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Acknowledgements
We are grateful to Hannah Engljaehringer for excellent research assistance, and for comments by Hans-Joachim Klöckers, JeanFrancois Jamet, Johannes Lindner, Jacopo Cimadomo, Massimo Ferrari, Gernot Müller and Zeno Enders, and participants of an internal seminar held at the ECB and of a workshop on risk sharing held at the Aristotle University of Thessaloniki on 29 October 2021. The views expressed are ours and are not necessarily shared by the European Central Bank.
Alessandro Giovannini
European Central Bank, Frankfurt am Main, Germany; email: alessandro.giovannini@ecb.europa.eu
Demosthenes Ioannou
European Central Bank, Frankfurt am Main, Germany; email: demosthenes.ioannou@ecb.europa.eu
Livio Stracca
European Central Bank, Frankfurt am Main, Germany; email: livio.stracca@ecb.europa.eu
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[1] While the presence of well-functioning risk-sharing arrangements can prevent cyclical divergences from turning into structural divergence, risk sharing is not per se a tool for promoting convergence. On the one hand, the divergence of economic activity across states, regions and countries provides an opportunity for integrated areas to share risk in order to smooth their consumption: that is, consumers in integrated economies benefit from output divergence. On the other hand, risk sharing can only counteract cyclical shocks, i.e. cannot ensure convergence towards similar levels of GDP per capita across states, regions and countries. A possible exception to this is the indirect contribution that appropriate levels of risk sharing can make to a better management of the business cycle across a monetary union. If risk sharing can help to adjust to cyclical shocks better, this presumably can also help to structurally adjust over time to better be able to achieve cross-regional income convergence.
[2] The early risk-sharing literature of the 1990s was oriented towards international risk sharing (Cole and Obstfeld, 1991; Obstfeld 1994), but was also pursued with an eye towards European integration and monetary union (Atkeson and Bayoumi, 1993; Persson and Tabellini, 1996). The debate is linked to the seminal work on Optimum Currency Area (OCA) theory, with Mundell (1961) and Kenen (1969) highlighting early on the need for both public and private risk sharing.
[3] Following the key policy reports by the Four Presidents (in 2012) and the Five Presidents (in 2015) proposing the completion of EMU under the headings of a fiscal union, financial union (banking union and capital markets union), economic union and political union, a set of French and German economists made a proposal to combine risk-sharing and risk-reducing” elements to complete EMU (CEPR Policy Insight No 91). This contribution was debated by other academics and brought together in Pisani-Ferry and Zettelmeyer (2019). Central bankers have also expressed views in this regard, e.g. on the role of a complete financial union in shock absorption by the President of the Deutsche Bundesbank and the Governor of the Banque de France (Weidmann and Villeroy de Galhau, 2019).
[4] For example, this is the perspective taken by observers who emphasise the strong role that private risk sharing plays in the US economy (Jones, 2016). On this premise, some policymakers recommend that the euro area should focus on completing the banking union and capital markets union and leave aside any further development of the fiscal union dimension in EMU (Heijdra et al., 2018).
[5] The importance of this should not be underestimated, especially when it comes to the debate on EMU. The idea that taxpayer resources may be pooled for the purposes of public risk sharing then also implies the need to still adhere in one way or another to the general precept of no taxation without representation”, thus requiring appropriate governance, accountability and legitimacy structures that limit the potential for a political or even existential crisis following an economic one, echoing the political union elements envisaged in the Five Presidents’ Report and analysed at greater length elsewhere. For a recent discussion showing the pertinence of such arrangements given the interplay between the financial crisis and the political ramifications in Europe highlighting the need to complete the euro area as an economy and polity, see Macchiarelli et al. (2020).
[6] It could be argued, moreover, that durable goods purchases can also be thought of as a saving vehicle that can be used to smooth consumption.
[7] See also Roeger and Vogel (2017) who analyse the impact of automatic horizontal fiscal transfers on risk sharing and consumption smoothing in a 2-country DSGE model of monetary union.
[8] The Support to mitigate Unemployment Risks in an Emergency (SURE) instrument does not, however, entail centrally administered direct fiscal transfers but rather up to 100bn euro in loans to EU member state governments with the purpose of supporting their unemployment benefit expenditures.
[9] One may note that cross-border public risk sharing may be additional to significant within-border shockabsorption mechanisms such as the fiscal automatic stabilisers of state budgets in a union of states. As Alcidi et al. (2017) point out: Despite the absence of a centralised EA stabiliser, the automatic stabilisers in the euro area bring about a larger degree of insurance against asymmetric shocks (about 20%) than that provided by the US federal budget (11%).” While they do not report on any contribution that state-level automatic stabilisers may play in the United States (even if they are expected to be smaller than those of euro area countries), it is important to keep in mind that the shock-absorption capacity of a monetary union may not rely purely on cross-border risk sharing (unless risk sharing is defined in the broadest sense), but may depend on other shock-absorption mechanisms. Therefore, other policy tools that are not related to (cross-border) risk sharing may nevertheless provide shock absorption.
[10] Alcidi et al. (2017) also point to the implications of differently arranged (semi-)fiscally (con)federal systems. These may have different implications both for the respective contributions of public and private risk-sharing arrangements as well as the type of shock that these address: To some extent, this is attributable to the higher degree of market-based risk sharing in the US and to the existence of other public institutions enhancing financial stability and private risk sharing in the US. Yet we show that US federal fiscal policy appears to be primarily a stabiliser of US-wide shocks, rather than idiosyncratic shocks.”
[11] TARGET stands for Trans-European Automated Real-time Gross settlement Express Transfer system.
[12] If there are financing gaps in the euro area arising from net capital outflows and trade deficits, these may to a certain degree be balanced by TARGET(2). In other words, the existence of the infrastructure that goes hand in hand with a single currency can play a role in terms of absorbing asymmetric shocks since it means that the unavailability of international reserves, which is usually the key problem in a balance of payments crisis, is in theory not a policy concern (Corsetti et al., 2017).
[13] This distinction is particularly relevant as Eisenschmidt et al. (forthcoming) argue, by analysing the evolution of TARGET balances during three phases (pre-crisis, global financial and sovereign debt crises, and the ECB’s asset purchase programme (APP) period), that the underlying drivers of the TARGET balances differed markedly. In other words, TARGET balances may be driven by different events over time, even if excess liquidity is always the end-driver of these balances.
[14] At the same time, the authors corroborate the view of Merler and Pisani-Ferry (2012) that the existence of TARGET while providing a shock-absorbing effect in times of sudden stop also means that it is easier than outside of a monetary union to create sudden stops in the first place. Fagan and McNelis thus find that from a welfare perspective, TARGET financing results in only a small welfare gain in the country affected by a sudden stop. The intuition is that TARGET exacerbates the tendency towards over-borrowing and lower precautionary saving, leading to an increased incidence of sudden-stop episodes.
[15] They also point out that the entire period of 2008-14 was one of unconventional monetary policy. Moreover, they argue, by conducting a counterfactual analysis, that if there were regular settlement” of the accumulated uneven TARGET2 positions by transferring valuable assets”, economic activity in the core countries receiving those transfers would have been higher.
[16] G. Tabellini hints at this in Risk sharing and market discipline: Finding the right mix”, VoxEU.org, 16 July 2018.
[17] A key recent policy contribution is that of the 7+7 French and German economists, which was preceded by a series of short articles related to risk sharing and risk reduction in the VoxEU column.
[18] And more recently the European Commission’s proposals linked to all of the aforementioned unions, for example, the reflections of 31 May 2017, the October 2017 proposals for completing banking union and the 6 December 2017 package of proposals on fiscal and economic unions.
[19] This evident crossover between public and private risk sharing is also underlined by Schelkle (2017) who argues that, in fact, the Federal Deposit Insurance Corporation performs the role of a fiscal backstop for state budgets in a systemic crisis in the United States.
[20] Here the debate sometimes takes the form of the extent to which bail-in” of private assets might be necessary before public assets are used to absorb shocks. Also, some authors argue that bail-in is essentially a form of risk sharing, as it redistributes savings from creditors to debtors (see Ioannou and Schäfer, 2017). It could, therefore, be functionally equivalent to transfers from public surplus to public deficit countries through the savings channel (e.g. Sandbu, 2017). This fairly recent proposition has not yet been tested empirically. The magnitude of this effect is likely to be contingent on a high degree of financial integration: the more bail-inable assets are held domestically, the less these losses are spread interspatially and the smaller the cross-border risk-sharing effect.
[21] The debt contract should be intended for the Home country as a whole, including all debt liabilities vs. foreigners, both public and private. In this sense, we do not distinguish between private and public debt within countries.
[22] Note that with the CES aggregator and the non-unit elasticity of substitution we are not in the ColeObstfeld special case where movements in the terms of trade provide full risk sharing irrespective of asset markets. The full model specification and the Matlab programs used to do the simulations are available from the authors on request.
[23] Note that this is not strictly true because there are movements in the terms of trade that provide some insurance to the Home consumer, so a full transfer from the public sector may actually overdo risk sharing. Indeed, in a calibration with 𝜃=1 we find that it is the Foreign consumer who borrows after a negative Home output shock.
[24] An interesting extension of this setting could be a situation where the central capacity is unsure about the stationarity of the shock in real time. Also note that if the two countries experience a shock in the same (e.g. negative) direction, we assume that the fiscal capacity will need to pay a transfer according to the net effect of the idiosyncratic shocks. In other words, the country that is hit harder by the negative shock receives the net transfer.
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