Bulletin
Investor Alert

London Markets Open in:

Project Syndicate Archives | Email alerts

Nov. 2, 2021, 8:41 a.m. EDT

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

new
Watchlist Relevance
LEARN MORE

Want to see how this story relates to your watchlist?

Just add items to create a watchlist now:

or Cancel Already have a watchlist? Log In

By Diane Coyle

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 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  CO (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.

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.

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.

1 2
This Story has 0 Comments
Be the first to comment
More News In
Economy & Politics

Story Conversation

Commenting FAQs »

Partner Center

Link to MarketWatch's Slice.