Endogenous policy leads to incomplete risk sharing

Abstract

We analyze risk sharing and endogenous fiscal spending in a two-region model with sequentially complete markets. Fiscal policy is determined by majority voting. When policy setting is decentralized, regions choose fiscal spending in an attempt to manipulate security prices. This leads to incomplete risk sharing, despite the existence of complete markets and the absence of aggregate risk. When a fiscal union centralizes fiscal policy, complete risk sharing ensues. If regions are relatively homogeneous, median income residents of both regions prefer the fiscal union. If they are relatively heterogeneous, the median resident of the rich region prefers the decentralized setting.