Many popular discourses on international trade are about the consumer goods we buy. Political rhetoric naturally follows the same path. These arguments miss the fact that most consumer goods produced in one country use inputs sourced from other countries through complex global supply chains. The production structure of the modern economy is like an iceberg – the small tip above the water level does not give the sailor an idea of the vast quantity that is out of sight.
The extraordinary events of the past two years have highlighted the fact that the supply of components, or more commonly what economists call intermediate goods, is a more important issue when thinking about economic flexibility. A good example is what has happened in the global automobile industry. Persistent shortage of semiconductors has affected the production schedules of automobile companies around the world over the past two years. There are long waiting lines for the delivery of cars.
The International Monetary Fund (IMF) has highlighted global supply chains in the latest edition of its World Economic Outlook released in April. Economists at the multilateral lender have cited three interesting examples from the global automobile industry. General Motors has announced that it will bring its use of unique semiconductor chips to just three types of microcontrollers, which can be easily substituted for each other. Tesla rewrote the software used by its cars to run on semiconductors available at the time, rather than clogging up their assembly lines. The first is an exercise in standardizing inputs, while the second is an example of building greater flexibility into a production system.
A third example is how Toyota responded to disruptions after the 2011 earthquake in Japan. This standardized components across all models so that different units could share inventory across different factories. A database was built into the Toyota system to track suppliers as well as inventory availability. The carmaker regionalized its supply chain to reduce dependence on a single location. Toyota asked its single-source suppliers to either produce at multiple locations or keep additional inventory. Lessons like these will resonate with manufacturing companies as they learn from the many supply shocks that have affected the global economy since early 2020.
What about national policy? Policy makers in India have already created some macroeconomic buffers after experiencing other shocks, and these generally serve the country well. Shortage of foreign exchange, coupled with food shortages in the early decades after independence, which led to a persistent balance of payments crisis before 1991, prompted the Indian government to hold additional stocks to deal with the unexpected setbacks. However, maintaining flexibility through additional stock is a fiscal cost for the government. This strategy cannot be used in all areas; It would be like building two bridges across a river if one fell at some point.
Nor is protectionism the answer. The idea that a country can produce everything it needs within its borders is impractical. Global production networks are too complex for such a strategy to be successful. What American astrophysicist Carl Sagan said in another context is also true in terms of economic exchange: “If you want to make an apple pie from scratch, you must first invent the universe.” Import duties increase domestic costs. An old insight from business economics still holds up: an import tax is actually a tax on exports.
The question is how international trade policy can be adapted to absorb the lessons of the past two years so that global supply chains are more resilient. A starting point is to think not of individual goods, but to the set of consumer and intermediate goods. The best way to do this is through the square matrix of the input-output table. A table like this will help figure out how specific components go into producing each other and ultimately the consumer goods we buy.
The International Monetary Fund provides two useful principles for making the supply chain more resilient when supply shocks occur. First, supply chains must be geographically diversified. Second, there should be greater ease of substitution so that a company can quickly switch input sourcing from one country to another.
A series of supply shocks over the past two years – from lockdowns and closed ports to war in Europe – have tested the resilience of global supply chains. Much of the global supply chain has adapted, and the proof of pudding is in our personal experiences as consumers. The reductions we saw during the first lockdown were generally not experienced again, although the decreasing severity of subsequent restrictions also played a role. However, there is no doubt that what has happened underscores the need for more flexibility to deal with major setbacks.
The overall text of supply chains should not be concentrated in a single country, that the production of intermediate goods has a risky domestic bias in many sectors, and that more general global moves to control China should work to India’s advantage, as long as it remains a trading nation rather than a protectionist one.
Niranjan Rajadhyaksha is CEO and Senior Fellow at Earth India Research Advisors, and a member of the Academic Advisory Board of the Meghnad Desai Academy of Economics.