Why nations must say no to friend-shoring

CHENNAI: In an important speech to the Atlantic Council in April, US Secretary of the Treasury Janet Yellen issued a welcome call for revitalising the world economic order. But she also generated headlines with a single sentence advocating what she called “friend-shoring”: that is, limiting the trade of key inputs to trusted countries in order to reduce risks to the supply chains on which the United States and its partners rely.

This should worry us. Today’s global supply chains – made possible by reductions in tariffs and lower transportation and communication costs – have transformed production by allowing firms to manufacture goods wherever it is cheapest to do so. This has generally meant that while high-value-added inputs (such as research and development, design, advertising, and finance) are sourced in advanced economies, manufacturing moves to emerging markets and developing countries. The benefits are obvious. Final products are significantly less expensive, so even the poorest people in rich countries can buy them. At the same time, developing countries participate in the production process, using their most valuable resource: low-cost labour. As their workers gain skills, their own manufacturers move to more sophisticated production processes, climbing the value chain. As workers’ incomes rise, they buy more rich-country products.

By 2017, for example, China had more iPhone users than any other country. Knowledge workers in rich countries then earn higher incomes as the market for high-value products grows. Of course, even though trade yields net benefits, the distribution of gains and losses matters. Trade is not simply “win-win.” Hollowed-out small towns in the American Midwest attest to the downside of offshoring production. It has ever been thus: Across the advanced economies, today’s rust-belt towns and cities initially grew by putting traditional craft workers elsewhere out of work. With the right policy support, however, trade need not leave people or communities behind. In Scandinavia, firms constantly focus on upgrading their workers’ skills so that they are ready for change.

These are the basic, Economics 101 arguments in support of free and fair trade. But in recent years, global supply chains have displayed new vulnerabilities. In their desire to maximise efficiency, companies have sometimes overlooked resilience. Climate disasters (including floods, droughts, and wildfires) and shocks like the pandemic-induced lockdowns have highlighted “just-in-time” supply chains’ many chokepoints.

As a result, firms are now considering whether they should increase their inventories as an additional buffer. They are also looking for ways to reduce chokepoints by diversifying production locations across countries, and to increase flexibility by making inputs more substitutable. Such private-sector responses can preserve the viability of global supply chains. But resurgent protectionism – cloaked and augmented by new geopolitical rivalries – constitutes a more dangerous threat. The tit-for-tat tariffs between the US and China during Donald Trump’s presidency were the opening salvos. The West’s subsequent restrictions on the Chinese telecom giant Huawei’s sales, and China’s restrictions on Australian imports, added more policy uncertainty to the mix. Now, Russia’s war of aggression against Ukraine has introduced the possibility of an angry public broadening official sanctions beyond what policymakers intend.

If all that is not sufficient to make corporate CEOs rethink the value of their global supply chains, government advocacy of friend-shoring certainly will. True, national security can never be taken lightly. It is legitimate for a country to ensure that goods and services essential to its national defense are produced domestically or by friendly neighbours. The problem is that “essential” is often broadened by protectionist interests to include even widely produced commodities like steel or aluminium.

If any forthcoming friend-shoring mandates were to apply such a broad categorisation, they would have devastating effects on international trade. After all, friend-shoring will typically mean trading with countries that have similar values and institutions; and that, in practice, will mean transacting only with countries at similar levels of development.

The benefits of a global supply chain stem precisely from the fact that it involves countries with very different income levels, allowing each to bring its comparative advantage to the production process – PhD researchers from one, for example, and unskilled assembly-line workers from another. Friend-shoring would tend to eliminate this dynamic, thereby increasing production costs and consumer prices. While some labor unions would welcome the reduced competition, the rest of us would regret it.

Moreover, it is not even clear that on-shoring or near-shoring production helps to increase resilience or the reliability of supply. In the US, baby formula is supplied by a government-supported oligopoly of four domestic firms that are protected from foreign competition by high tariffs. But, at this moment, there is no baby formula to be had in some US states, owing to problems in just one facility. So much for building resilience through domestic production!

By the same token, concentrating production within a gated community of advanced economies would not necessarily increase the security of the community. As Brexit showed, friends do not always stay friends. Even countries as close in temperament as the US and Canada had serious disagreements during Trump’s presidency. Even more to the point, existing economic interdependencies can make geostrategic rivals more reluctant to launch missiles at one another. Many observers have noted that China will think twice before invading Taiwan now that it has seen the damage that sanctions are doing to Russia.

But if China were to prepare for an invasion, it would start by reducing its reliance on Western economies, a process that Western friend-shoring would inadvertently advance. Economic entanglements may be messy, but they help keep the peace. Finally, friend-shoring would tend to exclude the poor countries that most need global trade in order to become richer and more democratic. It will increase the risks that these countries become failed states, fertile grounds to nurture and export terrorism. The tragedy of mass emigration will become more likely as chaotic violence increases.

Friend-shoring is an understandable policy if it is strictly limited to specific items directly affecting national security. Unfortunately, the term’s public reception already suggests that it will be used to cover much else.

Raghuram G. Rajan, former governor of the RBI, is Professor of Finance at the University of Chicago Booth School of Business

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