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The realities of economic interdependence: Its benefits and frustrations

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 1984
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Along with the benefits there are some frustrations, but the alternative would be worse

That the world economy has become much more interdependent, integrated, and internationalized during the past three decades is a generally recognized fact. In recent years, however, in the wake of the worldwide problems of inflation, recession, high energy prices, and debt-servicing difficulties, there has been some questioning of the benefits of this phenomenon and there have even been some suggestions that perhaps greater economic independence, and hence a less integrated world economic system, might be preferable. To consider the feasibility, let alone the desirability, of such a marche-en-arriére, it is important to appreciate the degree to which the process of interdependence has proceeded, what its benefits and implications have been, and thus, implicitly, the potential consequences of reverting to a less interdependent international economic system.

As a simple working definition, the concept of economic interdependence may be taken to denote a situation in which (1) what happens in other countries will affect economic performance in an individual country and (2) what an individual country can or wishes to do will to some degree depend on the actions and policies of other countries. It usually means both. Economic interdependence, in short, means that the economic well-being of any one country is affected by the actions and policies of other countries.

But the simplicity of the concept conceals many complexities and shades of meaning. To begin with, interdependence is a matter of degree: no country is totally dependent upon others and none is absolutely isolated. The extent of interdependence (however defined) varies considerably among countries. Similarly, a particular country may be dependent on one other country, a few countries, or the outside world at large, and these dependencies may—indeed often do—change over time. Moreover, beyond the scope of this article are the very important political and military implications of interdependence that interact with and are frequently a function of economic interdependence.

Historical perspective

The high degree of interdependence that characterizes the world economy today—described in greater detail below—may be traced to the policies adopted in the aftermath of World War II to prevent a recurrence of the parlous state of the international economy during the 1930s. That decade had witnessed the progressive disintegration of international economic relations, with the imposition of mounting barriers to international trade and payments, resort to “beggar-thy-neighbor” policies (that is, policies taken at the expense of other countries), and general economic instability and insecurity. On top of these came the numerous restrictions on international payments and exchange necessitated by the war itself.

This article was prepared by the Editorial staff

Thus, by the end of World War II, the world economy was enmeshed in an extensive network of restrictions on international trade and payments. For most countries, trade was limited to essentials, bilateral arrangements in trade and payments were common, exchange restrictions in many forms abounded, and capital movements were under the strictest control. In such circumstances, the economies of nations were to a considerable degree sheltered from each other.

The various arrangements that came into force after the end of World War II, notably the establishment of the Fund, the Bank, and GATT, and associated with this, the launching of what later came to be called the “Liberal International Economic Order,” were the key to the process that fostered the progressive internationalization of the world economy. These institutions provided the framework, in an atmosphere of relative economic stability, for a gradual but continuous process of liberalization, at first limited to international trade and payments and, at a later date, extended to capital movements. This process was reinforced by, and in turn facilitated, other developments including the achievement of high levels of employment in industrial countries, much greater factor mobility (capital and labor migration), a major expansion (assisted by rapid technological change) of international transport and communications, the revolutionary advance in electronics, and the growth of transnational corporations.

The impact of these developments on the international economy was direct and highly visible. The world experienced an era of unprecedented growth, during which the volume of trade increased almost sixfold. This allowed, and was aided by, the recovery of the economies of the European nations and of Japan, as well as rapid development in many other countries.

This so-called golden age of the international economy is assumed by some to have come to an end—or at least to a pause—in 1973, with the formal abandoning of the fixed exchange rate system that had been the centerpiece of the Bretton Woods monetary system, and the quadrupling of energy prices. The ensuing decade has been one of severe economic turbulence for the world economy, characterized by high rates of inflation, substantial balance of payments disequilibria, two major recessions, rapid growth of external indebtedness, high interest rates, and creeping protectionism. Yet, and in spite of the increase in protectionist measures, the world economy has remained highly integrated and indeed, in one respect at least, this very turbulence has led to greater integration. This is the rapid growth of international credit and capital markets in the 1970s. It facilitated a major recycling of the surpluses of oil exporting countries following the rise in energy prices, thus permitting countries with serious strains in their balance of payments to obtain financing, while providing an outlet for those countries with large surpluses. The mirror image of these capital movements, however, was the accumulation of very high levels of external debt which, especially in the early 1980s, created major debt-servicing difficulties.

How interdependent are we?

There is no need to resort to elaborate quantitative analysis to demonstrate the growing interdependence of the world economy. A number of basic indicators suffice to show this trend. A key indicator, and one that has traditionally been used as a basic index of interdependence, is the growth of international trade as compared with the growth of GDP. Trade, as a function of national income, grows with it; but if trade grows at a more rapid rate than income, this indicates greater reliance on outside markets for the domestic product as well as on outside sources for domestic consumption and production.

The nominal value of world exports of goods and nonfactor services rose from about $605.3 billion in 1960 to $2,170.5 billion in 1980 (Table 1). When adjusted for inflation, this translated into a 6.7 percent annual growth rate in real terms in the value of world exports. However, during the same period world GDP rose at an annual average rate of 4.4 percent in real terms. Combining these two magnitudes to obtain another measure of economic integration, the ratio of world exports to GDP rose from 12.2 percent in 1960 to 21.8 percent in 1980.

Table 1World exports and GDP, 1950–80
Exports

(In billions

of dollars)
Annual

growth rate

(In percent)1
GDP

(In billions

of dollars)
Annual

growth rate

(In percent)1
19502,812.04.02
19553,423.0>4.02
1960605.3>7.34,166.6>5.4
1965853.6>8.95,407.6>5.2
19701,298.9>5.76,948.8>4.0
19751,649.1>5.58,307.7>3.8
19802,170.59,969.9>
Source: Work Bank data.

Indicates data not available.

Least squares growth rate.

End-point growth rate.

Source: Work Bank data.

Indicates data not available.

Least squares growth rate.

End-point growth rate.

While the above demonstrates the growing interdependence of the world economy based on aggregated data, it need not imply increasing dependence for individual countries. The disaggregated data presented in Table 2, however, support the global data in that they show an increase in the number of countries for whom the trade/GDP ratio has increased. Taking all countries, the data show that the number of countries that rank lower in export/GDP ratios (up to 20 percent) has decreased, with a corresponding increase in the number of countries that rank higher (20 to 70 percent). When disaggregated by country groups, the same phenomenon is clearly apparent for industrial countries and oil exporting countries, although it is less pronounced in the case of non-oil developing countries. The data on input/GDP ratios show the same trend, albeit in a less clear-cut way.

Table 2Ratios of merchandise exports to GDP
Under 1010–2020–30Exports as percent of GDP50–6060–7070

and over
30–4040–50
In percent of countries
World
196027.134.519.89.92.52.53.7
197018.835.921.73.86.63.81.97.5
198016.125.324.012.08.04.05.35.3
Industrial countries
196020.045.025.010.0
197015.035.040.05.05.0
198010.020.045.010.010.05.0
Oil exporting countries
196016.650.016.716.7
197010.040.010.010.030.0
198020.040.040.0
Non-oil developing countries
196030.929.118.29.13.63.65.5
197022.339.414.54.07.94.01.36.6
198020.030.018.012.08.04.04.04.0
Source: International Monetary Fund, International Financial Statistics Supplement on Trade Statistics, 1982.
Source: International Monetary Fund, International Financial Statistics Supplement on Trade Statistics, 1982.

Of particular significance to the increasing interdependence of the world economy is the situation of the United States, which remains the largest economy in the world. While three decades ago many countries were already highly dependent on trade, the United States was relatively independent of international trade: exports of goods as a percentage of GDP in the United States in 1952 amounted to only 3 percent. This situation has changed drastically: by 1981 U.S. exports as a percentage of GDP amounted to 8.8 percent.

Financial interdependence

Another, very important, manifestation of growing interdependence concerns financial flows. The progressive liberalization of controls on capital movements and, for the past decade, the regime of flexible exchange rates have given major impetus to the rapid growth of international capital flows. Capital flows comprise many types, including official development assistance and other official flows, direct or portfolio investment, other long- and short-term banking flows, and export credits. Official development assistance grew by nearly 6 percent a year over the past decade, although it has been steadily declining as a share of total flows since the early 1960s. The major part of direct investment is by industrial country corporations in other industrial countries; since 1970, this has almost doubled. Portfolio investment has risen dramatically; it almost doubled between 1975 and 1981 in the industrial world, and rose two and a half times over the same period in the developing countries. In these, it represented about 5 percent of total flows in 1961–63 and accounted for 32 percent in 1981.

On a global basis, long- and short-term capital flows rose almost tenfold between 1975 and 1981. Many of these pass through the international capital markets, an interbank system that has provided a vivid manifestation of increasing global financial interdependence since the early 1970s. In September 1963, the earliest month for which data are available on foreign currency activity in Europe, the BIS quoted the short-term foreign currency assets of its reporting banks (net of redepositing) as $12.4 billion. In 1980, these assets were $575 billion. Euromarket banks have spread beyond Europe to offshore centers in the Caribbean, Latin America, the Near East, and Southeast Asia; to meet different types of demand they have developed innovative and efficient instruments. As restrictions on capital flows have been reduced, the Euromarket has become more integrated with national banking systems.

One of the effects of the greater financial integration has been the large flows of short-term funds across borders in response to interest rate differentials and anticipated exchange rate changes. The advent of flexible exchange rates in 1973 has also expanded the function of the market in two other ways: Euromarkets had long been a source of reserve funds for central banks; this function has grown in importance as the balance of payments positions of many countries have been subject to swings that have increased in size in recent years. Dependence on the markets has also grown as exchange rate changes have increased the risks of commercial transactions and traders increasingly need the protection of forward cover.

The Euromarkets have played a particularly important role since 1973 in recycling the unprecedented balance of payments surpluses resulting from the oil price rises. Between 1973 and 1982, the oil exporters’ current account positions and the deficits of the oil importing countries fluctuated widely, with the developing country importers less successful at controlling their deficits than the industrial countries (Table 3).

Table 3Current account positions and private market financing by principal groups of countries, 1973–82(In billions of dollars)
1973197419751976197719781979198019811982
All Industrial countries
Current account position20–11201–233–6–401–1
Borrowing through private markets19272450595791116126103
Banking16221031393869969957
Bonds351419201922202746
Medium-term credit commitments121869133424399552
Oil exporting developing countries
Current account position76835403026911465–2
Borrowing through private markets1338910157638
Medium-term credit commitments31336108559
Non-oil developing countries
Current account position–11–37–46–33–29–41–61–89–108–87
Borrowing through private markets11161623182943515428
Banking10151521152540495125
Bonds1112343233
Medium-term credit commitments59913132742324337
Sources: Bank for International Settlements; Organization for Economic Cooperation and Development; International Monetary Fund, World Economic Outlook, Occasional Paper No. 21 (May 1983); and Fund staff estimates.

Almost all borrowing was from banks.

Sources: Bank for International Settlements; Organization for Economic Cooperation and Development; International Monetary Fund, World Economic Outlook, Occasional Paper No. 21 (May 1983); and Fund staff estimates.

Almost all borrowing was from banks.

Part of these deficits was met from official sources: about a third of the aggregate current account deficits of the non-oil developing countries is estimated to be covered by borrowing from official sources in 1983, which had met almost two thirds of the deficits of the low-income group. The major share of aggregate current account financing, however, was provided by private sources, mainly international banks. Between 1974 and 1981, almost 50 percent of the oil exporters’ current account surpluses were deposited in and onlent by BIS banks.

One issue that arises out of any discussion of lending in these times is that of debt, some aspects of which have created difficulties (Table 4). The total outstanding long- and short-term debt of non-oil developing countries rose from about 22 percent of their GDP in 1973 to 35 percent in 1983. Within the group, the net oil exporters and the major exporters of manufactures have been the most reliant on commercial bank lending and the low-income countries the least (private financial institutions have only supplied about 12 percent of their total debt since 1979).

Table 4Non-oil developing countries: external debt, 1973–831(In billions of dollars)
19731974197519761977197819791980198119821983
Total outstanding debt of non-oil developing countries130.1160.8190.8228.0278.5336.3396.9474.0555.0612.4664.3
Short-term debt18.422.727.333.242.549.758.885.5102.2112.792.4
Long-term debt111.8138.1163.5194.9235.9286.6338.1388.5452.8499.6571.6
By type of creditor
Official creditors51.060.170.382.498.7117.5133.0152.9172.4193.2218.7
Private creditors60.877.995.1114.8137.3169.1205.1235.6280.4306.4353.0
By analytical group
Net oil exporters20.426.034.142.453.361.270.579.496.5108.1129.0
Net oil importers91.4112.1129.4152.5182.7225.4267.6309.1356.2391.5442.6
Major exporters of manufactures40.851.760.973.185.2108.1127.7145.2170.6184.3212.4
Low-income countries25.429.733.238.346.553.159.567.073.080.190.8
Other net oil importers225.230.635.341.151.064.280.496.9112.7127.1139.4
Sources: World Bank, Debtor Reporting System; and Fund staff estimates and projections, quoted in World Economic Outlook, 1983.

For classification of countries in groups shown here, see the introduction to the appendix of World Economic Outlook. Excludes data for the People’s Republic of China prior to 1977.

Middle-income countries that, in general, export mainly primary commodities.

Sources: World Bank, Debtor Reporting System; and Fund staff estimates and projections, quoted in World Economic Outlook, 1983.

For classification of countries in groups shown here, see the introduction to the appendix of World Economic Outlook. Excludes data for the People’s Republic of China prior to 1977.

Middle-income countries that, in general, export mainly primary commodities.

Other forms of interdependence

Apart from the growth of trade and financial transactions, the increasing interdependence of the world economy can be gauged from a variety of other indicators reflecting both a widening and a deepening of economic contacts and interchange among nations. Mention may be made of two of these indicators.

The first is labor movements. Although textbooks traditionally have assumed labor to be an immobile factor of production, there has always been international migration of labor in response to international differences in income and employment opportunities. In the last two decades there have been large-scale movements of unskilled, semiskilled, and skilled labor, some legal and some illegal. These movements have taken place not only within the developed and developing countries but also between them. Estimates of migrant workers put their total in the late 1970s at 20 million, of whom 12 million were from developing countries. These immigrant workers were mainly concentrated in certain regions of the world: North America (6 million), Western Europe (5 million), and the Middle East (3 million). Other major destinations included West Africa and South Africa.

Movements of labor result in reverse movements of funds transmitted by workers. Between 1970 and 1980 the flow of worker remittances grew at an average annual rate of almost 26.5 percent. In 1980, remittances to developing countries yielded about $24 billion, up from an estimated $3 billion in 1970. The middle-income oil importing countries—among them the traditional labor exporters of Southern Europe as well as new exporters of migrants to the oil surplus states—earned most from this source. In 1982 it was estimated that remittance receipts by these countries were equivalent to about 34 percent of their current account deficits.

The second indicator concerns the growth of transnational corporations—large companies headquartered in one country but operating in several countries, as employers, purchasers of inputs, and sellers of output. The growing integration of the world economy, in particular the fall in barriers to trade and capital movements, has paved the way for the growth of these corporations. They, in turn, have contributed to economic integration by evolving into large transnational entities, not limited by constraints of domestic market size or costs of domestic inputs, but, on the contrary, availing themselves of the most advantageous conditions in labor, capital, and goods markets. In a sense, therefore, these “world” corporations, for whom national boundaries have limited meaning in economic terms, are good examples of some aspects of an integrated world economy.

Advantages and drawbacks

The benefits of economic integration and interdependence have become amply evident during the past decades. The world economy in the early 1980s, with all its undeniable problems, has an entirely different character to that of the world economy after World War II, and this is, in part, a reflection of economic integration. The enormous expansion of international trade in goods and services and the progressive freeing of capital movements across national borders have promoted a much more efficient utilization of the world’s resources, both physical and financial. Moreover, this expansion in international exchange has brought with it a spread of knowledge, technology, and managerial skills—developments that have served to spur economic growth in many developing countries.

Not every country has benefited from economic integration to the same degree nor have benefits been uniform during this entire period. But there can be little doubt that economic growth, on average, has been much greater than would have been possible had the postwar barriers to trade and payments remained in place, or had the world economy reverted to the conditions of the 1930s.

Economic growth is not an end in itself: it allows a higher standard of living and a better quality of life. Again, not all people have benefited nor have those that have benefited done so to an equal degree. But without the economic integration of past decades the substantial improvement in living standards in many countries would not have been possible. It has also been argued that the greater degree of economic interdependence has served to promote a more peaceful world.

Alongside its undisputed advantages, however, economic integration also has other implications, not all of them considered to be positive. To begin with, greater interdependence means ipso facto less independence—that is, in our context, a reduced degree of autonomy in domestic policies and actions. The success of economic policy measures taken in one country will, in an interdependent world, to a large extent depend on the policies, actions, and reactions of other countries. To that extent, domestic economic sovereignty is reduced and the effects of policies are more difficult to predict.

By the same token, the economic life of an individual country is more vulnerable to outside developments, both positive and negative. Changes in the level of demand (whether brought about as a result of policy or by natural factors), as well as changes in the conditions of supply, have a greater impact in a country that is more open and outward-looking than in a closed economy. And, to use a current example, decisions by banks in one country can have a far-reaching effect on the financial viability and development prospects of other countries.

The degree of vulnerability to outside economic impulses is not, of course, the same for all countries. The economic size and importance of an individual country is an important determining factor. Just as there are price-makers and price-takers for particular commodities, so in an integrated world economy the smaller or economically weaker nations, whether developed or developing, are liable to be more dependent than larger and economically stronger countries. A stronger economic power has relatively greater freedom to change and adapt its economic policies; for instance, the fiscal and monetary policies followed by major industrial countries have a direct and far-reaching impact on the economies of developing countries. Policies that may result in higher interest rates in industrial countries directly increase the burden of debt-servicing for debtor countries, most of which are developing countries. The difficulties, even for major industrial countries, of conducting an independent monetary policy in circumstances characterized by free capital movements and flexible exchange rates have been amply documented in the economic literature.

The implications of greater interdependence may also be looked at from the perspective of the international economic system. A more integrated world economy implies greater mobility in the transmission of economic forces; economic stimuli in one country—such as a higher rate of inflation—spread more quickly and have more direct effects. “Domestic” fiscal and monetary policies in an economically important country are not domestic in an integrated setting: they affect the economies of other countries and therefore the whole economic system.

Economic interdependence can therefore result in greater instability in the international economic system, because shortcomings in domestic policies are more easily and immediately transmitted to other countries. In recent years, this instability has been particularly dramatically demonstrated in the realm of exchange rates, with movements in rates that are not easy to justify by the underlying economic developments.

Thus, economic integration and interdependence have their drawbacks and difficulties, and these must not be underestimated. The instability and disruption that characterize the international economy are a cause for legitimate concern. For instance, the sudden surges in imports that have occurred in many countries, reflecting rapidly changing competitive conditions, have also had a serious impact on these countries. An abrupt dislocation of traditional patterns of production and trade, accompanied by large-scale unemployment, has been experienced by many of the older industrial nations.

And adjustment is a difficult, slow, and often painful process. In particular, as we have seen, the wholesale retrenchment of traditional industries (e.g., steel, textiles) no longer able to compete with imports has resulted, in some countries, in large bodies of unemployed labor, much of which is unskilled or semiskilled, and no longer young. Adjustment, including retraining and relocation, is especially difficult in such circumstances.

These problems and others all too vividly do exist and are brought to the surface by the openness and integration of the international economy. Their resolution is, as mentioned, difficult, costly, and time-consuming. But the solutions do not lie in measures to isolate the economies of individual countries, to reduce integration of the world economy, to achieve greater national economic independence, and to return to a state characterized by trade and payments barriers and other types of restrictions. Given the extent and nature of mutual economic dependence, this would not be a viable solution. But even if it were feasible, any such “relief” would be achieved only at considerable cost—cost in terms of a lower rate of economic growth, a less efficient utilization of resources, a more stagnant international economy, and ultimately lowered standards of living for all.

Excerpts from remarks by Fund Managing Director J. de Larosière to the American Enterprise Institute, December 1983

In a wide-ranging address on a subject related to that of the accompanying article—an address entitled “The domestic economy and the international economy—their interactions,” the Managing Director concluded with the following comments on the cooperative policies required in present circumstances:

The need for cooperation is not, by itself, controversial. What is more difficult is to know the kinds of action that will give concrete and beneficial effect to a desire to work together for mutually agreed objectives…. Perhaps the two central issues facing the world economy at the present time [are] the debt crisis facing many heavily indebted developing countries…[and] how to restore sustainable and balanced growth to the world economy at large. Needless to say, the solutions to these two problems are intimately linked….

The first thing I want to say about the debt crisis is that, with appropriate policies, it can be handled and overcome…. The second key point is that the debtor countries themselves must demonstrate that they are taking the necessary steps to regain financial viability, while preserving their capacity to resume economic growth in the medium term…. My third point concerns the need for a proper appreciation by creditors of their role in this process…. The task… is to achieve a smooth transition in which sufficient external financing is available to indebted countries to enable them to scale back their dependence on foreign savings in an orderly fashion, while preserving their ability to invest and grow in the medium term. This process has already proceeded a long way.

This brings me to the issue of how domestic and international economic developments are linked in the process of international recovery. Economic expansion has been proceeding quite strongly in the United States and Canada since around the beginning of this year, but a number of uncertainties surround the sustainability of global recovery. In the first place, recovery is not yet sufficiently well spread geographically. Second, there are a number of factors that threaten to undermine a recovery of business fixed investment which, itself, is central to a sustainable expansion.

First, interest rates remain extremely high in relation to ongoing rates of inflation.… Second, uncertainties about the future course of inflation still remain. The prospective trend of prices beyond the next couple of years depends on policies that are not in all cases clearly established and may yield to political pressures. Third, profitability in manufacturing remains at a low level, particularly in a number of industrial countries.

This is not an exhaustive list of the issues facing international policymakers. Nevertheless, it does point to a number of areas in which domestic and international policies interact. The most prominent example is the determination of interest rates in a world where international capital markets are increasingly integrated. Interest rates are influenced both by the current balance between the demand for and supply of investable funds, and the perception of how this balance is likely to evolve in the future. They are also strongly influenced by inflationary expectations—and by the degree of uncertainty that surrounds these expectations.…

In an interdependent world, the policies of all countries impinge on the global environment of their trading partners. The institutional framework in which these interactions can be discussed already exists, in embryo, in particular in the surveillance responsibilities of the International Monetary Fund, and in less formal arrangements such as those engaged in by the Summit countries. The need is not for new institutions so much as for the political will to use more intensively those we already have.

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