Yves here. On the one hand, these authors no doubt performed their supply chain analysis and largely wrote their paper before the Ukraine war and its sanctions onslaught. On the other, it illustrates how experts and participants have blind spots about the potential for paradigm shifts, in large measure because they have strong incentives to preserve the existing status quo, no matter how creaky it has gotten. In ECONNED, we called this process paradigm breakdown:

Paradigm breakdown, meaning key elements of the current system are no longer viable, but that is a possibility that no one is prepared to face, since the old system seemed to work well for a protracted period. Thus the authorities reflexively put duct tape on the machinery rather than hazard a teardown.

Covid disruptions, bird flu, and pre-war fertilizer shortages were already creating serious food price increases in the US. But the sanctions on Russia are creating an entirely different and more durable changes, not mere disruptions or “shocks”, given the near-certainty that the US will not roll them back, even if Zelensky agrees to a peace treaty with Russia. The West is going to suffer lasting shortages of key materials, such as palladium, nickel, aluminum, steel, copper and platinum. Ukraine is a major supplier of neon, necessary to chip-making. Russia provides several important inputs to fertilizer, so food will become more scarce and costly. And that’s before we get to the impact of wheat shortages (and the West being a less-preferred customer) and higher energy prices (which emergency reserve releases can moderate for only a matter of months).

Papers like this remind me of Keynes’ observation about bankers:

A ‘sound’ banker, alas! is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.

Making Russia more of an autarky, which Russia can survive, is going to force the rest of the world in that direction. Very few seem willing to get in front of that development…save the serious gloom and doom types, aka preppers, who are generally seen as extremists, and may well be….unless they are eventually proven right.

By Richard Baldwin, Professor of International Economics at The Graduate Institute, Geneva; Founder & Editor-in-Chief of VoxEU.org; ex President of CEPR and Rebecca Freeman, Trade Associate, Centre for Economic Performance (LSE). Originally published at VoxEU

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 column 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 spectre of broad and long-lasting shocks to multiple economies.

What should be done about this? Noting many challenges to global supply chain resilience, Seric et al. (2021) examine how firms involved in global supply chains can help mitigate the effects of supply disruptions. Further, recent research on global supply chain risks has shown that inventory management helps firms mitigate global supply chain shocks (Lafrogne-Joussier et al. 2022).

This column, based on Baldwin and Freeman (2021), (1) examines how the literature has thought about sources of shocks, risk and resilience in the context of global supply chains, including whether a shift in the thinking around risk is called for; and (2) offers 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, and so on (Miroudot 2020), as well as disruptions from broader sources like trade and industrial policy changes, and political instability. They can be concentrated (e.g. the 2011 Japan earthquake) or broad (e.g. the Covid-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 global supply chains 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 global supply chains, which were pervasive, persistent, and affected multiple sectors at once. And while many firms do have contingency strategies in place, few firms engaged in global supply chains – 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 ten 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 global supply chain risks:

• The propagation of micro into macro shocks
• Whether global supply chains amplify the trade impact of macro shocks
• The costs and effects of delinking/decoupling from GSCs (e.g. 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 (Martins de Sa et al. 2019, 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 global supply chains with a ‘wedge diagram’ (Figure 1). The diagram, styled on classic optimal-portfolio analysis, has risk and reward on the y-axis and the x-axis, 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 internalise 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-famine actions.

Misperception of the location of the frontier. Another market failure can arise due to information asymmetries. Modern global supply chains 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 this is 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 (2021).

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 has one as well given that it is almost universally considered 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 (Antràs 2020), 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 (White House 2022).

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 (Costinot et al. 2013), 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!

See original post for references