International Risk Sharing

According to standard theory, one of the central benefits of international financial markets is the possibility of reducing national consumption risk. A basic measure of risk sharing is hence the degree to which national consumption rates move in unison across countries. In the simplest theoretical model of international financial markets, efficient risk sharing implies that consumption growth in a given country closely tracks world consumption growth. With integrated financial markets, consumption growth should hence be highly correlated across countries--and more highly correlated than output growth. Yet, despite the liberalization of international financial markets and the strong growth in international capital flows during the past few decades, this prediction is sharply at variance with the evidence. Empirically, national consumption closely tracks national output, while cross-country consumption correlations are generally lower than cross-country output correlations. Hence, it would seem that countries are not fully exploiting the welfare benefits of international risk pooling. Documenting the pattern of (incomplete) risk sharing, and understanding the financial frictions at its roots, is thus of great interest for economic research and policy. This special issue of the Canadian Journal of Economics consists of a selection of papers that offer novel empirical and theoretical perspectives on international risk sharing. All papers were presented at a conference on ‘International Risk Sharing’ held at ECARES (Université Libre de Bruxelles), in October 2010.