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Government in microstates

December 18, 2010

I’ve long had my suspicions about shrinking the government in microstates. In a larger economy one of the main arguments for liberalisation is to allow the market to coordinate activity. Centralised structures of command proved bad at managing production across the enormous range of activities that characterise the modern economy. State firms were particularly poor at things like assessing the quantity of specific consumer goods that need to be supplied. In Friedrich Hayek’s phrase, only the ‘man on the spot’ can know exactly what he needs, and these requirements can only be realised in the marketplace.

In a tiny economy, though, this particular argument for domestic liberalisation is weaker. Small populations and a a tiny production base mean that it should be possible for a central authority to coordinate a considerable amount of economic activity – for instance to assess the goods that consumers need and what needs to be imported. Mostly, microstates don’t produce much, especially consumer goods. The possibility of central coordination is one reason why the cooperative movement has featured so prominently in many Pacific island states (co-ops are also popular because people tend to be quite communitarian).

The economies of many microstates are much smaller than the revenues of many corporations. The GDP of Tuvalu is about US$35 million. Even Papua New Guinea, the region’s largest economy, has a GDP of only US$8 billion. General Motors’s annual revenue last year was US$131 billion. Kraft Foods generates revenues of about US$50 billion. If multinationals can co-ordinate and plan their diverse range of activities, then why can’t small governments, whose operations are much less complex or dissipated?

Domestic competition in microstates will always be very limited, if not non-existent, which means that there are fewer incentives for domestic private companies to use efficient production techniques, to keep costs down or to source cheaper imports. In essence, some markets are unlikely to work as well as they might in larger economies.

Small island states are simply confronted with costs that are so high that certain private sector operations can be unviable. As a World Bank Report says about small island economies: “In most cases the data suggest that capital would earn negative returns if it invested in a micro economy and had to bear all the cost of the inefficiencies itself. Similarly, if the whole burden were visited on labour so that wages were zero in a micro-economy, total costs in manufacturing would still exceed world prices” (Winters 2004).

This is not to say that other motivations for giving a more prominent role to the private sector do not exist, the main argument being that government-run enterprises can be so inefficient that they present larger hidden costs than is at first apparent. Closer international economic relations make sense, as they will exert some degree of competitive pressure and improve the flow of services trade – which tend to be more viable in small, isolated countries. Greater international competition makes small states operate more like large private businesses.

Neither does this note of caution about the role of the private sector mean that governments in microstates should run everything. But it does throw doubt on any policy of rapid or wholesale liberalisation without supporting institutional structures. Governments should probably move into areas that complement private-sector activity, providing things like infrastructure and information, and running important social services. There also remains an argument in favour of a central agency or a well-run state enterprise performing a back-stopping role.

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