Ever since the oil crisis of the 1970s and the creation of the Strategic Petroleum Reserve, the United States has held millions of barrels of oil in a stockpile to safeguard the country—and its economy—from future supply shocks. Just as oil has kept the world’s economic engine running, a new critical component has emerged: the microchip. Everything from satellites and missiles to cars and toasters are powered by chips, making the semiconductor industry a linchpin of both the global economy and national security. The recent chip shortage affected virtually every industry, revealing a new vulnerability that businesses and policymakers are scrambling to address.
Chris Miller, associate professor at Tufts University and author of Chip War: The Fight for the World’s Most Critical Technology, and Dennis Lockhart, former president and CEO of the Federal Reserve Bank of Atlanta, join this episode of The OUTThinking Investor to examine the global competition to fortify supplies of semiconductors. They discuss the role of geopolitics in chip production, how artificial intelligence is driving innovation and demand, and macroeconomic implications for investors to consider.
For more on the near-shoring of strategic industries, visit PGIM’s OUTFront report, A New Era: From Deglobalization to Regionalization.
Episode Transcript
>> Along the coastline of the Gulf of Mexico, salt domes lay thousands of feet under the earth. These ancient geological structures are fascinating, and they were a mystery to most people until the Strategic Petroleum Reserve was created. In response to OPEC's oil embargo to the US in the 1970s, President Gerald Ford established the Strategic Petroleum Reserve. To safeguard the country from future supply shocks, millions of barrels of oil would be stored for use in times of crisis. Fortunately, the Gulf Coast salt domes happen to be the ideal place for storage. They're dry, geologically stable, and they can hold vast quantities of oil, close to the refineries of Texas and Louisiana. Oil has been the lifeblood of the modern economy, and supply shocks are extremely difficult to predict. But the economy today is radically more complicated than it was in the 1970s. Supply chain disruptions that echoed around the world during the COVID pandemic revealed a new vulnerability: microchips. The shortage of microchips that began in 2020 directly or indirectly affected virtually every industry around the world. And that's still being felt today. Are microchips the new oil? Amassing a stockpile of microchips may not be the answer, but policymakers and business leaders need practical solutions to lessen the risk of future supply shocks for these essential components.
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To understand today's investment landscape, it's important to know how we got here. This is The OUTThinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. In this episode, two experts discuss the industry that designs and produces microchips, better known as chips or semiconductors, as well as geopolitical and economic impacts. Chris Miller is associate professor at The Fletcher School of Tufts University and author of the book "Chip War: The Fight for the World's Most Critical Technology." Dennis Lockhart is former president and CEO of the Federal Reserve Bank of Atlanta.
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The global chip industry today is a game of high stakes, with several leading firms holding competitive advantages and countries looking to shore up weak spots across economic and geopolitical landscapes. Chris Miller explains what's important to know about the microchip industry and what's driving productivity, innovation, and competition.
>> The chip industry is a key driver of technological progress. When we think of tech, we often think of search engines or social media companies, but the entire digital world only exists, thanks to semiconductors, and almost all of the advances in technology we've experienced over the past three-quarters of a century stem in part from advances through semiconductors. And if you think of what it takes to run a software system or to remember data over time, there are chips inside of your computer and your smartphone and the data centers that process and store much of your data, and these chips have tiny circuits on them called transistors which flip on and off, producing all of the ones and zeros undergirding all of digital computing. The advances that Silicon Valley and the entire tech sector have made over the past 75 years have stemmed in no small part from the chip industry's ability to produce ever smaller transistors to cram more and more of them onto chips, and therefore to produce more processing power and more memory capability at an exponentially growing rate in comparison to the past. And so just to put a number on this, the first commercially available semiconductor sold in the early 1960s had four transistors on it. Today, if you go to the Apple store and buy a new iPhone, the primary chip on the iPhone will have 15 billion transistors on it, and that gives you a sense of the advances in computing power that the rest of the economy has benefited from.
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>> Now, almost anything with a power button relies on semiconductors. It's not just your phone and your laptop. Our homes and businesses are filled with appliances, gadgets, and toys that operate with semiconductors. Most new cars today come with over a thousand semiconductor chips. Much of the world was oblivious to this until the COVID pandemic created a chip shortage.
>> Car companies themselves were surprised, I think, by their reliance on semiconductors. Their own supply chain divisions had thought that their most critical components were the engines or the axles or the wheels. And it turns out that the most important components in many ways were semiconductors. Both because the chips inside of cars are getting more and more complex and important over time, but also because the production of semiconductors is increasingly specialized and concentrated. And so for many types of semiconductors, there are just a couple of companies capable of making that type of chip anywhere in the world. And when it comes to the most advanced processor chips, the type of chip inside of your smartphone or your PC, 90% of them can only be made by one company in Taiwan. So there's extraordinary concentration in the chip industry that goes far beyond the type of concentration we see in nearly any other segment of the economy.
>> That hasn't always been the case. The industry has evolved quickly alongside the surge in demand for chips.
>> Today, the US is still the world's largest player in the chip industry, but the US's expertise today is primarily in the design of semiconductors, whereas the actual manufacturing of semiconductors increasingly takes place in East Asia, in China, and South Korea, but above all in Taiwan, which has the most advanced facilities in the world for manufacturing advanced processor chips. And this has been a model of production that has been extraordinarily efficient. It has driven technological progress and it's been very beneficial to many US tech firms. Companies like Apple, NVIDIA, Google, Microsoft, and many others rely on the Taiwan Semiconductor Manufacturing Company to produce many of their most advanced chips.
>> As tensions have been brewing between China and Taiwan and the US and Taiwan, concern has also grown over the concentration of chip manufacturing in East Asia. Dennis Lockhart has been cautiously watching the situation unfold.
>> For the moment, the Taiwan Semiconductor Manufacturing Corporation, TSMC, is by far the dominant supplier and has the capability to manufacture at scale, in high volumes, and with high-quality product, and that simply does not exist in the United States at the same level as TSMC. I do see a sort of dilemma developing. And the way I would characterize that dilemma is if they were to move early -- and there's been some reference to the takeover of Taiwan by the Chinese -- they would be in a position conceivably to control supply to the United States and products that are essential to the United States economy of advanced chips. If they wait, we will be further and further along in diversifying our sources, including domestic sources. So I can see that as a kind of tradeoff developing in the strategic thinking of the Chinese. And it just speaks to how central to all of this is chips, semiconductors, TSMC, Taiwan, and geopolitics around the Taiwan Straits.
>> The Taiwan Semiconductor Manufacturing Company is at the center of this unfolding situation. How was it able to build such a massive competitive moat and how has it maintained that moat amid such growing demand?
>> TSMC was founded in 1987 by an entrepreneur named Morris Chang, who had spent most of his career at Texas Instruments, where he played a really instrumental role in building up that company's semiconductor manufacturing operations. And Morris Chang realized that if he built a company focused exclusively on manufacturing, doing no chip design, but manufacturing chips for other customers, he could build a business that had exquisite manufacturing capabilities because that was its primary focus, but would also benefit from economies of scale since he would produce more chips than all of his competitors.
>> The firm has almost single-handedly led the chip industry with its world-class manufacturing. But it doesn't have a monopoly over value creation, which takes place in the chip industry across the supply chain.
>> If you look inside of a semiconductor manufacturing facility, you'll find ultra-precise machine tools that themselves can only be made by a couple of companies in the world. So, for example, to manufacture an advanced chip of the type that you'd find in your smartphone, you need machines that can lay down layers of ultra-thin material, just a couple of atoms thick with basically perfect uniformity. Or you need tools called lithography tools that can shoot rays of light with a certain wavelength, a specific wavelength of 13.5 nanometers with a high level of power which is used to carve the transistors into the chip on your iPhone, and these machines cost $150 million a piece. They involve the flattest mirrors humans have ever made, explosions happening at a temperature of 40 times the surface of the sun. And so tools like these are themselves monuments of human engineering and creativity, and the companies that make them are absolutely critical components in the semiconductor supply chain. They've got capabilities that in many cases simply can't be replicated. So today, for example, there's only one company in the world, ASML, the largest tech company in Europe, that produces these types of lithography machines. And without their machines, you simply can't make the most advanced semiconductors.
>> Companies like NVIDIA and AMD and Qualcomm have become some of the world's largest semiconductor companies without manufacturing a single chip. This is an important point in the escalating cold war between the US and China, with chips at the center of these tensions. Around five years ago, the US government initiated a series of policies aimed at limiting China's ability to acquire or manufacture advanced chips.
>> Although the US designs many of the world's most advanced chips, they're actually manufactured, in many cases, in other countries like Taiwan, for example, and they're often manufactured partly using US-made machine tools, but also partly using machine tools made in other countries. And so the US has had to assemble a group of countries who implement roughly comparable export controls, like Japan, like the Netherlands, to implement these type of strict restrictions on China. In addition to that, the US has used the fact that today, every advanced chip-making facility in the world, including in China, has to have inside of it several types of US-made tools to force other countries to implement US export controls as well. And so that has given the US government very broad extraterritorial power to limit different companies' access to advanced chipmaking technologies. And it's also induced China to respond because the Chinese government is aware that its inability to produce advanced semiconductors is a critical vulnerability. The Chinese government is extraordinarily concerned about what would happen if during a military crisis, the US tried to dramatically restrict its access to semiconductors and is trying via a vast subsidy program to kickstart its own chip industry.
>> Meanwhile, is it possible that Europe might be quietly gaining power by largely staying out of the middle of the US-China tensions?
>> Europe, to some extent, is caught in between. European countries have their own interests. For example, Germany and German mid-sized companies, machine tools companies, and such are big exporters to China. So they have economic ties that are really very important to them. Having said that, at least around the Ukraine issue, there's been solidarity between Europe and the United States. And that has been made abundantly clear to the Chinese in recent meetings. I do think that the Europeans, you know, will protect their own interests and walk a bit of a tightrope to ensure that they're handling their relations with China in a way that serves their particular purposes that's natural and to be expected. We are putting great effort, I think, as a country in our diplomatic corps' putting great effort into restoring the strength of alliances, our alliances with European countries and via NATO. So this is likely to be a navigation problem for the Europeans. They're going to have to navigate pressures that come from the United States to conform to certain policies that are, for example, denying China certain various important equipment.
>> This clearly impacts US-China relations and the chip industry, not to mention Taiwan's security. But it also impacts any firms that the chip industry touches. That finer point was underestimated by most firms, many of which are now trying to better understand their dependencies and plan for potential scenarios going forward.
>> What we've seen over the past several years is when it comes to the electronics industry, almost every major foreign company operating in China is trying to diversify their production base, and many are even splitting their production into a China-focused and a non-China-focused supply chain to prepare for future regulatory risks or geopolitical crises.
>> These efforts are grounded in the potential for a de-coupling of US and China trade relations.
>> The notion of de-coupling certainly has been in the air now for several years and a broad policy direction that has been supported in certain political circles. My sense of how realistic it is that the US and Chinese economies are very highly integrated with many facets, well beyond just consumer goods coming to the United States from China. And therefore, I think it's very unrealistic to expect that we're going to be in a world where we can separate from China economically. I think more realistically, we are going to have many aspects of our economy dependent on China and vice versa, and we're going to live in that complex situation of being at one time geopolitical competitors and at the same time highly linked economically to each other in ways that it would be dangerous to disrupt.
>> That may be logically true, but the realities of legislation in the US and Europe could chart a different path. Congress passed the CHIPS Act in the US, and the EU is working on a similar package. Other countries, including Japan, India, and South Korea, are taking similar action. Can the US succeed?
>> Obviously, this is a serious initiative and one with some of the best minds and best corporate capabilities behind it. Having said that, it's a tremendous challenge. I think there are probably nuances to the labor situation and nuances in terms of managing and managing to both volume and cost that are going to be big challenges for the partners involved in these new facilities. So one wonders if we have the right stuff in all of our workforce to operate with the same kind of, in the case of TSMC, what appears to be total dedication, the workforce, to the company.
>> There are already early reports of staffing issues at the future TSMC site in Arizona. Other challenges may include regulatory issues and, of course, water supply. Beyond the practicalities of nearshoring chip manufacturing, is the current situation likely to destabilize geopolitical relations? Conventional wisdom says yes. Chris Miller has another view.
>> The key risk to stability in East Asia today is the question of the security of Taiwan. China's desire to control Taiwan has been a constant in international politics since the founding of the People's Republic in 1949. But what's different today is that Chinese military capabilities are substantially greater, and therefore, the US ability to defend Taiwan is in question today in a way that it has never been before. That's the reason why there's extraordinary concern right now about peace in the region. That's also the reason why there are fears that Chinese leaders could think that a campaign of pressure against Taiwan might be in their interests if they believe a war is something that they could win. And that's why the escalating chip war, if it leads to an increased differential in technological capabilities between the US and its allies on the one hand and China on the other, and if this technological differential is applied to military systems, as certainly the Pentagon plans to do, this could, in the end, be stabilizing if, in fact, it leads to a increase in the US ability to deter China from attacking Taiwan by making China more convinced of US military capabilities to do so. Now that's something that will only develop if, in fact, it materializes over a longer time horizon, five or 10 years. And for the short run, over the next several years, we should expect this tension to be destabilizing because the US is likely to continue to escalate its technological restrictions on China. Other countries in the region, like Japan, are likely to follow suit. And China is likely to respond by trying to punish certain Western firms that are going along with these types of restrictions while simultaneously pouring ever greater sums into its efforts domestically to find ways around these foreign-controlled choke points.
>> Recent developments may indicate how trade relations might be managed.
>> For example, there have been efforts on the part of the United States to restore or to resurrect diplomatic engagement. So Ambassador Nicholas Burns has made efforts to talk at high levels with the Chinese government and to get a dialogue resuming. Commerce Secretary Raimondo has meetings -- or has had recent meetings with her counterpart. And in those meetings, the Micron ban will be, or has been, I believe, discussed. So there are bound to be these incidents, if you will, that are part of the tit-for-tat that we're experiencing in our relations with China that end up on the agendas of our highest-level government officials and diplomats as we talk. And I think the important point is it is far, far better to be in pretty constant dialogue with the Chinese government and addressing the individual items that come up from time to time than it is to not be talking to each other. That, I think, is far more dangerous.
>> The future of semiconductors is nearly impossible to imagine apart from artificial intelligence. How has the chip industry influenced new technology such as AI?
>> If you look at the question of what has driven advances in AI over the past decade, you quickly discover that it's not the case that computer programmers or software engineers have gotten 16 times smarter over the past decade. But it is the case that, thanks to Moore's law and the doubling every two years, chips have gotten roughly 16 times better over the past decade, delivering 16 times as much computing power for roughly the same price. And this trend has been absolutely critical in the development of AI systems that we're seeing generate much excitement today. It's not a coincidence that just as the current boom in generative AI is peaking, we're also seeing shortages across the United States and globally of the types of chips like graphic processing unit chips that are needed to train AI systems; nor is it a coincidence that NVIDIA, the company that is the largest producer of these types of GPU chips, has seen its stock price rocket upwards on the expectation that increased training of these types of generative AI systems will require more and more semiconductors. And indeed, that has been the trend of the last decade. The more AI we need, the more semiconductors we'll require. The relationship is reciprocal because the chip industry has been a leader in applying advances in computing to produce more capable chips. The more advances we have in AI, the better our chip-making capabilities come, which fuels further advances in AI.
>> Dennis Lockhart echoes that thought.
>> That is only going to increase. We appear to be in the dawn of the AI era. You know, it's early, so it may fizzle in some respects. But certainly, just in the last few months, it's become clear that artificial intelligence and generative AI are now beginning to become central to planning for the future on part of corporations at an economic management level.
>> With the US being a global hub of AI, nearshoring efforts in the US may, in fact, be coming at just the right moment. Thanks to our experts, Chris Miller and Dennis Lockhart, for their insights on the evolution of the chip industry. Join us for the next episode of The OUTThinking Investor, when we'll apply many of these insights to the advancement and investment implications of artificial intelligence. The OUTThinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review.
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