NCPA - National Center for Policy Analysis

Good News is Bad News: Leverage Cycles and Sudden Stops

September 25, 2015

Suppose a new business opens and is an immediate success. The owner may choose to stay at the current location, but more than likely, when business is good and all projections promise future growth, the owner will choose to expand, typically taking out a loan, borrowing against future income.

Every business cycle has highs and lows. Yet when owners -- during a period of economic expansion -- borrow against the future, they expose themselves to a greater risk that an unfavorable and likely future shock will lead the constraint to bind. By acting on knowledge about good news for future, owners are more likely to engage in risky financial decisions which limit the businesses ability to absorb inevitable negative shocks in the future. 

Sudden Stops are almost always after a period of substantial expansion when investment, consumption and output are all high. While it is good news that the future will be profitable, business owners would do well to calculate for the rise and fall of the market before making plans for the future of their company to prevent a sudden stop.

Source:  Ozge Akinci and Ryan Chahrour, "Good News is Bad News:  Leverage Cycles and Sudden Stops," Federal Reserve Bank of New York, September, 2015.

 

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