Rebecca Freeman and Richard Baldwin
Supply disruptions caused by systemic shocks such as Brexit, Covid and Russia-Ukraine tensions have catapulted the issue of risk in global supply chains to the top of policy agendas. In some sectors, however, there is a wedge between private and social risk appetite, or increased risks due to lack of supply chain visibility. This post discusses the types of risks to and from supply chains, and how supply chains have recovered from past shocks. It then proposes a risk-reward framework for thinking about when policy interventions are necessary.
The past couple of years have been rife with upheaval – whether we are speaking of people’s day-to-day lives, disruptions to business-as-usual, or international trade flows. The Brexit shock in Britain sparked initial concerns about the impact on global supply chains (GSCs). This was followed by the much larger and wider shock from the Covid-19 pandemic. The current political situation between Russia and Ukraine, including many countries’ sanctions and bans on the import of Russian products, is likely to perpetuate the specter of broad and long-lasting shocks to multiple economies.
What should be done about this? Noting many challenges to GSC resilience, Seric et al (2021) examine how firms involved in GSCs can help mitigate the effects of supply disruptions. Further, recent research on GSC risks has shown that inventory management helps firms mitigate GSC shocks.
This post, based on Baldwin and Freeman (2022), examines: (1) how the literature has thought about sources of shocks, risk and resilience in the context of GSCs, including whether a shift in the thinking around risk is called for; and (2) a brief discussion on how to apply our proposed framework to policy discussions and future work on the topic.
Sources of shocks
GSCs are composed of firms and firms face risks. Some of these risks are exogenous supply and demand shocks, other shocks emanate from other firms or transportation disruptions.
- Supply shocks include ‘classic’ disruptions such as natural disasters, labour union strikes, suppliers going bankrupt, industrial accidents, etc (Miroudot (2020)), as well as disruptions from broader sources like trade and industrial policy changes, and political instability. They can be concentrated (eg the 2011 Japan earthquake) or broad (eg the Coivd-19 pandemic).
- Transportation is part of the services sector, and thus potentially subject to different shocks than goods.
- Demand shocks confront firms with risks stemming from damage to product and company reputation, customer bankruptcy, entry of new competitors, policies restricting market access, macroeconomic crises, and exchange rate volatility.
Another important dimension of risk concerns the idiosyncratic-versus-systematic nature of shocks. Most firms involved in GSCs are aware of idiosyncratic shocks – those which affect single sectors or factories in single nations. These are frequent. Systemic shocks are a different matter.
From the 1990s until recently, shocks rarely involved many sectors/nations simultaneously. This is really what was new about the Covid-19 shocks to GSCs, which were pervasive, persistent, and affected multiple sectors at once. And while many firms do have contingency strategies in place, few firms engaged in GSCs – not even the most sophisticated multinationals – had prepared for systemic shocks. This is a real change.
The Business Continuity Institute Supply Chain Resilience Report 2021, which surveyed 173 firms in 62 countries, found that over a quarter of firms experienced 10 or more disruptions in 2020, while the figure was under 5% in 2019. Firms cited Covid-19 for most of the rise in disruptions, although Europe-based firms also pointed to Brexit as an important source of shocks.
There are two other likely sources of systemic shocks: climate change and geostrategic tensions. In short, systemic shocks may become the norm and thus require changes to business models worldwide.
Even though the pandemic waxed and waned regionally it has been global in nature. Because of this, the impact was felt in almost all goods producing sectors. We cannot know how frequently future pandemics or disruptive global events will occur, but it is likely that Covid-19 will continue to be disruptive for many months or years.
Economic analysis of GSC risks, resilience and robustness
The literature has focused on three aspects of GSC risks:
- The propagation of micro into macro shocks.
- Whether GSCs amplify the trade impact of macro shocks.
- The costs and effects of delinking/decoupling from GSCs (eg, through reshoring).
Our paper reviews these three literatures, but for the sake of space, we concentrate on policy issues here. Before doing so, we touch upon the critical distinction between resilience (ability to bounce back quickly after a shock) and robustness (ability to continue production during the shock). To ensure resilience, much of the focus is on designing the supply chain with an eye to the riskiness of locations overall. In contrast, robustness strategies focus more on ensuring redundancy of external suppliers or having multiple production sites for internally produced inputs. See Martins de Sa et al (2019) and Brandon-Jones et al (2014).
Do we need new GSC policies?
A touchstone principle of the social market economy is that government intervention is merited if there are gaps between the private and public evaluations of costs, benefits, and/or risks. When it comes to GSC policy, we argue that policy may improve market outcomes when there is a wedge between private and social evaluations of risk.
We illustrate this for GSCs with the ‘wedge diagram’ (Figure 1). The diagram, styled on classic optimal-portfolio analysis, has risk and reward on the y and x axes, respectively. Firms like cost-savings and dislike risk (as shown by the indifference curves), but their choices are constrained by the fundamental risk-reward frontier shown. The frontiers take their shape since putting all production in the cheapest location increases risk by decreasing geo-diversification.
Where does the wedge come from? Public versus private risk appetite. In the GSC world, divergences in public-private risk preferences can arise from a range of mechanisms whereby individual firms do not internalize the full risk of their actions. Private firms optimally choose point P given their preferences. In some sectors, many governments have preferences that give greater weight to risk reduction, so the public trade-off leads to a lower-risk optimum, creating a wedge between public and private risk evaluations. This divergence is clear in sectors such as banking where, in the past, government provided guarantees when the risk went wrong and in food production where individual producers underinvest in anti-famines actions.
Misperception of the location of the frontier. Another market failure can arise due to information asymmetries. Modern GSC are massively complex and even the most sophisticated firms can be unaware of the location of their third-tier suppliers and beyond (Lund et al (2020)). As a result, private firms may face more risk than they know. This situation is depicted as the actual risk-reward trade-off taking place above the perceived trade-off, which would also result in a wedge. When the case, private firms are at point P’ when they think they are at P.
Figure 1: The public-private wedge analysis of GSC risks
Source: Baldwin and Freeman (2022).
Policies to mitigate risk
Risk mitigating policies – such as those in banking and agriculture – are clearly warranted when such a public-private wedge exists. Banking is the classic sector with a wedge, but food is as well given that it is almost universally considered as too critical to national wellbeing to be left to the market. Most nations have policies that promote domestic production, create buffer stocks to smooth demand and supply mismatches, or both. These typically involve large scale outlays such the US Farm Bill and the EU’s Common Agricultural Policy.
It seems likely that critical sectors, including medical supplies and semiconductors, will be viewed more like agriculture and banking going forward than they have been since the perception is that they are marked by a public-private wedge. Policies that tackle the wedge can be usefully classified into tax/subsidy measures, regulatory measures, and direct governmental control. And, as firms are more likely to shift production structures when they perceive a permanent policy shift, we speculate that these sectors are most likely to restructure and reorganise their GSCs. On the policy side, there have been clear moves to evaluate critical sectors. For example, the Biden administration has established a Supply Chain Disruptions Task Force to address the challenges arising from a pandemic-affected economic recovery.
A target-rich research environment
We end our paper, and this column, with a call for research. On the trade theory side, almost no analyses had delved into the role of risk in GSCs when we started circulating our paper in 2021. For example, in the received wisdom literature (Grossman and Rossi-Hansberg (2008)), the basic trade-off turns on separation costs versus cost-saving gains in a model without risk. As the discussion of the International Business literature in our paper makes clear, the risk-GSC nexus serves up a rich menu of un-modelled, yet important phenomena. Of course, risk considerations are not entirely new, but the theory has largely assumed away risk for convenience, and this has been echoed in the empirics.
On the empirical side, the possibilities are even greater. Nothing helps econometricians more than truly exogenous shocks. The years 2020 and 2021 were bursting with exogeneity. Because of this, coupled with the availability of massive, high-frequency, online data, and headline-grabbing importance, we conjecture that there is a great deal of impactful empirical research to be done on risk and the shape and nature of GSCs. Overall, we see exciting times ahead for GSC researchers. Things have, as they say, changed so much that not even the future is what it used to be. It is riskier than we thought!
Rebecca Freeman works in the Bank’s Research Hub and Richard Baldwin works at the Graduate Institute Geneva (IHEID).
If you want to get in touch, please email us at email@example.com or leave a comment below.
Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.