I propose a novel channel of international risk sharing: the common currency channel. I theoretically show how the central bank of a currency union can use the common currency to insure member countries against consumption risk from idiosyncratic productivity shocks. A trade-off between risk sharing and moral hazard emerges: a central bank which enables risk sharing induces countries to free ride on each other's production efforts. I study this trade-off and derive rules for a central bank striking the optimal balance between insurance and incentives. Monetary policy determines current account imbalances that are financed through the central bank rather than through the transfer of marketable assets. Optimal policy is contingent on the realization of aggregate production and on the severity of the underlying moral hazard friction. Revisiting European Central Bank policies during the Eurocrisis between 2008 and 2014, I interpret the buildup of TARGET2 balances as risk sharing through the common currency. I find that the common currency channel accounts for up to 60% of risk sharing among Eurozone countries in the early stages of the Eurocrisis. I conclude that the common currency can be a substitute for risk sharing through fiscal integration.
Mitigating climate change is a global public good to which many different countries contribute. The incentive of each country to contribute through the provision of effective climate policies depends on other countries’ contributions. Climate policy risk spillovers arise when expected changes to climate policy stringency in one country affect expected climate policy stringency in another country. We present evidence for the existence of such climate policy risk spillovers from the United States (US) to the European Union (EU). Using an event study approach, we find significant effects of US climate policy events on the price of EU emission allowances (EUA): US policy events that signal weaker US commitment to climate protection decrease the price of EUA futures while US policy events that signal stronger US commitment to climate protection increase the price of EUA futures. This evidence is in line with the notion that financial markets expect EU climate policy to follow the direction of US policy. More broadly, our results point to the importance of regulatory risk spillovers that affect global climate policy coordination.
Agency Cycles (with Christoph Carnehl)
The sociological literature indicates that within diverse communities, agents create externalities on each other when they consume market goods to express their identity. We provide a model in which local governments use taxation and agents adjust social networks to address identity expression externalities. We study how diversity affects social networks and taxation, and how the existence of a tax response to identity expression externalities impacts network choice. Taxation and network adjustments can be strategic complements or substitutes depending on agents’ taste for out-group identity expression: the marginal value of taxation as a tool to regulate identity expression can be increasing or decreasing in the agent’s exposure to out-group identity expression. Based on our theoretical framework we estimate a simultaneous equations model using US city data on ethnic diversity, taxation, and segregation. The empirical results indicate that segregation decreases as city governments use taxation to regulate identity expression.