Trade Costs, Limited Enforcement and Risk Sharing: A Joint Test

This paper addresses the question of whether goods or asset market frictions are necessary to explain the failure of consumption risk sharing across countries. I present a multi-country DSGE model with Armington specialization. There are iceberg costs of shipping goods across countries. In asset markets, contracts are imperfectly enforceable. Both frictions separately limit the extent to which countries can pool risk. The model suggests a test for the presence of each of the two types of friction that can be implemented using data on bilateral imports. I implement this test using a sample of developed and developing countries. I find that both trade costs and asset market imperfections are necessary in order to explain the failure of perfect consumption risk sharing. However the null hypothesis of financial autarky is rejected