Public and Private Risk Sharing: Friends or Foes? The Interplay between Different Forms of Risk Sharing

Abstract

Well-functioning risk-sharing arrangements are essential for the shock absorbing capacity and resilience of an economy, even more so for countries in a monetary union where the single monetary policy is unable to address asymmetric shocks. The common shocks that euro area member states have been facing over the past years are just that: common. Yet their impacts are far from equal across countries, implying that risk sharing remains an important issue. This paper discusses the different forms and channels of risk sharing and reviews the main arguments in favour and against the development of different forms of public and private risk sharing in the euro area, focusing in particular on whether they act as complements or substitutes. It proposes a stylised theoretical model of a monetary union to test the complementarity or substitutability between public and private risk sharing. While the model calibration finds that substitutability prevails, the model also contains an interesting complementarity whereby a central fiscal capacity makes private risk sharing more efficient, especially in crisis times. Our findings are relevant for the ongoing policy discussion on EMU deepening as the provision of public risk sharing as well as the overall degree of risk sharing are still comparatively low in the euro area.

Keywords: Economic and Monetary Union, monetary union, Risk sharing

JEL Classification: C23, E62, G11, G15