Global trade flows are the world economy’s “hidden wiring:” Instead of trading finished goods, countries exchange product components and services, linking nations across the world through spread-out supply chain models. But this also means far-away economic shocks can now have a much greater impact on U.S. prices, jobs, and investment decisions.

Now, risks like extreme weather events, geopolitical flare-ups, and cybersecurity threats are shaking up the international economic landscape – and could reduce the openness critical to many of today’s trading partnerships. What might that mean for the future of global trade?

Download the papers authored and presentations given by economists Pol Antras, Şebnem Kalemli-Özcan, and Tommaso Monacelli at the Boston Fed’s 69th Economic Conference, “The U.S. Economy in a Changing Global Landscape.”

Allison Ross:

For decades, fundamental realities of global trade were illustrated using the famous example of “wine and cloth.”

Nineteenth century economist David Ricardo came up with it to explain his theory of “comparative advantage,” which holds that countries specialize in what they produce most efficiently and trade for the rest.

In Ricardo’s example, Portugal specializes in wine but stops making cloth. Portugal may make amazing cloth, that doesn’t matter. It decides the opportunity cost – the sacrifice required to make it – is too high, relative to wine.

But meanwhile, England stops making wine. It’s also specializing in what it makes most efficiently – including cloth! A mutually beneficial trading partnership is born.

Ricardo’s theory of comparative advantage holds up today. Nations still specialize in goods and services with the lowest opportunity cost, and they import the rest.

But these days, they don’t trade completed products like “wine and cloth” as much.

Instead, global trade is built on the exchange of product components and services. And these move through multi-step processes that span nations and industries. Harvard economist Pol Antras explains:

Pol Antras:

Essentially, we saw this fragmentation of productions across borders, by which, instead of exchanging finished products – cars, furniture, this and that – we basically took production processes that had largely been carried out domestically, and we started doing different parts of the production in different places.

And as a result, when I look at customs forms in the U.S., I’m not just seeing imports of cars from Mexico, or imports of furniture from China. Very often, what I’m seeing are intermediate inputs, components, things that are slices of much larger global value chains.

Allison Ross:

This is a massive change. And it’s occurred for the same basic reason Portugal decided to focus on wine: It’s more efficient. Boston Fed senior economist Omar Barbiero says the products are often better, too.

Omar Barbiero:

Each company in the world will have some comparative advantage to produce a specific good. And it's a good that they scale up and provide, that good, that they're very good at producing, to as many people as possible. That's going to make it cheaper for everybody else to get that thing, and so that's the advantage, and that's how global trade is supposed to work.

On top of that, multi-stage, and a lot of teamwork across countries, also implies that there's a lot of innovation, spillovers, and knowledge that gets spread out.

I think we can all agree that teamwork usually creates something that is larger than the sum of the parts.

Allison Ross:

But there are disadvantages to all this interconnection. The spread-out supply chains that form the backbones of modern trade also create dependencies and vulnerabilities.

Boston Fed Research Director Egon Zakrajsek notes that because economies and industries are now linked in new ways, they’re also exposed to unexpected economic disruptions called “shocks” in new ways.

Egon Zakrajšek:

Probably the biggest disadvantage of such a production model is that it's very complex. So, you have a very, very intricate linked chains, and if something goes wrong along any of the chain links, and there's many things that can go wrong, then that can ripple through the entire production process.

And so, it just exposes inherently a very complex system. It just exposed to shocks, and those shocks also travel in unpredictable ways, shaking the whole system.

Allison Ross:

And by the “whole system,” Zakrajšek means everybody. There was a time when the U.S. was seen as largely isolated from these shocks, due to its size and relative self-sufficiency.

But with stronger, tighter trading links between all countries, far-away events can now have a much greater impact on U.S. prices, jobs, and investment decisions.

Here’s Brown economics professor Şebnem Kalemli-Özcan:

Şebnem Kalemli-Özcan:

The U.S. is not immune or isolated from this type of global risks when these global risks are really at the sector/country level and also can travel through these full-fledged networks of trade, production, and finance.

Allison Ross:

I’m Allison Ross, and this is Six Hundred Atlantic, a podcast produced by the Federal Reserve Bank of Boston.

Today, we’re looking at global trade flows, the world economy’s “hidden wiring.” The episode is based on material from the Boston Fed’s 69th Economic Conference, “The U.S. Economy in a Changing Global Landscape.”

The quotes and materials are pulled largely from the conference presentations and discussion. But we also interviewed Barbiero and Zakrajsek after the conference.

In her opening remarks at the conference, Boston Fed President and CEO Susan Collins said today’s global economy faces growing uncertainties and risks – things like extreme weather events, geopolitical flare-ups, and cybersecurity threats.

These risks are increasingly shaking up the global economic landscape, and could lead to greater fragmentation, or isolation – a retreat from the openness that has created our new global trade flows. What could that mean?

Susan Collins:

And while greater fragmentation can insulate firms from some global risks, it can end up amplifying economic volatility by reducing the diversification both of firms’ suppliers and of their customer markets. This, in turn, can make economies less resilient both to external and to internal shocks.

A fragmented global economy can also impede long-term productivity growth by hindering the diffusion of new technologies and ideas across borders.

Allison Ross:

Collins notes there could be benefits, too. Firms looking to get through difficult times often do so by improving efficiency while cutting costs.

She added that more change is ahead, regardless.

Susan Collins:

The increase in global risks and the movement toward greater economic fragmentation will likely be major, and could be transformative, and the intertwined forces shaping our economic landscape are likely to unfold over the coming years.

Allison Ross:

One constant during the decades-long shift in how products are made and moved is that the U.S. has been at center stage in the world economy. Today, it accounts for about a quarter of it.

Antras said stability is the big story of the U.S. economy during the past 50 years. And so is increased openness. Protectionist measures like tariffs can give the impression the U.S. has tried to wall itself off from the world. Antras said the opposite has happened.

Pol Antras:

If anything, the U.S. has become more open in the sense of selling abroad more of what it produces and buying from abroad more of what it consumes.

Allison Ross:

Antras spoke of two supply chain models that now dominate global trade. They’re called the “spider” and the “snake.”

The spider supply chain has a core. That’s where the product is assembled. That core is fed by the spider’s “legs” – the different routes through which needed materials are supplied.

The Boeing 737 airplane is produced using a spider supply chain. It’s assembled in the U.S., but 70% of its parts are produced abroad. For example, its wing tips are made in Korea, and its cargo access doors come from Sweden.

The snake, meanwhile, has no core. Assembly doesn’t happen in one place; important steps are compiled all over.

For example, semiconductor production happens in a snake. Antras showed how a semiconductor is assembled over 100 days in four countries, during three trips around the world.

Pol Antras:

So, it’s a sequence of stages that need to happen somewhat in a predetermined manner.

Allison Ross:

Snakes and spiders don’t look alike in real life or in trade. But the interconnection they create means that when a shock like war severely curtails oil production, or a pandemic shuts down major shipping ports, that shock will eventually reach all participants, either directly or indirectly.

For the U.S., the size of its impact doesn’t depend on how much it’s trading, but where it’s located on the spider or the snake.

What’s striking is that nations and firms can be impacted even if they’re not on a particular supply chain at all – because their partners might be impacted, or their partners’ partners.

Omar Barbiero:

The supply chain is very complex and has multiple nodes and a cascade of nodes, something that happens very far away from me can spill over to me, kind of like a butterfly effect, right? A butterfly spreads his wings somewhere, and then a hurricane comes to me.

Allison Ross:

All this is extremely hard to trace and predict – and that creates uncertainty.

So, it's natural that in a more complex supply chain, a company has a very hard time understanding all the shocks that they're exposed to. And this naturally raises the uncertainty ... about like how their costs are going to move tomorrow.

Allison Ross:

So, what does a company or governments do in the face of this uncertainty? Often, it makes its best guess. Leaders read what signs they can and make decisions that affect prices and entire economies – sometimes in negative ways. Here’s Collins:

Susan Collins:

Elevated uncertainty can also lead to increased volatility in financial markets, potentially affecting firms’ access to capital and their investment strategies – which could have important implications for economic activity and for financial stability.

Periods of heightened uncertainty can also influence firms’ pricing strategies, employment decisions, as businesses may hesitate to adjust prices (or) commit to hiring. And prolonged uncertainty may also discourage innovation and, as a result, hamper longer-term productivity growth.

Allison Ross:

And almost by definition, when firms are responding to uncertainty, they aren’t acting on good information.

Energy prices offer a great example of how hard it is to read the links between different markets. Tommaso Monacelli, an economist at Boccini University in Milan, Italy, wrote a paper on this for the conference. He says how people respond to energy prices illustrates that the signals people act on aren’t always good ones.

Monacelli says high energy prices have become a widely misinterpreted “global warning light” on inflation.

Here’s why: People know that transportation costs are on some level bundled into energy prices. So, firms everywhere – even those with no involvement in energy markets – watch rising energy prices and figure transportation costs are headed up, too.

Tommaso Monacelli:

Firms, in using energy prices as a signal, they’re going to partly misinterpret changes in energy prices as being due to underlying transportation disruptions.

Allison Ross:

Companies might then react by pre-emptively raising prices to cover their anticipated transportation cost increases. So, their fears about rising prices lead to rising prices. Here’s Barbiero:

Omar Barbiero:

It has kind of a spillover effect on everybody else, and it becomes kind of like a self-fulfilling prophecy.

Allison Ross:

Reducing this uncertainty is exactly why economists and other researchers are trying to understand these new trade flows. Because it ultimately affects prices and overall economic resiliency.

Omar Barbiero:

Understanding the wiring will help us understand why and how shocks travel farther and faster than they used to, and why inflation can be more or less sensitive to disruption. It can also make us understand better measures.

It can help us understand price sensitivities to foreign shocks in a more correct way.

Allison Ross:

Zakrajšek, the Boston Fed’s research director, compares it to studying roadways and how drivers respond to the unexpected.

Egon Zakrajšek:

It's like think of a complex interstate highway system in a major city. You have roads coming in, big intersections, exit ramps, circles and stuff like that. So, you can tell me an accident happened somewhere in this grid. Well, how is that accident going to affect the traffic patterns going forward? Well, you need to understand how these things are connected, where the bottlenecks are, what the things are.

Zakrajšek adds that today’s highly interconnected global economy didn’t develop quickly or by accident. Its benefits come with tradeoffs, and these days we’re learning more and more about what those are. And we’re weighing whether they’re worth it or should be rolled back.

Egon Zakrajšek:

But now, we are experiencing a number of large changes, political changes, geopolitical changes, which bring the tradeoffs between, say, efficiency and resiliency and robustness much more into perspective. And the kind of things that have happened for various reasons, geopolitical reasons, trade policy, are forcing firms to re-evaluate and robustify, shorten those chains, make them less complex in order to precisely increase the resiliency. But that comes at a cost. That is a costly endeavor. That means you have to reroute. That means there's potentially loss of efficiency, lower productivity, higher costs. So, all of these are the tradeoffs that occur, but they do not occur in a vacuum.

Allison Ross:

Some of the significant, global changes Zakrajšek refers to fall into the category of geoeconomics, which is when governments use their economic leverage to achieve political ends.

The main tool of geoeconomics is coercion, rather than cooperation. It’s being used more widely by governments these days, and there are benefits. But the tradeoffs are real.

We’ll look at the revival of geoeconomics, and the costs of coercion, next time on Six Hundred Atlantic.

You can find links to the recordings, papers, and other material from the Boston Fed’s 69th Economic Conference in the show notes or at bostonfed.org under “News and Events.” Subscribe to our mailing list and find interviews and seasons at bostonfed.org/six-hundred-atlantic. And we would greatly appreciate if you’d rate, review, share, and subscribe to Six Hundred Atlantic on your favorite podcast app.

This episode was written by Jay Lindsay and edited by Amanda Blanco, Nick Brancaleone, Omar Barbiero, Egon Zakrajšek, and Darcy Saas. Chief consultant was Omar Barbiero. Graphics and web design by Michael Konstansky and Michael Sorokach. Production consultants are Nick Brancaleone and Michael Sorokach. Recording and engineering by Steve Osemwenkhae. Project managers are Allison Ross, Nick Brancaleone, and Peter Davis.

I’m Allison Ross, thanks for listening to Six Hundred Atlantic.