Economic challenges of developed small states in a globalised economy November 2011

1. Economic challenges of developed small states in a globalised economyNovember 2011 Gylfi Zoega University of Iceland

2. Economic models commonly assume constant returns to scale in production where Y is output, A is the level of productivity, L is labour and K is capital and +=1. A measures both production technologies AT and social technologies AS (Eggertsson, 2008). Size matters if +>1, there are scale economies due to increased division of labour (as in A. Smith, 1776). By social technology we mean: • Formal rules, government and institutions • Social norms • Beliefs • Enforcement mechanisms

3. Due to the failure of collective action, self-interests of ruling groups, beliefs, values or limited understanding societies may end up with inefficient social institutions. Example: religion (heaven and hell) used more where administration is weak (Hull and Bold, 1994). How does government fit in? We start with the production function where and Ag is chosen from a set of possible institutions I where Lg denotes public employment and Lp private employment.

4. Increasing returns to scale in public administration (Alesina and Spoalare, 1997) and defence (Harden,1985):  > 1 • Fixed costs of providing public goods. • Per capita cost of public good provision is likely to be decreasing in country size. Example: National defence, foreign service, … • Administrative burden increasing in size (Kazarda, 1974): >1.

5. Benefits of small size • Kasarda (1974) argues that social systems experience an increasing administrative ratio with increasing system size. Mayhew and Levingar (1976) find that the expected level of interaction in a system is a multiplicative function – instead of additive – of system size. • In contrast Noell (1974) found in a study of 50 state governments in the U.S. that the proportion employed in state governments declines with increasing system size. This implies economies of scale in public administration. • Blau (1972) finds a downward-sloping relationship between size and administrative burden where economies of scale first dominate but at a declining rate. • Nolan (1979) finds a U-shaped relationship where economies of scale first dominate.

6. Public sector challenges in small countries (Farrugia, 1993, and others) • Multitasking within public sector. • Wider perspectives. • This weakens expertise in each area. • Increases job pressures, lowers job satisfaction. • Difficult tasks sometimes postponed due to the daily demands for prompt decision making. • Small populations. • Limited number of able individuals with required training (Streeten, 1993). • Competing demands: pundit–politician–professor. • International commitments. • Necessary • Time consuming

7. Public sector challenges – continued. • Interpersonal relations. • Closely integrated network of personal relationships. • Facilitates and obstructs communications. • Informal decision making processes. • Quick implementation of decisions. • Conflicting pressures. • Decisions can be modified due to personal interventions and community pressures. • Nepotism and corruption in extreme situations. • Transparency. • Lack of anonymity problematic.

8. Social cohesion. • Factions, grudges, polarisation. • Small issues assume national prominence in small states. • Community rivalry and civil strife. • Deadweight losses. • Small country syndrome. • Small countries tend to have a strong national and cultural identity • Attempt to emulate larger countries without realising their uniqueness.

9. Other issues. • Imperfect competition in non-traded goods sector. • Lack of diversification into more activities makes small economies vulnerable to terms of trade shocks (Armstrong and Read, 1998). The data: volatility but no obvious effects on growth and income per capita. Head (1995) finds that the variances of both output growth and consumption growth are negatively correlated with population size.

14. Small states have more volatile output and consumption (Easterly and Kray, 2000, Head, 1995). • Due to less diversified endowments and production.

15. Globalisation Globalisation involves an increase in the scale and complexity of businesses. Firms may then enjoy economies of scale by extending their operations to other countries. Increased trade linkages also make systems more complex. In contrast public administration is constrained by the local labour force and Local institutions.

16. Public sector workers may not be able to provide adequate supervision of domestic businesses. • They may not fully understand international regulations. • Systems become too complicated for politicians to understand fully. • Bureaucrats become more important but at the same time their comprehension is also limited. • Danger that adherence to the letter of the law instead of an understanding of their meaning prevails.

17. Examples: Icelandic fishing industry: successful and secret! Pharmaceutical industry: successful Less successful: The globalisation of Iceland’s banking system.

18. Large size is no guarantee: http://www.emailthis.clickability.com/et/emailThis?clickMap=viewThis&etMailToID=1448493341&pt=Y http://www.emailthis.clickability.com/et/emailThis?clickMap=viewThis&etMailToID=1911773950&pt=Y