The Case for Small Countries
Antonio Martino
Advantages of size. I intend to argue that, despite the advantages of size, small countries can outperform large ones, as evidence shows. My argument is based on the value of information on public budget in small and large countries and the consequent constraint on public budgets.
With over 194 countries in the world, it's easy to think the word "country" equates to a massive land area with large numbers of people. Some nations are so small that cities within other nations are giants compared to them. Mostly found in Europe, the Caribbean, and the Pacific, there are many countries in the world with an area of less than 400 square kilometers. The top 10 smallest countries in the world cover a total area of 1491.4 km² which is smaller than the area of the city of Houston, Texas (1625.2 km²)
On a first glance, big countries have two great advantages over small ones. The first is given by the size of the exploitable population. A large population means that the per capita cost of public spending decisions tends to be smaller than is the case in small countries. A $1 billion spending translates itself in a per capita cost of $10 if the population is 100,000,000, in one of $100 if it is 10,000,000. It’s a great deal easier, therefore, to raise the funds needed to finance the production of public goods, like defense, in a large than in a small country. Defense is only the most conspicuous example, others include a monetary and financial system, a judicial system, infrastructures for communication, police and crime prevention, public health, embassies, and national parks. As Alberto Alesina puts it: “A larger country (in terms of population and national product) is less subject to foreign aggression. Thus, safety is a public good that increases with country size. Also, related to the “size of government” argument here, smaller countries may have to spend proportionally more for defense than larger countries given the economies of scale in defense spending. Empirically the relationship between country size and share of spending on defense is affected by the fact that small countries can enter into military alliances, but in general, size brings about more safety. In addition, if a small country enters a military coalition with a larger one, the latter may provide defense, but it may extract some form of compensation, direct or indirect, from the smaller partner.” [1]
The second advantage is offered by the size of the domestic market. To the extent that larger economies and larger markets increase productivity, then larger countries should be richer. In fact, an extensive literature on “endogenous growth” emphasizes the benefits of scale. However, the five largest countries (by population) in the world are China, India, the United States, Indonesia, and Brazil. Among them, only the United States is a rich country. By contrast, many of the richest countries in the world are small. Of the ten richest countries in the world, in terms of GDP per capita, only four have populations above 1 million. [2]
The conclusion is obvious: if small countries want to overcome the disadvantage of a small domestic market and prosper, they should be open to international interchange.
The duties of government were thus stated by Adam Smith: “According to the system of natural liberty, the sovereign has only three duties to attend to; three duties of great importance, indeed, but plain and intelligible to common understandings: first, the duty of protecting the society from the violence and invasion of other independent societies; secondly, the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice; and, thirdly, the duty of erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals, to erect and maintain.” [3]
What is a disadvantage for defense and some other public goods becomes a great benefit in general. The size of the exploitable population means that the per capita cost of public spending tends to be higher when the population is small. The value of being correctly informed about the costs and benefits of public spending, therefore, is higher in small than in large countries. As a result, public opinions in small countries tend to be better informed on public budget’s decisions than in large countries. Small countries tend, therefore, to be more subject to democratic scrutiny and control than is the case in large ones.
This is one of the reasons why small countries tend to have more responsible governments and a more prudent management of public finances than big ones. This is, in my opinion, the main factor behind small countries’ economic success.
Consider two countries with roughly the same population size: both with highly educated populations, both spared the damages of WWII, both internationally known for the high quality of their products. The main difference between them is the generosity of nature: one, Sweden, largely endowed with natural resources; the other, Switzerland, very scarcely endowed. In 1970 Sweden ranked third in the OECD list of high per capita income countries, Switzerland second. Today, while Switzerland has kept her place in the rank, Sweden has fallen down to a much lower level.
The explanation of the difference in the performance of the two countries is simple: while Switzerland has kept public spending and taxation under control at a relatively low percentage of national income, Sweden has adopted an all-embracing and expensive welfare state. Public spending in Switzerland today is in the order of 35%, while in Sweden in some years it has reached an incredible 60%.
In other words, Wagner’s law of increasing state activity has applied to Sweden but not to Switzerland. Wagner's law, known as the law of increasing state spending, is a principle named after the German economist Adolph Wagner (1835–1917). He first observed it for his own country and then for other countries. The theory holds that for any country, that public expenditure rises constantly as income growth expands. The law predicts that the development of an industrial economy will be accompanied by an increased share of public expenditure in gross national product.
This difference is all the more remarkable in that the degree of homogeneity is very different in the two countries, Sweden being much more homogeneous than Switzerland. In this case, it was not size that made the difference – the population was almost the same in both countries – it was the constitution. The Constitution of Switzerland is, in my opinion, the best written Constitution in the world. The bulk of political decisions is in the power of the cantons and the confederate government has its spending and taxing capacities explicitly and effectively limited by the Constitution. Similar considerations apply to Liechtenstein and Monaco: their economic success has nothing to do with natural resources. It’s largely due to their constitution.
Homogeneity or the lack of it are very important, though they played no role in the Switzerland vs. Sweden case, because heterogeneity may translate itself in the formation of secessionist movements. This factor shows its relevance in a great number of countries, especially large ones.
In general, however, small homogeneous countries tend to perform better than large heterogeneous ones. This rule has some exceptions, Switzerland being the most conspicuous: a small heterogeneous country performing exceptionally well.
Things being so, small countries should perform better than large ones, except in the production of public goods like defense and foreign policy. What we are seeing today is a movement in the direction of a “new federalism”. The number of small countries tends to increase and so does the formation of international arrangements aimed at providing defense and foreign policy to small countries. Another public good whose production is attributed to the international organizations is free trade. They make sure that no barriers are introduced in the international interactions between small countries.
This is how the EU should perform. However, as we know, it’s not the way it does. Defense and foreign policy are still the responsibility of national governments and this results in inefficiency, especially in the field of defense. All European countries member of the EU spend on defense 50% of what the US does and get only 10% of the US military capability. The reason is obvious: when decisions on defense spending are made at the national level some degree of duplication and waste is unavoidable.
If total public spending is kept in check by democratic control, the need to raise total revenue is also constrained. This is why small countries in general tend to have low tax rates and a favorable fiscal climate. Low taxation encourages spending and investing, both foreign and domestic. Thus the myth that small countries are tax heavens. This is true only in the sense that they are not tax hells. Their tax systems are favorable to savings and investments and therefore they tend to attract foreign capital.
I do not think there is anything wrong with having a fiscal climate favorable to savings and investments, and it certainly seems wise for small countries to adopt such systems. The shortage of natural resources can thus be remedied by capital inflows.
A question arises at this point: should money and monetary policy be in the responsibility of national governments or should it be entrusted to international organizations? In the case of the EU, it was decided in favor of the international solution. That option, however, is not necessarily the optimal solution.
If the country is not too small, it would probably be better to leave money and monetary policy in the hands of national governments. The case for an international currency is largely based on the idea that, by so doing, we’d protect money from the risk of debt monetization. National currencies are exposed to instability resulting from the government financing of public spending through monetary expansion. International currencies are not exposed to that risk.
This is true. However, national currencies can be managed prudently and international ones are not necessarily immune from mismanagement. Inflation and deflation are bad at the national level, but they’d be disastrous for an international currency. Nations member of the EU have experienced monetary mismanagement and monetary instability in the past, but a European inflation or deflation would be devastating.
In conclusion, I believe small countries can outperform large ones if they are open to international interchange. They can overcome the disadvantage of size by being part of an international organization supplying them a sufficient amount of defense. This would require an effort on their part to resist the interference of larger countries or of the international organization on their autonomy.
Some small countries are not succeeding in this task. San Marino is almost non-autonomous, being dominated by Italy and the EU. The Vatican has succeeded in preserving its autonomy mostly because of the Holy See and the Catholic Church. Other small countries have not been that lucky.
Preserving the country’s independence is very important and international arrangements endanger the country’s autonomy. However, international alliances are unavoidable for most small countries because they are the only way to secure the necessary amount of defense. Switzerland is again the exception to this rule, being able to have the desired amount of nationally produced defense without having to enter into an international alliance.
Alfonso X, “the learned” King of Castille (1252-1284), is quoted as remarking: “If the Lord Almighty had consulted me before embarking upon the Creation, I would have recommended something simpler.” Alas, he was not consulted: we are doomed to live in a complex world.
[1] Alberto Alesina, The Size of Countries: Does it Matter?, Journal of the European Economic Association, 1, no. 2-3, 301-316
[2] Alberto Alesina, ibidem.
[3] Adam Smith, The Wealth of Nations, (1776), The Modern Library, New York 1937, 651.