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Small Open Economies and Vagaries of Globalization

by Jukka Pekkarinen

Empirical investigations of the growth of nations give some support to the hypothesis that smallness as such is a factor that inhibits growth. A small country may lack the necessary scope of markets for utilizing economies of scale or matching the various types of skills required for bringing a new product to the market.

To overcome the handicap of smallness, small countries have sought for access to international markets. In fact most small industrialized countries can be characterized as small open economies with a high share of foreign trade in GDP as well as concentration of export industries on a few branches.

Specialization, on the one hand, promotes efficiency. But, on the other hand, it increases the sensitivity of the economy to external shocks of various kinds. Shocks which have a strong impact on some main export sector of a small economy can disrupt its whole economic fabric. To avoid this, small open economies have to be flexible.

In practice, small open economies have opted for various sorts of buffers to shield themselves from extra instability and uncertainty due to their high degree of external exposure. A typical response of a small open economy has consisted of developing a sophisticated system of social security and welfare services as well as centralized wage bargaining and a consensual model of economic policy making based on close co-operation between government and well organized labour market partners.

This in turn raises the question, are small open economies faced with a double handicap, i.e. not only smallness as such but also institutions like big government, powerful unions and centralized bargaining which, in economists’ eyes, are generally considered to inhibit growth and prosperity?In practice, small open economies have opted for various sorts of buffers to shield themselves from extra instability and uncertainty due to their high degree of external exposure. A typical response of a small open economy has consisted of developing a sophisticated system of social security and welfare services as well as centralized wage bargaining and a consensual model of economic policy making based on close co-operation between government and well organized labour market partners.

European experience does not support such a conclusion. As a matter of fact, the growth and stability performance of small open economies has been relatively good. In comparisons based on PPPadjusted level of GDP per capita, various indices of standard of living and human development as well as the level of unemployment etc., small open economies on the Northern and Western edge of the continent generally outperform most of the bigger European countries. Moreover, differences in the level of well-being have increased to the favour of small countries in the sense that the latter have either been rapidly catching up more advanced big economies or, if already above the level of the big countries, have succeeded in extending the gap further. Nor is there any indication that, in comparison with bigger countries, small countries should have had any overwhelming lack of stability.

One is bound to conclude, then, that small open economies have succeeded in finding a good match between protection and stability on the one hand and dynamism as flexibility on the other. Their welfare states have a resemblance with a collective insurance system which heals for market failures without having any serious backlash on labour demand or supply. The centralized wage bargaining system in turn aims at co-ordination which safeguards overall stability of cost developments without excessively preventing adjustment of wage differentials at the local level.

In the early 1990s, while preparations for the euro were made and it was introduced, the good relative performance of the small countries has become all the more striking. This suggests two things. First, the euro may have been of greater marginal advantage to small countries by e.g. providing them with access to new markets and better shelter against the turbulence of international money and currency markets.

Second, the small European economies, thanks to their ability to co-ordinate wage bargaining, may have been better equipped to meet the challenge of common monetary policy. Through their better ability to control wage cost developments, these countries have found a better match between low inflation and low unemployment than bigger countries capable of creating, at best, only various sorts of loose ‘social pacts’.

But the risk remains for a small open economy that sometimes the disruptions emanating from the external environment are so overwhelming that the country just can’t cope with them, not at least in the short run.

Recent experience of the Finnish economy exemplifies this last point. The Finnish economy was subjected to two successive shocks in the 1990s. First, at the beginning of the decade, the country was hit by a sharp recession. From 1990 to 1993, total output in Finland declined by 12 per cent and unemployment rocketed from 3.5 per cent to more than 16 per cent. The roots of the recession can be traced back to an overexplosion of credit markets in the late 1980s due to failures made in the design of financial deregulation.

In 1994, a rapid export-led expansion was launched which lasted until 2000. Annual growth rate reached 5 per cent on average; and employment increased rapidly. Yet unemployment came down much more slowly than was generally expected, and at the end of the decade the unemployment rate still stayed above 9 per cent.

The combination of rapid output growth, respectable increase in the number of jobs and stubbornly high unemployment in Finland during the Figure 1: Change in Finland’s employment by industry during the recession and recovery Source: Roope Uusitalo’s calculations based on data from the Labour Force Survey (LFS). Industry classification according to ISIC 23 digit classification as used in the LFS. years of rapid growth in the 1990s can be attributed to pattern of growth itself. Expansion was biased towards a few export industries to the extent that it in fact entailed a second shock in the course of the 1990s.

Share of exports in Finnish GDP almost doubled to close to 50 per cent (at fixed prices). Growth was concentrated in telecommunications and related industries, which recruited mostly highly educated labour force. These vacancies were to a large extent filled by people coming directly from various institutions of higher education, while people who had become unemployed during the recession, having a low educational record, lacked the required skills. The pattern of jobs growth during the expansion differed markedly from concentration of job shuffling during the previous recession (see Figure 1).

It seems that these two successive shocks, i.e. recession and exportbiased expansion thereafter, exceeded the adjustment capacity of the economy. As a consequence, extensive long-term unemployment and labour market exclusion led to a significant increase in the incidence of poverty in Finland. More generally, the recent Finnish experience reveals that sometimes the structural shifts in a small open economy can be so abrupt that even well-developed flexibility mechanisms do not suffice to absorb them. Instability risks of external exposure can sometimes lead to unpleasant consequences.

Jukka Pekkarinen is the Director of The Labour Institute for Economic Research in Finland, which is an independent and non-profit research organization founded in 1971. Dr Pekkarinen is also a member of the WIDER Board.