Risk to Control Risk

Can low risk be risky? In this continuous-time macroeconomic model, low measured volatility may disguise the buildup of hidden systemic run risk. Runs trigger large drops in asset prices and real production and propel the economy into a highly unstable crisis regime. Agents take on too much leverage in the hidden risk regime because they disregard their contribution to the economy’s exposure to systemic runs. Surprisingly, a leverage cap can increase hidden run risk by deepening crises that follow runs. Economies exposed to less volatile fluctuations due to real shocks are more prone to systemic runs: stability breeds instability. This trade-off suggests that full stabilization of business cycles is not necessarily optimal once runs are taken into account. Instead, policymakers may consider allowing risk to control risk.