Evolving Supply Chains and Inflation
Last month, I had the pleasure of participating on a panel in Calgary at the Pacific Northwest Economic Region (PNWER) annual summit with Allison Gifford (Amazon Canada), Ted Alden (Western Washington University and Council on Foreign Relations), and Chris Sands (Wilson Center). The discussion, themed on evolving global supply chains, was wide-ranging in scope—covering inflation, supply chain bottlenecks, trade policy, geopolitics, and the future of U.S.-Canada economic and commercial linkages. Below are some of the key themes and takeaways from the discussion.
Inflation is very much front and center, but its origins are both on the supply and demand sides. Inflation is, at its root, a gross imbalance in supply and demand. What makes today’s inflation so vexing and pernicious —and unlike earlier bouts such as the OPEC-driven price increases of the 1970s—is that it derives from both supply AND demand disruptions. On the demand side, households have more income, supported by stimulus checks and a tight labor market driving up wages, but have also shifted their consumption more towards physical goods and away from services. More money, and more demand for goods that often enter through our ports, means less space at warehouses and more bottlenecks. This intersects with a supply chain and logistics system that was already overtaxed, fragile, and suffering from labor shortages (especially in long haul trucking).
Married to this, retailers elected to draw down inventories during the earlier stages of the pandemic in the face of overwhelming uncertainty about the U.S. consumer. Then, after apprising consumption was quickly on the mend, retailers large and small began to ratchet up their inventories. This created what economists call a “fallacy of composition,” i.e., when everyone does the “right” or “rational” thing, it ends badly for the group. The term is more often used to describe periods when households collectively increase their savings rates—a responsible and “right” behavior—which then leads invariably to a reduction in aggregate private household consumption and a recession (and even possibly deflation). In the case of supply chains, when retailers in near unison began to increase inventories, the sudden change in demand overwhelmed the logistics system, and hence long backlogs of ships at anchor or adrift and goods not getting to shelves. Throw into the mix a cargo vessel stuck in the Suez Canal and lockdowns in China for good measure.
Supply and demand disruptions drive the inflation of the here and now, but longer-term structural factors will also play a part. At the time of China’s ascension to the WTO in December 2001, Chinese wages were 26x cheaper than U.S. workers. In 2019, just prior to the pandemic, they were four times cheaper. China’s growth model is facing significant headwinds. These include expansive non-productive debt (nonfinancial debt equal to 270% of GDP, up from 140% just prior to the Global Financial Crisis), meaning every unit of bank-financed debt yields less and less real output; declining productivity (owing to the larger share of state sector access to bank credit in recent years); and a declining working age population. Economies grow by either one of two ways (or both)—growing population and/or increasing productivity. Neither is in China’s favor right now. A declining working age population (the result of China’s One-Child policy but also common demographic trends among developing economies, explained by the “demographic transition theory”) has translated at least since 2010 into higher wages.
This all matters for inflation because low-cost Chinese labor, translating into low-cost consumer goods in the United States and elsewhere, has helped offset stagnant real median household income in the United States. U.S. workers have not seen their wage-based income grow substantially in real terms for decades. For many blue-collar workers, a larger share of their income derives from wages, and not from assets, despite the surge in the market since the early 1980s. China has made sizable investments in infrastructure to gain economies of scale to offset rising labor costs. But at some point, the Chinese worker will no longer be able to subsidize the consumption of U.S. households. And very few parts of the world have the deep labor markets and available infrastructure to absorb and carry the mantle of low-cost manufacturing, at least at anything approaching the scale of China. Even those that have the labor force will see other mitigating costs offset these savings. In net, we should expect a higher cost of goods in the near future. That’s not near-term inflation, but it will be inflationary.
Global supply chains are shifting, albeit slowly. And Canada might be well-positioned. I point readers to a recent article (paywall) in Foreign Affairs by Shannon K. O’Neil, fellow at the Council on Foreign Relations. O’Neill’s central argument is that the strongest geopolitical ties, particularly on trade, have almost always been regional in nature, i.e., geography matters (a lot). One insight (of many) from her article:
“Although the 1990s saw the creation of the World Trade Organization (WTO) and the expansion of its membership and oversight powers, what has been as important, if not more so, over the last 30 years has been the proliferation of bilateral and multilateral free-trade agreements, which tend to involve countries in the same region.”
O’Neill’s thesis, if true, bodes well for U.S.-Canada ties, and for Canada (and Mexico) itself on the very front-and-center issue of reshoring and what Janet Yellen has called “friend-shoring.” Automation has softened the challenge of reshoring, although most forms of manufacturing remain highly labor cost sensitive and enmeshed in highly developed ecosystems that include materials, complimentary industries and suppliers, and port and transport infrastructure, much of which China has spent significant treasure over many years to develop. And one should not ignore the ineluctable pull of the Chinese domestic market, especially as, despite its wavering economic model and decelerating growth rates, its middle class continues to grow and demand goods commensurate with middle class consumption, be it iPhones, luxury bags, and so on. For these manufacturers, pulling out of China (either directly or by switching third-party OEMs) would be tantamount to abandoning this ever-growing domestic market.
And the main topic of the morning…evolving supply chains. First, some key words, evocative if lacking consensus on meaning: resiliency, robustness, and the self-reliance. One can also throw in “international order,” which could refer to a formalized set of rules or a broader, one either dominated or shaped by a hegemon, or more diffuse “zeitgeist” or guiding principles and ideas, e.g., those institutions whose origins tie back to the Bretton Woods meetings in 1944, the binary Cold War blocs that organized nation states into U.S.-led or Soviet-led alignments (with some notable outliers), the triumph of neoliberalism and the logic of markets, or the post-9/11 world. (We could elaborate much further but self-restrain for the sake of brevity.)
Discussions of supply chain “resiliency” are a growing phenomenon, widely expressed across near all nations engaged in complex supply chains. But resiliency can mean several things. Not everything China produces can be shifted back to the United States and allies. But the Biden Administration made clear where it wants to see some of those shifts to occur. The Administration’s 100-day review of supply chains in 2021 (Executive Order 14017) identified four key areas as critical to U.S. national security: semiconductor manufacturing and advanced packaging; large capacity batteries; critical minerals and materials; and pharmaceuticals and advanced pharmaceutical ingredients (APIs).
The CHIPS and Science Act, signed into law August 9, will allocate $52 billion in chips subsidies—for companies to build or expand chip production in the United States and for research and worker training—along with restrictions on investments in China for firms receiving subsidies. According to the Center for a New American Security, the deal effectively dispels the taboo of industrial policy. The bill is the largest five-year investment in public R&D in U.S. history and includes provisions for the “formulation of a national technology strategy, needed to guide long-term U.S. tech policy, and an initial cut at restrictions on S&T infrastructure spending by U.S. firms in China.” The CHIPS and Science Act will also just be the start of the wave of new legislation directed at U.S.-China competition.
The Act’s signage comes the same week as a flurry of new stories, both in China and foreign outlets, on the waste and inefficacy of China’s own semiconductor chip initiative, the China Integrated Circuit Industry Investment Fund, known colloquially as the “Big Fund.” Since 2014, China has invested tens of billions of dollars in an effort to get a leg up on advanced chips, but the results have been anemic, at best. The latest reports (paywall) detail graft, waste, and abysmal outcomes.
Be like the 70s (sort of), not the 30s. The 1970s global economic system was knocked off kilter by the Nixon Administration’s decision in 1971 to end dollar-gold convertibility, the rise of resource powers through OPEC, and the organization’s use of newfound power in the form of an oil embargo in 1973. Despite the economic unease of the decade, punctuated in the United States by stagflation (high unemployment and high inflation), the period was also one of global cooperation. Global powers worked together to stitch together a reformed global monetary system, one based increasingly on freely convertible exchange rates, the creation of the G-7, and trade deals. Compare this with the 1930s, when rather than cooperation, countries resorted to high tariffs and beggar-they-neighbor economic and currency policies, helping to precipitate the Second World War. Today, uncertainties are ripe in the global economy: the Ukraine crisis, U.S.-China rivalry and tension, inflation, trade protectionism, supply chain disruptions, severe labor shortages…to name just some. In some areas, there is a high degree coordination, e.g., Ukraine, but less so elsewhere.
China and Russia want out of the current system. The international system since the end of the Second World War has been largely defined by U.S. economic and military power. The economic and security regimes we still live under today—e.g., NATO, IMF, GATT (now WTO), World Bank—were forged in Bretton Woods in 1944 and in the period immediately following Allied victory. China has largely benefited from the existing system, one that has allowed (and encouraged) capital mobility, trade, and globalizing of supply chain, helping to fuel the Chinese economic “miracle.” In the case of China, the often-stated goal was to integrate its economy, if not its political system, into the existing international order. Or, to borrow the words from Robert Zoellick, encourage China—and Russia—to become “responsible stakeholders.”
The Global Financial Crisis deeply undermined confidence in the predominant economic system. And neither country nowadays seems bent on participating and sustaining this existing international order. Both are signaling their desire to move towards one that is more fragmented, more decentralized, and more amendable to their vital interests and systems of government.
The consumer matters. Consumers nowadays care more and more about whether the goods they buy adversely impact the environment (and how much), whether forced labor was used at any part of the supply chain, and other less tangible factors. Consumers want to know more about supply chains and institutional investors want to know what they’re investing in. Companies are now charged with mapping their supply chains and providing much greater transparency on their sourcing. More legislation akin to the Uyghur Force Labor Act will likely come down in the coming years, putting more pressure on firms to invest in data-rich and transparent supply chains. These developments will also possibly make it easier to impose Magnitsky Act sanctions, too.