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Global macro & geopolitics from a small economy perspective

It’s a small world after all

David Skilling
28 October 2011

This is the latest edition of an email series containing reflections on globalisation, policy, and public sector issues. One of the problems that advanced economies are facing in dealing with various structural challenges is that the world is a more crowded place because of the rapid growth of emerging markets. So this week’s Observer considers the impact of the latest phase of globalisation on the effective size of countries, and what this means for policy approaches as well as for the behaviour and performance of the global system.

Making the large small
It is well understood that globalisation makes small countries larger, as they can access global markets and are not restricted to their domestic market. And indeed, small advanced economies have performed strongly over the past several decades – benefiting from strong global growth, a rules-based multilateral system, and reduced cross-border barriers. But the current phase of globalisation is also making large advanced economies smaller. The global economy is becoming genuinely global, with emerging markets now accounting for over half of global GDP growth. The share of global GDP produced by advanced economies has been reducing relatively slowly, from about 75% in 1980 to about 68% in 2010. But this rotation is accelerating, and advanced economy GDP is projected to reduce to about 40% of the global total by 2030. And China is widely expected to become the largest economy in the world within the next 15 years. Institutionally, this movement in the global economic order is reflected in the transition to bodies such as the G20.

As importantly, globalisation is reaching further into the domestic economies of all countries, including larger countries. Technology and new business models are increasing the share of economies that is exposed to international competition; much less is genuinely non-tradable. Even large economies are affected by global pressures on the income distribution, sharp exchange rate movements, and external economic shocks. Differences remain between large and small; being the reserve currency issuer still matters. But the great convergence process is steadily reducing the effective size of large countries.

Canaries in the mine
Perhaps the best place to start to consider what this means is to examine the behaviour and performance of small countries. Small countries are the canary in the mine of the global economy. These countries tend to be much more exposed to the global economic environment, and have more experience with dealing with intense globalisation. The policy approaches of small countries are therefore likely to provide guidance as to how other countries will increasingly respond to the challenges and opportunities of globalisation.

There is no single small country approach to economic policy; the Nordic countries are different from Hong Kong, for example. But there are some general ways in which policy in small open economies differs from that in large economies. Three areas seem more prominent in small country policy debates. First, deliberate competitive positioning to ensure that the country can attract and retain capital and labour, and grow. Some countries compete by creating a world-class business environment and others compete by developing key sectors. But without a distinctive value proposition, small countries are in trouble. Second, more active management of risk and increased investment in resilience because small countries are more exposed to shocks and have reduced margin for error. For example, small countries are more likely to be fiscally prudent and to be thoughtful about social insurance arrangements. And third, a more active pursuit of regional and other relationships to find ways of expanding their effective size. In addition to being strong supporters of the multilateral process, small countries are adept at managing their portfolio of relationships.

Different countries apply these principles in different ways; the way in which Singapore competes and manages its risk exposures is quite different from Denmark, for example. But, in general, policy in small countries is much more responsive to the global environment and accepts that it cannot shape the external environment. This gives an indication of the policy direction in which medium-sized and large countries may track over the coming years as the great convergence continues to reduce their effective size.

Thinking about the market structure of the global economy
It is often argued that a more distributed world will lead to an under-supply of global public goods and to a less stable world as countries compete with each other (although the current arrangements hardly seem optimal). And a broader distribution of global economic power certainly makes policy-making in the larger advanced economies more difficult, as the effectiveness of policy approaches weakens in a smaller economy context. But even if this change in the market structure of the global economy causes some problems, the change seems almost inevitable given the power of the great convergence process. In any case, based on the above observations of small country behaviour and performance, it may be that a non-polar world with more smaller, less dominant countries may contribute to global prosperity and stability.

Countries competing to develop the best policy settings, and feeling an increased pressure to respond effectively to a changing external environment in a way that fits their context, may create a more dynamic, innovative global economy – not the mercantilist environment sometimes feared. Indeed, small, advanced economies have out-performed over the past several decades, and have a reputation for policy innovation. A more distributed world may also be more resilient, both because of the increased attention to risk management within smaller countries – and also because it is less likely that shocks generated in a large country will be able to radiate through the system. There will be fewer elephants in the room than has been the case. Smaller countries also have a greater stake in an orderly, cooperative environment as they are more exposed to what happens beyond their borders.

Either way, managing the shift to a more distributed model of global economic (and political) power will require new institutions, networks, and approaches to be developed to manage a more complicated set of relationships. The world may increasingly be driven in a more bottom-up than a top-down way. It is a world that small countries are likely to feel at home in.