Project Syndicate: Broken supply chains are a market failure. What’s the right way to restore resilience?

CAMBRIDGE, United Kingdom (Project Syndicate)— In the period leading up to the 2008 global financial crisis, a few prescient voices warned of potentially catastrophic systemic instability. In a famous 2005 speech, Raghuram G. Rajan explicitly cautioned that although structural and technological changes meant that the financial system was theoretically diversifying risk better than ever before, it might in practice be concentrating risk. At the time, Rajan was mocked; former U.S. Treasury Secretary Larry Summers was not alone in thinking him a “Luddite.”

This episode comes to mind because of the widespread shortages emerging around the world. Markets for gastruck driverscarbon dioxide (extraordinarily), toysready-to-assemble furnitureiPhonescomputer chips, and much else have been affected. Will these supply shocks prove merely a temporary disruption as the global economy recovers from the impact of the COVID-19 pandemic? Or are we instead witnessing a meltdown of the global production system?

Parallels to financial crisis

And in the latter case, what would be the supply-chain equivalent of leading central banks’ interventions to prevent a global financial collapse in 2008?

The supposed diversification of supply resulting from market liberalization frequently seems to be illusory.

The parallels between today’s supply shocks and the 2008 financial shocks are striking. Before each crisis, the prevailing assumption had been that decentralized markets would provide adequate resilience, whether by spreading financial risks or ensuring a diversity of alternative supplies.

In the energy sector, for example, there has been a steady shift away from national self-sufficiency toward reliance on global markets. The European Union started the “liberalization” process in 2008, enabling new competition in gas and electricity in what was intended to be an EU-wide market. Although some had previously expressed concerns about the implications for security of supply, policy makers pressed ahead with legislation to entrust European economies’ energy imports to global markets.

But most analysts—and policy makers—failed to anticipate that the global markets for gas and many other commodities would turn out to have bottlenecks or gatekeepers. The supposed diversification of supply resulting from liberalization frequently seems to be illusory. For many products, including semiconductors or CO2 (a fertilizer byproduct) for food processing, supplies have become more concentrated. And the splitting of global production chains into ever more specialized links over several decades has led to unexpectedly close correlations between supply shocks in different industries, as with fertilizer and food or semiconductors and cars.

It is unclear whether current widespread product shortages are merely a temporary disruption or evidence of a global production meltdown. But today’s supply shocks offer striking parallels with the 2008 global financial crisis, and may require a similarly bold policy response.

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

How to think about resilience

So, how should policy makers think about this lack of system resilience, and what can be done to counter it? Northwestern University’s Benjamin Golub has shown that queuing theory offers insights into how a small change in a well-functioning system (such as cutting two supermarket checkout lanes down to one) can lead to huge increases in wait times. Conversely, introducing a little slack into a system adds a lot of resilience.

Likewise, the classic cobweb model shows how time lags can destabilize markets and trigger large fluctuations in demand and supply. If demand is less responsive than supply to price signals, and expectations about the future prove incorrect, then a delay in suppliers’ responses drives volatility.

In the short term, decentralized markets and price signals are the problem, not the solution.

W. Brian Arthur’s famous El Farol Bar problem, which combines decisions made over time and the need to form expectations, produces a similarly unstable outcome. And as McKinsey & Company’s Tera Allas has pointed outsystem dynamics was invented to think about supply chains as complex, nonlinear dynamic systems.

So, there are plenty of mental models for understanding the current shortage problem. The pressing challenge is how to restore stability and ease the shortages so that people are not facing a holiday season with no toys, turkeys, or gas.

Government response

A top priority is to have better data and better business intelligence in government. Even after 30 years of globalization, there is astonishingly little detailed, publicly available information on product flows in global supply chains. Ministries need to restore the kind of engineering-based industry knowledge that was more common back 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 need to step in—whether by deploying soldiers to drive gasoline tankers or providing production subsidies—to mitigate some of the shortages.

When the immediate supply concerns abate, firms and policy makers must consider what kind of insurance or slack they should build into the production system over the longer term. Just as banks needed to increase their equity buffers after 2008, we perhaps now need to step back from just-in-time production and redefine productivity in light of supply-chain risks.

This commentary was published with permission of Project SyndicateThe Great Supply-Chain Massacre

Diane Coyle, professor of public policy at the University of Cambridge, is the author, most recently, of Cogs and Monsters: What Economics Is, and What It Should Be (Princeton University Press, 2021).

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This post was originally published on Market Watch

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