Although most economists would guess that governments tend to be smaller in more open economies, Research Fellow Dani Rodrik shows in Discussion Paper No. 1388 that the cross-country evidence shows quite the opposite. He claims that there is a robust partial correlation between openness, as measured by the share of trade in GDP, and the scope of government, as measured by the share of government expenditure in GDP.

The explanation that best fits this evidence, according to Rodrik, focuses on the role of external risk. Government consumption appears to play a role in insulating economies subject to external shocks. Societies seem to demand and receive a larger government sector in return for a larger doses of external risk. The evidence is found in Rodrik’s regressions where openness interacts with the volatility of the terms of trade and product concentration of exports. In each case, the interaction term is strongly significant while the coefficient of openness turns either statistically insignificant or negative when significant. Other possible explanations for the observed correlation between openness and government spending, such as indivisibilities in government spending or differing external borrowing constraints, fail to account for the association between openness and size of government.

Why do Open Economies have Bigger Governments?
Dani Rodrik