Welfare States are very different across countries, and are made up of a large variety of policy instruments in each country. Be it through taxes and subsidies, or regulation, or social security schemes, every State shelters citizens’ lives from labour market risks – everything ranging from catastrophic accidents to temporary job loss or even minor career uncertainties.

In an ideal world, insuring such risk would be the job of perfect financial markets. In our imperfect world, market participants’ limited power to collect information and enforce contracts make it economically and politically sensible for Governments directly to administer schemes meant to try and address life-shaping problems that market interactions can’t solve.

Private and public insurance schemes are always imperfect, always coexist, and the balance between them depends on the structure of economies and societies.¹ Once a upon a time, industrialisation led to increased specialisation, and urbanisation made it necessary to replace family- and village-level safety nets with national Welfare States. Nowadays, in some countries, public education, pensions, and unemployment insurance or employment protection legislation make it relatively unnecessary for households to access financial markets in order to finance human capital accumulation, fund retirement, or smooth out labour income fluctuations. In other countries, relatively efficient financial markets let households manage income risk privately, and it is not as necessary for policy to smooth out labour incomes and buffer their implications for household consumption.

In a paper written for the Reserve Bank of Australia “Financial System: Structure and Resilience” conference, I consider how the different pace and depth of international “globalisation” trends can shed light on the character of tradeoffs between risk, social policy, and financial market development. Internationalisation of goods and factor markets is relevant to risk and to risk-control instruments in a variety of ways. To the extent that trade and specialisation across countries’ borders introduce new risks in workers’ life, public policies tasked to control such risks can explain why governments are larger in more open economies - as Dani Rodrik found in his famous 1998 paper.² To the extent that risk can be covered by market instruments, however, more intense international competition may be accompanied by financial market development, not by government redistribution. Government redistribution, in fact, may itself be hampered by countries’ openness not only to market interactions, but also to cross-border tax-dodging and benefit-seeking tendencies that undermine governments’ powers to enforce collective policies.

In the data, differences across countries and periods in the relevant variables are intriguingly consistent with the idea that intensity of redistribution depends on its usefulness (as safety nets are not as much needed in economies where low openness reduces risks, or financial markets can control risk effectively) and viability (as international competitiveness considerations make redistribution less affordable in more open economies). Across countries, higher openness is accompanied by more extensive government redistribution (as in Rodrik’s data). That relationship is however weaker in countries with deeper, more efficient credit markets. Along the time-series dimension, and especially in developed countries, there is instead a tendency for increasing openness to be associated with a decline in government size and in social policy as a share of GDP.

The dynamics of the variables of interest is consistent with the notion that “globalisation”, driven by technological and multilateral trends, weakens governments’ power to enforce Welfare State schemes. And it certainly challenges the political and economic sustainability of international economic integration in countries where such schemes play the predominant role in households’ life plans, and household financial markets are poorly developed.

If globalisation amplifies labour income risks at the same time as it makes it increasingly difficult for governments to smooth out those risks’ implications for households’ welfare, accessing efficient private financial markets becomes extremely important for households. Larger income fluctuations and shrinking public budgets naturally increase demand for private financial services. If that demand is not met by adequate supply, lower welfare will foster resentment against international economic integration.

Even as governments can no longer enforce extensive redistribution, they have an important role to play, working together when necessary, in provision of property-right and contract enforcement services to market interactions. Financial and insurance markets are not the type of markets that will work well if left alone. A solid financial market infrastructure is needed to let private contracts smooth, to the extent possible, the consumption implications of income flows destabilised by increased specialisation and foreign shocks. Globalisation may call for retrenchment of governments’ redistribution activity, but also calls for stronger supervisory, regulation, and antitrust action.

Footnotes

1 See for example, the Sapir Report, or Sapir (2006), “Globalisation and reform of the European Social Models.”
2 Rodrik, Dani (1998) “Why Do More Open Economies Have Bigger Governments?” Journal of Political Economy 106:5, pp.997-1032.