Misallocation due to Incomplete Markets

We quantify the economic waste caused by limited risk-sharing and imperfect consumption smoothing within and across borders. We measure misallocation by the fraction of factor endowments left over if financial markets were completed and consumers were compensated to maintain their status quo welfare. This measure is a multi-agent extension of Lucas’s (1987) consumption-equivalent variation and does not rely on a social welfare function or on interpersonal utility comparisons. We provide exact formulas and deadweight-loss triangle approximations to quantify misallocation without taking a stance on income processes or portfolio problems. Applying our formulas to US household consumption data, we obtain benchmark estimates of losses equivalent to roughly one-fifth of aggregate consumption at every date and in every state. Across countries, abstracting from within-country heterogeneity, the losses are equivalent to roughly 5 percent of consumption in every country. The international losses are driven by fast-growing countries such as China and India, while unexploited consumption-smoothing opportunities among countries at similar levels of development are much more limited. Thus, most of the potential gains from more complete markets come from insuring household-level risks domestically and from intertemporal trade between fast-growing and slower-growing countries, rather than from additional risk sharing among similarly advanced economies.