Economic Resilience and Market Efficiency in Small States Gordon Cordina University of Malta April 2007

Background Vulnerability of small states is well documented Vulnerability is proneness to exogenous shocks Different degree of success of small states can be ascribed to extent of policy-nurtured resilience Resilience is to ability to withstand and rebound from the effects of adverse shocks Efficiency of resource allocation is a fundamental element of resilience

Main Themes Relationship between market efficiency and resilience Increased incidence of market failure in small economies Policy intervention and heightened proneness to policy failure in small economies Imperative of enhanced efficiency and better governance in small economies

The Relationship between Market Efficiency and Economic Resilience

Vulnerability and Resilience Vulnerability is exposure to exogenous shocks Effects of shocks are asymmetric, with negative effects outweighing positive ones Vulnerability can hamper development if not countered by resilience Resilience is developed through policies which help the economy to: – withstand the effects of negative shocks – rebound quickly from the effects of negative shocks

Resilience and Market Efficiency Resilience thus requires: – an efficient allocation of resources – an ability to quickly reallocate resources efficiently For an efficient resource allocation, prices have to reflect the true costs and benefits from production For an effective reallocation of resources, there needs to be flexibility and mobility of capital, labour, products and services

Resilience and Market Efficiency Examples of market efficiency and resilience to shocks in small states: – Shocks to tourism demand – Shocks to oil prices – Globalisation, regional integration and international competition

Resilience and Market Efficiency Market efficiency requires: – private participation – competition between private agents Public policy is essential to market efficiency and hence economic resilience: – securing legal and property rights – ensuring market access and proper competition – investing in public goods and institutional capacity

Market Failure in Small States

Situations of Market Failure Markets do not achieve allocative efficiency and welfare maximisation in the presence of: – monopolistic conditions – external effects – sluggish market adjustment – missing markets – asymmetric information – uncertainty – socially undesirable distribution of resources

Monopolistic Conditions Distort price signal through monopolistic rent- seeking Are prevalent in small states due to: – Small size of markets – Thinness of markets – Indivisibilities in investment expenditure

External Effects Price signal would be distorted by reflecting only private effects Are more prevalent in small states due to: – Small land area – High density of population and economic activities Notable consequences include: – Infringement of property rights and costs of litigation – Limited effects of positive externalities – Vulnerability to global externalities

Sluggish Market Adjustment Response to price signal would be hampered by immobility of resources Is more prevalent in small states due to: – High concentration of economic activities in unrelated sectors – Thinness and shallowness of markets

Missing Markets Not technologically possible to meet demand Concern mainly capital and insurance markets in small states due to prevalence of shocks Resource constraints lead to reliance on external markets, with potentially sub-optimal outcomes

Asymmetric Information Lack of information leads to incorrect: – pricing decisions – interpretation of price signals More prevalent in small economies due to: – presence of relatively large players in markets – weak bargaining power in international trade arena

Uncertainty Price signals are distorted or are not followed More prevalent in small economies due to exposure to exogenous shocks Consequences include – lower investment – exchange rate volatility

Socially Undesirable Resource Distribution Market access is restricted to owners of factor inputs Socially undesirable income distribution more likely in small states due to: – Concentration of economic activities in a few unrelated sectors – Insufficient economic development due to other instances of market failure

Policy Failure in Small Economies

Policy Failure Policy intervention may fail on account of: – mistakes of commission – mistakes of ommission These may be further amplified into: – Unpredictable changes and costly mistakes – Obfuscated objectives – Implementation errors – High costs of intervention – Stifling of private initiative

Unpredictable changes and costly mistakes These may be further compounded in small economies due to: – Large size of government – Widespread effects of individual policy interventions

Obfuscated Objectives Obfuscation between economic, political and social objectives in small economies may be due to: – Proximity of social relationships – Concentration of power within a small group of elite

Implementation Errors Policy implementation errors may be more widespread in small economies due to: – Insufficient human resources – Inadequate institutional capacity

High Cost of Intervention Policy intervention may be more costly in small economies due to: – Indivisibilities in the functions of government

Stifling of Private Initiative Government intervention may have particularly stifling effects on private sector initiative due to: – Culture of dependence on the State of employment and income – Dependence on state for major investment initiatives

Imperative of Better Governance in Small Economies

Imperative of Better Governance Enhanced efficiency and better governance is the solution to rectify market failure without incurring policy failure This is imperative for small economies with higher incidence of both market failure and policy failure

Imperative of Better Governance There exists no single model of good governance that can be uniformly applied Small states as a group have widely divergent governance performances But is it probable that small states could more successfully emulate best practices in other small states with similar problems and constraints

Thank you