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Automobile and electronics makers worldwide have had to reduce output because a severe drought in Taiwan hit the island’s production of semiconductors. This and other global supply-chain disruptions—many of them caused by the covid pandemic—have prompted advanced economies to take steps to mitigate the potential impact. But what types of government action make economic sense?

Supply-chain bottlenecks can have a significant economic effect. Germany, for example, imports 8% of its intermediate products from low-wage countries, while the US relies on these economies for just 4.6% of its inputs. Problems with input deliveries recently led Germany’s Ifo Institute to lower its forecast for German gross domestic product (GDP) growth this year by almost half a percentage point to 3.3%. This vulnerability helps explain why the EU has earmarked part of its €750 billion Next Generation EU recovery fund to bolster Europe’s semiconductor capabilities. Intel is on its way in, while Bosch, Europe’s largest auto supplier, has opened a plant for chips in Dresden with European subsidies, the latest in a series of battery cell projects in ‘Silicon Saxony’, which policymakers hope will reduce Europe’s dependence on Asian suppliers and grant resilience.

US policymakers have similar concerns. In June, a task force presented its assessment of America’s supply-chain vulnerabilities across four key products: semiconductors and advanced packaging, large batteries of the sort used in electric vehicles (EVs), critical minerals and materials, and pharmaceuticals.

Some might argue that rich country’s efforts to strengthen domestic and regional production networks reflect a new form of economic nationalism driven by fear of China. But the crucial question is whether companies really need state help to protect themselves from supply-chain turbulence.

There are three ways advanced-economy firms can make their input supplies more resilient, and only one of them requires government involvement. One option is to re-shore production from developing countries. Recent research that I co-authored shows that the covid crisis, by increasing the relative costs of supply chains, accelerated a re-shoring trend that began with the 2008-09 global financial crisis.

The production disruptions and higher transport costs resulting from the pandemic made supply chains more expensive; the price of containers used to ship goods from Asia to the West rose about eightfold. Lending rates fell sharply relative to hourly wages after the financial crisis, making robot-based production much cheaper than employing workers.

A second way for firms to insure against supply-chain shocks is to create large inventories. Rich-country firms long ago adopted lean Toyota-style operations to reduce costs, but many may switch from ‘just in time’ production to a ‘just in case’ model that, while more expensive, offers greater safety and predictability.

Third, companies can dual-source or even triple-source inputs, relying on suppliers from different continents to hedge risk. But this diversification strategy has its limits. For example, a highly specialized supplier that invests in research and development for a specific input is not easily replaceable.

Heavy regional concentrations of suppliers also make diversification difficult. Most producers of chips, battery cells, rare earth materials and pharma ingredients are based in Asia. Taiwan Semiconductor Manufacturing Co and South Korea’s Samsung dominate the global semiconductor market, while China produces about 70% of the world’s EV batteries.

The current global semiconductor shortage illustrates how geographic clustering of input suppliers can cause upheavals. In a 2012 paper, Daron Acemoglu and his co-authors showed that disruptions of an asymmetric supply network—in which one or few suppliers deliver inputs to many producers—can spread across the world economy and potentially cause a global recession.

Jean-Noël Barrot of HEC Paris and Julien Sauvagnat of Bocconi University studied three decades worth of major natural disasters in the US, and found that suppliers affected by a flood, earthquake, or similar event impose large output losses. When a disaster hit one supplier, firms’ sales growth declined by an average of 2-3 percentage points. And the effect spilled over to other suppliers, amplifying the initial shock.

Similarly, Vasco Carvalho of the University of Cambridge and his co-authors show that the disruption caused by Japan’s 2011 earthquake affected supply chains and led to a 0.47-percentage-point decline in its real GDP growth in the year [after] the disaster.

In such cases, governments can play a useful role by helping provide firms with more potential alternative suppliers. By providing incentives to firms to move into sectors with high vulnerability to supply disruptions, governments in the EU and US can ensure that a sufficient number of suppliers are available in both Europe and North America to hedge against the risk of disruption.

The world has recently experienced a cascade of supply-chain disruptions, and will likely suffer from more global pandemics and extreme weather in the future.

Business leaders and policymakers must think about how to minimize the effects of such shocks on production networks and the global economy—and when government should step in. ©2021/Project Syndicate

Dalia Marin is a professor of international economics at the Technical University of Munich’s School of Management, and a research fellow at the Centre for Economic Policy Research

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