The Cyclicality Of International Risk Sharing Within The Euro Area

International risk sharing – namely the degree of smoothing of idiosyncratic output shocks within a group of countries – tends to vary cross-sectionally, depending on the features of the countries involved and on the explicit or implicit risk sharing arrangements in place. But it also varies over time: recent studies have shown that international risk sharing can be highly dependent on the business cycle, typically declining during recessions, that is when it is most needed. The interaction of these three dimensions (channel, country, and time)is particularly interesting in the case of the euro area. The latter entails peculiar economic, political and institutional arrangements, it has evolved over time, and it has endured several recession-expansion cycles since its creation. This chapter finds that the degree of risk sharing among euro area countries varies over the business cycle, but with changing patterns over time. The chapter also analyses business-cycle effects on three risk sharing channels – namely international factor incomes, international transfers and credit markets – and then investigates to what extent financial frictions are responsible for muted smoothing responses. From a policy perspective, the chapter’s findings that financial integration affects international risk sharing during recessions and booms suggests that the pursuit of the Savings and Investment Union and further elimination of financial barriers to the completion of the Single Market would contribute to improve shock-absorption in the euro area. Our results could also rationalise a more active role of counter-cyclical fiscal policy.