Collective risk sharing: The social safety net and employment

The direct effects as well as the policy responses to the financial crisis have raised the issue whether individuals carry too large costs and consequences of changes which are beyond their control and influence. Collective risk sharing is considered insufficient and in need of expansion. The policy focus is thus shifting from incentives to insurance, and it is debated how welfare state arrangements can trade-off efficiency and equity concerns. While this trade-off is core to economics, most policy analyses and advice focus only on the incentive or distortion side. This paper looks at the insurance side based on the fact that it is impossible to separate redistribution from collective risk sharing. It is argued that insurance effects are crucial for behavioural responses and hence the relation between efficiency and equity. However, two factors limit the scope for collective risk sharing, namely, adverse incentive effects (common pool) and the nature of shocks. It is argued that the former depends crucially on policy design, and in particular the extent to which eligibility criteria in the social safety net have an active focus on job search and employment. Collective risk sharing schemes are vulnerable to persistent shocks, and it is an important question whether welfare arrangements themselves are a source of more inertia or persistence in the adjustment process. It is argued that there is no evidence that this is the case, but nonetheless persistent shocks pose a serious challenge to an extended welfare state.