The Impact of Risk Cycles on Business Cycles : A Historical View

We investigate the effects of financial risk cycles on business cycles, using a panel spanning 73 countries since 1900. Agents use a Bayesian learning model to form their beliefs on risk. We construct a proxy of these beliefs and show that perceived low risk encourages risk-taking, augmenting growth at the cost of accumulating financial vulnerabilities, and therefore, a reversal in growth follows. The reversal is particularly pronounced when the low-for-long risk environment persists and credit growth is excessive. Global-risk cycles have a stronger effect on growth than local-risk cycles amid their notable impact on capital flows, investment, and debt-issuer quality