Financial openness, volatility, and the size of productive government

This paper analyzes the impact of financial openness on the size of the government in a stochastically growing small open economy when public spending is productive and volatility-reducing using a portfolio approach. The main result of the model is that economies that are more open are associated with a smaller productive public sector. The lower risk associated with more open economies due to risk diversification implies that the government is less inclined to increase the scale of its activity to maximize welfare when productive spending is also volatility-reducing. The empirical evidence based on a sample of 16 OECD countries for the period 1970–2004 broadly supports the main results of the model, even though some results are mixed.