Openness, External Risk, and Volatility: Implications for the Compensation Hypothesis

Abstract

A central assumption in the globalization literature is that economic openness generates economic insecurity and volatility+ Based on this assumption, scholars of international political economy have proposed the compensation hypothesis, which claims that globalization bolsters rather than undermines the welfare state by increasing public demand for social protection against externally generated economic instability+ The openness-volatility link is dubious, however, on both theoretical and empirical grounds+ In this study, I revisit the volatility assumption, focusing on a crucial difference between openness and external risk in their effect on volatil-ity+ My statistical analysis of a panel data set from 175 countries~1950-2002! finds a consistent effect of external risk on volatility of the major economic aggregates, but a largely insignificant effect of openness+ These findings suggest that economic volatility may be a mistaken link in explaining the openness-spending nexus, calling for further research on the causal mechanisms linking the two+ for their invaluable support and thoughtful comments+ Finally, I would like to appreciate the editor-in-chief and two anonymous reviewers for their perceptive criticisms that greatly improved this article+ 1+ For prominent examples of the research on government growth, see Coughlin, Mueller, and Murrell

Government size and growth: Accounting for economic freedom and globalization

“…Recently, however, Kim (2007) and Down (2007) have noted that the link between economic openness and volatility is not there-neither theoretically nor empirically. While big government may still be a consequence of openness, there is currently no agreement on the theoretical mechanisms.…”

Openness and Macroeconomic Volatility: Do Development Factors Drive Such Ambiguous Results?

“…The model structure and the explanatory variables are based on Kose [9] and Kim [11]. Following Kose et al [9], trade openness (OPEN) is defined as each country's exports plus imports as a share of GDP.…”

“…Hirata et al [10] find that terms of trade shocks explain a large share of macroeconomic volatility in the Middle Eastern and North African countries of Egypt, Morocco, Tunisia, and Turkey. Kim [11] includes as many as 175 countries in a panel in an effort to separate openness from external risk over a period from 1950 to 2002. The volatilities of income, private consumption, and investment are modeled as functions of trade openness (exports, imports, or the sum of both, as a share of GDP) and financial openness (the share of gross private capital flows), as well as a number of measures of external risk.…”

Output Volatility and Its Transmission in Transition Economies: Implications for European Integration

“…His sample of more than 100 countries appears to include a few in Eastern Europe, although the time period begins as early as 1951. Other shocks that generally originate from abroad have also been found to be influential: Hirata et al (2007) show terms of trade shocks to have an impact on Middle Eastern and North African volatility, while Kim (2007) focuses on volatility in the terms of trade of a group of countries.…”