The Common Currency Channel of Risk Sharing

Abstract

I propose a novel channel of international risk sharing: the common currency channel. I theoretically show how the central bank of a currency union can use the common currency to insure member countries against consumption risk from idiosyncratic productivity shocks. A trade-off between risk sharing and moral hazard emerges: a central bank which enables risk sharing induces countries to free ride on each other's production efforts. I study this trade-off and derive rules for a central bank striking the optimal balance between insurance and incentives. Monetary policy determines current account imbalances that are financed through the central bank rather than through the transfer of marketable assets. Optimal policy is contingent on the realization of aggregate production and on the severity of the underlying moral hazard friction. Revisiting European Central Bank policies during the Eurocrisis between 2008 and 2014, I interpret the buildup of TARGET2 balances as risk sharing through the common currency. I find that the common currency channel accounts for up to 60% of risk sharing among Eurozone countries in the early stages of the Eurocrisis. I conclude that the common currency can be a substitute for risk sharing through fiscal integration.

Keywords: central bank, risk sharing, currency union, monetary policy, moral hazard, Eurosystem, Target

JEL Classification: E58, E65, F32, F45