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Leverage as a State Variable for Employment, Inventory Accumulation, andFixed Investment

  • Charles W. Calomiris
  • Athanasios Orphanides
  • Steven A. Sharpe

The importance of a firm's balance sheet for determining its investment and employment decisions is the central assumption of macroeconomic models of 'debt deflation' or 'debt overhang.' According to these models, firm investment decisions are influenced not only by the fundamental opportunity set of the firm, but also by the firm's existing financial condition, especially its leverage. This paper tests that assumption by examining whether the responsiveness of employment, investment, and inventory accumulation to exogenous changes in sales depend on the leverage of the firm. We find that leverage acts as an important state variable for conditioning the response of all three variables to changes in sales. We also find that this effect varies depending on the state of the economy. During recessions, higher leverage magnifies the contractionary effect of declines in sales on investment; during times of positive sales growth, higher leverage tends to dampen the expansionary effect of growth in demand. The size and significance of leverage conditioning effects are larger during recessions. These results support theoretical models of the potential importance of 'debt overhang' effects. Firms that use debt to finance expansion during times of increasing demand suffer reduced ability to maintain growth during recessions as a consequence of their higher leverage.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4800.

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Date of creation: Jul 1994
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Publication status: published as Capie, Forrest and Geoffrey Wood (eds.) Asset Prices and the Real Economy. Macmillan, 1997.
Handle: RePEc:nbr:nberwo:4800
Note: CF
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