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We investigate the effects of financial risk cycles on business cycles, using
a panel spanning 73 countries since 1900. Economic agents use a Bayesian
learning model to form their beliefs on whether risk is high or low. We
construct a proxy of these beliefs and study their interaction with economic
growth and investment behavior. The longer the agents perceive risk as low,
the stronger their risk-taking behavior, initially augmenting growth but at
the cost of the buildup of financial vulnerabilities and therefore, followed by
a reversal in growth. The reversal is particularly pronounced when the low-
for-long risk environment and credit growth are excessive. The impact of
global risk cycles is much stronger than country-level risk cycles highlighting
the importance of the global environment. Strengthening beliefs of global
low risk affects growth amid its notable impact on capital flows, investment,
and lending quality, challenging monetary policy independence, especially
for emerging economies.
