To Explain What's Wrong With the Supply Chain, Start With the Labor Shortage

Another culprit: Consumers switching their spending from services to goods during the pandemic

Image Credit: Suriyapong Thongsawang/Getty Images

Is it high demand or a shortage of workers that’s breaking the supply chains? What are companies doing to fix the problem? Are there policy changes that could help, or is it just a question of riding it out? Daniel M. Rothschild, the executive director of the Mercatus Center at George Mason University, explored these issues with Christine McDaniel, a Mercatus senior research fellow who studies trade, globalization and property rights.

DANIEL M. ROTHSCHILD: I wanted to distill this whole question into the simplest possible form, so I wrote a haiku about what's happening in the supply chain, and I want you to tell me what I'm missing.

Demand for items And a tight labor market Made the prices rise

CHRISTINE MCDANIEL: Yes, that's one way to sum it up.

ROTHSCHILD: Tell me what I'm missing and tell me where that's wrong.

MCDANIEL: It's not wrong. There's just a lot of layers to it, but the tight labor market is key. It was a lot of different things coming together at once. One way to explain this is through an example of what a typical person has gone through. Before COVID hit, the economy was going gangbusters. Remember, it was running really hot. Unemployment was less than 4%. Do you remember that?

ROTHSCHILD: Right.

MCDANIEL: I remember when the full-unemployment level was around 6%. Then it went down to 5%. Then, when it was less than 4%, we were like, "Wow, we can really do this." Then bam, COVID hit, demand drops off the cliff, people stay home. The average person doesn't go to work. If they're running a business, they scale back. Activity for consumers and businesses scaled way down.

Meanwhile, pretty soon, the stimulus checks start coming out. You might cancel that gym membership, but you will probably buy running shoes or a Peloton. Multiply this by millions.

ROTHSCHILD: Consumers are basically shifting away from purchasing services to purchasing durable goods?

MCDANIEL: Exactly. Remember, around the world the same type of thing is happening, so everyone's staying home, factories shutting down. But now there's this big demand for goods.

People are online even more. Where are all the container ships? They are filled with PPE [personal protective equipment] being shipped from China to every corner of the world, including corners that don't normally get a lot of container ships. So once they unload, they either sit there or they're getting sent back empty. Meanwhile, the consumers are demanding all these durable consumer goods. There's not a lot of container ships to ship them in.

And that’s just the maritime issue. Meanwhile, all the different engines in the global economy for global supply chains are having kinks because now people are staying home, you've scaled back, inventories are getting drawn down. Then the stimulus checks keep coming. People have more money and keep ordering. Boom, we see inflation. Remember, this whole time, interest rates are quite low.

A polite way to say it is a lot of things are going on, a lot of bad things—the perfect storm. Now we have high prices, labor shortages, maritime shipping shortages, and there are about 5 million fewer people in the labor force today than there were before the pandemic. Think of that.

ROTHSCHILD: A couple of different things there that I think are worth unpacking. First is just this issue of transporting goods across a global supply chain. The basic theory, as I understand it, would say you've got short-term inelastic supply of containers and ships. To a lesser extent, you've got short-term inelastic supply of labor. This should lead to prices increasing, and high prices would incentivize more capacity to come online. Why is it that we haven't seen that? This seems to be a world in which there are not a lot of oligopolies. So why are we not seeing prices rise and new equilibriums develop?

MCDANIEL: We are seeing prices rise, and new equilibriums are developing. I think it takes time, but I think they are happening. Do you remember when there was a big shortage of toilet paper in the very, very beginning?

ROTHSCHILD: Right.

MCDANIEL: That was a supply-chain issue. Toilet paper was going to supermarkets, hotels, offices, etc. But nobody was in their offices. Everyone went to the supermarket to get toilet paper. Supermarkets were out, and what was the solution? Import more toilet paper. It was also to reroute and redo the supply chain to stop toilet paper going to the offices since nobody was there and reroute them to the supermarkets.

ROTHSCHILD: Consumer toilet paper is different than commercial toilet paper, an excellent illustration of the principal-agent problem at work.

MCDANIEL: Exactly. For a while there, you did see some hoarding going on. You saw big price spikes going on in toilet paper. That's supply and demand, but it eventually worked itself out. People do freak out when supply-demand gets really out of whack or prices go really, really high or really, really low, but it did work itself out. We're actually starting to see a slowdown of the consumer-goods demand growth. It's slight, but it appears to be happening.

ROTHSCHILD: You mentioned that 5 million Americans are still out of the labor market, despite the fact that we're seeing wages increasing pretty substantially. One of the stories that you told in an op-ed right before Thanksgiving was that one of the effects of this was that we saw bigger turkeys on supermarket shelves this year, not for any reason other than they couldn't find enough people to slaughter and process the turkeys. They were living longer and coming onto supermarket shelves at higher poundages.

What is it that's driving people to stay out of the labor market?

MCDANIEL: A few factors. One thing is if you have COVID, you're not going to go to work. Or if you've been around someone who's tested positive, you might stay home. Or you might just be wary to go back to the office or get back to work. People are sick. People are taking care of loved ones. Also, with schools—not so much now but over the past 16 months—remember, schools were opening, closing, opening, closing.

At least one parent probably had to stay home with the kids. And then the stimulus checks. For a lot of people, they just pocketed that money, and if they could still work, they did. But we also know that on the margin for a number of people, this reduced the incentives to stay in the labor market. Look, if you have enough money to pay your bills and you really didn't like your job in the first place, there may not be a lot of incentive for you to go back right away.

Plus, demographics in the U.S. We've got a lot of people who are on the verge of retiring, and this just nudged them to do so maybe a little bit earlier.

ROTHSCHILD: David Beckworth [a Mercatus senior research fellow] has an interesting chart that he produced from FRED [Federal Reserve Economic Data]. It shows a 25-year deflationary trend for durable goods at an average of about 2.5% per year, but 7.5% inflation this year. That's a 10-percentage-point increase in prices for durable goods. What does this tell us besides the obvious fact that people are demanding and paying more for tangible goods? What does it tell us more broadly about supply chains and inflation?

MCDANIEL: Well, a few things. We know that globalization has been a big driver of deflation for the past three decades, especially on the goods side. If you look at how your Nike shoes, smartphone or car is made, three to six countries are typically involved. (We have been seeing a trend of deglobalization for a few years, after the financial crisis, then Brexit, the Trump tariffs, retaliation.)

But the global supply chain is only as strong as the weakest link. Remember when a lot of those auto parts suppliers moved from China to parts of Southeast Asia like Vietnam, Thailand, Malaysia, etc., largely to escape the tariffs but also not knowing how the U.S.-China trade wars were going to go. They thought they were doing a good thing and improving their resiliency.

Well, guess what? Vietnam shut down for three months from COVID. They got killed, and that put a huge crimp in auto-parts supply chains—including, obviously, Toyota's and GM's and Ford's and others. All it takes is one part of your supply chain to break down and then you're out of business for a while. That is why we are seeing more and more companies start to build parallel supply chains.

I was talking to Toyota, and they said they got a dose of this in Japan’s 2011 earthquake and tsunami. After that, they realized that even though they had a tight supply chain, they needed to do a lot more to keep track of what they needed, where it was at every single moment of every single day. They said they figured it was 25,000 to 30,000 parts to build a car.

Now 1,400 of those were essential, critical, could not be substituted for. What they did is they built this huge database of where those 1,400 parts were. They did this for the 25,000 parts as well, but real detail was included for the 1,400 parts—their suppliers, their suppliers' suppliers, and their suppliers’ suppliers' suppliers. Think of it as a digital distributed ledger where everyone is plugged into this database, so if your supplier's supplier's supplier is reporting that their community has a COVID surge, then the red flag goes up and that gets back to Toyota headquarters.

This has really helped them in COVID. Because they had gone through that disruption, they redid their supply chain and they built up their resiliency. Lego now has at least three parallel supply chains—North America, Asia, Europe—largely due to COVID. Companies are doing this on their own—or some companies are—and the companies that are doing it, they're going to be better off. The companies that don't do it, they may not survive.

ROTHSCHILD: The question that everyone's going to ask is, what are the policy levers that are available, either in the U.S. or to foreign governments? You point out that there's deglobalization occurring. We see COVID waves and spikes that are happening asynchronously around the world. Is there anything that the U.S. can do, either by executive order or by legislation or deregulation, that would have a significant impact on this, or is it just a matter of riding it out?

MCDANIEL: There’s very little policymakers can do in this. One thing that President Biden could do is, with a stroke of his pen, get rid of all the tariffs. That wouldn't hurt. Although the bittersweet side of that is it could actually induce even more demand. Trade people would like to think trade has so much influence, but really, trade is just a residual.

What can government do? They could do a couple of big things, but they can't be done overnight. They could repeal the Jones Act, which requires that to travel from one U.S. port to another U.S. port, it has to be a U.S. ship. U.S. ships can be serviced and built only by U.S. labor and equipment. You never know. Sometimes in a crisis, big things happen.

ROTHSCHILD: That potentially is a big deal—given the backups we've seen at West Coast ports—to be able to move goods between U.S. ports to facilitate the unloading of ships, to facilitate moving things closer to their final destinations.

MCDANIEL: Yes, repealing the Jones Act would be a huge deal. There are other things that could be done, but those are more at the state or local level. For instance, rules and regulations on how long trucks can idle or who can drive those trucks. We have a driver shortage—do we want to let more people come in from other countries to drive these trucks? That could help things.

Just in terms of the complexity of this issue, the role for government is to try to get rid of these constraints and not try to micromanage the supply chain.

ROTHSCHILD: It sounds like we're just going to have to sit back and ride it out for a while. There are a few opportunities to help on the margin, but we’ve just got to wait until supply chains figure out what's happening. We see companies like Toyota doing more innovative things with managing their global supply chains and just not assuming that parts will be available when they're needed. Well, I guess that's where we're going to have to leave it.