Integration makes risk an opportunity to be shared

Policy makers need structural economic models in order to run counterfactual analysis and quantify the potential benefits of their interventions. In the past, many studies have focused mainly on the benefits of policies aimed at stabilizing short-term fluctuations - often referred as business cycle fluctuations. Recent concerns about global long-run economic growth, however, have prompted a novel and large body of policy-related studies that directly consider long-run growth risks, i.e., sources of uncertainty that unfold over long horizons and that are connected to medium- and long-run growth cycles. These risks should be interpreted in the spirit of the study written by Bansal and Yaron (Journal of Finance, 2004) and can be related to several relevant dimensions such as, for example, climate change, fiscal interventions, inflation dynamics, and innovation activities.
In 'Growth Risks, Asset Prices, and Welfare' (Economics Letters, 2021), I measure and characterize the welfare costs of aggregate consumption in an economy in which agents care about both short- and long-run risks as they feature a preference for early resolution of uncertainty. In other words, these agents are sensitive to news about the long-run prospects of the economy. This setting produces novel results that contrast with the common view in the welfare cost literature.

Specifically, prior studies suggest that fluctuations are costly mainly because they are random and people are risk averse. I show that the attention devoted so far to risk aversion is misplaced. Welfare costs are mainly driven by the degree of patience of the agent, i.e., the relative weight associated to future consumption, as opposed to risk aversion. In a representative household model, the low average of the US risk-free rate can be explained by either strong precautionary motives or extreme patience. In a Bansal and Yaron economy, the level of risk aversion required to match the historical equity premium is moderate and the average risk-free rate is matched by assuming a high degree of patience. As a result, long-lasting fluctuations are extremely costly and hence policies oriented to long-run stabilization can be extremely valuable.

These results apply also to international trade policies. In a joint paper with R. Colacito entitled 'The Short and Long Run Benefits of Financial Integration' (American Economic Review P&P, 2010), we note that there is an extensive theoretical literature in economics that has predicted negligible welfare gains from international financial integration. This conclusion is at odds with the results of many empirical studies pointing to significant inherent gains attained in terms of portfolio diversification, decreased cost of equity capital, and reduced financing constraints. We find large welfare gains from international financial integration. The intuition behind our results is that financial integration leads international investors to benefit from increased risk-sharing opportunities at different frequencies. Local short-run shocks are associated to negligible benefit from international risk-sharing. Long-run growth risks, in contrast, generate substantial opportunities for international risk-sharing and make international financial integration very valuable.

Summarizing, a long-run view of the economy makes policy making more complicated than one may think.