Incomplete Insurance and Open-Economy Spillovers of Labor Market Reforms

This paper studies how an unemployment-benefit reform in one member state of a monetary union affects savings, net foreign asset positions, and fiscal space across member states when households face incomplete insurance. Lower benefits reduce unemployment and increase fiscal space in the reforming country. Employed workers increase their precautionary savings to compensate for reduced public insurance. A portion of these savings is invested abroad, pushing the non-reforming country into a negative net foreign asset position and lowering its long-run consumption. Despite raising fiscal space and long-run average consumption in the reforming country, the reform may decrease ex-ante welfare because it reduces insurance and depresses consumption during the transition as households self-insure through higher savings. We discipline our proposed model with firm-level evidence on Germany’s post-reform tradable-sector expansion following the Hartz IV reform of unemployment benefits. In our simulation, this reform accounts for a substantial share of the observed post-reform open-economy adjustment, whereas the earlier wage moderation cannot explain most of the observed patterns.