Agency Costs, Balance Sheets and the Business Cycle

The 1980s witnessed large increases in corporate debt and sustained asset price inflation. More recently, asset prices, particularly commercial property prices, have fallen significantly. The effect of these changes on balance sheets, and their implications for the business cycle, have generated considerable interest among academics and policy makers. In this paper, we review recent theoretical models that link the evolution of the business cycle to changes in firm equity. This link arises out of the asymmetry of information between borrowers and lenders and between managers and owners. These asymmetries lead to distortions in decision making which affect both the supply of and demand for credit, and ultimately investment and output. Deteriorations in the net worth of corporations and financial institutions are likely to lead to a reduction in both credit demand and supply and to an amplification of the business cycle. We develop a simple model in which the information problems between risk-averse management and the firm’s owners lead to investment decisions that depend upon the financial condition of the firm. We also review the Australian evidence of the importance of balance sheet strength on the availability of finance. Empirical results suggest that asset price inflation or increases in corporate equity, even after controlling for general business conditions, lead to finance becoming easier to obtain. This suggests that a collapse of asset prices, or an aggregate demand shock that reduces firms’ equity, will result in decreased supply of external finance.