Musing about Shocks and Trends in an Era of Production Fragmentation

Yesterday's NYT article, Crises in Japan Ripple Across the Global Economy noted:
In the wake of Japan's cascading disasters, signs of economic loss can be found in many corners of the globe, from Sendai, on the battered Japanese coast, to Paris to Marion, Ark.

...Volvo, the Swedish carmaker, was working with a 10-day supply left of Japanese-built navigation and climate control systems.

"It's hour-by-hour work to get a grip on the situation," said Per-Ake Froberg, chief spokesman for Volvo, as it girds for a production halt.

Breaking Down the Effects

At this juncture, it's useful to categorize the various effects emanating from this shock to the Japanese economy (the article actually covers oil and sovereign debt shocks as well). First, there is the aggregate demand shock, as Japanese spending either falls or rises over time; there is a composition of spending effect, as spending shifts, perhaps toward investment and away from consumption. Both of these have some implications for US (and rest of world) exports.
Second, there are supply side/trade effects, highlighted by the article. That is, Japan is a provider of some key inputs into the production of electronic goods. From the article:

• At Shin-Etsu Chemical, the biggest maker of silicon wafers used for microchips, production was halted because of quake damage at its main plant.
  
• A Texas Instruments chip fabrication plant in Miho, Japan, that produced 10 percent of the company's output suffered "substantial damage" and might resume full production only in July.

More examples: [0] [1] [2]

Production Fragmentation, Vertical Specialization, and De-Globalization

What are the implications of a fragmented production process, combined with lean production, for the propagation of shocks throughout supply side? Bems, Johnson and Yi (2009) discuss vertical specialization, and the implications for the propagation of shocks, while Tanaka (2009) notes that Japan is a particularly sensitive to shocks to the supply chain. If power is restored quickly to factories, or multinational firms are able to rejigger sourcing (e.g., supplying car engines from the US for Japanese made cars), then there should be minimal impact on aggregate supply (and more relative price changes than general price level increases).

A more interesting question is what the shock, combined with other trends, has for the future of vertical specialization. The cost of energy comes into play in the sense that some of the fragmentation of the supply chain has been induced by reduced transportation costs, trade liberalization, and the development of information and communication technologies over the past two decades. The second and third factors are still in play, but transportation costs are closely linked to energy prices. [3] This is particularly true for air transport.

Figure 1: Log price of oil per barrel WTI (gray line, left scale); log index of inbound air freight (red line, right axis), old series (blue line, right axis). Source: St. Louis Fed FREDII, and BLS.

In contrast, the cost of seaborne transportation, as measured by the Baltic Dry Index, remains far below peaks achieved in 2008.

Figure 2: Baltic Dry Index, March 2008-March 2011. Source: Bloomberg.

Updated 4pm Measures of container shipping costs are also rising, but are far below 10.77 recorded in 2008, at 3.31 as of February 2011.

Figure 3: HAMBURG INDEX - Containership Time-Charter-Rates; Container T/C rates (geared, 1000-2000 TEU). Source: Koenig & Cie..

TEU is short for "twenty foot equivalent unit" where a standard 40 8 8 container equals two TEUs. Prices "in USD pro 14t/TEU pro Tag"

Seaborne freight costs are apparently less affected by fuel costs, and more influenced by the stock of available ships (ships ordered in 2007-08 are now coming into service); the latter has been increasing putting downward pressure on transport costs. [4]

In other words, not all transport costs are rising. The change in the relative costs of transport modes should have some interesting implications. While about 90% of freight is moved by sea by weight, a much higher proportion of the value of freight is moved by air. (Harrigan (2010) observes that by about 2003, over 20% of total value of imports arrive by air; close to 40% if one excludes NAFTA in the calculation of imports).

To the extent that production fragmentation relies upon just-in-time inventory management, a reversal of the trend in decreasing air freight to sea freight costs would induce a deceleration of the process of production fragmentation, or perhaps even a reversal.

Harrigan (2010) also notes that the pattern of comparative advantage for trade in final goods should also change.

Macro Forces and Macro Implications

Higher energy prices could reduce the extent of production fragmentation/vertical specialization. To the extent that higher energy prices are offset by greater supply of sea freight capacity, we shouldn't expect a big impact on transportation costs for final (as opposed to high-value intermediate) goods, so the insulating effecs I conjectured in this post would probably not come to pass.

However, if the costs relevant for vertical specialization change at the same time as relative factor prices and the geographical location of demand sources change, one trend that we might see would be an overall flattening out of the trend toward vertical specialization. That point is made in this FT article:

The global supply chain made sense when most of it pointed in the same direction -- from Asian producers to western consumers. As Asia and Latin America join the consuming bandwagon it will make more sense for multinationals to site production and assembly close to their customers, which has the side effect of cutting transport costs.

That is likely to mean a return to regional production centres, with Chinese factories switching from exporting to producing for Asian consumers and new factories making goods for the US being sited in Latin America. One spin-off advantage will be an increase in production flexibility for companies essentially making the same product in two or more global locations.

That will simplify those complex supply chains, helping companies to cope with shocks like the one inflicted by Japan's earthquake. But this shift from "offshoring" to "nearshoring" is being driven by growth, not natural disasters.

I agree that macro forces (location of demand, relative factor prices, transport costs) will dominate, but I also think the demonstrated sensitivity to supply disruptions might also alter the calculus of offshoring/onshoring-vertical specialization that firm managers make. This in turn will have implications for trade flow sensitivities to exchange rates. [5] [6] It might also have implications for wages and income distribution. [7]