Between the lines: Small countries looking best placed for recovery

SIZE matters, in economics as well as other things. The collapse of the Icelandic banking system has raised questions about the economic viability of small nations, especially in the current global financial crisis. Could an independent Scotland have bailed out RBS and HBOS or are we lucky that Gordon Brown was in charge, not Alex Salmond?

Economists have long argued over the optimal size for a national economy. A big nation state has the advantages of a wider internal market; economies of scale; and the ability to provide collective fiscal "insurance" if a particular region or business sector gets into trouble – as we have just seen in the UK.

Equally, economists identify diseconomies that occur with increasing size: longer lines of decision-making; and one-size-fits-all monetary and fiscal policies which can be grossly inappropriate for individual regions and sectors. My view is that such diseconomies – exacerbated by the domination of London within the overall UK economy – have long affected the Scottish economy, slowing the growth rate in comparison with the independent small economies of northern Europe.

That is not to say Scotland does not benefit from being within the UK common market. But our chronically sub-optimal performance in GDP growth, productivity, and research is incontestable, suggesting the losses outweigh the gains.

Those who are now crowing about an "arc of insolvency" base their case on the fact that (1) the majority, if not all, of the small, north European economies are entering recession; and (2) only the action of the US, UK and larger EU states to stabilise the global financial system has stopped these smaller economies being swept away.

Apart from Iceland (which counts more as a micro economy) countries such as Sweden, Denmark, Finland, Austria and Switzerland are rich because they have large manufacturing export sectors – unlike Scotland. It is hardly news their rates of growth will decelerate because the world economy is in a downturn, but they are not slowing because their banking sector is imploding. Switzerland is unique in this group in having a global banking arm as well as strong manufacturing. Swiss banks have seen huge write-offs as a result of toxic debt, but the overall strength of the economy has allowed the country to ride out this problem.

Of the smaller economies, Ireland is unique because its recession has been triggered by a collapse of a local housing boom. Again, the underlying strength of the economy (particularly the low public sector debt) allowed the Irish government to protect its commercial banks from the storm. For this, the Irish were roundly denounced by Mr Brown – a week before he was forced to follow suit. (Incidentally, don't crow about yesterday's austerity budget in Ireland: our time is coming. Mushrooming UK public debt will soon raise taxes here.)

So, no "arc of insolvency" to speak of. However, recently, all the smaller European economies have suffered from the generic global problem of the inter-bank markets freezing up in the wake of the Lehman Brothers failure in New York. This is hardly a problem of their own making but they still catch the blizzard blowing out of Wall Street and the City of London, where the crisis began.

In response, the Scandinavia central and commercial banks have co-operated in trying to provide collective support during this crisis. The lesson here is that multilateral action is the only way forward in such unique circumstances, as size is no defence from market panic – last week the entire British banking system was within 24 hours of crashing. I respect the scale and boldness of the Treasury rescue bid, but it did not actually unblock the inter-bank markets. That only started to occur (slowly) with the eurozone collective action announced last Sunday in Paris.

As for any future economic recovery, I think the smaller economies are in a far better position than the UK, which suffers from the double whammy of over-extended banks and housing crash. For a start, the smaller economies enter the downturn from a higher economic base. Let's look at the economic fundamentals, starting with GDP per capita – a proxy for how well-off individuals are. Taking the EU27 average as 100, Sweden (125), Denmark (120), Finland (116), Austria (126), Ireland (146), Switzerland (137), Norway (181) and troubled Iceland (125) are all ahead of the UK (115).

The next fundamental is productivity. This tells you the capacity of an economy to cope with change. Again, we will measure this using the EU27 average as 100, this time for output per worker employed. Once again, the UK fares badly at 109. But most other small economies outdo Britain, with Austria posting 118 and Ireland a hot 138. The latter is particularly interesting, and reflects Ireland's heavy investment in education and hi-tech manufacturing. Bank capital can be wiped out easily but a high skills base and modern manufacturing plant are real things hardwired into the economy and will help you out of any downturn.

Next, let's look at the proportion of GDP spent on research: the chances are that any return to growth in the next economic cycle will be innovation led, rather than credit led. The latest comprehensive figures come from 2006, but the rank order will not have changed much. In that year, the UK invested a miserly 1.8 per cent of its GDP in research and development. We were beaten hands down by Sweden (3.7), Finland (3.5), Denmark (2.4), Austria (2.4), and Switzerland (2.9). Even Iceland, despite its dangerously loose banking sector, managed to invest 2.8 per cent of GDP in new R&D in 2005.

Now let's look at capital investment in fixed plant and IT equipment. Economies with a deeper capital base will grow more quickly out of recession. In 2007, the UK invested 16 per cent of GDP in new fixed capital. The record of most of the smaller European economies far outweighs this: Austria (21), Denmark (21), Ireland, (22), Switzerland (19 in 2006), Norway (18) and Finland (18). Tiny Iceland managed a respectable 23 per cent, which will stand it in good stead now its banks have imploded.

In the end, it is the soundness of the policies which a country follows that determines its economic success or failure, not its size per se. But it helps if you have the policy flexibility of a small economy. As Chancellor, Gordon Brown gave us a credit bubble and poorly regulated banks. I sincerely hope he has learned his lesson.