The New Normal: Supply Chain Interruptions

Consequences and possible EU economic policy responses

After the fall of the Iron Curtain and China’s integration into the world economy, international trade increased significantly. The Lehman bankruptcy first put a damper on this development. Then, in recent years, disruptions to global supply chains have further interfered with cross-border trade. It is to be feared that such disturbances will increase rather than decrease. This has negative economic consequences for all economies. The EU should prepare for supply chain disruptions to continue.

International division of labor in “the good old days”

For a long time, the international division of labor was characterized by three key features: just-in-time production with minimal stockpiling, the use of low-priced inputs from all over the world, and – optimally – cooperation with just one supplier.

This type of international division of labor results in considerable efficiency gains. Consumers benefit from this development: they can consume a larger quantity of goods and services for which they pay lower prices.

However, this type of production only works if the required raw materials and components are delivered without delays. In recent years, however, with increasing frequency.- this prerequisite has not been met.

Global supply shortages stemmed from a variety of factors: production stops due to the coronavirus pandemic, and the interruption of international transport routes due to the blockade of the Suez Canal by a container ship in March 2021. Then, the war-related disruption of international trade following Russia’s attack on Ukraine and now the attacks by the Houthi rebels in the Red Sea are constraining supplies – blocking the shipping route through the Red Sea and the Suez Canal.

Economic consequences of disrupted supply chains

Production interruptions or breakdowns in transportation routes are responsible for the loss of expected deliveries of raw materials and components from abroad.

A production shutdown in another country leads to a reduction in the global supply of the affected components or raw materials. The consequence of this supply shortage is a price increase. It raises the costs of production for the companies that need these inputs. And for consumers, this means higher prices.

If there is no substitute for the missing inputs, companies will have to reduce their production or even stop it completely. Again, the result is a shortage and accompanying rise in prices for the consumer products missing those inputs.

Interruptions to global transportation routes are less dramatic because the necessary intermediate inputs are still available. However, if companies stick to the concept of just-in-time production, the lack of deliveries might stop production.

If disrupted transportation routes result in longer routes, transportation costs rise. This also can mean higher prices for consumers.

And there is another consequence: the longer a trade route cannot be used, and the longer the detours, the more ships are out at sea. They – and the containers they carry – are therefore unavailable for the planned transportation of other goods. Consequently, this can disrupt transportation on other routes, causing a domino effect.

Supply chain disruptions dampen the dynamics of the international division of labor.

The growth of global cross-border trade was already dampened by the Lehman Brothers’ bankruptcy in the Fall of 2008. The increase in the monthly volume of global trade in goods between 2010 and 2019 was weaker than between 2000 and 2008.

The main reason for that development was increasing protectionism, i.e., the use of tariffs and other trade barriers. More recently, economic sanctions in the context of the war in Ukraine have been added to the mix.

The supply chain disruptions outlined above are making the international division of labor more expensive. As a result, a further weakening of international trade is to be feared. An increase in these disruptions can be expected in the future for at least two reasons.

Reasons for increasing supply chain disruptions in the future

1. Climate-related interruptions to production and transportation routes

As climate change progresses, an increase in extreme weather events is to be expected. Examples include heavy rainfall with flooding, storms, heat waves, and droughts. They can damage physical production facilities, which then have to reduce or even stop completely – at least temporarily – their production. As a result, there are no deliveries of products from the affected regions.

Climate-related damage can also affect the transportation infrastructure, i.e., roads, railroads, bridges, etc., which also causes supply chain disruptions. The same applies if the water levels of rivers are so low due to a lack of water that these waterways can no longer be used by ships – or only with a significant reduction in transport volumes.

2. Geopolitical tensions

In recent years, more and more countries have been using trade policy instruments to achieve their geopolitical goals. Examples include punitive tariffs, economic sanctions, and export and import bans, to name just the most important ones.

The aim of these interventions is to use the associated economic damage to persuade the government of the affected country to change its behavior. In this way, the country imposing the sanctions can better enforce its geopolitical interests.

Possible reactions to supply chain disruptions

Companies and economies have various options for responding to the threat of an increase in supply chain disruptions.

• Increasing stock levels: To prevent the threat of supply bottlenecks for important intermediate products, companies can build up larger stocks of these inputs. This is a departure from just-in-time production.
• Diversification of supplier relationships: To reduce dependence on one supplier, it makes sense to purchase the required inputs from several companies in different regions of the world. This means turning away from the principle of single-sourcing.
• Shifting the production of inputs back to the home country: To avoid dependence on foreign suppliers, the required inputs can also be produced in the home country. The resulting reshoring is a departure from the principle of global outsourcing.

All of these options can reduce an economy’s dependence on imports and thus reduce the risk of production stoppages due to a lack of inputs. However, these measures also imply a loss of efficiency. Higher costs are incurred, e.g., in the form of higher storage costs, higher costs due to the necessary coordination with many supplier companies, or higher costs of production in the case of domestic production.

The result of these efficiency losses is a rise in the costs of production, which raises the price of consumer goods. The rising costs of production worsen the competitiveness of European companies compared to suppliers from other countries.

To keep these economic burdens as low as possible, a coordinated economic policy response from the EU is a good idea.

Options for economic policy action for the EU

1. Diversification of supplier countries

One conceivable response of the EU is to diversify its importing countries through new trade agreements. With a view to the urgently needed ecological transformation, agreements with sun- and wind-rich EU neighborhood countries for the production of renewable energies are one option.

Transfer payments from the EU are also an option for building the necessary infrastructure in these often less developed regions. One example is the Green Partnership with Morocco adopted by the EU in October 2022.

2. Direct investment in supplier countries

Another option is to intensify direct investment in the countries where the EU imports inputs. An approach could be to acquire shares in the companies concerned to gain more secure access to their production.

If this is not possible, building production capacities in countries with price and competitive manufacturing advantages can be considered. The price advantage in production outside the EU is maintained, and ownership of the production facilities ensures access to the products manufactured there.

These measures are particularly effective against geopolitical supply chain disruptions. However, the risk of production shutdowns in times of crisis remains. In addition, the dependence on working transport routes between the country of manufacture and the companies based in the EU remains.

3. EU-wide stockpiling of essential primary products and raw materials

Strategic reserves are a useful way of being better prepared for a lack of supplies from abroad. Many countries that are dependent on the import of crude oil, for example, have legal regulations on the formation of corresponding strategic reserves.

Such reserves can also be created for essential intermediate products, e.g., semiconductors. to take advantage of economies of scale in stockpiling, it may make sense for several EU countries to hold joint stocks.

4. Development of joint production capacities

The last resort is to build up production capacities in the EU. From an economic point of view, this option is the most expensive, as it involves setting up production facilities that are not actually needed due to the cost advantages that exist abroad.

To prevent 27 EU countries from building up their own capacities, there should be a coordinated EU approach. Building national production facilities would not be very efficient, especially if production is characterized by high fixed costs. The establishment of fewer production sites for essential components in the EU would make better use of economies of scale and gains from specialization in production and thus reduce the costs of production compared to purely national production.

But even then, the current price advantage of companies in the countries from which the EU imports the corresponding inputs will remain. Without financial support, it will hardly be possible to set up production facilities in the EU. One example is the EU Chips Act, which mobilizes around 43 billion euros to promote domestic microchip production and thus become less dependent on foreign suppliers.

Conclusion

Supply chain disruptions will most likely accelerate the existing deglobalization trends. As a result, some productivity advantages of the international division of labor will be lost, leading to real losses in prosperity. To keep these losses to a minimum, the EU member states should agree on a joint approach so that they can at least still benefit from the division of labor at the EU level.

Economic policy decisions – e.g., the subsidized development of production capacities in the EU to reduce import dependencies – should be designed in such a way that they do not increase economic divergences within the EU. Otherwise, there is a risk of social tensions within the EU, which could weaken its ability to act politically.

About the author

Thieß Petersen is Senior Advisor at the Bertelsmann Stiftung, specializing in macro-economic studies and economics. His focus lies on the causes and effects of financial and economic crises as well as the chances and risks of globalization. Among others, he has recently worked on the effects of carbon pricing and the benefits of a potential global climate club.

Read more the EU and global supply chains

Five Reasons Why the EU Needs a Strategic Trade Policy

Why the EU Shouldn’t Impose Anti-Dumping Duties on EVs From China

Supply Chain Disruption: Global supply chains under pressure