The full report - The Flotilla Effect - Europe's small economies through the eye of the storm has been published today and can be viewed here.

The great French moralist André Gide's last reported words were, "I love small nations. I love small numbers. The world will be saved by the few" (Kohr 1970).

During the long boom of the 1990s and 2000s, that last-gasp proclamation took on an almost prophetic air. Small and nimble open economies like Ireland, Iceland, and the Baltic States became the poster boys of globalisation. Countries the size of Norway topped every feel-good league table in existence from gross domestic product (GDP) per capita to indexes of innovation, happiness, and peace.

Small is successful (think Sweden), sexy (think Costa Rica), smart (think Singapore), even cool (think Iceland). Yet recently, something strange tends to happen every time there's talk of carving a new independent country out of an old colonial one. Take Québec in Canada, for instance, or my own beloved Wales in the United Kingdom. Faced with the prospect of a people choosing its own destiny and charting its own course, the champions of the status quo gravely intone that such a move would not be economically viable. Without the colonial country as benefactor, we're told, the small could never survive.

So, why the new pessimism? Well, now that economic conditions have turned, so has the tide of ideas. The travails of small countries have made big headlines worldwide in a series of Lehman Brothers-like moments. The sovereign debt crisis in Greece, the banking collapse in Iceland, and Ireland's fall from "Celtic Tiger" grace have all led to a shift in the intellectual terms of trade. "Big is best" has replaced "small is beautiful" as the new global mantra. This was perhaps best summed up by an epithet attributed to Paul Volcker, former U.S. Federal Reserve Chairman (with a sideways nod to Roy Scheider's character in the movie Jaws): "In turbulent times, it's better to be on the bigger boat."

Can the small survive and thrive through the present storm? How does country size affect economic performance? And what would independence do for a place like Wales? These are more than just academic questions for me. After almost a decade at the coalface of politics in the House of Commons as a Welsh Nationalist Member of Parliament, I came to the John F. Kennedy School of Government at Harvard University (HKS) to find solid foundations for my lifelong dream. But size matters to all of us. My own continent of Europe is a patchwork mosaic of meso-economies and microeconomies. Where China and the United States are building supertankers, Europe is in flotilla formation--built to ride, not rule, the waves. Is it destined to flounder?

The Invisibility of Scale

For most of the twentieth century, economics was silent on the question of country size. A single conference in 1960 was the sum total of intellectual output on this issue during most of the postwar period (Robinson 1960). By contrast, intellectual revolutions of the 1980s, represented by new growth and new trade theory, were based on the idea of increasing returns to scale. The upshot was that large countries--where economies of scale seem more feasible--were predicted to do better. But the empirics pointed in a different direction. In fact, there is growing evidence of an inverse scale effect. As Xavier Sala-i-Martin of Columbia University--he of the leopard and zebra suits--put it some years ago, "as time goes by, the desirability of having smaller nations increases. And the economists who say so are not (I repeat, NOT) some crazy Catalan nationalists" (Sala-i-Martin 1998).

They are, in fact, mostly French nowadays: to be specific, the French Economic Observatory team headed by J-P. Fitoussi at the Parisian Institut d'Études Politiques (popularly known as Sciences Po), which has been conducting a five-year-long program supported by the French National Research Agency (ANR) on "country size and growth strategy." In a remarkable series of papers, largely unnoticed in the English-speaking world, this new school of geoeconomists claims to have discovered a "size nexus" at work in the European economy, with smaller lead countries like Ireland and Finland outperforming larger laggards like Germany and France (Laurent and Le Cacheux 2010; Alouini 2010; Napoletano and Gaffard 2010).

My own analysis (carried out with the help of fellow HKS Student Ben Levinger) confirms the French results (Price and Levinger 2011). Using World Bank data, we found that small European Union (EU) countries (those with fewer than 15 million people) enjoyed a 50 percent increase in exports per capita between 2000 and 2008, compared to a 35 percent increase for larger states. The small, it seems, have gained disproportionately from the expansion of trade since the introduction of the euro. How has this trade bonus affected growth? Figure 1 shows small countries closing the growth gap by almost two-thirds, down from 35 percent to 14 percent, over a thirteen-year period. As Figure 2 shows, this small country premium has existed for decades, even for those countries that joined the European Economic Community at its inception.

Figure 1 -- Change in GDP Per Capita, EU-27 (Sources: International Monetary Fund; calculations by author.)

Figure 2 -- Real GDP Per Capita Change, EU Founders (Sources: International Monetary Fund; calculations by author.)

To understand the shape and strength of the relationship between size and economic performance, we compared average country growth rates and population between 1996 and 2007--the period of relative calm between the economic turbulence suffered by Eastern Europe following the fall of communism and before the onset of the global economic crisis. What we found in general was that the larger the country, the significantly slower the economic growth. In fact, over the last thirty years, among the Western European members of the EU, differences in population size alone (measured on a logarithmic scale) can account for 50 percent of the differences in average GDP per capita growth rates using a simple linear regression, with the mighty minnows once again outperforming the Big Five (UK, Italy, Germany, France, Spain). Following the recent economic crisis, this relationship simply broke down: from 2008 through the third quarter of 2010, small countries did no better (yet also no worse) than large countries. A rising tide lifts small boats faster, it seems, but they're no more likely to sink in a storm.

The Big Advantages of the Small

The latest crisis aside, what might lie behind this remarkable story of small country success under normal economic circumstances? There are broadly three potential sources of small-scale advantage: openness to trade, social cohesion, and adaptability.

Openness to Trade

Due to the smaller size of their domestic market (relative to total income), small economies tend naturally to be more export-oriented than large countries (Dunning 2001).This means they are better positioned to benefit from the expansion of trade and are more skilled in responding to changing conditions, developing specialization in niche markets and internationalizing their businesses. As Nobel Laureate Gary Becker has argued:

In fact, small nations now have advantages in the competition for international markets. Economic efficiency requires them to concentrate on only a few products and services, so they often specialize in niches that are too small for large nations to fill. (Becker 1994)
Social Cohesion

Small countries are more socially homogeneous, more equal, easier to run, and therefore better governed. Stronger accountability and higher trust improve their ability to find social compromise, lowering the transaction costs and complexities of the policy-making process. This contrasts with larger countries where there often exists a disincentive to collective action.

Adaptability

Small countries' vulnerability to exogenous shocks means they are better at adapting to change and implementing structural reform. Jeffrey Frankel, for example, has written of the role of small countries as global innovators (2010). This natural innovativity also extends to science and technology: Switzerland, for instance, has more Nobel Prizes per capita than anywhere else in the world and three universities in the world's top 100 (Oswald 2008). See Table 1 for examples of small country innovations.

Table 1 -- Great Little Innovators

Country and Policy Innovation

New Zealand: Inflation targeting (1990)

Chile: Private pensions (1990s)

Singapore: Congestion charging (1975)

Sweden: Keynesian demand management (1930s)

Estonia: Flat taxes (1994)

Costa Rica: Abolition of the military (1948)

The Flotilla Effect

There was a time when being small was a barrier to economic success. The actual problem may have been not so much in being small as being lonely--take, for example, a once flourishing Venice marooned by the sudden change in the trade routes to Asia. Today, Europe's small countries are at most two hours away from markets and minds measured in the hundreds of millions. The EU has undoubtedly provided important economic shelter for its smaller states without which the impact of the crisis would have been much graver. But with that important rider, it's clear that in Europe over the last thirty years, small size is significantly correlated with higher growth. To return to the Volcker metaphor, in turbulent times, small countries can be said to behave more like a wood chip--tossed about on the waves but difficult to sink. When good times return, Europe's flotilla of small boats may once again prove quicker and more adept at charting a new economic course than the supertankers that are all too often "too big to sail."

The Independence Prospectus

What, then, of independence? How would newly formed small countries fare in the global economy?

We are fortunate in having at the heart of Europe a historical field trial in the economics of independence. Independent Luxembourg (population 500,000) and the neighboring Saarland region of Germany (population approximately 1 million) both have economies with roots in coal and steel. While Luxembourg was to become one of the founding members of the European Coal and Steel Community (ECSC), the EU's forerunner, the Saarlanders rejected the option of independent statehood and membership of the ECSC by two-to-one in a referendum in 1955. Both regions had to grapple with the painful restructuring of their steel industries, but while Luxembourg is now home to the global giant ArcelorMittal, the Saar steel industry is a pale shadow of its former self. The difference in growth rates for the independent nation of Luxembourg and the neighboring region that rejected independence is striking (see Figure 3).

Figure 3 -- Real GDP Growth, Luxembourg and the Saarland (Sources: World Bank, Kim 2003, Eurostat.)

During the last thirty years, Luxembourg has pulled progressively ahead, outstripping economic growth in the Saarland by 2.5 to 3.5 percentage points a year on average. The cumulative effect has made Luxembourg one of the richest countries in the world and left Saarland the poorest German Land in the former West. If anyone still doubts the potential economic value of independence, they should take the short drive from the Grand Duchy to Saarbrücken: it pays to be a (small) country in your own right rather than just a region of some other state.

And what about my homeland of Wales? Since 1990, its per capita real-terms growth rate has been a lamentable 0.9 percent on average. If Wales had become a small independent country when the Berlin Wall fell rather than remaining a stateless nation, it might have done much better. Indeed, the model that Levinger and I have devised--a linear regression of growth on population--would predict an average annual growth rate of 2.6 percent for a country of Wales's size. A free Wales might do better or worse depending on its choice of policies and the strengths of its institutions, but a growth rate similar to the current 0.9 percent would be an extreme outlier in a free-Wales scenario. Adding initial income as another variable gives our model even greater predictive power. Figure 4 shows the results of this simulation: Welsh people would be, on average, 39 percent "richer" had they constituted a small nation-state, not simply a region, over this time period, all things being equal. Wales could even expect, like Ireland and Denmark, to catch and surpass a now nonexistent "United Kingdom," joining the ranks of the smart, the successful, and the small. There may be many plausible reasons for opposing Welsh independence, but the risk of impoverishment can no longer credibly be said the strongest.

Figure 4 -- The Wales That Could Be? 2009 Gross Value Added (GVA) Per Capita (2000 US$) of EU-15 and Wales (Actual and Predicted from Model)

The question of size naturally looms large in a nation of three million that thinks itself too small to stand by itself. As Julio Cortázar debagged to Paris to be a better Argentinean, I came to Harvard to be a more effective Welshman. If my compatriots cannot be persuaded that sovereignty for a country the size of Iowa is an economically viable option, then statehood for Wales may always remain a pipe dream. Yet the message I will carry home is that the facts seem to be on our side. For once, we find ourselves swimming with the tide of history.

The full report , published today The Flotilla Effect - Europe's small economies through the eye of the storm can be viewed here.

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