Trade openness and sustainable government size: Evidence from central and Eastern European Countries

Abstract

The ongoing discussion regarding the role of the free market economy and the extent of state intervention is a critical subject in economics. This matter holds special significance for transition economies, as it presents both challenges and opportunities in such contexts. One may perceive the degree of trade openness as a path toward welfare societies. However, the dual impacts of trade openness on an economy, namely, the compensation and efficiency hypotheses, must be considered. The compensation hypothesis proposes that global trade can enhance the economic influence of the state, whereas the efficiency hypothesis advocates for a contraction in the state’s economic undertakings. This study focuses on interpreting this complex scenario, specifically in the context of the European Union’s transition economies. The aim of this research is to uncover how the economic magnitude of a nation influences trade liberalization, and consequently the free market economy, in Central and East European (CCE) countries, using public choice theory as a foundation. The research delves into the causal relationship between trade openness and government size in eleven CCE countries—Bulgaria, Croatia, Czechia, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia. The period covered in this study ranges from 1996 to 2021. The methodological tool utilized for this investigation is the Kónya bootstrap Granger causality test, which accommodates cross-sectional dependence and country-specific variances. The novelty of this study lies in its application of both the compensation and efficiency hypotheses to the context of 11 transition economies in the Central and Eastern European (CCE) region. The results from the Granger causality test demonstrate a unidirectional positive correlation between trade openness and the size of the government for Bulgaria, Croatia, Czechia, and Estonia. On the contrary, Slovenia exhibited a unidirectional negative correlation. These findings confirm the applicability of the compensation hypothesis in Bulgaria, Croatia, Czechia, and Estonia, while supporting the efficiency hypothesis in Slovenia.