THE PERFECT STORM – SUPPLY CRISIS

In the run-up to the 2008 global financial crisis, some prescient voices warned of potentially catastrophic systemic instability. In a famous 2005 lecture, Raghuram G. Rajan explicitly warned that while structural and technological changes meant that the financial system was theoretically diversifying risk better than ever before, in practice it could be concentrating risk. At the time, Rajan was the subject of ridicule; former US Treasury Secretary Larry Summers was not the only one to criticize him.

This episode is prompted by the widespread shortages that are occurring around the world. The markets for gas, truck drivers, carbon dioxide (extraordinarily), toys, ready-to-assemble furniture, iPhones, computer chips and many other things have been affected. Will these supply crises be merely a temporary interruption while the world economy recovers from the impact of the Covid pandemic? Or are we witnessing a collapse of the global production system? And in the latter case, what would be the supply chain equivalent of the interventions by major central banks to prevent a global financial meltdown in 2008?

The parallels between the current supply crises and the financial crises of 2008 are striking. Prior to each crisis, the prevailing assumption was that decentralized markets would provide adequate resilience, either by spreading financial risks or by ensuring a diversity of alternative supplies.

In the energy sector, for example, there has been a steady shift from national self-sufficiency to dependence on world markets. The European Union began the process of “liberalization” in 2008, allowing new competition in gas and electricity in what was intended to be an EU-wide market. Although some had previously expressed concern about the implications for security of supply, policymakers went ahead with legislation to entrust energy imports from European economies to world markets.

But most analysts – and policymakers – did not foresee that world markets for gas and many other commodities would turn out to have bottlenecks or gatekeepers. The supposed diversification of supply resulting from liberalization often seems illusory. For many products, such as semiconductors or CO2 (a by-product of fertilizers) for food processing, supply has become more concentrated. And the division of global production chains into increasingly specialized links over several decades has led to unexpectedly close correlations between supply shocks in different industries, as in the case of fertilizers and food or semiconductors and automobiles.

In addition, some shortages (such as those of truck drivers and shipping containers, or of gasoline in the United Kingdom) directly affect the logistics that connect the links in supply chains. As a result, vulnerabilities have quickly become mutually reinforcing and self-amplifying. The highly specialized, just-in-time design of the global production system brought substantial benefits, but its weaknesses are now clearly greater.

So how should policymakers think about this lack of system resilience and what can be done to counteract it? Benjamin Golub of Northwestern University has shown that queuing theory provides insight into how a small change in a well-functioning system (such as reducing two supermarket checkout lanes to one) can lead to a huge increase in wait times. Conversely, introducing a little slack into a system adds a lot of resistance.

Likewise, the classic spider web model shows how time lags can destabilize markets and cause large fluctuations in demand and supply. If demand is less responsive than supply to price signals, and expectations about the future turn out to be incorrect, the delay in suppliers’ responses causes volatility.

Brian Arthur’s famous Bluff Bar problem, which combines decisions made over time and the need to form expectations, produces an equally unstable result. And as Tera Allas of McKinsey & Company has pointed out, system dynamics was invented to think of supply chains as complex, nonlinear dynamic systems.

So, there are many mental models to understand the current shortage problem. The most pressing challenge is how to restore stability and alleviate shortages so that people do not face a holiday season with no toys, skyrocketing gasoline, lack of oil or who knows what else … .

One of the top priorities is to have better data and better business intelligence in government. Even after 30 years of globalization, publicly available information on product flows in global supply chains is astonishingly scarce. Ministries need to recapture the kind of engineering-based industrial knowledge that was more common in the days when industrial policy was considered a key government function.

But in the short term, decentralized markets and price signals are the problem, not the solution. Governments will have to step in – either by deploying soldiers to drive gasoline tankers or by providing production subsidies – to mitigate some of the shortages.

When immediate supply concerns diminish, companies and policy makers should consider what type of insurance or slack to build into the production system over the long term. Just as banks needed to increase their capital reserves after 2008, we may now need to step back from just-in-time production and redefine productivity in light of supply chain risks.