Real Credit Cycles
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Managers’ expectations often overreact to current conditions, leading to excessive optimism during economic booms and undue pessimism during downturns, significantly impacting credit cycles.
“…Despite its nonlinearity and the overidentified estimation with more target moments than parameters,our DE model captures both the volatilities of, and to a large degree the correlations between, real variables, beliefs, and financial outcomes in the firm data. To assess the role of overreacting expectations on macro outcomes,we also estimate and simulate a rational expectations (RE) model with θ fixed at 0, which does not match predictable forecast errors at the firm level…. Figure 4 plots the required TFP shocks, along with their implications for the growth of credit, output, investment, and corporate profit forecasts. The red lines connect the pre-crisis and crisis outcomes generated by the DE model, while the green lines present the data. In the top left panel, theDE model by construction perfectly matches the pre-crisis and crisis spreads. Remarkably, though, the bottom left panel shows that the pattern of TFP growth needed to account for the increase in spreads is virtually identical to the TFP growth observed during the period. This overlap is an untargeted feature and shows that in the DE model a moderate 1.5% reduction in TFP growth is able to produce the large observed increase in the average spread….”
New Shleifer, in the spirit of his last book (which largely mirrored the Minsky/Kindleberger view of boom bust cycles) argues that credit cycle basically work the same way - investors are too optimistic, so credit and investment overexpand. Subsequently, beliefs cool off, credit markets tighten, real activity declines, and default rates increase. Both inflated expectations and managers disappointment in those expectations play a key role in the cycle.
Using TFP (Total Factor Productivity) news as it’s impact as evidence"...We assess whether belief overreaction to standard TFP shocks may produce observed boom-bust credit cycles. We incorporate diagnostic expectations into a workhorse business cycle model with heterogeneous firms and risky debt. A realistic degree of diagnosticity, estimated from the forecast errors of managers of US listed firms, produces significant fragility of the economy during good times. This helps account for countercyclical credit spreads and for credit cycles at both the firm and aggregate levels. Lax financial conditions predict future increases in spreads, low bond returns, and investment drops. Spread increases of the magnitude observed during 2008-9 obtain from modest negative TFP shocks. Our results indicate that diagnostic expectations may offer a realistic and parsimonious way to produce financial reversals in conventional business cycles models...."
Core finding echo a wise man's belief that "it's never as good as you think it is, it's never as bad as you think it is", "...present novel evidence based on microdata that directly connects expectations to credit spreads, bond returns, and investment at the firm level. We first show that managers’ expectations of their firms’ profits overreact to current conditions: they are too optimistic in good times and too pessimistic in bad times. In turn, excess optimism about a firm’s future profits measured from expectations data predicts a one year-ahead increase in the firm’s credit spread, low realized returns on the firm’s bonds, and a decline in its investment growth. Overreacting beliefs appear to be directly linked to firms’ financial and real cycles...."
Ed Comment:“Overreaction is likely to paly a role even if it’s not the only factor, factors that likely vary significant from one set of circumstances to another. For example, the influx of risk-averse offshore saving from countries determined to export to achieve full employment despite manufacturing productivity growing faster than demand for manufactured products via allowed trade deficits surely would have destabilized the inherently unstable banking system and accelerated the growth of subprime mortgages independent of optimism/overreaction, which surely magnified the effects. In shocks, risk-underwriting equity gets wiped out. Which logically requires a retrenchment in risk taking.The misallocation of resources is exposed, leading to a logical retrenchment. It takes time to find a new reallocation of unused resources. And like a rodent, who gradually wonders further from his den in search of food and sex when he doesn’t encounter danger, will logically retrench (if he can) when he finally does discover danger because he has more data. This is basic quality control optimization strategy.So I think there are several reasons beside illogical overreaction that ought to cause fluctuating cycles independent of wage stickiness.”
Ed Comment:That's the least important of his three points. In order 1) by Annie's own spec the effect is very small 2) it's likely smaller still since he doesn't use a multiple regression, likely because he couldn't find any significance and the 3) some of the overinvestment doesn't come from over confidence/investment in their biz but from (misguided) diversification (because they have the cash flow to do it). So the effect from his cause-- over confidence in their business--is smaller still.
Ed Comment:You make a persuasive argument. I added the line, “I’m not saying I agree,” so you wouldn’t conflate my views with his, but then decided to take that line out. Anyway, when it crossed my desk, I thought you would like to see what he was saying, since your views bear on this topic.
Bruce Greenwald Comment:I don't know how you get animal spirits out of this. The good times leads to over-optimism effect is very small. A 1% increase in the current return on initial tangible capital leads to an average 0.04 % overestimate of the expected future return on capital according to the paper. But this is almost certainly an exaggerated number. It comes from a univariate regression when the regression should be a multivariate one which they do not report. Knowing Andre that is because nothing was significant in the multivariate regression. The use of time and firm dummies makes things even murkier. For example, the investment related overconfidence comes from looking at non-recession periods when an individual firm is investing unusually heavily. This is likely to be when a stupid management is expanding in unrelated markets instead of concentrating on operational efficiency. Not surprisingly, these managements are overly optimistic about what they are going to achieve. This is sample selection bias not animal spirits.
Ed Comment:Thought you might like to see this—evidence for animal spirts from Andrei Shleifer. (…not my highlighting.) Overreaction seems likely to play a role even if it’s not the entire story.