Economic integration and consumption risk sharing: A comparison of Eurozone and OECD countries

Abstract

Economic theory predicts that economic integration can facilitate improvements in international consumption risk sharing. We test this proposition by comparing risk sharing among Eurozone members and members of the Organisation for Economic Co-operation and Development (OECD) using a dynamic common correlated effects mean group estimator (DCCEMG). The results reveal that the OECD members outperform the Eurozone members in terms of short run and long run risk sharing, despite the barriers to risk sharing being considerably lower among the latter. We attribute this outcome to lower business cycle synchronization and stock return correlations among OECD members, which creates better opportunities to share risk within the group. The results highlight the trade-off between the benefits of business cycle synchronization and international risk sharing. More tightly integrated economies, facilitate trade in assets that promotes better portfolio diversification, while at the same time are characterized by higher business cycle synchronization that depletes agents of risk sharing opportunities. Consequently, our results give strong support to the hypothesis of “diminishing international diversification potential”. However, the benefits associated with the improved risk sharing are increasing with the number of countries in the monetary union.