Globalization Is Inefficient

It's widespread opinion that globalization forces governments exposed to international competition to cut taxes and spending to attract foreign investment, or at least to avoid the offshoring of domestic firms. Data, however, show that open economies tend to have overbloated public administrations.

The main explanation of this fact has been offered by Dani Rodrik, who asserts that in comparatively more open economies, companies and workers are more exposed to external risks and thus ask and obtain stronger protection from the government. This explanation is not very convincing: extra openness also means additional opportunities to diversify risk. Also, empirically, welfare spending does not seem correlated with economic openness. Gino Gancia and I propose a different explanation. Our idea is that more open countries have larger public sectors because the cost of public goods is lower the higher the degree of trade openness in a given country. The reason being that an expansion of the public sector reduces the private sector and thus the supply of exports. If world demand for domestic goods is negatively sloped, this leads to an improvement in the terms of trade. This in turn implies that the real cost of public expenditure has now been partly shifted on foreign consumers. This effect is stronger in more open economies, because the real effects in terms of trade variations are proportional to the volume of goods being exchanged. This effect can be very strong also in smaller countries, if they produce differentiated goods. For instance, Nokia manufactures cell phones which are perceived as being different from Motorola's. Thus also a small country like Finland can be a price-setter on international markets. If the price of a Nokia phone partly reflects the cost of taxation, then each unit sold abroad acts as a subsidy to the Finnish welfare state. Our data confirm that a positive correlation between the degree of trade openness (import+exports/GDP) and public spending only holds for countries producing differentiated goods.

It might seem not very plausible that the expansion of the government sector is driven by terms of trade considerations. It is less so, when one understands that in an open economy, the movements in terms of trade and in relative wages are connected. An increase in public spending translates into a shift of domestic spending from the private to the public sector, and this augments domestic labor demand, since public goods are almost exclusively produced with domestic labor, while domestic goods are partly imported. Our results are similar to the Keynesian argument which states that public expenditure can be used to sustain domestic labor demand.

The growth in the public sector induced by globalization worsens general welfare because it causes an excess in public spending, absent an international coordination of fiscal policies. Such negative effects compensates the positive effects of globalization on the private economy. WTO would seem like the right forum to discuss who to coordinate fiscal policy internationally. The main hurdle, however, is that fiscal policy is seen as a prerogative of national governments, notwithstanding the externalities it generates.

A discomforting implication of our results is that globalization can increase the temptation for policymakers to resort to public resources for their own private ends. This occurs since the waste of public resources is smaller in an open economy, since it's partly compensated by an improvement in the terms of trade. Contrary to what is commonly believed, globablization can thus protect and even promote inefficiency in the public sector.