The future of small economies in a changed world

Published in the Straits Times

After several decades of an international economic and political environment that has been highly supportive of strong small economy performance, there are indications of meaningful change.  From the risks of greater frictions in globalisation, to the rise of populist policies and increased geopolitical pressure, aspects of this new context are likely to be challenging for small advanced economies.  Indeed, there has been much commentary about the emerging external challenges facing Singapore, from the growing potential for protectionism to changes in the security environment in Asia.

So are small economies structurally disadvantaged relative to larger economies in this new world?  Is the strong performance of small economies over the past few decades simply due to the specific environment enjoyed over this period?

The past 200 years of economic history provides some insight into how changes in the international environment impact small economies, including Singapore.  My analysis suggests three key lessons.

First, the performance of small advanced economies is clearly sensitive to the state of the global economic and political environment.  In general small economies like Singapore perform best in periods of healthy global growth, strong globalisation, and geopolitical stability.  But this has not always been the world that small economies have operated in.

From 1820, when relatively broad-based economic data becomes available, larger economies were closer to the income frontier than were smaller economies.  I define the income frontier as the highest per capita income level in each year, averaged across the top three countries. Through the 19th century, it was the larger economies that were best placed to benefit from the Industrial Revolution and the first wave of globalisation: from Germany and France to the UK and the US.  There were exceptions: newly-colonised Australia and New Zealand, for example, benefited from resource endowments and tight links to the UK.

The first half of the 20th century was full of economic and political shocks – two World Wars, protectionism and hyperinflation, and a Great Depression.  This was bad for many countries, large and small, but small economies were particularly exposed.  

But the process of post-war reconstruction and the second wave of globalisation from the 1950s provided support for a process of convergence of small economies to the income frontier.  The small Asian tiger economies, such as Singapore and Hong Kong, provide examples of this process.  In the 1970s, both small and large economies struggled to navigate a series of economic and political challenges – with no clear small economy edge.  But from the late 1980s, with intense globalisation commencing, small economies began to over-perform consistently.  This included countries from Singapore and Ireland to the innovative Nordic economies.

Second, although this historical record shows that small economies are sensitive to the global economy, there is also evidence of resilience to structural changes in the international environment.  There are several small economies that have a history of sustained strong performance over the past few centuries, being able to cope with economic and political shocks. Small economies should not be seen as fragile, able only to perform in highly supportive conditions.  

Switzerland, the Netherlands, Denmark, and Belgium have been able to sustain positions close to the income frontier over multiple economic and political regimes.  Switzerland is perhaps the classic example of a resilient small economy.  Switzerland first reached the frontier around the 1860s, having been an early participant in the industrialisation process.  Since then, Switzerland has remained at or near the income frontier – even through wars and economic shocks.

Many other small advanced economies have approached the income frontier over the past several decades.  For example, Sweden and Finland were able to build on their strong industrial bases by taking advantage of the opportunities provided by globalisation.  And Norway has catapulted to the top of the income rankings by virtue of well-managed use of its oil and gas resources.  Singapore, Hong Kong and Ireland converged rapidly towards the income frontier from the 1960s, on the basis of externally-oriented growth models that emphasised FDI attraction.  

These countries – from the Nordics to Ireland and Singapore – have now been at or near the income frontier for decades, and have been able to navigate through various economic and financial crises.  But it is more difficult to assess the depth of resilience of this group of small economies because this has not yet been tested by a marked shift in the underlying regime. 

Third, looking across the group of small economies that have been resilient to multiple regime changes, some common characteristics emerge.  Although there is no specific policy template for small country success, there do seem to be characteristics that reduce economic risk exposures and strengthen national resilience.  

Resilient small countries tend to have strong political institutions, supported by social capital and trust, which allow for high quality decision-making – both in terms of coherent policy strategy as well as flexible responses.  In addition, resilient countries tend to have strong national balance sheet positions, being creditors to the world; to have high levels of international competitiveness, with a large number of successful, internationally-engaged firms; to invest heavily in the future – from business investment, to R&D and human capital, to public infrastructure; and to be deeply integrated into their regional economies through economic and political institutions.

Singapore has many of these characteristics of resilience small economies, as well as an exceptional economic record over several decades.  But the key issue that has not been able to be fully tested is the extent to which the Singapore economic model is optimised for a particular model of globalisation.  Can this model continue to perform in a changed environment with greater frictions around international engagement?   The experience of other small economies that have successfully navigated regime changes may be useful in thinking about these risks.

Overall, the emerging global environment is likely to be less supportive for small economies than over the past few decades.  But we should not over-interpret this.  The historical record shows that small economies can perform well in challenging environments.  Many, although not all, small economies have characteristics that lend themselves well to ongoing strong performance: they are agile and flexible, competitive and disciplined.

So we should not be too downbeat about the outlook for small advanced economies.  Indeed, even in the challenging post-crisis period over the past several years, with sluggish world GDP and trade growth, small economies have continued to out-perform larger economies.  Small economies are a high-performing organisational form that can adapt to a changing international economic and political environment.    

However, there will likely be a wider distribution of economic outcomes across the small economy group.  Some small countries are better positioned to adapt to regime change than others.  As we move into an environment that may be markedly different, small countries should be thinking hard about how to build ‘deep resilience’ into their economies.  

Of course, small economies have long thought about developing resilience to shocks – building fiscal reserves, for example, to allow them to respond to economic shocks.  But in the current context, small economies should also be investing in building resilience to regime change in the international environment.  There will be a premium on improving the odds that economies can continue to perform even in less supportive environments; for example, in which cross-border flows of trade and capital are constrained.