DP2104 Stochastic Shocks and Incentives for (Dis)Integration
I present a political economy model of limits to regional redistribution under the threat of secession. The model depicts a union composed of two regions with centralized fiscal policy. The key feature is the trade-off between the benefits of secession embodied by autonomous fiscal policy and the benefits of integration – efficiency gains and risk sharing. I argue that previously stable unions may disintegrate in response to specific patterns of region-specific output shocks. The decision on secession depends on correlation and persistence of shocks. Integration is sustainable if the shocks are positively correlated and/or transient. On the other hand, the combination of negative correlation and high persistence of the shocks makes integration fragile. Benefits from risk sharing are greatest when shocks are negatively correlated and transient.