The implications of economic vulnerability for the growth and macroeconomic dynamics of small states

Abstract

The notions of economic vulnerability and resilience are among the mam issues studied within the context of the economics of small states. This thesis tests two principal hypotheses within this area, namely that: different levels of economic development can at least in part be attributed to the effects of vulnerability, defined as an inherent proneness to shocks, and to resilience, defined as the nurtured ability to withstand the effects of such shocks, and; economic vulnerability can lead to higher aggregate demand volatility and to more persistent macroeconomic imbalances. These hypotheses are tested by firstly obtaining stylised facts regarding vulnerability and resilience from the literature and out of empirical observation. Subsequently, the thesis develops theoretical models to explain such facts. An underlying theme in these models is that vulnerability may be expressed in terms of asymmetric responses to shocks, whereby the effects of negative shocks outweigh those of positive ones due to diminishing marginal product and utility. Finally, the thesis conducts econometric tests of the relationships derived from the theoretical models. The stylised facts regarding long term growth patterns include: economic vulnerability is a relevant concept, especially for small states; small states on average do not exhibit low per capita incomes but have greater cross-sectional dispersions as well as higher fluctuations in income growth rates, and; small vulnerable economies tend to invest a larger share of their output. The stylized facts concerning short run aggregate demand fluctuations include that small states: have larger fluctuations in the growth rates of aggregate demand components; tend to experience more persistent deficits on their external current account; depend to a greater extent on government expenditure but exhibit no marked tendency towards higher fiscal deficits. Towards explaining the stylised facts concerning growth, the neo-classical growth model is extended to decompose the effects of vulnerability into those originating from exogenous shocks and those attributable to the economy's specific susceptibility to the effects of such shocks, the latter reflecting economic resilience. The lack of resilience emanates out of diminishing marginal productivity which causes negative shocks to have relatively larger effects than positive ones. This leads to the conclusion that it is possible for the more vulnerable economies to achieve a higher capital stock and output at the cost of lower consumption. This happens as the vulnerable economy saves and invests, if appropriate structures exist, to build its resilience. From an aggregate demand perspective, vulnerability is modelled to introduce uncertainty in consumption decisions. This causes economic behaviour to be better explained by the Keynesian rather than by the rational expectations paradigm. The income multiplier process is more relevant under conditions of vulnerability while negative shocks to income would induce a lower marginal propensity to consume than positive ones. This runs counter to the supply-side reactions identified in the model of economic growth, leading to excess aggregate demand situations often reflected in pressures on the current account. The modelling of import expenditure highlights the effects of trade openness and of dichotomies between export- and domestically oriented productive sectors as potential sources of both vulnerability and resilience. The modelling of government consumption indicates an enhanced role for demand management policies in vulnerable economies. Econometric analyses based on an error-correction specification applied to panel data in general appear to confirm the hypotheses derived from theoretical models. The findings of the thesis point to the importance of national and supranational efforts towards developing resilience. Among the avenues for further research, there is the need to incorporate vulnerability and resilience more widely in economic models and to extend these concepts to other dimensions of economic development.