International Risk Sharing and European Monetary Unification

Leonardo Leiderman
Mario Bléjer, David Cheney, Jacob Frenkel, and Assaf Razin
Published Date:
June 1997
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Bent E. Sørensen and Oved Yosha 

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.

We explore risk sharing patterns among European Community (EC) countries and among countries of the Organization for Economic Cooperation and Development (OECD) during 1966–90. A central finding is that about 40 percent of shocks to GDP are smoothed at the one-year frequency, with about half the smoothing achieved through national government budget deficits. At the three-year differencing frequency, only 20 percent of shocks to GDP are smoothed, with all the smoothing achieved through government lending and borrowing. An important implication is that the restrictions on budget deficits imposed by the 1992 Maastricht treaty may threaten the stability of the European economic and monetary union (EMU) in the absence of alternative risk sharing mechanisms. (Most EC countries are close to or above the maximum public-debt-to-GDP ratio allowed under Maastricht.)

Our methodology for measuring the amount of income and consumption smoothing achieved through various channels is based on a decomposition of the cross-country variance in GDP. Consider, for example, the national accounting identity GNP = GDP + net factor income. If there is smoothing through net factor income flows—namely, income smoothing via cross-country ownership of productive assets—GNP should have a smaller cross-sectional variance than GDP. Similarly, if there is consumption smoothing via saving, national consumption should have a smaller cross-sectional variance than national income. The cross-sectional variance decomposition of GDP enables us to measure the amount of cross-sectional smoothing achieved at each level of smoothing, as a fraction of shocks to GDP absorbed at that level.

Our results indicate that factor income flows do not smooth income across countries. This is true for the entire OECD group as well as for EC members, for the entire period as well as for two subperiods. Since factor income flows are an important component of income smoothing via capital markets, this suggests that European capital markets are less integrated than U.S. capital markets. We provide evidence in support of this interpretation.

We also find, for the period 1981–90, that the fraction of shocks to GDP smoothed via international transfers—including EC structural funds—is on the order of 3–6 percent, considerably less than the 13 percent fraction of shocks to the per capita gross state product smoothed by the federal government in the United States. The bulk of the income and consumption smoothing among OECD and EC countries is achieved through savings: countries save less in bad years. For the period 1966–90, we find that 40 percent of shocks to GDP of OECD countries are smoothed through this channel, with 60 percent of shocks not smoothed.

A back-of-the-envelope calculation reveals that if the EC wishes to achieve, through its budget, a degree of intercountry insurance comparable to that of the United States—namely, 25 percent of shocks to GDP not smoothed—the size of the budget has to increase dramatically, by some six to ten times. (The percentage of a shock to GDP not smoothed in the EC exceeds the percentage of a shock to gross state product not smoothed in the United States by about 35 percentage points. The fraction of a shock currently smoothed through the EC budget is 3–6 percent.) EMU may enhance capital market integration but this certainly cannot happen overnight. If monetary unification progresses according to schedule, the EC may have to provide greater inter-regional insurance until capital markets are sufficiently integrated to carry out this role, as they do in the United States.

Cross-country consumption smoothing can be achieved in several ways. Individuals in one country can save or dissave; the funds can then be transferred across country borders by financial intermediaries. Furthermore, the government of a country can borrow or lend internationally to smooth expenditure. Finally, corporations can choose to retain more or less profits; the retained profits can be invested in physical assets in the country where the corporation operates, or in financial assets; the funds may then finance investment in other countries. To get a sense of the relative importance for cross-country consumption smoothing of the various saving channels, we decompose total smoothing via saving to smoothing via personal, corporate, and government saving. We find that corporate and government saving are each responsible for about half the smoothing (about 20 percent of shocks to GDP smoothed by each component), and that there is no cross-country consumption smoothing through personal saving.

As noted above, the large amount of consumption smoothing achieved in the EC through government borrowing may not be sustainable in an EMU where fiscal coordination must be maintained. Until intercountry credit markets develop to allow substantial consumption smoothing through personal saving, the potential reduction in consumption smoothing via budget deficits of national governments may call for a yet greater insurance role for EC institutions, imposing a further burden on the EC budget.

Other researchers have looked into the cross-country smoothing role of net exports. Since saving is related to net exports through the identity S = I + (X − M), the physical cross-country flows of goods generated by saving merits examination. We, therefore, decompose the smoothing through saving into smoothing via I and X − M, finding that all the smoothing is achieved through domestic net physical investment, with virtually no smoothing via net exports.

The finding that shocks to output are smoothed cross-sectionally through domestic net physical investment is consistent with the pro-cyclical behavior of investment in aggregate U.S. data. The finding of zero cross-sectional smoothing via the current account is consistent with the well-known Feldstein-Horioka puzzle; that puzzle complements our finding that there is no smoothing through factor income flows and gives further indication of the limited cross-country risk sharing achieved via capital and credit markets among EC and OECD countries.

In our empirical analysis we deflate all the magnitudes (GDP, GNP, S, and so on) by the country consumption deflator. That is, we measure the national accounts figures of each country in terms of real consumption in that country. Of course, exchange rate fluctuations may affect consumption decisions and risk sharing patterns. If, for example, a country’s currency appreciates in real (inflation adjusted) terms, the citizens and the government of that country can, in principle, purchase more goods at international prices with a given amount of the country’s currency. We find, using our data, that this effect is very small, namely, that changes in the real exchange rate have a small effect on consumption patterns.

We do not examine the effects of labor mobility on smoothing of GDP shocks. Previous research has indicated that labor mobility among U.S. states smooths approximately 2.7 percent of an income shock at the annual frequency. Since labor mobility is lower among European countries and regions than among U.S. states, it is therefore unlikely that labor mobility among EC and OECD countries substantially affects risk-sharing patterns at the annual frequency.

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