When the “Unthinkable” Becomes Reality
The long-term implications of the Covid-driven collapse in global supply chains.
In the years before the global financial crisis of 2008, I served as a staffer at the Federal Reserve Board. I recall writing a stream of memos extolling the virtues of the U.S. financial system. Echoing the received wisdom of the day, I asserted that our financial system was efficiently moving risk to those entities that were best positioned to bear it. The results were stronger economic growth and a more resilient economy.
Moreover, I speculated, perceived market excesses were unlikely to create first-order disruptions. The millions of investors who were putting their money at risk had incentives to ensure that pricing remained reasonably aligned with fundamentals. Broadly speaking, the financial system was optimized and a source of strength.
Then the U.S. financial system melted down. Suddenly, we faced an uncontemplated—indeed, a previously unthinkable—set of challenges. The collapse of the intellectual framework that we had previously accepted as fact meant that the response to the crisis was constrained by a lack of understanding: We were on unfamiliar terrain.
That experience shares some unsettling similarities with the current disruptions in global supply chains. Like the U.S. financial system in the years before the financial crisis, many observers were convinced that pre-Covid supply chains were optimized. Firms had successfully scoured the globe to find the suppliers that would best meet their production needs. In parallel, they had implemented “just in time” techniques to keep their inventories as lean as possible.
The global economy’s flexibility, coupled with evolving tracking and shipping techniques, was enabling firms to both minimize inventory carrying costs and maintain fully reliable access to inputs. Some even argued that these innovations were dampening swings in inventories and, thus, helping to reduce volatility in real GDP and the performance of the overall economy.
These trends were warmly welcomed by investors, who tended to value capital-light business models more generously. This was true across not only national borders, but also within industries. Businesses could reasonably hope that outsourcing capital-intensive portions of the production chain would drive up their share prices.
However, now that supply-chain disruptions are cascading through the global economy, it’s become clear that these strategies were critically conditioned on the assumption that linkages with the rest of the world would remain robust, predictable, and cost-effective.
To some extent, the vulnerabilities embedded in these strategies were exposed by the trade war with China and associated sanctions programs. But the pandemic exposed them even more starkly. Fundamentally, Covid-19 has driven a massive rebalancing in spending toward goods. Given the magnitude of this rebalancing, mismatches between the demand for goods and their supply were inevitable. But the farflung and complex nature of supply chains amplified the challenges.
Likewise, the ongoing lockdowns and reopenings of economies around the world have caused disruptions in production, unevenness in demand, and swings in the contours of trade flows. Things have been thrown even further out of sync because the pattern of lockdowns has varied somewhat across countries. Notably, this past summer, critical Asian suppliers locked down in response to the delta variant, while the demand for goods in the United States remained red hot. The upshot was an exacerbated mismatch between supply and demand.
As a related matter, the pandemic has pushed global shipping and logistics into turmoil. The main challenge has been the sheer volume of goods that customers are demanding, especially U.S. consumers. The results have been spiking global shipping costs—particularly for goods manufactured in China and shipped to the United States—and exceptional pressures on the functioning of the ports.
See also:
- Covid-19 Supply Chain Disruption
- Covid-19 Has Exposed the Risks of Thin Supply Lines
- Consider FX in Supply Chain Restructuring
- Covid-19 Impacts on Trade
In sum, the pandemic has not only disrupted global supply chains, but also up-ended the received wisdom on supply-chain management. This has two important implications.
First, as companies look to the future, they will need to respond to these harsh lessons. This is likely to mean holding larger inventory buffers and, possibly, sourcing inputs closer to home. The extent of such changes will depend on how quickly the current disruptions recede and whether markets incentivize such changes.
And second, as in the global financial crisis, we remain in the throes of a scenario that we previously considered unthinkable. Our ability to respond and chart a course forward is constrained by the lack of an intellectual playbook. While there are good reasons to expect that supply-chain tensions will abate during the year ahead, the uncertain environment leaves us vulnerable to further disruptions, especially if the pandemic continues to flare.