Ask Joannes!

Have a question about Economics? Ask Jóannes! Email Questions to: j.jacobsen1@lse.ac.uk The London School of Economics

Q: What development problems are specific to small open economies like Mauritania and Guyana, for example? How come larger countries like India and China can get their act together but most small open economies seem to fall by the wayside?

Jóannes: These are problems that are common to all economies both small and large. Whether and why small economies have worse track records than bigger economies I don't know, but I can think of 2 potential problems specific to small economies. 

The first is that in a small economy there are a lot of increasing returns to scale that cannot be exploited due to the smallness of the economy. In the public sector this means that there are large fixed costs associated with running a legal system, health system, education system and so on and so forth. These costs must be spread over a small number of people so on a per capita basis the costs associated with "running the system" will be much larger in the Faroe Islands or Iceland than in the States or Germany for example. In the private sector it means that in the market for nontradables there typically is only room for a very small number of firms in each sector (in the Faroe Islands in many sectors there are only 2 firms). Therefore there will be very little room for gains from specialization and a lot of monopoly power for the firms to exploit. These are problems that are almost impossible to circumvent (other than making more babies, which is fun but messy and carries with it a lot of responsibility that you may not want just because you were drunk and...I got carried away for a moment there, sorry about that).

The second problem is related to your question about the government helping with the financing of investment. A small economy almost by definition can only have comparative advantage in a very limited number of goods (the Faroe Islands and Iceland have comparative advantage in 1 good, i.e. raw fish). But many politicians and their MBA advisors (I am not fond of MBA's that venture into economic policy advising, because they suck at it) want to "spread the risk" and other intuitively plausible but with regards to industrial economic policy stupid notions. On top of that they want to spread into "high-value added sectors", which they think is biotec, software programming etc. In short they want the industrial structure of their countries to look like the industrial structure of the US or other large countries. Beside the fact that more often than not basic industries are just as "high-value added" as the more fancied ones, this is impossible. Sectors like biotec, chemicals and so on require enormous investments for years if not decades and a lot of people and capital. But betting on these sectors implies by the definition of a small economy that there is a relatively large drain on people and capital for use in all other sectors of the economy. In an economy that isn't even large enough to exploit the full range of opportunities in the sectors where it has comparative advantages, diverting resources into industries that are "in vogue" but offer little in the way of economic advantages to the country, can be a very costly proposition. A Minister of Trade and Industry that wants the Babe Islands (let me know if you find them on your Atlas, I'll pay the tickets. They are probably in a hot and steamy part of the globe.) to produce airplanes, computer software, genetically modified Dutchmen (flying or walking) is about as advantageous to the Babe Island economy as Mugabe is to Zimbabwe.

So summa samarium of all this babbling in the middle of the night is that small economies (or rather the politicians and their MBA advisors of small economies) have to learn to live with that the fact that it is optimal to have a narrow industrial base, often in less than glamorous industries (except the Babe Islands of course, which could profitably use their large endowment of women with large endowments in a variety of industries where...never mind, you get my drift).  

On a more serious note, I think that as usual, the tax authorities have cheated big time. They probably have taxed at least a third of our points away and given them to either themselves or more likely wasted them on "wine, women and song" (or is it "sex, drugs and rock'n'roll"?). But we knew beforehand that fighting the tax men would be an uphill struggle, so what the heck.

Q: Should Small Open Economies have Flexible or Fixed Exchange Rates?

Jóannes: Regarding the question of fixed versus flexible exchange rates addressed in Stiglitz's article I really have no idea which is better for a small economy. There's a lot of "on the one hand...but on the other hand" kind of thing in this question. The Faroe Islands has a completely fixed exchange rate (we use the Danish krone, or króna in Faroese) and we are doing very well, or rather extremely well at the moment. Iceland has its own currency, the Icelandic króna (same word, different currency) and they are also doing very well, or rather are also doing extremely well at the moment.


Q: What if developing country governments helped finance business investment to promote growth?

Jóannes: I really do not think that the problem lies in macroeconomic policies. And I must admit that I strongly disagree with your view that (part of) the solution lies in the government financing of business investment. At this stage I will again recommend to you the book "The Elusive Quest for Growth" by William Easterly (no I do not get commission fees, even though I probably should. The book is absolutely brilliant, that's all.)

Jagdish Bhagwati mentions that the success rate of business investing by the private sector is about 70 percent, while for governments it is far smaller. I can verify that for the Faroese case. Our (right and left wing) governments have over the last decades focused on this plan and it has been an utter and total disaster every single time. One reason why this has been so is that government politicians and officials have no clue about which sectors are worth investing in for the future (and crucially their own money is not at stake) so any choice is going to be on lofty ideas and hunches and the idiotic "this is what they did in Japan" story. A just as serious problem is that with the government subsidizing some sectors (to the detriment of other sectors in the economy, an issue that most politicians and MBA's forget) is that the biggest profit opportunities will be in working the system, rather than the market. The economic record of Faroe Islands of the 70s and 80s provides enough examples of all the things that can (and will) go wrong to fill the LSE library with horror stories that make "The Shining" read like "Alice in Wonderland".

j.jacobsen1@lse.ac.uk