Michael Keating, University of Aberdeen, discusses requirements for small states to thrive, arguing that small states do equally or better than larger states.

At one time, it was generally assumed that large states enjoyed advantages in the form of large internal markets, military capability and economies of scale. Now it is increasingly recognized that small states may do equally well or better in the modern world.

Scholars have identified two requirements for small states to thrive. The first is an external shelter to provide security and access to markets. This could take the form of military alliances or free trade agreements. Often it means membership in international or supranational organizations such as NATO or the European Union. Small states have little stake in doctrines of absolute national sovereignty, which are of more interest to those states with the means to enforce it, and that have a large stake in rules-based international regimes.

The second requirement is an internal buffer or adjustment mechanism to allow them to respond flexibly and rapidly to changes in the external environment, including recessions and shifting patterns of trade. This can take many forms but we have identified two ideal-types.

One is the market-liberal form, which entails accepting and bending to external pressures. It is based on attracting mobile investment and domestic investment with low taxes and consequently low levels of public service provision. There is wage flexibility downwards as well as upwards to adjust to changing terms of trade; this entails a lack of collective bargaining. Welfare provision is minimal and residual. There is free movement of workers in and out so as to adjust to the needs of the labour market. Such a model, rolling with the global waves, may generate high rates of overall growth but it is highly cyclical, with steep booms and recessions. This is sometimes (misleadingly) described as the Singapore model. We have found evidence of it in the post-Soviet experience of the Baltic states. It is also illustrated by the experience of New Zealand in the 1980s as it adjusted to the loss of British markets when the UK joined the European Community.

The second ideal-type is the social investment welfare state. Social investment is a way of treating public expenditure not as a drain on resources, but as a contribution to development. This includes directly productive investments, such as infrastructure and research, as well as appreciating that things like health and education that enhance the quality of the labour force as well as being valuable in themselves.

This entails a large public sector in order to provide these public goods. Public expenditure also acts as a stabilizer during economic cycles, sustaining demand and employment. Tax levels are correspondingly high. In a globalize world, where investment capital can move around there are limits to the rates of business taxes. Instead, there are broad-based consumption taxes. There is a universal welfare state, meaning that public services are for everybody, not just the poor. This reconciles the middle classes to the welfare state and sustains public support for it, generating a sense of shared national purpose. With these commitments and limited resources, high-welfare small states cannot afford to allow high and persistent unemployment. They therefore use active labour market policy to get people back into work quickly. Being vulnerable to currency crises and unable to sustain the huge debts that are accumulated by super-powers, small states will be fiscally prudent and balance their budgets, at least over the economic cycle.

Another adjustment mechanism is social partnership in which business, labour and the state cooperate to make necessary adjustments without massive unemployment or loss of production. This requires broadly representative employer and employee groups with a high coverage, so that each can plausibly be presented as speaking for the community rather than a sectoral interest. Sometimes, these states have a model of capitalism that embraces a ‘coordinated market economy’ rather than being based on short-term share value maximization. The result is that levels of output can be maintained and economic cycles are less pronounced. This ideal-type resembles the social-democratic ‘Nordic model’ that has been invoked in the Scottish debate, although over recent years it has evolved in different directions in the Nordic zone.

It may be that small size has an influence on both these models. Where lines of communication are shorter, it may be that priorities can be identified and decisions taken. On the other hand, small policy communities may be prone to group-think and reluctant to accept the costs of adjustment. Small size may enable debates on public priorities and common interests, or it may allow veto-points to emerge. The evidence suggests that it is not ethnic or cultural homogeneity that encourages social cooperation and trust in small states but rather the performance of government and repeated success.

Ideal-types should never be confused with real cases. Social partnership, in particular, has declined in much of the Nordic zone from the old days of corporatism, when the peak representatives of capital and labour could bargain, do deals and deliver. Social partnership is more in evidence in Norway these days than in Sweden. Capital is now much more footloose, while labour organization and coverage has declined. Austerity has affected public services, which have themselves become more differentiated. Yet there is still a difference between the low-cost, deregulatory mode of adjustment to change and the high-cost, negotiated mode.

What is not possible is to mix and match elements of these models at will, as there is a complementarity among them. Ireland may have committed this error during the ‘Celtic Tiger’ years. Public spending was increased but the country did not develop a fully-fledged universal Nordic-style welfare state; the health system remains an inefficient mix of private and public schemes. Low corporate taxation was used as a prime development tool, building up an extensive foreign direct investment (FDI) sector, which was detached from the domestic economy. There was an effort at social partnership but it was undermined by low union membership while the FDI sector was able to free-ride on it to secure wage control. Public sector workers appear to have benefited disproportionately.

This blog was originally posted by the Scottish Centre on European Relations.