Mitigating Risk Together: The Advantages of Collaborative Private and Public Risk Sharing
A problem shared is a problem halved – the benefits of private and public risk sharing.
What is the best way to absorb economic shocks? Some argue for private risk sharing, others for public risk sharing. However, in this ECB Blog post, we contend that combining both offers the best protection against poor economic performance for European citizens. Moreover, with Europe coping with two unprecedented economic shocks caused by the global pandemic and the war in Ukraine, risk sharing becomes necessary to increase resilience and preserve convergence within the Economic and Monetary Union (EMU).
Risk-sharing matters as shocks are not symmetric.
Joint, external shocks like the coronavirus pandemic result in asymmetric impacts across Member States due to these states’ different economic, financial, and institutional structures. European countries have also been affected differently by shocks caused by the war in Ukraine. In addition, the implementation of sanctions imposed on Russia and different dependencies on various energy sources matter for their exposure to the shock, leading to asymmetric impacts across Member States. The asymmetries resulting from these shocks pose a dilemma. Should public resources at the European level be used to deal with them, or should that be left to market mechanisms?
The Optimal Interaction of Private and Public Risk Sharing
Thus far, the economic debate has focused on “either public or private risk sharing.” Private risk sharing mainly refers to providing risk sharing via the banking sector and capital markets. Public risk-sharing refers to risk-sharing via standard fiscal tools and potentially via public goods delivered at the European level. However, we contend that good arguments and evidence exist that the two-public and private-should complement each other, especially in times of crisis.
The Euro Area Lags Behind on Risk Sharing
The euro area has lower risk sharing on average than the United States- to compare it with another similarly sized continental monetary union. However, we observed a rise in risk sharing within the euro area immediately following the global financial crisis. This highlights the role of euro area financial assistance instruments in shock absorption, considering risk sharing deteriorated after 2015. The question is, should public or private risk sharing be promoted, or both, and to what degree, to provide for consumption smoothing and reduce economic divergence between member states following each shock?
- Private risk-sharing can be hampered by the interconnected nature of financial markets, causing national and international spillovers of risks.
- Public risk-sharing must be balanced against the associated moral hazard risk created by shielding individuals or firms from the full consequences of their actions.
- Countries’ institutional set-ups, including national social security systems and the relative importance of capital markets and banking sectors, affect the trade-off between public and private risk sharing.
The COVID-19 pandemic and the war in Ukraine have caused economic shocks across Member States. As shocks are not symmetric, risk sharing is necessary to increase resilience and preserve convergence within the Economic and Monetary Union. The public and private risk-sharing mechanisms should complement each other, especially in times of crisis. The lack of risk sharing in the euro area calls for carefully examining how public and private sectors can be balanced to provide for consumption smoothing and reduce economic divergence between member states following each shock.
Public or private? When dealing with economic shocks that hit Member States asymmetrically, this may not be the right question. Looking at the optimal interaction of public and private risk-sharing mechanisms is essential to provide adequate protection against poor economic performance. The euro area might have lower risk-sharing than the United States. Still, with careful consideration, the public and private sectors can work together to increase resilience and preserve convergence within the Economic and Monetary Union.