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Box sets » Fiscal risks and sustainability - July 2022 | Box: 2.3 | Page: 58

Why interconnection matters for the economy

There are signs that global economic integration has stalled in recent years on some measures and reversed on others. This box discussed the implications of integration for the economy and public finances.

This box is based on OBR data from June 2022 .

Growing interconnection between economies has been a significant factor in spurring economic growth, increasing average income levels, and reducing absolute poverty levels across the globe over the past two centuries.a Interconnection between countries can be facilitated through multiple channels including trade in goods and services and movements of capital.

Trade in goods and services. Economic theory and empirical evidence suggest that greater trade intensity increases productivity and real GDP over the long run. There are several different channels through which this happens. First, trade can boost the level of productivity by allowing countries to specialise in their areas of comparative advantage – through opening up exporting opportunities for products that a country is relatively more efficient at producing, and allowing a country to import products that it is less relatively less efficient at producing. Increased trade intensity can also have dynamic effects on productivity (longer-lasting effects on growth rates) by allowing countries to access new technologies and knowledge that supports innovation and more efficient modes of production.b It can also enhance welfare by increasing the choice of products that consumers have access to or by lowering prices.c Increased trade intensity has been fuelled by the progressive liberalisation of global trade policies. Stronger economic growth as a result of greater trade intensity boosts the public finances by increasing growth in domestic tax bases and thus government revenue, often by more than is lost from the lowering of tariffs on trade.

International capital flows. Access to international financial markets allows for greater diversification of investments, improved risk-sharing, and a more efficient allocation of global resources.d Increased foreign direct investment is also found to have a positive impact on GDP through human capital transfer and the development of financial markets.e The broadening and deepening of international capital flows have also helped to reduce long-term interest rates in advanced economies.f Movement of capital can therefore support the public finances by boosting real GDP and tax revenue, as well as potentially by reducing debt interest costs.g

This box was originally published in Fiscal risks and sustainability – July 2022

a Revenga, A., and A. Gonzalez, Trade has been a global force for less poverty and higher incomes, World Bank blogs, February 2017.
b See OBR, Discussion paper No. 3: Brexit and the OBR’s forecasts, October 2018, for more information on the theoretical and empirical links between trade intensity and economic growth.
c Were, M., Differential effects of trade on economic growth and investment: a cross-country empirical investigation, Journal of African Trade, December 2015.
d Obstfeld, M., Risk-taking, global diversification, and growth, NBER Working Paper, June 1992.
e Almfraji, M. A., and M. K. Almsafir, Foreign direct investment and economic growth literature review from 1994 to 2012, Procedia-Social and Behavioral Sciences, May 2014.
f Warnock F. E., and V. C. Warnock, International capital flows and U.S. interest rates, Journal of International Money and Finance, October 2009.
g Carvalho D., and M. Fidora, Capital inflows and euro area long-term interest rates, European Central Bank working paper, June 2015.

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