Abstract

Mechanisms for achieving income insurance and consumption smoothing are essential for the stability of a monetary union. Without such mechanisms, countries in recession will have an incentive to leave the economic union. Central fiscal institutions can provide cross-country income insurance via a tax-transfer system and by allocating grants to the governments of specific countries. Market institutions can also provide risk sharing. The members of a union can share risk via cross-ownership of productive assets, facilitated by a developed capital market; they may smooth their consumption by adjusting their asset portfolio in response to shocks, for example, through lending and borrowing on international credit markets. In previous work, jointly with P.F. Asdrubali, we found that in the United States—a successful monetary union—62 percent of shocks to the per capita gross product of individual states are smoothed on average through transactions on markets, 13 percent are smoothed by the federal tax-transfer and grant system, and 25 percent are not smoothed. Therefore, although perfect insurance is not achieved, there is considerable risk sharing among U.S. states, mainly through interstate capital and credit markets.