Globalization and Risk Sharing

We study the effects of globalization on risk sharing and welfare. Like the previous literature, we assume that governments cannot commit to enforce the repayment of debts owed by their citizens. Unlike the previous literature, we assume that governments cannot discriminate between domestic and foreign creditors when enforcing debt payments. This creates novel interactions between domestic and international trade in assets. (i) Increases in domestic trade raise the benefits of enforcement and facilitate international trade. In fact, in our set-up, countries can obtain international risk sharing even in the absence of default penalties. (ii) Increases in foreign trade raise the costs of enforcement and hamper domestic trade. As a result, globalization may worsen domestic risk sharing and lower welfare. We show how these effects depend on various characteristics of tradable goods and explore the roles of borrowing limits, debt renegotiations, and trade policy. Copyright 2011, Oxford University Press.