Tuesday, May 19, 2009

Risk sharing among states: Canada does it well

While individual and firms can, at least to some extend, insure against various eventualities hitting them, governments do this remarkably little. Of course, they have some policies available, like fiscal policy, monetary policy and in particular borrowing against future tax revenue, but they do not exploit risk sharing. The only exception are the facilities provided by the International Monetary Fund. But within countries, it appears some good mechanisms are in place.

Faruk Balli, Syed Basher and Rosmy Louis look at Canada at the various ways the provinces have to share risk. Interestingly, only 19% of the risk is left after: capital markets (40%), federal government transfers (25%), and credit markets (16%). The large share of capital markets is attributable to the fact that the relevant banks are present nationwide. Federal transfers include direct transfers to provinces through perequation as well as federal social programs. Finally, the direct access of provinces to credit markets has become less important for smoothing, likely because of more chronic provincial deficits (instead of cyclical ones) and the more positive correlation of them across provinces.

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