Misallocation due to Incomplete Markets

We quantify misallocation caused by limited risk-sharing and imperfect consumption smoothing within and across borders. We measure misallocation as the share of resources left over if financial markets are completed and consumers are 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 that can be applied without specifying income processes or modeling households’ portfolio choices. We find that incomplete risk sharing across US households destroys the equivalent of about 20 percent of aggregate US consumption. Incomplete risk sharing across countries, abstracting from within-country heterogeneity, destroys the equivalent of roughly 5 percent of world consumption. The latter is 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.