuesday, August 29, 2017

More about leverage and the business cycle

What is the actual evidence for the Austrian business cycle/Minsky idea that businesses are induced to leverage up during expansions, which becomes unsustainable, and eventually must lead to a disciplining contraction?

The evidence seems to me to loudly proclaim the opposite.

Here is a chart of corporate leverage and changing profit margins.

The red line is nonfinancial corporate debt as a proportion of operating profits, net of tax.  The grey line is the YOY percentage change in real operating profits.

It seems clear to me that firms tend to deleverage through expansions.  Where leverage rises, it is generally associated with falling profits that are usually a leading indicator of a coming recession.  The explanation for this seems obvious.  Firms confront negative profit shocks, which cause their balance sheets to shift out of equilibrium.  They cut back on investment in order to try to pull leverage back down to the comfortable level, which over time seems to have moved between about 4x to 6x operating income.  After the contraction, profits rebound, and firms use that expansion to finally allow their leverage to decline.

Here is a graph of these same two series.  Here I have converted the leverage measure so that it also is a measure of the YOY change.  Then, I created a scatterplot of these two series.  Could this be more clear?  Firms clearly deleverage when profits rise.

The change in profit is on the x-axis and the change in leverage is on the y-axis.

Notice where zero is on the x-axis.  There are only a few quarters where leverage as a proportion of operating profit increased moderately during periods of moderate profit growth.  Overwhelmingly, during expansions, firms deleverage.


  1. https://www.fnlondon.com/articles/el-erian-the-lost-lesson-of-the-financial-crisis-20170818?link=TD_mansionglobal_articles.a2aa4e199540b4fe&utm_source=mansionglobal_articles.a2aa4e199540b4fe&utm_campaign=circular&utm_medium=FINNEWS

    I think you disagree with the above…yet I wonder if helicopter drops are an answer

    1. If the Fed agreed with your premise for helicopter drops, they would be doing regular MP and we wouldn't need helicopter drops.

  2. I like this. Key point is that "leverage" depends on denominator as well as numerator and often -- as here -- the denominator is where most of the action is.

    Also think FIH is profoundly anti-Keynesian idea. Implies that problem is excess optimism of boom rather than excess pessimism of slump.