DP3866 Endogenous Policy Leads to Inefficient Risk-Sharing

Author(s): Marco Celentani, José Ignacio Conde-Ruiz, Klaus Desmet
Publication Date: April 2003
Keyword(s): complete markets, efficiency, endogenous policy, risk-sharing
JEL(s): C72, D50, D72, E61
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3866

We analyse risk-sharing and endogenous fiscal spending in a two-region model with sequentially complete markets. Fiscal policy is determined by majority voting. When policy setting is decentralized, regions choose pro-cyclical fiscal spending in an attempt to manipulate security prices to their benefit. This leads to incomplete risk-sharing, despite the existence of complete markets and the absence of aggregate risk. When a fiscal union centralizes fiscal policy, security prices can no longer be manipulated and complete risk sharing ensues. If regions are relatively homogeneous, median income residents of both regions prefer the fiscal union. If they are relatively heterogeneous, the median resident of the rich region prefers the decentralized setting.