Effects of hyper-globalized supply chains on economic efficiency
Global supply chains used to be the last thing policymakers worried about. The topic was largely the concern of academics, who studied the possible efficiency gains and potential risks associated with this aspect of globalization. Although Japan’s Fukushima nuclear disaster in 2011 had demonstrated how supplychain disruptions could impact the global economy, few anticipated how central the problem could become.
Not anymore. Today’s supply-chain bottlenecks are creating shortages, propping up inflation, and preoccupying policymakers around the world.
US President Joe Biden’s administration deserves credit for recognizing that supply chains are key to future economic security. In February 2021, Biden issued an executive order directing several federal agencies to secure and strengthen the American supply chain; and in June, the White House published a 100-day review on “Building Resilient Supply Chains, Revitalizing American Manufacturing, and Fostering Broad-Based Growth.” The review’s most important contribution is its observation that global supply chains have imposed various social costs: “Our private sector and public policy approach to domestic production, which for years prioritized efficiency and low costs over security, sustainability and resilience, has resulted in supply chain risks.” The review then asks whether hyper-globalized supply chains are so great for economic efficiency after all.
The default position among economists is “yes, they are.” When two firms enter into a transaction in which each will gain something, that is good for both firms and also probably for the rest of the economy, owing to the resulting efficiency improvements and cost reductions. Whether this involves a US manufacturer offshoring the production of some inputs to a Chinese firm is beside the point.
Yet supply chains can pose a danger to an economy in two important ways (beyond the defense-related concerns mentioned above). The more complex a supply chain becomes, the greater the economic risks. A break in any link can affect the whole chain and send prices surging if it creates sudden shortages of a necessary input.
The worst-case scenario is when a failure in one part of the chain triggers domino effects, bringing down other firms and bringing the entire sector to a standstill. Logically, this scenario is similar to what one finds in financial networks, where the failure of one bank can push others into insolvency or even bankruptcy, as happened in 2008 following the collapse of Lehman Brothers.
In principle, because uncertainty is costly, businesses will take these risks into account when deciding to build supply chains. In practice, however, there are good economic reasons why firms may overextend their supply chains. For one thing, firms will account for their own risk, but not for the systemic effects they are creating, nor for the risks they are imposing on other firms or the entire economy.
Moreover, when global competition creates powerful incentives to reduce costs, even small price differences offered by foreign suppliers can become attractive, especially in the short term.
A second way that companies may overextend their supply chain is subtler but no less important. The problem, the White House review notes, is that “the US has taken certain features of global markets — especially the fear that companies and capital will flee to wherever wages, taxes and regulation are lowest — as inevitable.” This statement echoes economist Dani Rodrik’s prescient observation that globalization is not just about trade in goods and services; it is also about the sharing of rents. The most straightforward mechanism for this process is the offshoring of inputs, the mere threat of which can be used by managers to keep wages low. This happens on both ends of the offshoring transaction: US companies can pay less to their employees by expanding their supply chain to countries where wages are already lower as a result of lax labor regulations.
A fragmented supply chain may also make it more difficult for workers to organize for collective bargaining, creating yet another benefit for businesses. Companies may even reap tax advantages from globalizing their supply chain, if doing so allows them to book profits in lower-tax jurisdictions.
The White House report proposes keeping more of the supply chain in the US, especially in manufacturing. But how can this be achieved? A two-pronged approach would be the most effective. First, the need for meaningful inducements for businesses to invest in their domestic supply chains implies that the tax advantages of offshoring inputs should be eliminated, and the opportunities for labor-regulation arbitrage should be curtailed.