Factors Behind Greater Interconnectedness, and Whether Governments Should Fear Deglobalisation's Effect on Budget and Balance of Payments

Answer

Part (a) — Factors behind greater interconnectedness [10]

Free trade and comparative advantage. By the theory of comparative advantage, trade benefits all parties when each specialises in the good it produces at lower opportunity cost. Differences in factor endowments and technology generate differences in relative factor prices and hence opportunity costs, creating the basis for international specialisation. The mutual gains motivate countries to trade, deepening interconnectedness.

Improvements in technology. Advances in information and communications technology — the internet, e-commerce — and in transport, notably containerisation, have cut shipping costs by saving time, manpower and infrastructure. Lower transport costs let consumers obtain a wider range of goods at lower prices, a major driver of globalisation.

Government policy. Recognising trade’s gains, governments have removed trade barriers, helped by the WTO’s forums for negotiating liberalisation. Liberalisation has extended to capital flows, especially long-term FDI, which finances development in recipient countries and earns returns for the financing firms — further binding economies together.

Part (b) — Should governments fear deglobalisation’s effect on budget and BOP? [15]

Deglobalisation is the diminishing interconnectedness of economies — less trade, slower flows of labour and capital, less competition. Whether it threatens a government’s budget and balance of payments depends decisively on the nature of the economy.

Thesis: a small, open economy should be concerned. For Singapore, where total trade exceeds 400% of GDP, a significant fall in exports lowers net exports and, given their large share of AD, causes a substantial fall in aggregate demand.

Falling real national income means lower disposable income and hence lower tax revenue, worsening the budget position. On the BOP, since the balance of trade is a key contributor to Singapore’s surplus, falling net exports could turn the surplus into a deficit, while loss of confidence among footloose investors cuts FDI, worsening the financial account. So a small open economy should be concerned.

Anti-thesis: a large economy with twin deficits need not be. For the USA — already running budget and trade deficits — deglobalisation may help. Less foreign competition and reduced labour inflows revive domestic firms, raising the derived demand for labour; higher employment lets the government cut welfare payments and collect more tax, easing the budget deficit. On the BOP, if US consumers switch from imports to domestic goods and the fall in imports outweighs any fall in exports, the trade deficit narrows, improving external stability.

Judgement. Whether a government should be concerned turns on its economy’s structure and starting position. A small, trade-dependent economy that relies on net exports and FDI for growth and external surplus — Singapore — has good reason to fear deglobalisation on both the budget and the BOP. A large economy with twin deficits and a big domestic market — the USA — may even benefit, at least in the short run. The concern is therefore not universal but conditional: deglobalisation threatens those whose prosperity is built on openness, and may relieve those whose deficits stem from it. Even for the USA, however, the gains are bounded — retaliation and the loss of comparative-advantage gains would eventually raise costs and lower welfare — so no government should treat deglobalisation as costless.