Revisiting the Case for a Fiscal Union: the Federal Fiscal Channel of Downside-Risk Sharing in the United States

51 Pages Posted: 19 Nov 2021

Date Written: October 19, 2021

Abstract

Differentiating between standard risk measures and downside risk has a longstanding tradition in finance. Interestingly, this fundamental distinction has been neglected in the literature on risk sharing. Drawing on a simple definition in Markowitz (1959), we translate downside-risk metrics appropriate for stock returns into ones that can be used in our macro-forecasting setting, and propose a new methodology to estimate channels of downside-risk sharing, with an application to the federal fiscal channel in the United States. Our work reinstates some discarded arguments as to why a fiscal union could be desirable, as our findings suggest that public risk sharing is considerably higher than was previously thought. We also show that the great importance long attributed to the capital market channel estimated with popular income smoothing methodologies is instead entirely driven by the neglect of the effect of capital depreciation. Therefore, our paper argues that the relative importance of the fiscal channel as compared to the capital market one has been substantially underestimated.

Keywords: downside risk, risk sharing, fiscal unions

JEL Classification: C80, E01, E17, E64, H29

Suggested Citation

Rossi, Luca, Revisiting the Case for a Fiscal Union: the Federal Fiscal Channel of Downside-Risk Sharing in the United States (October 19, 2021). Bank of Italy Temi di Discussione (Working Paper) No. 1351, Available at SSRN: https://ssrn.com/abstract=3967219 or http://dx.doi.org/10.2139/ssrn.3967219

Luca Rossi (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

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