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

47 Pages Posted: 16 Oct 2020 Last revised: 29 Dec 2021

See all articles by Jon Danielsson

Jon Danielsson

London School of Economics - Systemic Risk Centre

Marcela Valenzuela

Pontificia Universidad Católica de Chile

Ilknur Zer

Board of Governors of the Federal Reserve System

Date Written: December 23, 2021

Abstract

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.

Keywords: Stock market volatility, uncertainty, Minsky’s hypothesis, financial instability, risk-taking, granular instruments (GIV), global financial cycles

JEL Classification: F30, F44, G15, G18, N10, N20

Suggested Citation

Danielsson, Jon and Valenzuela, Marcela and Zer, Ilknur, The Impact of Risk Cycles on Business Cycles: A Historical View (December 23, 2021). Available at SSRN: https://ssrn.com/abstract=3706143 or http://dx.doi.org/10.2139/ssrn.3706143

Jon Danielsson

London School of Economics - Systemic Risk Centre ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44.207.955.6056 (Phone)

HOME PAGE: http://www.riskreasearch.org

Marcela Valenzuela (Contact Author)

Pontificia Universidad Católica de Chile ( email )

Vicuña Mackenna 4860
Santiago, R. Metropolitana 7520421
Chile

Ilknur Zer

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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