Integration of financial markets within the euro area has so far failed to deliver for households looking to maintain their living standards and manage risks in the face of unexpected fluctuations in their incomes. That is the central finding of a study by Professors Tullio Jappelli and Luigi Pistaferri, published in the June 2011 issue of the Economic Journal.
Europe''s economic and monetary union (EMU) has been the single most important policy-induced innovation in the international financial system since the collapse of the Bretton Woods system. It has removed exchange rate risk and lowered cross-border transaction costs, opening the possibility for the creation of a fully integrated continental financial market comparable to that of the United States.
But to what extent has this process of regulatory reform affected the ability of households to diversify, insure and shoulder risks? These researchers address this question by studying the effect of the euro on the behaviour of Italian households. The conclusion of their study is not pretty: they find that EMU has not had any significant impact on the ability of consumers to reduce the impact of income shocks.
In theory, the process of financial market integration should improve the ability of consumers to maintain their living standards unchanged in the face of shocks and increase opportunities for sharing risks. First of all, integration spurs the efficiency of financial intermediaries and markets in countries where the financial system is more backward and more heavily regulated (as was Italy before EMU).
This fosters the growth of domestic financial markets and the entry of foreign banks – and should improve households'' access to credit. As a result, country-specific shocks should have a smaller effect on consumption when international financial markets are integrated, since they can be diversified away by borrowing abroad or holding foreign assets. At the same time, easier access to credit should help domestic borrowers to buffer specific shocks to their incomes.
Jappelli and Pistaferri''s result that the introduction of the euro has not produced significant changes in consumption-smoothing opportunities in Italy signals that financial integration remains a work in progress for the euro area. While integration has progressed substantially since, and in part owing to, the introduction of the euro, many markets are still fragmented and the pace of integration varies among member states.
Indeed, the effect of financial market integration is quite visible in the European bond markets, and there is some evidence of increased integration of equity markets, with a decline in ''home bias'', although important institutional barriers remain.
Credit markets, by contrast, have integrated at a slower pace, reflecting in part the informational advantage enjoyed by local lenders as well as differences in taxes, labour regulation and financial regulation. Further progress towards credit market integration is necessary to feel the benefits of integration and its effect on consumption smoothing.
''Financial Integration and Consumption Smoothing'' by Tullio Jappelli and Luigi Pistaferri is published in the June 2011 issue of the Economic Journal.