Revisiting the Case for a Fiscal Union: the Federal Fiscal Channel of Downside-Risk Sharing in the United States

Differentiating between standard risk measures and downside risk has a longstanding tradition in finance. Interestingly, this fundamental distinction has been neglected in the literature on risk sharing. Drawing on a simple definition in Markowitz (1959), we translate downside-risk metrics appropriate for stock returns into ones that can be used in our macro-forecasting setting, and propose a new methodology to estimate channels of downside-risk sharing, with an application to the federal fiscal channel in the United States. Our work reinstates some discarded arguments as to why a fiscal union could be desirable, as our findings suggest that public risk sharing is considerably higher than was previously thought. We also show that the great importance long attributed to the capital market channel estimated with popular income smoothing methodologies is instead entirely driven by the neglect of the effect of capital depreciation. Therefore, our paper argues that the relative importance of the fiscal channel as compared to the capital market one has been substantially underestimated.