April 17, 2005 to April 23, 2005
Small Countries
Why Small has Become Beautiful-BECKER
In the Federalist papers, Alexander Hamilton argued for the proposed U.S. Constitution that gave the federal government great powers because he claimed large countries with strong central governments have freer internal markets, can better deal with foreign aggression, and can raise taxes more easily to pay for needed government services.Yet since 1946, the number of countries has grown from about 76 to almost 200. Some of that growth has been due to countries gaining independence from colonial powers, such as India or Zaire. Others resulted from a subdivision of countries into smaller units, such as the breakups of Czechoslovakia into the Czech Republic and Slovakia, or of Yugoslavia into several independent nations. Agitation to form independent nations continues in all regions of the world.
Has this splintering into smaller nations, often due to nationalistic aspirations, lowered their economic efficiency? My conclusion is that developments in the global economy during the past 50 years have greatly reduced the economic disadvantages of small nations enumerated for his time by Hamilton. In fact, being small now may even have efficiency advantages. This would help explain the splintering of nations along ethnic, religious, linguistic, and geographic lines.
In the past, larger nations generally provided bigger domestic markets with relatively low barriers to movements of goods, services, capital, and labor. By contrast, tariffs, quotas, capital and immigration constraints severely limited the movement of goods, capital, and people across national boundaries. But many of these barriers have come tumbling down as international trade has boomed for the past half century, propelled at first by GATT and then by the World Trade Organization (the WTO). Members of the WTO are forced to have low tariffs and quotas on import of most goods and services, and to some extent, on capital as well. As a result, world imports and exports have grown since 1950 at the remarkable rate of about 10 per cent per year
In other words, small countries can now gain the advantages of large markets through trading with other nations. So it is no surprise that international trade generally constitutes a larger fraction of the GDP of small nations than of large ones. For example, exports in 2004 relative to GDP are about 10 per cent for the United States compared to 37 per cent for Iceland. Most poor nations that experienced rapid economic growth during the past four decades also were extensively involved in international trade. This is true not only of the Asian tigers- South Korea, Taiwan, Japan, Singapore and Hong Kong- but also of Chile and Mauritius. These are all small except for Japan. In addition, much greater use of international trade helped rescue the two giants, China and India, from their long economic sleep.
Smaller nations even have some advantages in a world with much international trade. Their exports are too little to be considered a threat to other nations, so they are not subject to as many barriers as those from large nations, They often specialize in niche markets that are too insignificant, or not accessible, to large nations. For example, the tiny principality of Monte Carlo with about 5000 citizens has become a tax haven and gambling center for rich sports stars and other wealthy individuals. Singapore and Hong Kong have been mainly trading centers for shipments of goods to their much larger neighbors. Mauritius has succeeded by concentrating on textiles and tourism.
Apropos of Hamilton's other arguments, small nations can now free ride on the military umbrella provided by the United States, NATO, or the United Nations. Small nations may still be at a disadvantage in providing other government services, but powerful groups in large nations often use the economies of scale in raising taxes and dispensing subsidies to exploit weaker ethnic, national, or economic groups. Smaller nations are usually also more homogeneous, so the powerful interests there have fewer other groups to exploit.
Tariffs and quotas on foreign producers impose a relatively big economic cost on small countries since they have little influence over the international prices of imports and exports. This cost reduces the ability of domestic producers to get politicians and voters to go along with their efforts to weaken competition from producers in other countries.
The economic consequences of the reunification of East and West Germany demonstrate some of these advantages of being smaller. East German productivity was much below that in West Germany when the communist government was overthrown. Economists both inside and outside of West Germany warned against the consequences of both exchanging one East German mark for one West German mark, and preventing East German wages from falling much below those in West German. The result not surprisingly has been very high rates of East German unemployment- still around 20 per cent- with the unemployed and others supported by massive financial transfers from West German taxpayers. These transfers more than a decade after reunification still amount to 4 per cent of total German income.
Both Germanies would have been better off economically if East Germany remained independent, and had an agreement with West Germany for free movement of goods, people, and capital across their borders. Wages in the East would then settle at a fraction of those in the West to reflect the lower productivity of East German workers. These low wages would attract companies from Germany and elsewhere to outsource some activities to the East that would provide jobs and raise employment and wages. Unfortunately, the prospects of attracting investments in East German have worsened with the expansion of the EU to include central European nations, like the Czech Republic, Slovakia, and Poland, with much cheaper, and less unionized, labor.
The split into the Czech Republic and Slovakia about a decade ago is also instructive. There was concern then that Slovakia would have trouble going it alone because they received transfers from the richer Czech region, and because many powerful leaders in Slovakia were ex-communists. But economic pressures forced a much more realistic assessment of what they needed, so Slovakia threw the communists out of power, and prospered by reforming rapidly toward a freer market economy.
My conclusion is that economic consequences no longer discourage secessionist movements that are driven by hostility among different religious, ethnic, linguistic, and other groups. This explains the continued secessionist pressure in some countries, such as the recent call by the main leader in the Basque region of Spain for a referendum there on whether they should become more or less completely independent from the rest of Spain. They already have considerable autonomy, so this example shows that giving power to regions is an imperfect substitute for full independence. Political pressure remains strong among French Canadians for Quebec to become independent from the rest of Canada, although this sentiment is weaker than a decade ago as Canadian regions have received greater autonomy. Many Kurds in Iraq, Iran, and Turkey still dream of an independent Kurdistan. The Tamils in Sri Lanka, and different groups in Indonesia continue their fight for independence. And is it any surprise that most Taiwanese do not want to become part of a greater China, despite growing threats from China?
Mainly due to the growth of the global economy and globalized trading, the evidence is overwhelming that small nations can now do very well economically, perhaps better than larger ones. In light of this evidence, it is surprising how many people, including economists, continue to believe that their economies will be ruined if secessionist movements succeed.
The Size of Countries'Posner's Comment
I agree with Becker that the costs to nations of being small have declined and that this decline, along with the dismantling of the colonial empires (mainly of Great Britain and France), are factors in the growth in the number of nations since World War Two. I am going to focus, however, on the benefits side of nation size. Even if the costs of being small decline, unless there are benefits to being small one would not expect the decline to affect the number of nations, especially if we assume as we should that there are significant transitional costs to splitting up a nation.
The question of what determines the size or scope of a nation has parallels concerning the size of business firms and other private and public organizations, and even the size of animals. In the case of a firm, size is determined mainly by the relation of size to average cost. When the firm is very small, an increase in its size, by permitting greater specialization of its workforce, is likely to reduce the average cost of the firm's output and thus make it more competitive. But beyond some point the gains from specialization will be exhausted and average costs will begin to rise because of increased costs of control. Effective control of a huge firm may require multiple layers of hierarchy, slowing and distorting information flows, although decentralization, as in a multidivisional firm like General Motors or General Electric, may enable the number of layers of supervision, and the associated costs, to be minimized.
Economies and diseconomies of scale (or scope'roughly, cost as a function of the number of products a firm produces as distinct from the quantity it produces of a single product) in the conventional economic sense also play a role in the determination of the size of countries. But other factors play a role as well, such as the advantage of size in defending against other nations. Here the analogy is to animals. Large animals are less vulnerable to predators than small ones are, and as a result tend to survive longer. (I am speaking of the individual animal, not the species.)
Historically, size has been enormously important to national survivorship. The nations that have disappeared completely, such as Prussia, Burgundy, the Republic of Texas, and the countless small kingdoms and principalities in Italy and Germany before the unification of those nations in the second half of the nineteenth century, have generally been small countries, though Becker is correct to note the continued survival of tiny "niche" countries, such as Monaco; this suggests that there is no minimum efficient size of a country, as there is of a steel producer. Large nations, however, have frequently fissured, such as Austria-Hungary and the Soviet Union, suggesting the existence of diseconomies of scale in the "market" for nations. Pakistan, a large but noncontinguous state, split in two. South Africa lost Namibia, Indonesia lost Papua New Guinea, Ethiopia gained and then lost Eritrea, and so on. What is new is that smallish nations, like Yugoslavia and Czechoslovakia, have also split; nevertheless, the splitting of small nations remains an infrequent phenomenon.
As Becker explains, with free trade the gains in specialization to a nation from having a large internal market diminish. And changes in military technology have reduced the military value of a large population, though not of a large GNP, which is a function in part of population. Nevertheless, if one glances over the entire history of nation formation and dissolution since the middle ages, one sees that the decisive factor has been the rise of nationalism. Nationalism is the belief that national boundaries should follow the contours of a "nation" in the sense of a population that has a common language, race or ethnicity, religion, historical origin, or culture, at least if that population lives in a contiguous area rather than being a diffuse minority in a larger polity, as some "nations" in the sense just defined, such as Jews and Armenians, are. The territorial nations of Israel and Armenia are limited to the areas in which the members of the ethnographic nation inhabit a compact, contiguous geographical area.
The greater the differences'in values, skills, language, and so forth'between two "nations" that inhabit adjacent territories, the fewer their common interests, and this complicates governance if they are made parts of a single territorial nation, in much the same way that corporate governance would be complicated in a firm that sold life insurance, diamonds, and hubcaps. The added costs may be offset, however, and in the nation case by defense considerations as well as by economic ones. If barriers to trade make large internal markets important for economic growth, then different "nations" in the ethnographic sense may share a single territorial "nation." As those barriers recede and the military value of a large population declines, we can expect the nationalist principle to prevail. But this need not necessarily result in smaller nations. The mergers of the two Vietnams and of the two Germanies, and the reincorporation of Goa into India and Hong Kong into China, are examples of post-World II Two boundary changes that have increased the size of nations. (And in all likelihood someday the two Koreas will be united and Taiwan will be absorbed into China.) It may be an accident that the number of nations in the world has increased since the World War II. The number could have declined if more ethnographic nations had been divided up among different territorial nations rather than being combined in single territorial nations.
The merger of the two Germanies may have been an economic mistake, as Becker persuasively argues. But the diseconomies of scale in a nationalistic state, that is, a state with a homogeneous population (despite its racial, religious, and cultural heterogeneity, the U.S. population is homogeneous compared for example to Belgium, with its sharp regional division between French-speaking and Dutch-speaking populations, or even Switzerland), are small within a broad range. For just as a business firm can minimize diseconomies of scale and scope by decentralization, so a nation can greatly reduce those diseconomies by federalism. As a result, a large nation like the United States is able to compete economically with much smaller nations. In addition, its population size and consequent aggregate wealth enable it to achieve great military power, which prosperous small nations cannot do.
The analysis is incomplete, however, because one observes that many adjacent nations having a common language and culture do not merge: the U.S. and Canada, for example; Mexico and the other nations of Central America; the Spanish-speaking South American countries; Germany and the German-speaking Swiss cantons; and the Arab nations of the Middle East and North Africa. The explanation offered by Adam Smith for the American Revolution may have general application: within each ethnographic nation there is a governing class that anticipates greater benefits from ruling its nation than from sharing power with other elites within a broader territorial union.
Response on Small is Beautiful-BECKER
A few comments.
Being small has some disadvantages in international negotiations, but mainly small countries slip through the cracks of various barriers and obstacles.
The WTO and monetary unions among small nations certainly is often part of the explanations why being small is not as disadvantageous as in the past, and has certain advantages.
True, a homogeneous culture may help a nation integrate, but countries splitup typically because the cultures are different and sometimes clash. Examples include Yugoslavia, the Serbs and Czechs in the former Czechoslovakia, Ukraine and Russia, and so forth. Splitting up enables them to engage in trade and movement of capital and people without cultural, religious, or ethnic clashes getting in the way.
I will stick by my analysis of East and West Germany. If they had stayed independent, wages would have fallen in the East. Of course, some young people would have moved to the West-they do anyway! But new companies would have started attracted by the low wages, and these wages would also have attracted companies from other nations, especially West Germany, if the labor environment more generally was attractive. To be sure, the 1-1 exchange of currencies was politically necessary, given integration, but isn't this political necessity another reason why integration was a bad idea from an economic viewpoint?
International trade grew partly because of the growth in nations, and partly because trade increased between nations. But as you realize, the large growth in U.S. exports and imports is an indication of the general growth in international trade. This is one of the important factors that made small nations more viable economically.
Small Countries--Posner Response to Comments
These were interesting comments. One that particularly struck me is that a small country may lack enough human capital to man key offices in government, universities, the professions, and businesses optimally. Suppose that there is a threshold number required to manage even a small government, university, etc. and that the percentage of people qualified for these managerial positions is very small. That is not a problem for a large country but can be one for a small one. It might follow that outstanding institutions would be found only in large countries. One answer is that small countries can frequently free ride on the institutions of the large countries--even in government, by joining a federation or confederation.
A question was raised concerning my statement that Pakistan had split in two--the questioner thought I might have meant India. British India indeed split, in fact into four pieces--India, Pakistan, Burma, and Ceylon (Sri Lanka). I was (as another comment notes) referring to the fact that Bangladesh used to be East Pakistan but became independent after a war between India and Pakistan.