Paul Krugman rightly dismisses claims that the focus by advocates of austerity on the recent economic performance of small states such as Estonia and Latvia is irrelevant because they are too small to matter. Paul suggests that
every economy — even a small one — is potentially a "natural experiment" that teaches us more about how economies in general work. Beyond that, the Baltics now loom large in the imagination of austerity's defenders, particularly since Ireland keeps refusing to play along and be a success story.
However, care must be taken not to apply the evidence from small states to large states uncritically. Scale matters in the adjustment of countries to economic shocks. And this serves to invalidate many of the conclusions that the defenders of austerity would wish to draw for larger states.
Let me explain what I mean.
It is not unreasonable to expect that the variance of growth rates for small states should be higher than for large states. Small states are more open to trade and factor, especially investment, flows. They also tend to be more specialised. For both reasons they are more vulnerable to exogenous shocks. Although the evidence that the share of government consumption in GDP is usually high in small states might serve to dampen market volatility effects in such countries but make them more vulnerable to changes in the size of the state through, for example, fiscal consolidation. Nevertheless, evidence that small states, defined as a population of 2 million or less, do have a greater volatility of GDP is provided here, in this World Bank paper and here.
What this means is that it is probable that, other things equal, the recent Great Recession is likely to have produced a stronger downturn and a stronger upturn in small states GDP than that found in larger states. Just as the harder you throw a ball down the bigger the bounce, so GDP in smaller states might have been expected to bounce back more strongly. As Simon Wren Lewis states, by logical extension, if you
close the whole economy down for a year. The following year we could get fantastic growth as the economy starts up again.
The following chart offers some, all be it slight, supportive evidence
So, country size does matter.
It matters because the experience of small countries helps teach us how economies work. But it also matters because the experience of small countries is not a good guide to what happens in larger states. And the evidence on small country volatility provides a further reason to reject the arguments of the advocates of austerity who cite the economic performance of Latvia and Estonia and other small states in support of their claims.
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