The notion of interdependence originates back to Adam Smith's The Wealth of Nations, where he suggests that 'a general plenty' may diffuse through all ranks of society through means of specialisation and the division of labour. Economic interdependence, as defined by the Oxford Dictionary of Archaeology (2 ed.), is based on the concept that ‘in the division of labour, individuals depend on others to produce all or most of the goods they need to sustain their lives'. Whilst such economic interaction is commonly thought of as a dollar value of the transaction of goods and services between nations (Cooper), several academics have challenged this fundamental paradigm over time. Baldwin suggests that economic interdependence may be conceived as the opportunity costs incurred from potential exit costs that incur as a result of breaking existing economic ties between nations. Whitman, cited by Baldwin, further expands on Cooper's definition and proposes that economic interdependence should also involve the degree of sensitivity of a country’s economic behaviour to policies and development of countries outside its border. However, empirical evidence to support the latter definition is a lot harder to find, given its ambiguity (Baldwin).
Approaches to measure economic interdependence
As economic interdependence may be perceived differently depending on the scale and context involved, various methods are used to measure the degree of interdependence between and within countries. The below documents some of the approaches that have been adopted to measure the degree of economic interdependence.
Hierarchical Network Approach
This approach is based on the precept that globalisation increases the integration and interdependence between the economy of different countries. The Hierarchical Network Approach is used to measure economic interdependence by analysing growth clusters and cross-country liaison, and business cycle synchronisations. The cross-country liaison or economic interaction between countries or states is most commonly measured by Pearson's cross-correlation coefficient. The correlation matrix is a methodical method which exhibits the mutual relationship of countries over a specified time period. To measure growth clusters, economists need to get hold and analyse changes in GDP for each country over a specified period of time. The relationship between interdependence and business cycles is calculated by the distance correlation matrices over a period of 10 years. The combination of results from the data presents the economic interdependence of countries over time. By this measure, trends from the data has shown that the degree of world economic interdependence is growing due to globalisation.
Another way of measuring the degree of economic interdependence is via a geopolitical approach, which is based on the presumption that economic interdependence may exist because states trade with each other to obtain strategic goods that are needed for national industry and defence. The geopolitical approach is based on both vertical and horizontal interdependence. Vertical interdependence measures how a change in the price of a good in Country X will affect Country Y (or how changes in price in State A will affect State B), whilst horizontal interdependence calculates the degree of bilateral trade, transactions and investment involved between both countries. Both vertical and horizontal interdependence data must be used to measure economic interdependence. This is because that in the given situation that there is a high correlation of vertical interdependence between country X and country Y, if there is no horizontal interdependence (transaction of goods, services or capitals) between both countries, country X and country Y will have little/no economic interdependence. Vertical interdependence without horizontal may arise due to other factors such as changes in worldwide economic forces. For instance, consider the case of trade and the flow of factors among Arab states (which is typically very limited); whilst we observe parallel movements in factor prices, this may just be due to the effect of global market forces that affect all economies in the same fashion.
Exit Model Approach
As suggested by Baldwin and Crescenzi, economic interdependence may be modelled as a function of potential economic exit costs, which may deter, motivate or fail to affect political conflict. A key challenge that is faced is the need for a valid method to measure exit costs and interdependence, whilst maintaining a systematic approach with many countries involved (a large-n analysis). Crescenzi addresses this by interacting bilateral price elasticity data with trade activity data, to represent both market structure and the intensity of potential economic exit costs. Whilst the price elasticity data reflects one state's ability to react to economic change that is initiated by another state, its interaction with trade share data is vital as it indicates how intense the interdependent relationship is relative to each state's economy and trade portfolio within the global market. Given these two components, Crescenzi furthers his study by explaining the relationship between economic interdependence and its association with political conflict.
The Evolution of Economic Interdependence
Global economic interdependence has grown exponentially in the span of a generation, as a result of great technological progress and associated policies that were aimed at opening national economies internally and externally to global competition.
Paehlke notes that investment and international trade have drastically increased over the last 100 of years except during the World War I and World War II. Over time, economic interdependence has incorporated other aspects that were brought about by contemporary globalisation - as a result of the onset of the age of computerisation, telecommunications and low-cost travel and shipping. As international trade have been increasing at a rate beyond 8% during the 1950s to 1970s, and has also been driven by improvements in information technology in the 1990s, economic interdependence between countries have increased even more rapidly.
Given such rapid increase in international trade and capital flows that are traditionally associated with globalisation, there has been increasing interest in the issues of financial and economic interdependence, partly driven by the contagion that resulted from the financial crisis.
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