Rethinking supply chains

CAMBRIDGE  —  Starting in the 1980s, transnational production enabled the expansion of global trade and low prices for goods, contributing significantly to economic growth. But the shocks caused by the COVID-19 pandemic and the Ukraine war have shown firms that the efficiency gains implied by the global division of labour, and just-in-time production, come at the cost of resilience. With global supply-chain bottlenecks unlikely to resolve themselves soon, firms have turned their attention to reshoring or at least “friend-shoring”, which seeks to combine closer geographic proximity with greater geopolitical peace of mind.

But turning re-establishing the shorter and more national (or regional) supply chains of a generation ago will be costly in terms of growth. For a hint of just how costly, look no further than post-Brexit Britain’s lack of any post-pandemic trade recovery. The United Kingdom’s independent Office for Budget Responsibility estimates that productivity will be 4 per cent lower in the long run than it would have been had the UK retained its deep trading links with the European Union. The specialisation enabled by globalisation has brought significant benefits, as many economists (including me) have long argued.

Businesses will adjust to supply-chain shocks in different ways. Some will reshore. Some will find subcontractors in diverse locations. And some may opt for increased automation. The latter two strategies will carry a lower productivity penalty than reshoring, but will involve adjustment costs and new investment. All three options will roll back some of the globalisation of the past four decades.

Other firms, however, will not be able to take any of these steps, given the scale and nature of the upstream activities they have outsourced over the years. In some sectors, such as pharmaceuticals and chemicals, outsourced production accounts for as much as 15-20 per cent of total output.

After 1980, there was a substantial shift among companies toward buying components, rather than making them in-house. This reflected the spread of information and communication technologies that made it possible to send instructions and receive feedback instantaneously, along with a management philosophy that emphasised cost efficiency and lean production. Many multinational firms kept high-value activities such as research and development or design in the headquarters’ countries, and sent formulae or blueprints to factories in lower-cost locations such as Malaysia and China. After an initial learning period, these facilities could produce goods at a far lower cost than at home, and often with more consistent quality.

Over time, however, this pattern has generated another hidden cost: the loss of what is often termed tacit knowledge, or know-how, in manufacturing. This refers to the kind of tweaking and learning from experience that never gets written down but happens on every production line. Such insights can provide vital feedback to researchers and engineers, but the feedback is lost when production takes place thousands of kilometres away.

Rich-country firms have allowed these capabilities to erode for decades and cannot reshore them quickly. East Asian manufacturing centers such as China, Malaysia, and Singapore have developed sustainable, hard-to-replicate advantages in specific sectors and also in areas such as logistics.

This presents problems for policymakers, too. Secure supplies for key commodities such as food and microchips are now at the top of most governments’ agendas. Some advanced economies have launched initiatives aimed at rebuilding their manufacturing capability, such as the EU’s ambitious 43 billion euros ($45.5 billion) semiconductor plan or California’s $100 million proposal to manufacture insulin and other generic drugs.

Such plans may be a good idea, but they will need considerable time and money to succeed. Meanwhile, strategic stockpiles are another possibility. Some countries already hold oil or gas stocks, and many have food reserves such as the cheese and butter stocks in the United States, albeit aimed at supporting farm incomes rather than ensuring security of supply. (The UK, however, ran down its strategic food stockpiles in the mid-1990s.)

Current supply-chain bottlenecks have also highlighted a generally unnoticed reduction in competition. Although economists have been pointing to increasing concentration in many markets, the focus has generally been on the large “superstar” companies at the end of production chains. But today’s shortages are a reminder that the more specialised each link in the chain becomes, the less competition there can be at each stage.

At least until recently, competition policy had shown little concern about vertically integrated companies so long as the retail market remained competitive. The presumption was that pressure at the downstream end would flow upstream. Some had already started to question this consensus amid growing evidence of large firms’ market power. But the shortage of carbon dioxide, a fertiliser byproduct, in UK food production and the huge impact of one factory closure on supplies of baby formula in the US make the same point forcefully.

These supply-chain challenges are a consequence of forgetting that other considerations besides economic efficiency matter, and that hands-on craft knowledge cannot be transmitted online. Unfortunately, problems that have been four decades in the making cannot be solved overnight, and the best course of action for policymakers is not obvious. That is all the more reason to start rethinking the model now.

Diane Coyle, professor of Public Policy at the University of Cambridge, is the author, most recently, of “Cogs and Monsters: What Economics Is, and What It Should Be” (Princeton University Press, 2021). Copyright: Project Syndicate, 2022. www.project-syndicate.org