Consumption Risk-Sharing across G-7 Countries
Olivei, Giovanni P., New England Economic Review
An intensely debated issue in international economics concerns the extent to which investors exploit the gains from international trade in financial assets. Economic theory has long recognized the potential benefits of open capital markets. International financial transactions offer countries a larger poor of resources from which to finance profitable investment opportunities, thereby promoting growth and smoothing the time profile of consumption and investment. Through open capital markets, firms and households can also diversify away idiosyncratic country-specific risks. Still, despite the continuing process of financial integration and globalization, it is unclear whether such benefits are fully exploited in actual practice.
This article focuses on the extent to which investors take advantage of international diversification opportunities. At least two related pieces of evidence suggest that international diversification of risks is far from perfect. To begin with, several studies have documented that domestic investors hold too little of their portfolios in foreign assets. According to the predictions of a standard capital-asset-pricing model, U.S. investors should hold over one-half of their wealth in foreign equities (see Lewis 1995). In actual practice, this figure is less than 10 percent. Additionally, there is little evidence of international consumption risk-sharing. An optimal international portfolio allocation implies that investors perfectly pool all idiosyncratic country-specific risks. With such an allocation, a country's domestic private consumption is affected only by uninsurable global shocks. As a consequence, one should observe consumption growth rates to be highly correlated across countries, except for prefere nce shocks and measurement errors. However, the evidence shows that domestic consumption is correlated with domestic output, implying that country-specific risk is not diversified away through international asset markets.
Of course, the observed lack of international risk-sharing could simply be a reflection of the fact that the potential welfare gains from diversification are small. Still, a growing body of work suggests that the gains from international risk-sharing, far from being trivial, could amount to several percentage points of a country's annual domestic consumption. If this is the case, understanding the current and potential risk-allocation role of world financial markets appears to be an important task.
In this study we reexamine some of the evidence concerning the degree to which international financial markets help countries diversify away country-specific risks to achieve a mutually preferable allocation of consumption. We do so by looking at national consumption correlations across the G-7 countries. Prior studies have documented a lack of coherence in international consumption fluctuations. However, these studies do not cover the 1990s, a period that appears particularly fruitful for testing the extent of international risk-sharing. Trade and capital flows suggest that the world has become increasingly integrated in recent years. For example, some of the countries we consider (Italy and France) removed all barriers to capital account transactions only during the 1990s. Moreover, in contrast to the previous two decades, business cycle fluctuations during the 1990s in the G-7 countries have been driven, to a sizable extent, by country-specific shocks. It then seems interesting to investigate whether a tr end toward increasing globalization and greater incentives to international diversification of risks have been accompanied by an increase in consumption risk-sharing.
The rest of the paper is structured as follows. Section I reviews how global consumption allocations behave in an ideal setup with perfect capital mobility and markets for insuring against all idiosyncratic risks. Section II presents evidence on international consumption correlations for the G-7 countries and shows how the correlations have evolved over time. …