Why small countries are richer and happier

One of the most remarkable developments of modern times is the proliferation of small states. One reason for this is the disintegration of colonial empires, beginning in 1776 with the American revolution, when 13 small British colonies successfully fought for their independence and formed a federation, the United States. In the 19th century, the Spanish and Portuguese empires in Latin America broke up, while in the First World War the Russian, Ottoman and Habsburg empires all collapsed. The disintegration of empires coincided with the advance of democracy. In 1914, there were only 13 properly functioning democracies in the world; now there are 89. The number of independent countries has gone up from 76 in 1946 to 195 in 2017, of which 193 are members of the United Nations, while two countries have a special status, the Vatican City and Taiwan.

A combination of large markets and small states makes eminent economic sense. It also makes political sense.

Although the triumph of democracy after the Second World War encouraged the foundation of small states, its main impetus was the expansion of international free trade. In 1776, Adam Smith had given the generally accepted explanation of wealth creation: division of labour and free trade. But Smith also noted that “the division of labour is limited by the extent of the market”. This is not an acute problem for a large political unit like the long-gone Habsburg empire or the present-day US where the domestic market is big. But for a small country protectionism is much more costly. If its economy is closed, the inhabitants forgo the benefits of a more extensive market. If, on the other hand, the economies of many countries are open and the inhabitants trade freely with one another, they reap the benefits of the division of labour. Thus, perhaps paradoxically, economic integration makes political disintegration, or at least decentralisation, less costly and therefore more likely. 

Indeed, small states usually have more open economies than large ones. They rely more on international free trade. Unsurprisingly, they tend to be wealthier. Of the ten richest countries in the world today, in terms of GDP per capita, only four have populations over one million: the United States (320 million), Switzerland (eight million), Norway (five million) and Singapore (six million). Of these five countries, four would normally be considered small, while one is a federation of 50 states. 

Again, of the five largest states in terms of population, China, India, the United States, Indonesia and Brazil, only America is really a rich country. There are two additional reasons why small states tend to have open economies. First, they are usually homogeneous, which may make it more difficult for special interest groups to distort political decisions in their favour. Secondly, small economies usually have little or no control over world prices. It is therefore even more inefficient than in larger economies to subsidise domestic products in order to give them an advantage over imports. The benefit for the domestic producer will be much smaller than the cost for local consumers.

Thus, a combination of large markets and small states makes eminent economic sense. It also makes political sense. Large markets, bound together only by free trade, enable strangers who inhabit different and often distant countries to cooperate as producers and consumers. These individuals need not live together or like one another. Their interactions are confined to what is of mutual benefit to them; they are neither unwilling neighbours nor reluctant compatriots, only customers. This is the basic truth in two trenchant historical observations by supporters of free markets. “Had we advanced so far as to see a good customer in every foreigner, there would be much less inclination to shoot at him,” the Anglo-German politician John Prince-Smith said in 1860. “If soldiers are not to cross international boundaries, goods must do so,“ wrote American economist Otto T. Mallery in 1943.

Small nations make no less political sense than large markets. They tend not to be as militant or aggressive as larger powers. Moreover, they can be expected to be homogeneous, implying a high level of trust as well as social cohesion, widespread solidarity and transparency. All of this facilitates the spontaneous mutual accommodation of different individuals. 

This was recognised by the Anglo-Austrian economist and political philosopher Friedrich von Hayek, who wrote in his 1944 book, The Road to Serfdom: “In a small community common views on the relative importance of the main tasks, agreed standards of value, will exist on a great many subjects. But their number will become less and less the wider we throw the net: and as there is less community of views, the necessity to rely on force and coercion increases.” In the midst of war, Hayek reflected on recent history: “It is no accident that on the whole there was more beauty and decency to be found in the life of the small peoples, and that among the large ones there was more happiness and content in proportion as they had avoided the deadly blight of centralisation.”

While large markets encompassing many small states with open economies should certainly seem realistic and desirable to free traders, the problem of vulnerability remains. Therefore, small states often enter into alliances. If they had not been united, the 13 colonies on the east coast of North America would not have defeated the British. Such alliances may become federations, as the US did. 

Europe, on the other hand, developed differently. After Hitler and Stalin divided up Europe in 1939, for a while only six democracies remained (three of them islands): the United Kingdom, Ireland, Iceland, Sweden, Finland and Switzerland. Learning from history, Western democracies in 1949 founded a defence alliance, Nato, mainly based on the great military strength of America. Limiting itself to clear and narrow objectives, Nato has had more success than most other international organisations. 

But for small nations, the arguments for military alliances are stronger than for customs unions. Why should it take lengthy negotiations for a country to lower tariffs, since it is obviously in its own interest? Free trade should extend to the whole world, not only to the fellow members of a customs union. This is why the European ideal for free traders should be an open market rather than a closed state. They should wish to see the European Union as a loose federation of small and medium-sized states rather than a large, unified and harmonised federal state, with the pretensions of a superpower. 

While large markets encompassing many small states with open economies should certainly seem realistic and desirable to free traders, the problem of vulnerability remains. 

A federation of different states – on the model perhaps of the Swiss federation – has the additional advantage of increasing political competition for citizens, or rather taxpayers and wealth creators. Thus it may act as an important constraint on power, as Edward Gibbon eloquently argued in his History of the Decline and Fall of the Roman Empire:

The division of Europe into a number of independent states, connected, however, with each other, by the general resemblance of religion, language and manners, is productive of the most beneficial consequences to the liberty of mankind. A modern tyrant who should find no resistance either in his own breast or in his people, would soon experience a gentle restraint from the example of his equals, the dread of present censure, the advice of his allies, and the apprehension of his enemies. The object of his displeasure, escaping from the narrow limits of his dominions, would easily obtain, in a happier climate, a secure refuge, a new fortune adequate to his merit, the freedom of complaint, and perhaps the means of revenge. But the empire of the Romans filled the world, and, when that empire fell into the hands of a single person, the world became a safe and dreary prison for his enemies. The slave of Imperial despotism, whether he was condemned to drag his gilded chain in Rome and the senate, or to wear out a life of exile on the barren rock of Seriphus or the frozen banks of the Danube, expected his fate in silent despair. To resist was fatal; and it was impossible to fly. 

Free trade in Europe requires a common European market, which should as a matter of course also be open to other international markets. But it certainly does not need a new Roman empire, imposed on the small nations of Europe.