In an important speech to the Atlantic Council in April, US Treasury Secretary Janet Yellen issued a welcome call to revive the world economic order. But he also made headlines with a sentence he called “friend-shoring”: that is, limiting the trade of critical inputs to trusted countries in order to reduce risks to the supply chains on which the US and its allies rely. We do.
This should worry us. Today’s global supply chain—made possible by reduced tariffs and lower transportation and communication costs—has transformed production by allowing firms to manufacture goods where it is cheapest to do so. This generally means that while higher value-added inputs are sourced in advanced economies, manufacturing goes to emerging markets and developing countries. The benefits are clear. The final products are much less expensive, so even the poorest people in rich countries can afford them. At the same time, developing countries participate in the production process using their most valuable resource: low-cost labor. As their workers acquire skills, their own manufacturers move up the value chain to more sophisticated production processes. As workers’ incomes rise, they buy more rich-country products. For example, as of 2017, China had more iPhone users than any other country. Knowledge workers in rich countries then earn higher incomes as the market for higher value products grows.
Of course, even though the business makes a net profit, the distribution of profit and loss matters. Business is not just ‘win-win’. Hollowed-out small towns in the American Midwest testify to the downside of offshoring production. It has always been this way: in advanced economies, today’s rust-zone towns and cities initially put traditional craft workers out of work. However, with appropriate policy support, business need not leave people or communities behind. In Scandinavia, firms constantly focus on upgrading the skills of their employees so that they are ready for change.
These are the basic arguments in support of free and fair trade. But in recent years, global supply chains have displayed new vulnerabilities. In their desire to maximize efficiency, companies have sometimes overlooked flexibility. Shocks such as climate disasters (including floods, droughts, and wildfires) and pandemic-induced lockdowns have exposed many choke points of ‘just-in-time’ supply chains.
As a result, companies are now considering whether they should increase their inventory as an additional buffer. They are also looking for ways to reduce choke points by diversifying production locations across the country, and to increase flexibility by making inputs more replaceable. Such private sector responses can maintain the viability of global supply chains.
But protectionism, overshadowed by new geopolitical rivalry and enhanced protectionism, poses a more pressing threat. Tight-for-like tariffs between the US and China were opening salutes during Trump’s presidency. The West’s subsequent sanctions on sales of Chinese telecommunications giant Huawei and China’s restrictions on Australian imports added more policy uncertainty to the mix. Now, Russia’s war of aggression against Ukraine has presented the possibility of making official sanctions widely public beyond what policymakers intended.
If that’s not enough to make corporate heads reconsider the value of their global supply chains, government advocacy of friend-shoring certainly will. True, national security can never be taken lightly. It is lawful for a country to ensure that the goods and services necessary for its national defense are produced domestically or by friendly neighbours. The problem is that ‘essential’ is often broadened by protectionist interests to also include widely produced goods such as steel or aluminum.
If any upcoming friend-shoring mandates were to impose such broad classifications, they would have disastrous effects on international trade. After all, friend-shoring will generally mean doing business with countries that have similar values and institutions; And, in practice, this would mean dealing only with countries with similar levels of development.
The benefits of a global supply chain stem precisely from the fact that it includes countries with different income levels, allowing each to bring its own comparative advantage to the production process—for example, PhD researchers and unskilled assembly from the other— line worker. Friend-shoring would eliminate this dynamic, leading to increased production costs and consumer prices. While some labor unions will welcome less competition, the rest of us will regret it. Furthermore, it is also unclear whether on-shoring or near-shoring helps to increase production flexibility or reliability of supply. In the US, baby formula is supplied by a government-backed elite of four domestic firms that are protected from foreign competition by high tariffs. But, at this time, some US states have no infant formula due to problems in just one facility. So much for household flexibility!
By the same token, concentrating production within a gated community of advanced economies will not increase the security of the community. As Brexit showed, friends do not always remain friends. Even in close-knit countries such as the US and Canada, there were serious disagreements during Trump’s presidency. Even more, the current economic interdependence could make geo-strategic rivals more reluctant to launch missiles at each other. Observers have noted that China will now think twice before attacking Taiwan given that it has seen sanctions damage to Russia. But if China were to prepare for aggression, it would begin by reducing its reliance on Western economies, a process that Western Allied-shoring would unwittingly pursue. Financial complications can be messy, but they help keep the peace.
Ultimately, friend-shoring will weed out the poor countries that need global trade the most to become richer and more democratic. This would increase the risk that these countries would become failed states, fertile grounds for nurturing and exporting terror. The potential for mass migration will increase as chaotic violence escalates.
Friend-shoring is an understandable policy if it is limited to specific items directly affecting national security. Unfortunately, the public reception of the term already suggests that it will be used to cover much more. ©2022/Project Syndicate
Raghuram Mr. Rajan is a former Governor of the Reserve Bank of India and Professor of Finance at the University of Chicago Booth School of Business.