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

Abstract

We investigate the effects of risk cycles on business cycles, using a panel spanning 150 years and 74 countries. We capture risk cycles by identifying periods when agents’ perception of financial risk is high and low. A long- lasting low-risk environment encourages risky investments that ultimately augment growth but at the cost of building up of vulnerabilities in the economy and thus, has a boom-to-bust effect on growth: an initial increase followed by a reversal in two years. Such an effect is particularly stronger for countries with excessive credit growth. Global risk cycles have a more pronounced effect on growth than local risk cycles, highlighting the relative importance of the global environment. Low-risk affects growth amid its notable impact on capital flows, investment, and lending 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