Man is born free, but he lives in global supply chains

It is hard to imagine a more thorough stress test for globalisation than the double whammy of a once-in-a-century global pandemic followed in short order by a land war between two of the world’s major commodity producers. The COVID-19 recession was one of the most unusual in modern economic history.

Central banks put their foot to the monetary floor, and the resulting wave of liquidity — as well as a temporary increase in household savings rates — led to substantial increases in household wealth in many advanced economies. This has translated into a boom in demand for goods and services that has placed strain on logistics and supply chains around the world.

Now, central banks around the world are struggling to keep a leash on inflation without choking off the post-pandemic recovery, and their task has been made more difficult by supply bottlenecks in key sectors that are pushing up prices. The Russia–Ukraine war has only made a difficult situation worse, by pumping up the price of energy and causing a food crisis that will hit the world’s poorest hardest, and has already unseated the Sri Lankan prime minister. Meanwhile, in the background, the deteriorating and increasingly polarised geopolitical environment makes international cooperation to address the challenges facing the world economy tricky.

Some critics have questioned whether the global economy’s buckling supply chains are a sign that globalisation went too far. They question the sustainability of the pattern of production that has characterised development in fast-growing Asia over the past few decades — whereby the manufacturing process for any given good is increasingly dispersed across countries, with parts and components often crossing national borders several times before the final good is assembled. In particular, they wonder whether it might be possible to cut geopolitical rivals out of supply chains altogether, with China a particular target.

Few countries have taken to this with as much zeal as Japan, which has handed out billions of dollars in cash to promote the ‘resilience’ of its supply chains, mostly by reshoring activity to Japan or diversifying foreign operations. It’s not obvious what effect, if any, this largesse has had on Japanese supply chains.

There may be some geopolitical benefits to a more diversified set of destinations for Japanese corporate investment, but it’s likely that firms would be diversifying their supply chains anyway, as wages rise in China and labour-intensive manufacturing moves elsewhere. Whatever benefits these policies bring to Japan — and it is hard to concretely identify any — they come with significant costs, and not just budgetary ones, either.

According to Yasuyuki Todo, Japan’s efforts to reduce its exposure to uncertainty abroad will only mean that its economy becomes less resilient to risks at home. As Todo argues in the first of this week’s lead articles, ‘Onshoring does not necessarily promote supply chain resilience because Japan bears a substantial risk of natural disasters, including mega earthquakes and the expected eruption of Mt. Fuji that could hit major industrial regions in the near future.

Enforced onshoring may also distort the allocation of production activities across countries and lead to economic inefficiency.’ Todo’s research on the Great East Japan Earthquake has shown that while participation in complex supply chains can expose firms to risk, by diversifying their selling and purchasing relationships, it can also help firms insure against risk.

Good public policy must be made on the basis of an objective consideration of costs and benefits. Just because global markets are currently under significant pressure does not mean that any government intervention will make things better. Indeed, intervention could well make things worse. In the case of the growth of international supply chains, the benefits have been underappreciated and, especially in recent years and in richer countries, the costs have been overegged.

Conventional trade statistics are not designed to capture the ways that dispersed global production networks facilitate trade in intellectual property from mainly developed countries to developing ones. Richer countries underestimate the benefits of globalisation because those benefits are not rigorously recorded by statistical systems designed for a bygone, simpler age.

That is not to say that there are no risks in a global economy increasingly tied together by complex production networks. Shocks to one part of a complex network can cascade through the network, causing major problems downstream, as witnessed in the difficulties in the automotive sector caused by a lack of key inputs like batteries. Some global supply chains set up in relatively calm economic conditions have tended to lack redundancy and hence have failed to respond nimbly to shocks like COVID-19. The risks, however, should not be exaggerated.

Markets are generally much better than governments at pricing relevant risks. Governments can play a role in calming markets where there are strong social reasons for intervention — such as in food markets. They can also help by providing critical infrastructure like boosting capacity in ports and freight rail, and, significantly, by reducing the fiscal and administrative costs of international trade through initiatives to cut red tape in customs procedures and getting cutting tariffs where possible.

Attempts to use subsidies or other incentives to ‘reshore’ or ‘nearshore’ manufacturing, on the other hand, is likely to result in a great deal of waste and very little by way of ‘resilience’.

This is because the economic logic that has led to the flourishing of complex and long global supply chains is different — indeed antithetical — to the kind of protectionist reasoning motivating the return of old school industrial policy in Japan, the United States, and elsewhere in the region.  As Jayant Menon points out in our second lead article this week, the jury is in, and the verdict is clear: efforts to encourage reshoring have largely been a failure.

‘There is little evidence that the trade war has resulted in significant reshoring of production. If punitive tariffs have failed at reshoring production, direct subsidies have not fared any better, even though subsidies can be better targeted because they can be tied directly to reshoring, avoiding the spill-over to third countries’. As Menon persuasively argues, the costs to domestic economies, and to the global economy more broadly, of knee jerk policy responses to what will prove to be temporary stresses in supply chains, could be significant.

Supply chains are under pressure, but overreacting by trying to restrict the free working of global markets to obtain an illusory sense of ‘economic security’ is a recipe for long-run stagnation.

This article was published by the East Asia Forum.