Government size and openness revisited: the case of financial globalization

Abstract

SUMMARYThe volatility of international capital flows to emerging markets has been well documented. Financial globalization may not in general fulfill its theoretical role as a risk sharing mechanism in financially underdeveloped economies, and hence may provide an impetus for compensating government spending. Comparative studies of the public sector have provided evidence of a robust positive association between government size and openness of the economy to trade flows. This paper extends the existing literature by investigating the relationship between government size and financial openness for 87 developing and developed countries between 1976 and 2003. The analysis reveals a positive relationship between exposure to international capital flows and government size. Furthermore, interacting capital flows with income levels shows that richer open economies tend to have smaller government size. These findings are consistent with the hypothesis that benefits of financial integration, in terms of improved risk‐sharing and consumption smoothing, accrue only beyond a certain minimum level of financial development.