List of Tables
List of figures
Section 1: Introduction
Section 2: Literature review
2.1. Embedded Liberalism
2.2. Credible Commitment and the nature of government
Section 3: Theoretical Framework
3.1. Compensation Theory
3.2. Efficiency theory
3.3. Credible commitment theory
Section 4: Research design and methodology
4.1. Data Source
4.2. Data Operationalization
4.2.1. Independent variable: Social expenditure
4.2.2. Dependent variable: Openness of the economy
4.2.3. Control variables
4.3. Research Methodology
Section 5: Data Analysis and Results
5.1. Ordinary least square Regression analysis
5.2. Diagnostic tests
5.2.1. Test for normality
5.2.2. Regression output (Newey-West correction)
Section 6: Conclusion
List of Tables
Table 1: Coding of the variables for data analysis
Table 2 Social expenditure and economic openness regression analysis
Table 3 Breusch-Pagan / Cook-Weisberg test for heteroscedasticity
Table 4 Test for normality
Table 5 Social expenditure and economic openness regression analysis
List of figures
Figure 1: Distribution of social expenditure
Figure 2: Distribution of openness of an economy
Figure 3: Correlation between social expenditure and economic openness
Economic openness, social expenditure and credible commitments
The aim of this paper is to study the relationship between globalization, government expenditure and credible commitments of the government. Moreover, the hypothesis that states increase social spending to build support for increasing economic openness was tested. The study is deeply grounded in an extensive literature on the research works in the related area and on compensation hypothesis, efficiency hypothesis, and credible commitment hypothesis. An empirical analysis of economic and social data of twenty-three OECD countries was performed for the period between 1960 and 2013 to test the hypothesis. The hypothesis, more government expenditure leads to greater globalization was not rejected. Hence, it was proved by empirical investigation that more social expenditure leads to more economic openness.
Section 1: Introduction
The last fifty years have been characterized by gains in international integration and growing public sectors (especially in industrial economies), with expanding welfare states. As per the current conventional wisdom, however, large-scale public provision of social insurance and progressive systems of redistributive taxation are incompatible with economic globalization (Alesina and Perotti 1997; Mishra 1999). Traditional left-right ideological disagreements notwithstanding, a significant strand of thought has perpetually maintained that markets and governments are, in fact, complementary to each other. The argument is that governments can help develop the political support required to promote flexible markets by offering social insurance policies, by stabilizing the aggregate level of economic activity, or by otherwise diminishing the risk of disruption from open markets. A classic statement of this opinion is presented by Ruggie (1982) who claimed that in the outcome of the tragedy that was the interwar period, policymakers established a range of domestic and international institutions which attempted to blend a multilateral commitment to free trade with domestic stability. Ruggie (1982) termed this historic compromise as the “embedded liberalism”.
The previous decade has seen a burgeoning literature that examines both the determinants of individual trade policy choices and the political economy underpinnings of globalization. Most empirical studies find that individual's skill levels fundamentally determine trade policy preferences and not the industry of employment, gender, the area of residence or personal factors (Scheve and Slaughter 2001; Mayda and Rodrik 2005). Moreover, an important conclusion is that there is a positive correlation between trade openness and the size of the public sector (Rodrik 1998). This compensation hypothesis highlights the impacts of globalization on the demand side of the political market that the voters pressurize governments to provide them with increased social insurance to moderate the exposure to greater levels of external risk caused by globalization, thereby increasing social welfare spending. This implies that compensation could be an effective political strategy for creating a free trade alliance. It would be possible to maintain support for economic openness only if the workers who are supposed to be the losers of globalization are compensated, and the anxiety associated with rising imports are reduced. Otherwise, it would be tough to prevent protectionism and countries would not be able to take full benefit of the possibilities provided by open markets. Thus, the sustainability of globalization crucially depends on the ability of advanced democracies to revive the compromise of embedded liberalism (Ruggie 1982).
Previous empirical evidence had tested the compensation hypothesis by analyzing the effects of international trade on social welfare spending, finding ambiguous conclusions (Gemmell et al. 2008). This paper endeavors to answer the question that does the increase in social expenditure by the government leads to more open economies and globalization. An explanation to this question is the so-called compensation hypothesis which was first introduced by Cameron (1978) and subsequently supported by Katzenstein (1985), Rodrik (1998) and Ruggie (1982). The compensation hypothesis proposes that states actively seek to provide better social policy and accordingly increase social spending to compensate potential losers of increasing economic openness. Using the latest available data of the Comparative Political Data Set 1960-2013, we tested the hypothesis for the OECD countries in which the social security system is more robust record higher levels of support for free trade and globalization. The results from the data analysis found that the hypothesis is not rejected.
This paper is organized in the following manner. In the next section includes the literature review which analyzes the research work conducted in the field of social spending, economic openness and credible commitments. The third section covers the theoretical framework. In the fourth section, we present our database, a sample of 23 OECD countries for which data on government's social welfare spending is available and which also takes part in the CPDSI. After presenting other factors that may impact the support for globalization, we present the results of the econometric analysis in the fifth section. Section six sets out our principal conclusions of the investigation.
Section 2: Literature review
Economic globalization is broadly defined as the process of integration into global markets facilitated by lower transaction costs. Consequently, economic globalization creates a threat of international economic competition and dependency on foreign markets (Marshall and Fisher 2013). As argued above, the effects of globalization may differ by transaction type, and hence FDI flows, FDI stock, portfolio equity stock, and trade need to be examined separately, all to be measured annually as a percentage of GDP (Marshall and Fisher 2013).
Economic policies are determined by an amalgamation of ideas, interests, and institutions (Hall 1997). Individuals develop their trade preferences from both ideas and economic self-interest, which are then channeled through their countries institutional framework to create economic policy outcomes. As direct voting never decides trade policy, the incentives diverse individuals have to organize and lobby the government has a critical impact on the policies that governments implement (Olson 1971).
Each of the social welfare states serves at least four goals that mitigate social and economic issues that are unavoidable byproducts of capitalism. They incorporate several policies expected to alleviate both poverty and income inequality that are inherent in capitalist labor markets. They also counter market inefficiencies that inhibit or prevent individuals from entering the labor market. Lastly, welfare states spread the risk of investment in human capital (Barr 1992; O'Connor 1973). Hence, these programs secure widespread public support as they significantly enhance the economic welfare of many benefit recipients.
According to the prevailing conventional wisdom that dominates the discourse on globalization and welfare states, extensive public provision of social insurance, as well as progressive systems of redistributive taxation, are irreconcilable with economic globalization (Chen, Görg, Görlich, Molana, Montagna and Yemouri 2014). On the contrary, Molana and Montagna (2006) showed that the expansionary effect of welfare state policy (through boosting of the aggregate demand) in the presence of external economies could generate a virtuous circle of (a) higher demand, (b) greater specialization, and (c) improved productivity. Moreover, the interaction between aggregate growing returns and the expansionary effects of social welfare expenditure in their model provides for a reallocation of resources towards high-tech sectors that depend more heavily on highly specialized intermediate inputs, resulting in virtuous cycles of higher social protection, aggregate productivity, and social welfare. Hence, welfare state expenditure can increase country competitiveness, especially when vertical linkages and aggregate scale economies are important (Molana and Montagna 2006).
Although the "conventional wisdom" would point to a negative relationship between social expenditure and inward foreign direct investment (FDI), Görg, Molana, and Montagna (2009) argued and provided evidence that this may not necessarily be the case. They argued that FDI flows, while relatively liquid ex-ante, are characterized by notable immobility ex-post, hence necessitating a long-lasting ownership stake in a host country. Therefore, in addition to other determinants, a multinational organization's perceptions about the economic and social environment of a host country are crucial to their choice of location. The evidence produced by Görg, Molana, and Montagna (2009), based on country-level data on inward FDI flows for 18 OECD countries for the period 1984 to 1998, strongly supports their opinion that social welfare expenditure is valued by multinationals.
Rodrik (1998) argued that there may be a degree of complementarities between trade openness and government size as more open economies face higher external risk. This argument signifies that public expenditure should rise when output is more volatile, which revalidates the old Keynesian theme on the stabilizing role of government intervention (Gali 1994). Chen, Görg, Görlich, Molana, Montagna and Yemouri (2014), concluded that social welfare spending is positively correlated with country competitiveness if vertical linkages (resulting in aggregate scale economies) are strong. In such a scenario, as argued theoretically by Molana and Montagna (2006), there may be a virtuous cycle of (a) higher social protection, (b) aggregate productivity, and (c) welfare. Moreover, that social expenditure may be attractive to inward FDI and may also act to anchor firms in the home country (Chen, Görg, Görlich, Molana, Montagna and Yemouri 2014). People seem willing to boost the process of globalization if, in return, they are shielded from elevated levels of economic volatility, particularly employment insecurity, that globalization involves (Sanz, Coma and Steinberg 2007). Rieger and Leibfried (2003) going one step forward argued that globalization is only possible due to the existence of welfare programs.
2.1. Embedded Liberalism
Research scholars like Ruggie (1983), Cameron (1978), Katzenstein (1985), Rodrik (1997) and Garrett (1998), have long argued that the concerns about the relationship between trade liberalization and domestic economic inequality (and insecurity) are justified. However, such concerns do not necessarily turn the public that is exposed to more volatile labor markets against additional trade liberalization in the economy (Ruggie 1983: 261-285; Cameron 1978: 1243-1261; Katzenstein 1985; Rodrik 1997; Garrett 1998). As per this argument, trade liberalization and welfare expansion are in a mutually reinforcing relationship (a) trade liberalization is expected to increase demand on governments to cushion trade-induced insecurity and inequality by the expansion of the welfare state, (b) welfare state expansion as compensation could aid in maintaining public support for trade liberalization. In other words, a new grand domestic bargain or the new embedded liberalism compromise is likely to be made where public is urged to embrace the change and dislocation generated by trade liberalization; but governments will in return agree to protect those who are negatively affected by means of their social, economic policy positions (Ruggie 1983: 261-285; Ruggie 1996).
Ruggie (1982) argued that in the aftermath of the disaster that was the interwar period, policymakers developed a range of domestic and international institutions which endeavored to blend a multilateral commitment to free trade with domestic or internal stability. This historic compromise Ruggie termed as the “embedded liberalism”. When Ruggie (1983; 1996) proposed the concept of "grand social bargain," in which all the sectors of societies allow to open markets and governments in return promise to lessen the volatility of open markets and deliver social safety nets and adjustment support as compensation (Ruggie 1983: 261-285; Ruggie 1996). Ruggie also seemed aware of the problem of commitment involved in the grand social bargain, whereby emphasizing the role of the governments in establishing and sustaining the bargain. In the literature on political science that employs the concept of credible commitment; adequate attention has been given to institutional structures that perform a role in reducing political uncertainty (North and Weingast 1989: 803; North 1994).
Hays, Ehrlich and Peinhardt (2005: 473-4) commented on the argument: "Because trade causes economic dislocations and exposes workers to greater risk, it generates political opposition that democratically elected leaders ignore at their peril. Thus…political leaders have had to be aware of and actively manage public support for economic openness. To do this, governments have exchanged welfare state policies that cushion their citizens from the vagaries of the international economy in return for public support for openness."
According to Lee (2010), the new embedded liberalism compromise is grounded on the premise that the public trusts in its government's desire and ability to buffer trade-induced insecurity and inequality by welfare state expansion. Although government assistant packages like the Trade adjustment assistance (TAA) of the United States often come with the liberalization of trade, it is not clear if such programs proposed by the government as compensation to the public would make the new grand domestic bargain achievable in any conditions. It may be that an expansion in trade at time t – 1 has a discernible effect on social welfare spending at time t – that is, there may be a short-term causal correlation between trade and welfare spending. Even in such a case, nevertheless, if the welfare spending does not lead to public support for trade, the trade liberalization or openness-welfare nexus will not be viable. For the openness-welfare nexus to be mutually reinforcing and sustainable, the public should be prepared to compromise on trade liberalization plans in return for the assured assistance packages (Lee 2010).
The embedded liberalism thesis claims that governments can develop public support for trade liberalization by compensating those unfavorably affected by trade with welfare policies. As per the thesis, faced with heightened market risks, individuals look to government for policies that help to safeguard against those economic risks, which consequently leads to the extension of the welfare state or nation (Rodrik 1997; Garrett 1998; Garrett and Lange 1995: 627-655). Nevertheless, the claim that economic openness leads to welfare extension by inducing economic insecurity of those individuals at risk tells show only one side of the coin. Essentially, a majority of the research works predicting a positive relationship between openness and welfare adopt an implicit, simple "stimulus-response model of politics" (Rudra and Haggard 2005: 1015-1049). With the focus concentrated on the demand side of the trade liberalization-welfare growth nexus, the supply side of the nexus story has been mostly overlooked. Hays, Ehrlich, and Peinhardt (2005) rightly summarized, the embedded liberalism thesis is grounded on the notion that (a) there is a universal expectation among the citizens from their governments to counteract the increased vulnerability and insecurity correlated with trade, and to distribute the benefits of trade through government intervention or by expanding social insurance, and that (b) public support for trade liberalization depends on the willingness and capability of governments to do this effectively (Hays, Ehrlich, and Peinhardt 2005: 473).
When Ruggie (1983; 1996) proposed the concept of "grand social bargain," in which all the sectors of societies allow to open markets and governments in return promise to lessen the volatility of open markets and deliver social safety nets and adjustment support as compensation (Ruggie 1983: 261-285; Ruggie 1996). Ruggie also seemed aware of the problem of commitment involved in the grand social bargain, whereby emphasizing the role of the governments in establishing and sustaining the bargain. In the literature on political science that employs the concept of credible commitment; adequate attention has been given to institutional structures that perform a role in reducing political uncertainty (North and Weingast 1989: 803; North 1994).
In fact, several scholars have concentrated on a short-term term causal correlation between trade and government expenditure (Rodrik 1997; Rodrik 1998: 997-1032; Swank 2001: 133-162; Adserà and Boix 2002: 229; Mares 2004: 745-774). These scholars have argued that governments can easily garner public support for trade by offsetting the negative impacts of market integration by social welfare policies. The argument that economic openness leads to welfare growth by creating economic insecurity of those individuals at risk, however, depict only one side of the situation (Lee 2010). Given the temporal characteristic of the grand bargain, it is not unexpected that government policy initiatives to provide more welfare are sometimes faced with the public skepticism. Although promises usually accompany trade liberalization that losers from trade will be compensated, such promises are not binding. Probably, people are likely to endorse the grand bargain only when the government promises to buffer the unfavorable domestic effects of open markets are seen as credible. If the promises are viewed as not credible, the grand bargain would not be implemented, let alone maintained (Lee 2010).
Requirements that make such government promises credible may be (a) the legacy of earlier instituted welfare policies or (b) perceived success of government vary across countries. For example, as Ruggie noted that LDCs have never experienced the privilege of safeguarding from the vagaries of market exposure, which is expected to make security-enhancing roles of government promise, do not operate at the similar level as they do in countries with a prolonged welfare state tradition. Due to the ephemeral feature of the grand bargain, individuals are inclined to compromise only when the government's commitments to buffer the unfavorable domestic effects of open markets are perceived as credible. If the commitments are viewed as not credible, the grand bargain would not be enacted, let alone sustained (Ruggie 1983; Ruggie 1996).