A Cost of Capital Theory of Crisis

In the education of economists as well as in many economic professions, low costs of capital are considered to have a positive effect on investments in capital assets. Costs of capital reflect the market perception of uncertainty. A high cost of capital reflects more uncertainty, and a low cost reflects low uncertainty in the market. Therefore, it is considered to be rational to pursue more investments when this cost of capital is considered to be low, because in situations of low uncertainty the future outcome of investments is expected to be relatively certain. Furthermore, in asset valuation a low cost of capital will result in higher expected present values of capital assets. Thus, low costs of capital signal that it will be lucrative and rational to invest now. It can therefore be expected that market participants will react positively on low costs of capital and invest (more). If this reaction is limited to a few market participants only, it will probably not result in a strong growth of the economy. However, if the market will invest collectively and continuously based on the same cost of capital this may under certain conditions ultimately create a bubble and possibly end up in a crisis. So, this market behaviour triggered by low costs of capital can be sustainable and rational on a micro-level but can have unsustainable and irrational effects on a macro-level. This study endeavours to theorise what the role of the cost of capital can be in economic decision making under uncertainty and via this in the creation of crises. Its main proposition is that the cost of capital can trigger market irrationality that is reflected by speculative economic behaviour, resulting in a transformation of market stability into instability, possibly ending in a crisis. The study’s search has resulted in formulating and empirically exploring a Cost of Capital Theory of Crisis and culminated in two major findings: relatively narrow boundaries and the illusion of no uncertainty of the cost of capital. If the level of the cost of capital remains within relatively narrow margins, a situation of economic stability is expected. The illusion of no uncertainty arises when the cost of capital moves outside these margins and triggers irrational market behaviour, possibly resulting in market instability.