On the relationship between trade openness and government size

Abstract

AbstractDoes trade openness systematically imply bigger governments, as proposed by Rodrik (Journal of Political Economy, 106, 997 and 1998)? This paper presents a novel and more refined explanation for when and why international trade may enlarge the public sector. We propose that trade openness is associated with bigger governments via the compensation pathway if the price volatility of a country's export basket is substantial and the country is democratic. The first condition satisfies the prior that trade openness introduces uncertainty and external risk. The second condition ensures that the people's desire for greater economic security can be realised through government spending. Empirical evidence for 137 countries, that account for approximately 95% of world population, from 2000–2016 is consistent with this hypothesis. Exploring areas of public spending, we find intuitive patterns. Consistent with the compensation hypothesis, government spending on economic affairs and housing increases significantly with trade openness, whereas spending on education, health care, and the military is not affected. As with our general result, this is only the case in democracies that are subject to high price volatility on the global market.