The Home Bias and Capital Income Flows between Countries and Regions

Abstract

This paper documents a marked increase in international consumption risk sharing throughout the recent globalization period. Unlike earlier studies that have found it difficult to document a consistent effect of financial globalization on international consumption comovements, we make use of the information implicit in the relative levels of consumption and output to measure long-run risk sharing among OECD countries and US federal states.nWe derive our empirical setup from a deliberately simplistic model in which countries can trade perpetual claims to each other's output (Shiller securi-nties). Our framework allows us to distinguish between two channels of risk sharing: ex ante diversification that leads to income smoothing through cap-nital income flows and ex-post consumption smoothing through savings and dissavings. The model successfully replicates the patterns of income andnconsumption smoothing observed in both U.S. state-level and international data. The increase in international consumption risk sharing is closely associated with the decline in international portfolio home bias. While capital income flows remain relatively limited as a channel of risk sharing at businessncycle frequencies, we find that better international portfolio diversification has led to a considerable increase in capital income flows at medium and long horizons.