How easily can a small country produce above capacity?

Paul Krugman raises that question in connection with the Baltics.  In contrast to Krugman’s claim, I would think it is especially easy for small, open economies to produce “above capacity,” if only because resources can flow in from abroad.

As I understand the case for capital controls, recently endorsed by Krugman, that case almost requires a notion of an economy “heating up” in an “unsustainable” fashion; otherwise what’s the worry with the capital inflow?  Better to have the capital than not, unless you fear unsustainability.  (Don’t, by the way, be shocked if people who totally reject the rationale behind the capital controls idea are also inconsistent on this point and wish to argue that the Baltics were unsustainably over capacity.)

Imagine a lot of capital flows into a small, open economy, but based on unrealistic assessments of risks and future prospects.  Economic activity will be much higher.  Labor will come back home or reject what would otherwise be a decision to leave.  A lot more will be produced, at least temporarily.

Eventually foreign investors come to their senses and the whole process goes in reverse.  Now that foreign investors have learned their lessons, and withdrawn their capital and their ambitious plans for the future, the small economy cannot easily get back to where it was, at least not anytime soon.  To my eye this process and its unraveling seems fairly simple to grasp.  The fact that lots of labor is leaving, as has been the case in Latvia, if anything supports the plausibility of this scenario.

If you are focused on per capita effects, capital may move faster than labor, there may be ranges with increasing returns to scale, it may be the more productive workers who can leave, and momentum effects, among other possible mechanisms.

I also would reject any hard notion of “capacity” and view the matter as a sliding scale, depending on expectations and how much risk and fragility investors and suppliers of labor are willing to accept; see my Risk and Business Cycles for more on this point.


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