A Supply-Shock Era?

In "The New Supply-Side Era: The O-Ring Meets Geopolitics," economists Peter R. Orszag, Eric Van Nostrand, Noah Barbieri, and Layla McDermott argue that the global economy is entering a new era of supply-side shocks. They identify six such shocks in the past six years, including the pandemic, artificial intelligence advancements, Russia's invasion of Ukraine, tariff shocks, China's rare-earth export controls, and the war in the Middle East.

Using a metaphor from the space shuttle Challenger disaster, the authors introduce the concept of the O-ring theory of development. This theory suggests that the performance of a complex system can be limited by the weakest component, even when everything else is functioning well. In the context of the economy, this means that a single weak link can significantly reduce or destroy the value of the entire system.

The pandemic highlighted various "O-rings" in the US economy, such as cargo ships waiting offshore and various inputs that, when compromised, could disrupt production far beyond their initial point of impact.

The authors emphasize that these supply shocks differ from traditional demand shocks. While demand shocks tend to tamp down inflation, supply shocks can lead to rising prices. They note that after the Great Recession, there was no inflationary pressure, but this was not the case after the pandemic recession. The authors argue that the global economy now faces a parade of supply shocks arriving more frequently and sometimes in combination with each other, creating a new normal where disruptions are less catastrophic individually but more persistent collectively.

They highlight the physical and geographic nature of many of these constraints, such as shortages of key components, port capacity, the closure of an underwater seabed cable, chokepoints in shipping lanes, control of rare earth materials by China, and the production of advanced computer chips in Taiwan. This complex web of interconnections suggests that we are entering a world where economists must adopt a "geopolitical supply-sider" mindset, recognizing the prevalence and interconnectedness of supply-side shocks.