The Supply Chain Is the Economy

The term “supply chain” is just a name that we give to a nexus of logistics, inputs, processes, transportation, packaging, distribution, marketing, customer relations, vendor relations and human capital that in the aggregate support the supply and demand for every physical, digital, intellectual or artistic artifact on the planet and in space. The supply chain is everywhere.

One way to understand the complexity and pervasiveness of supply chain dynamics is to consider yourself a one-person supply chain as suggested by MIT scholar Yossi Sheffi in his book The Resilient Enterprise (2005). Sheffi’s thought experiment goes something like this:

You wake up in the morning to the sound of an alarm clock. It may have been purchased at Walmart and made in China. You roll out of bed and make some coffee (from Brazil or Costa Rica). You prepare a nice breakfast of eggs (trucked in from a local farm), toast (from a local bakery) and orange juice (moved in refrigerated rail cars from Florida).

Once breakfast is done, you check your email and news (on a computer made in China), then hop in your car (made in Tennessee by a Japanese company) and do some shopping. You buy some clothes (made in Thailand and Vietnam), pick up your new eyeglasses ready at the optometrist (with German lenses and Italian frames) and fill up your car with gas on the way home (with gasoline refined in Philadelphia from oil pumped in Nigeria, shipped to the refinery by tanker and delivered by truck to your local gas station). And so on.

You’re surrounded with physical goods and services sourced from all over the world and delivered by truck, rail or vessel to regional distribution and processing centers and then delivered to your local stores.

You complete what’s called “the last-mile” delivery in the supply chain by shopping in your own car, or you can have goods delivered to your door through e-commerce vendors like Amazon. You are at the center of your own human supply chain.

You get an even better idea of the global complexity involved when you consider what’s called the extended supply chain. This analysis involves taking all of the suppliers in your personal supply chain and thinking about the separate supply chains of those suppliers.

The alarm clock made in China has parts from vendors all over the world (semiconductors, copper cords, plastic moldings, LED displays). Your morning coffee is made in a percolator or drip-style coffee maker with stainless steel, tempered glass, semiconductors and other components from vendors in Germany, Taiwan and Mexico.

The coffee beans were roasted abroad, packaged and delivered by container cargo on vessels owned and operated by Maersk (Denmark), COSCO (China) or Hapag-Lloyd (Germany).

The vessels themselves were likely built in Korea.

The automobile you take shopping may have been made in Tennessee, but it includes semiconductors from Taiwan Semiconductor Manufacturing. The clothes you purchased were made from cotton grown in Egypt and include plastic buttons fabricated in Malaysia.

Of course, we can continue this analysis indefinitely. The plastic resins used in the Malaysian button factory may have come from a chemical firm in Germany. That’s the point. The supply chain is really endless because every output has one or more inputs, which have their own inputs all the way back to basic industries such as mining and steel foundries.

Of course, those industries have their own inputs of machinery and electricity. Making it all work is human capital from technical expertise to manual labor. The supply chain never ends.

The breakdown in the global supply chain can be summarized in two words: efficiency and energy.

Efficiency sounds like a desirable outcome. It implies cost reductions and lower prices for consumers. How can efficiency be undesirable?

All systems require some form of energy, yet energy appears to be plentiful on a global basis notwithstanding higher energy prices. How can energy be blamed for the breakdown?

These questions present the paradox of complex dynamic systems analysis. The global supply chain is one of the most complex systems ever created. Here’s the explanation of the paradox:

We’ll begin with efficiency.

The modern science of supply chain management began in the 1980s when the rise of globalization and the expansion of computing power combined to make supply chains more complex while offering tools to deal with the complexity.

Supply chain management lowers costs by creating options, sharing information, eliminating redundancies, encouraging cooperation among supply chain participants and other innovations.

But when you increase the length of a supply chain to reach lower labor costs in Asia, for example, you also increase the number of things that can go wrong along the way.

When you reduce your trucking providers to the two that offer the lowest rates, you increase your vulnerability if one of those two suffers a strike or is disrupted by a natural disaster. If you route all of your inbound cargo to the Port of Los Angeles (instead of Houston, New York City or Tacoma) in order to be close to your distribution center, what happens when the Port of Los Angeles becomes a global bottleneck, which it has?

Put differently, the hidden cost of efficiency is vulnerability. This brings us to the second problem – energy.

Complex dynamic systems such as the supply chain run on energy. The problem is that the energy inputs rise in a superlinear fashion relative to the scale of the system. In plain English, this means that if you double the scale of a system, you may increase the needed energy (electricity, money or labor) by a factor of five.

If you double it again, you increase the energy inputs by a factor of five again. This means that after doubling the scale of the system twice, the scale is four times larger, but the energy inputs are twenty-five times larger.

When the profits from increasing the scale of the system are high and energy costs are low, these lopsided ratios of scaling functions may still be profitable on net. Yet when profits start to shrink (because of competition from disruptive technologies) and energy prices start to rise (because of government regulation and inflation) the impact of energy input costs on a highly leveraged supply chain network becomes a constraint on the operation of the system as a whole.

The rising cost of energy inputs is exacerbated by outright energy shortages as are now emerging in China and Germany. China has coal shortages; coal accounts for over 50% of China’s electricity generating capacity. Germany has natural gas shortages, which may grow worse if Russia invades Ukraine and the U.S. imposes sanctions on Russia. These energy shortages are slowing output in both countries right now.

Other factors weighing on the supply chain today include the pandemic and geopolitical stress. Major trading nations such as Australia and China are pursuing the ridiculous goal of a zero COVID policy or no new outbreaks of the infection. This is impossible. It’s tantamount to pursuing a policy in which no one catches a cold. The goal is absurd but the costs are real.

Supply chains will have to be restructured. The biggest loser will be China because it is the source of many inputs in the broken supply chain that will be abandoned. The biggest winner will be the United States because it has the greatest capacity to onshore broken links and build replacements for lost capacity elsewhere.

Still, reconfiguring the supply chain will take five to 10 years to accomplish. In the meantime, you should expect empty shelves, higher costs and slower growth in companies most affected by the breakdown.

Regards,

Jim Rickards
for The Daily Reckoning