Global Supply Chain Crisis: Reality or Scapegoat?
It seems like the global supply chain just can’t catch a break. Just as COVID deaths and hospitalization rates are declining, the Ukraine war and resulting sanctions on energy threw another monkey wrench into the much-maligned global supply chain. It is useful to step back from the day-to-day crises of baby formula shortages, record diesel prices, and other impending doomsday scenarios and examine the actual performance and outlook of the supply chain, the state of globalization, and the implications for corporations and policymakers.
Global Supply Chain Drives Global Wealth
The global supply chain is a self-organized network connecting suppliers via layers of intermediaries to consumers and is a miracle of modern technology. It has enabled new business models and raised the standard of living throughout the world dramatically through Ricardian specialization to an almost unimaginable level. In 1990, 1.9BN or 35% of humanity lived in extreme poverty vs. 650M (or 8%) in 2018. The fact that 1.2BN people have been raised out of poverty is a testament to the success of global capitalism and the supply chain, which to give just one example, builds iPhones with components sourced in 43 countries.
Pandemic Disrupted Global Supply Chain
The COVID-19 pandemic impacted the supply chain in three significant ways. First, it forced producers and consumers to make planning decisions in an unprecedented environment with very high uncertainty. Some planning errors take time to resolve, but firms should largely be out of this phase by now. The recent China zero-COVID shutdowns should not be a significant factor as China will soon realize the folly of its policy.
Second, the recovery from the crisis and massive global fiscal and monetary stimulus created a surge in aggregate demand that we are still experiencing. While it is easy to criticize policy makers’ decisions for causing inflation, any honest analysis must consider the counterfactual of a 1930’s style total economic collapse with all its structural dislocations and human costs.
Third, for a variety of reasons, including generous transfer payments to citizens, COVID-19 resulted in labor shortages, which are beginning to ease with labor force participation rates slowly improving. Specific industries such as trucking may continue to experience employment shortages and imbalances for much of 2022 due to training and certification requirements.
Too much Stimulus in the Waning Phase of the Pandemic
Both the US Federal Reserve and the European Central Bank more than doubled their balance sheets from already high levels during the pandemic. The US Federal Reserve balance sheet now stands at a record $9 trillion compared to under $4 trillion before the pandemic and under $1trillion before the 2008 financial crisis. Because the massive liquidity injection is channeled through the banking system to creditworthy investors, it initially led to asset inflation evident in housing, equities, art, NFTs, etc. The additional extraordinary fiscal stimulus with federal net outlays reaching $6.8 trillion or 30% of GDP (levels not seen since World War II) then provided the spark for inflation to spill over into consumer prices with record inflation not seen in forty years. While both asset and consumer price inflation are related phenomena, asset inflation is politically acceptable whereas consumer price inflation is a political death sentence.
The emerging consensus is that the early 2020 $2.2 trillion CARES act made sense in the depth of the pandemic, while the subsequent $1.9 trillion American Rescue Plan and the $1.2 trillion Bipartisan Infrastructure Bill were too much and the likely reason for US inflation rates exceeding levels in other countries.
Given the inability of the Biden administration to move even pieces of Build Back Better through Congress, additional fiscal stimulus is extremely unlikely while aggressive Fed rate hikes and quantitative tightening (asset sales) are certain and will very likely trigger a US recession soon.
Great Power Conflict: Trade Wars and Real Wars
With the tragic Russian invasion of Ukraine shaking up energy markets, it is worth remembering that sanctions are a form of economic warfare that have costs to both sides in the conflict. What matters is the differential impact, or “economic kill-ratio” and how one responds to economic warfare. With 50% of the Russian budget coming from energy related revenues, reducing energy prices by increasing US supply is the most potent economic weapon available.
The US economy produces a dollar of GDP with half the energy (BTUs) today than it did in 1990 and less than a third of what it took in 1975, largely because of growth in sectors that are relatively less energy-intensive and significant energy efficiency advances. Still, the impact of sudden energy cost increases is devastating to the US consumer and a large contributor to inflation.
Let’s hope that China does not follow the Russian example and make a play for Taiwan. It’s worth remembering that Russia has a 10% market share in global energy, whereas Taiwan’s market share of advanced chip production is 90% and that it takes $10-20BN and five years to get a chip fab up and running. By contrast, a US shale well can be drilled in a matter of months under the right regulatory framework.
The West Reassessing its Relationship with China
China’s trade relationship with the West is far more important to globalization than Russia’s. About 75% of China’s exports go to what one might loosely term “the West “, if one includes transshipment trading hubs like Hong Kong, Singapore, and Taiwan, whereas Russia is a rounding error at 3% of China’s exports.
It’s also worth remembering that China’s comparative advantage is still low-cost factory labor, Russia’s is natural resources, and the West’s is knowledge. The West is the only trading block that could achieve self-sufficiency if it desired to do so. In contrast, even China's food security is questionable, and its manufacturing sector is highly dependent on western technology, such as ASML, Applied Materials, and Tokyo Electron for chip-making.
Hong Kong repression, COVID-19, Uyghurs, South China Sea militarization, and China’s cozying up to Russia have finally pushed global public opinion of China over the edge with western citizens polling at 75 to 80% negative views of China according to the Pew Research Center. The West’s surprisingly united response to the Ukraine invasion will hopefully dissuade the Chinese from near-term adventurism in Taiwan.
Corporations Starting to Diversify Supply Chains
Corporations and private equity firms have been very aggressive over the past thirty years in driving cost reductions through strategic sourcing and outsourcing, enabled by the end of the cold war and China’s and India’s increasing industrial capacity and low labor rates.
Clearly, corporations have begun to reconsider their reliance on China and are in the process of re-configuring their supply chains to be more diverse and resilient. Fifteen years ago, the US represented 22% of global manufacturing capacity with Japan in second place at 13%. Today, China is number one with 29% followed by the US at 17% and Japan at 8%. Reversing this trend will be a monumental effort as new suppliers need to be sourced and developed across many different countries.
Government Must Focus on Supply Chains Security
While trade is generally a politically stabilizing factor, western nations need to reexamine their trade relationships with potentially adversarial countries, especially China. This requires smart regulations and policies which cannot be expected to emerge from corporations acting in their own self-interest. The government’s first responsibility is national security, and supply chain security is a key component. It is simply unacceptable that rare earth minerals, critical precursor chemicals, essential pharmaceuticals, food staples, and baby formula are unavailable under any circumstances.
Although the Biden administration correctly identified six key focus industries in its “Executive Order on America’s Supply Chains” in February of 2021, it was unable to prevent the current baby formula crisis, further damaging its credibility in supply chain security.
Supply chain security is an important but complex problem that should be off-limits to partisan politics. Because corporations act only in their own self-interest, the government must play a much more prominent role in supply chain security no matter how arcane the issues might seem to voters.