Incomplete insurance and open-economy spillovers of labor market reforms

This paper studies how an unemployment-benefit reform in one member state of a mon- etary union affects savings, net foreign asset positions, and fiscal space across member states when households face incomplete insurance. Lower benefits reduce unemploy- ment 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 fis- cal 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 pro- posed 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.