COVID is doing to Supply Chains what the Housing Crisis did to Banks

A few days ago CNBC wrote about a new initiative at the White House:

“The White House is studying whether supply chains should undergo “stress tests” of hypothetical scenarios and whether to suggest stockpiling certain critical items, sources say. The administration is conducting a broader review into critical supply chains amid a global semiconductor shortage that has impacted the auto industry.”

This is revolutionary on many levels, but the main one is the fact that COVID, Trump’s tariffs, semiconductor shortage, the Suez Canal, and Covid vaccines did to supply chains what the housing crisis did for mortgage-based securities. 

In both cases, technical topics (supply chain and mortgage back securities) that most of us thought have nothing to do with our lives became concepts that can absolutely affect almost every aspect of our lives.  

Since the 2008 financial crisis, the government requires banks to go through similar stress tests to ensure they are ready for possible financial crises.  Many bankers I speak with do not see such tests as useful, but the fact we haven’t had to bail any bank since is a counterargument. 

When it comes to supply chains, things are different.  While I find the intention of the government to be positive, and I do agree on the importance of such tests, I find government intervention in this case quite unhelpful and even possibly risky.

The first reason is that supply chains are much more complex than financial instruments.  I know that may sound odd and self-serving as someone that teaches about supply chains. But this is quite evident from the type of instruments available to those managing supply chains vs financial institutions.  When it comes to the financial industry, everything is boiled down to money (I know I am oversimplifying). The main instruments are cash infusion, diversification, and the main risks are default or insolvency. And thus government regulation focuses on exactly these.  

When it comes to supply chains, the flows are more complex: we do have financial flows in the form of cash. Product flows, from raw material to final goods. And information flows, everything from demand forecasts to available information, both of product and capacity to manufacture the product or ship it.  

While the government can help with financial flows (loans, grants, etc), it cannot really help with product flows, unless it starts acting like a player in the supply chain. If we run out of toilet paper, what will the government do? 

I want to make sure it’s clear: I am not talking about planes and vaccines. In these cases, the government should absolutely be deeply involved in monitoring the supply chains. But then it is an active player in it. 

In the CNBC article, the government is considering intervening in supply chains of critical products, such as cars. I don’t see the government holding inventory of cars. Or toilet paper or kettlebells. 

If the government wants to regulate such risks, it needs to focus on the one flow it does control: information. By running a stress test, the government is focusing on collecting information from multiple stakeholders in the supply chain as a way of helping firms assess their own risks and potentially taking measures related to product flows. 

So why do I think it’s not going to work? Why am I claiming that there is a risk in forcing firms to over-manage their risks? 

Supply Chains are Complex

Let's start with the obvious: supply chains are complex. The toilet paper example is a little cliche by now, but the reality is that every product is now manufactured over multiple continents, by many different players.  The FT nicely shows the vaccine supply chains. 

You can see the same from a few years ago about the life of a DVD player. This is not a new phenomenon. Supply chains became increasingly complex over the last few decades. 

In trying to understand why supply chains are more complex, the tendency is to blame short-term optimization and offshoring.

The Drivers Behind the Trends

The reality is clearly more complex. While it’s true that there was a lot of pressure on firms to “clean” their balance sheets, and thus outsource and offshore their production, this is not enough to explain the complexity. 

One of the main trends of the last 20 years is significant market segmentation and an increase in the number of product variants, sometimes referred to as “SKU proliferation”.  One way to achieve this is to make products more modular, which allows more firms to build subcomponents.  The combination of modularity and outsourcing is quite powerful and allows firms to keep up with emerging technologies, without the need to internalize the cost of R&D and production.  There are exceptions to this (such as the iPhone and Apple), but the reality is that complex supply chains are driven by market trends that pertain to customer preferences, product design, and competitive strategy, in a way that goes deeper than just assuming that it maximizes short term shareholder value.

Over the last thirty years, as supply chains became more and more complex, firms realized (usually too late) that they needed to start developing risk management practices. The floods in Thailand that hit the hard drive industry or the tsunami in Fukashima are just a few examples.  

When we teach supply chain risk management, the first step is risk assessment. This assessment needs to take place whether it’s triggered by an event (as the ones mentioned above) or as a standard periodic activity (as it should be).  The idea behind such an assessment is to ensure that the firm has visibility into its supply chain, so it can mitigate the main risks and then hedge against the ones it cannot mitigate. 

In such an assessment, the first three steps a firm needs to take are: 

(i) Mapping its supplier network: its suppliers, its supplier’s suppliers, its supplier’s supplier suppliers (you get the point) 

(ii) Estimating the Time to Recovery: if it’s part of an event: how long will it take until the firms can recover to its planned capacity, and 

(iii) Estimating the Revenue at Risk: how much is at risk, and which supplier has a disproportionate impact on its revenues.  

Essentially, we recommend for firms to do these risk assessments (or stress tests) regularly. Furthermore, note that the first step is exactly the one the White House is planning to force firms to do. 

So why do we see so many failures of firms to hedge against risks? We can all agree that COVID was unexpected, but even my supply chain class slides have the risk of a “pandemic” on them since 2009. I am sure many firms were aware of this risk.   So why was almost every firm I know (but a few) not ready? We knew semiconductor supply chains are under immense pressure. Why were very few firms ready for it? 

The Tradeoff

There is an inherent tradeoff between long-term Return on Investment (ROI) and short-term ROI: Mitigation (such as carrying excess inventory) is expensive and pays off only in the long term. But the long term is usually too long, and likely won’t be on your “watch”.  Hedging strategies, such as having multiple suppliers or building flexible resources, are expensive as well. They can be value-creating, but the reality is that they are expensive and require a deep understanding of your supply chain. 

To be able to hedge, you need to understand not only your risk but also your supplier’s risks and their supplier’s suppliers’ risks. 

Again. Same point. The first step for any good supply chain risk management plan is having end-to-end supply chain mapping. 

The reality is that unlike the housing crisis where banks and lenders had very little incentive to manage their risks, in the supply chain setting government and firms are fully aligned. So what's the issue?

The issue is that the lack of visibility is strategic in the system.  Most firms do not want other firms to know their suppliers since it poses two big risks: the risk of disintermediated, and a price risk: once you know the supplier, you can figure out their cost, and negotiate the price down.  You can go directly and work with the supplier. 

When we teach supply chain management we talk about the fact that firms should optimize supply chain surplus (that is, end to end value), and then divide the (larger) pie among them.  But this is a privilege only big firms have. Most smaller firms have limited visibility into their supply chain.  If they cannot hedge their risks properly, how can the bigger firm they sell to can hedge properly their risk?  You need to know whether your supplier hedges and how in order to decide how to hedge. This is hard. Nearly impossible. It gets even more complicated when you realize that if some firms decide to hedge, it reduces the incentives for others to do. If you know that your supplier is carrying excess inventory, you can probably carry less, reducing your costs further. 

The main point here is that supply chains require system thinking. They are an emergent order. The decisions different nodes make pertain to product, information, financial flows in a way that make the set of instruments needed to hedge against risks much more complex. 

Legibility and Supply Chains

Until this point, I was primarily emphasizing the fact that I do not see the added value of regulating systems where all stakeholder’s interests are aligned with that of the government. But I claim that there is a risk in trying to regulate complex systems that are not well understood. 

James C. Scott’s in his book “Seeing Like a State: How Certain Schemes to Improve the Human Condition Have Failed” writes about “authoritarian high modernism” and the notion of legibility. 

As Venkatesh Rao writes, summarizing the book, here is the recipe:

1. Look at a complex and confusing reality, such as the social dynamics of an old city

2. Fail to understand all the subtleties of how the complex reality works

3. Attribute that failure to the irrationality of what you are looking at, rather than your own limitations

4. Come up with an idealized blank-slate vision of what that reality ought to look like

5. Argue that the relative simplicity and platonic orderliness of the vision represents rationality

6. Use authoritarian power to impose that vision, by demolishing the old reality if necessary

7. Watch your rational Utopia fail horribly

Scott and Rao write primarily about the public domain (Forestry and Agriculture), but I am afraid we see a similar issue here.  

What’s the actual risk for supply chains? In order to improve their visibility into their supply chains, firms may choose to source from more expensive suppliers that have a larger scale and can afford more sophisticated risk hedging mechanisms. This will result both in higher prices to consumers, but will also likely stifle competition from smaller and potentially more innovative suppliers, resulting in a worse situation to all players, but the incumbent supplier.  There is nothing wrong with it if customers are willing to pay for it. But if not, who is going to bear the cost of failure.

Government should intervene when there is a market failure, or in a situation where they believe that firms are not doing enough to protect their customers. But this is not the case here. Here, firms, government, and to a large extent, customers, are fully aligned.

I am not saying that firms should not strive to fully map their supply chains. They should.  But it’s in their (long-term) best interest to do that. And when it’s not it’s not because of their short-term view of the world.  When I speak with firms, one thing is very clear. There is a lot of pressure on them to drive costs down while keeping products available. While keeping up with technology. It’s not coming from their stakeholders, it’s coming from their customers. 

So if you don’t like firms optimizing for their short-term interest, vote with your wallet.  Prioritize firms that offer more visibility (such as Everlane) and those who have been more resilient or sustainable, if this is what you care about. 

For products that are TRULY critical, such as vaccines (and Kettlebells). The government should step in and ensure proper risk management.  

So, either take my supply chain management course or stay away from my supply chain.