Theories of monetary transmission based on asymmetric information imply that a contraction will increase the relative likelihood of default for firms which are constrained in their access to external financing due to information problems. The standard textbook description of the transmission mechanism implicitly assumes that all firms face the marginal cost of financing. But when information is assymetric, a firm's cost of external funds will depend on its net worth of firms or the ability of the banking system to issue loans, there will be a disproportionate increase in the cost of financing for credit constrained firms and an increase in their relative likelihood of failure.
We use panel data on the number and liabilities of business failures from 1895 to 1935, by industry, to characterize the relationship between aggregate economic variables and the probability of failure. We find that movements in the number of failures are better explained by the variation in aggregate prices and bank failures than by changes in real output. We also find that while cyclical downturns tended to derease size in trade industries and had little effect in manufacturing industries, periods of deflation and bank failure were accompanied by increases in the size of failed firms within an industry. These findings suggest the importance of financial variables in explaining firm failure and that moderately-sized, more highly leveraged firms had a greater difficulty withstanding deflation and banking crises.