To what extent does aggregate leverage determine financial fragility? New insights from an agent-based stock-flow consistent model

Many interpretations and developments of the Financial Instability Hypothesis (FIH) rely on aggregate leverage ratio indicators to proxy non-financial firms’ sector financial fragility. Internal critiques of the FIH’s framework call into question the generality of this assumption. The issues arise due to limitations in untangling the monetary implications of pro-cyclical profits and lacking considerations about the role played by profit-rate heterogeneity. We construct an agent-based stock-flow consistent model (AB-SFC) that adds some missing elements in the FIH. The model bridges the evolutionary theory with a Keynesian-Kaleckian demand engine, including the financial development required to study financial fragility processes. Using a synthetic index measuring the joint profit-debt distribution, we show how cash flows distribution across firms impact the aggregate leverage ratio-systemic financial fragility relation. The reasoning is that the bottom-end of the firms’ leverage ratio distribution (low-leverage) is more variable, functioning as a pivotal driver of the economy-wide leverage ratio. Considering that, the systemic financial fragility is a cushioned and imperfect mirror of the aggregate leverage ratio. The results contribute to the literature in many ways. We provide theoretical reasoning that aids comprehension of why the empirical literature finds little support for the FIH. We propose a theoretical underpinning that helps giving substance to the burgeoning empirically-leaned recent literature on the influence of debt and indebtedness on economic fluctuations. We show the relevance of the inclusion of an evolutionary engine into the FIH. Finally, the paper shows the crucial importance of using a micro-macro analysisto analysethe financial fragility of firms.