#170 - The Tradeoffs of Outsourcing

Dan Wang's 2021 letter is a worthwhile read if you are interested in US-China relations and China's strategic policy choices in the last few decades. One thought I had after reading it was that ideologically pure free trade may be good if policy goals center around maximizing America's consumption of goods, but may be suboptimal in the long-run if our policy goals center around durability of supply chains and availability of goods.

Nations' dependence on one another is all but required in the modern day global economy. Countries rely on each other for natural resources they don't have, exporting goods that they can produce cheaper than others, and for financial transactions that render both parties better off. For centuries the twin ideas of comparative advantage and free trade has been preached as the optimal strategy of two countries that have different core competencies (manufacturing vs technological inventiveness). The theory states that when two countries exchange freely, they will be better off because they will default to what they can produce most efficiently (cheaply) and trade for that which they cannot. At the present moment, America exports technological creativity in exchange for manufacturing the technology much cheaper overseas.

But what if this isn't the optimal strategy in the long-term? I wrote about free trade two years ago and at the time I was completely in favor of it, despite the devastating effects it can have on small manufacturing towns in America. But as the pandemic has illustrated how delicate supply chains can be in an interconnected global economy, I am rethinking my position on this. As China's ever encroaching economic power grows, some are beginning to question the wisdom of outsourcing almost all production of goods (except for the creative process) abroad.

At some point, when free trade is carried to its end state, each party is dependent on the other for their goods. Depending on the relative importance of goods, one party may have the upper hand. For example, in a recent 'Acquired' podcast, a guest raised the possibility of China taking over Taiwan, and through its annexation, Taiwan Semiconductor Manufacturing Company (TSMC). This would set America back several years if China decided to close off chip exports to America. It seems farfetched, but is it?

The basic question I am asking is this: what if free trade is actually optimal in the short run but suboptimal in the long run? What if doing the things that do not scale (building out our manufacturing base and domestic supply chain) matters more than taking the cheaper, more efficient route (i.e. building our manufacturing base at home instead of outsourcing it abroad to achieve a more capital light, higher margin economy)? What if we are actually 10 years behind China's manufacturing base and they have the economic upper hand? It would seem that China is more focused on building up self sufficiency in manufacturing and ensuring foreign dependency on their production capacity instead of exporting technology to the world (a role the US has largely played over the past 4+ decades):

"US restrictions are setting back Chinese companies in the short term, but I think it’s unlikely they can crush the broader effort to catch up. No country has monopolized a key technology forever: instead, the history of technology has mostly been a history of diffusion. And Chinese firms are hardly starting from a base of zero. The country has demonstrated a growing ability to master most industrial products and is doing well enough in digital technologies. It remains a dynamic market with a good and improving base of human talent. And perhaps most importantly, it is where most manufacturing is done today, which means its workers have the greatest exposure to technological learning. These advantages don’t guarantee success, especially not on a short timeline. But there’s a chance that things improve rather quickly. The development trajectories for many technologies were pulled forward with unexpected speed after Kennedy announced his moon target."

Links:

Let the wild rumpus begin (Grantham Mayo van Otterloo)

Money and payments: the US dollar in the age of digital transformation (Federal Reserve)

Was Larry Summers right all along about Biden's economic policies? (Intelligencer)

Brett Hall: politics has no place in science (TokCast Link)

How GE Violated Its Own Compensation Principles—and How Flawed Policies Led to a Fabled Company’s Long Decline (Roger Lowenstein)

Lux Capital’s Josh Wolfe is channeling sci-fi to bank on “the inevitable arrow of progress" (Institutional Investor)

Will climate change soon make Australia “uninsurable”? (Chris Leithner)

Business transformations (Michael Liu)

A century of quantum mechanics questions the fundamental nature of reality (Science News)

Don't Extrapolate From This Fake Business Cycle (TS Lombard)

Why I am no longer a tenured professor at the University of Toronto (Jordan Peterson)