Essays on risk sharing in economic unions

Abstract

This thesis investigates consumption insurance within economic unions from both a country and household perspective. Chapter 1 deals with the question of how an economic union like the Euro Area can support enough risk sharing, through transfer payments, to prevent the breakup of the union. I model the union as a dynamic contract between two countries. The contract captures two political restrictions which are especially relevant for the Euro Area. First, risk sharing must avoid `permanent’ transfers (including repayments of debt) between countries. Second, there is a requirement that countries implement policies to improve economic performance, which is subject to moral hazard. Relative to the previous literature, the specification of the reform process makes the moral hazard component of the model more powerful by allowing reform effort to have a permanent effect. I then characterize the optimal transfer system, which trades off risk sharing against reform incentives. I propose an implementation of this transfer system using trading of one-period bonds with state-contingent debt restructuring. Chapter 2, which is co-authored with Johannes Fleck, deals with household earnings risk in the United States. We observe that due to differences in economic conditions across American states, and the autonomy which state governments have in implementing means tested policies, identical households may receive very different levels of earnings insurance from the government simply because they live in different states. We quantify this variation in public insurance by simulating the response of the main state and federal tax and benefit policies to earnings shocks for a prototype household, adjusting any nominal dollar amounts for purchasing power using our own measure of state living costs. We confirm that there is significant regional variation in household earnings insurance, with a large contribution coming from the design of the federal Earned Income Tax Credit. Chapter 3, which is joint work with Ramon Marimon and Alessandro Ferrari, returns somewhat to the theme of Chapter 1. We address a gap in the theoretical literature on optimal transfers in currency unions, which fails to account properly for the participation constraints imposed by each country’s option to exit the union. We model a currency union as a dynamic contract between countries facing endowment risk and a nominal rigidity in the production of non-tradeable goods. The contract is constrained by each country’s outside option of reclaiming its own monetary policy, which optimally eliminates the labour market distortion caused by the nominal rigidity, and defaulting on any payment obligations accumulated within the union. We find that there is still some scope for considerable risk sharing in the union, although the presence of the nominal rigidity introduces consumption risk into the stochastic steady state of the currency union.