The Compensation Hypothesis Revisited and Reversed

This note describes how research on the link between globalization and openness has changed over time. Early contributions assumed that countries develop welfare states to compensate for volatility caused by economic openness (the compensation hypothesis). Recent findings have cast doubts on several steps in the causal chain implied by the compensation hypothesis. In many ways economic openness has been shown to be particularly beneficial for countries with high taxes and high income equality. Countries with large welfare states can use economic openness to mitigate some of the unintended side-effects of social protection and high taxes. The compensation hypothesis can thus be reformulated: Through trade, the citizens in large welfare states can enjoy some of the benefits associated with cheap labor and high wage dispersion despite their domestic economy being characterized by the opposite.