How Good is International Risk Sharing? Stepping Outside the Shadow of the Welfare Theorems

We revisit whether global output is (Pareto) efficiently distributed across countries over time. The efficient allocation of goods across regions requires that the relative marginal utilities of consumption across countries comoves with the relative costs of the country-specific consumption bundles. Standard approaches to evaluating this property exploit the Welfare Theorems and equate the observed real exchange rate with the social relative costs of consumption. Given the large literature documenting the disconnect between exchange rates, relative prices faced by consumers in a given market, and relative quantities consumed, we develop a methodology that measures relative costs that is robust to this disconnect. We find that relative consumption growth across regions is significantly more correlated with our computed shadow prices than it is with observed real exchange rates, suggesting an allocation closer to efficient risk sharing. Moreover, we provide a decentralization that matches observed prices and quantities, enabling us to rationalize the better implied risk sharing with the failure of the standard correlations. The decentralization involves a combination of segmented foreign exchange markets and pricing-to-market behavior in goods markets. The model implies that consumption allocations are insulated from excess fluctuations in the exchange rate via the equilibrium pricing behavior of exporters.