Political economy of fiscal unions

- A model of a fiscal union composed of two regions is presented.
- Fiscal federalism helps regions insure against asymmetric shocks.
- The nature of the shocks determines whether the union is politically feasible.
- Both inter-regional correlation of shocks and their persistence are important.

Fiscal unions often use fiscal transfers to counter asymmetric shocks, but such transfers may be politically controversial. I present a model of a two-region fiscal union with region-specific shocks where the threat of secession imposes a limit on fiscal redistribution between regions. I show that both correlation of shocks across regions and their persistence over time are important for political support for integration. The gains from inter-regional risk sharing are potentially large when shocks are negatively correlated and temporary. In contrast, unions with negatively correlated permanent shocks are likely to be fragile.