The Lack of International Consumption Risk Sharing: Can Inflation Differentials and Trading Costs Help Explain the Puzzle?

Abstract

The bulk of evidence on the lack of international risk sharing is based on regressions of idiosyncratic consumption growth on idiosyncratic output growth. This paper argues that the results from such regressions obtained from international data are, however, not directly comparable to those based on regional data: the standard practice of running such regressions on international data fails to account for persistent international differentials in consumer prices, whereas—implicitly—most of the literature based on regional data has accounted for these differences. When risk sharing regressions are set up in conceptually the same way in international and regional data sets, the estimated coefficients are also very similar. To explore this result further, we adapt the variance decomposition of Asdrubali et al. (Q J Econ 111:1081–1110, 1996) to allow for deviations from purchasing power parity across countries. While quantity (income and credit) flows are the dominant channel of risk sharing among regions, relative consumption and output price (internal terms of trade) fluctuations account for the bulk of the deviation from the complete markets outcome in international data. To the extent that persistent differences in consumer prices are an indication of goods market segmentation, our findings provide empirical evidence for the proposition by Obstfeld and Rogoff (NBER Macroeconomics Annual 2000, 2000) that segmented international goods markets rather than asset market incompleteness may account for the (apparent) lack of risk sharing between countries.