Supply chains are mainstream news now! Before last summer, it seemed that supply chains problems were just the domain of nerds who listened to Odd Lots. Now, they are on the cover of every newspaper and have become the specialization of the week for new MBAs and pundits, like me. What I do not want to do is talk about supply chains from a technical point of view. God knows I am not a process engineer. What I think is interesting here is that the commentators outside the logistics industry who got clued into these issues very early on have their background in money and banking. This is because there are strong parallels between the instability of the monetary system and of supply chains in that they are actually both "just in time" systems and their rise is deeply connected with all kinds of similar social issues such as the disempowerment of labor, persistently low interest rates, and instability. Both systems are basically systems of liquidity. Liquidity, or the ability to use debt to make payments on time, is the core of what financial systems do. It is about delivering cash just in time. Supply chains are the providers of liquidity for real things, just as financial systems provide liquidity for financial things. And that has strong implications. We have a vast and powerful institutional infrastructure to make sure liquidity does not break down in financial markets but we do not have the same thing in markets for real things.
Let's start with an excellent article in the Financial Times by Peter Atwater, which argues that supply chains are to the COVID crisis what securitization was to the 2008 crisis. Atwater argues that "just in time" supply chains have a lot of similarities to the securitization practices used by the pre-crisis financial industry. Both are ways of economizing on capital to maximize shareholder value. In fact, they rise together with the shareholder revolution of the 1980s forcing firms to become "leaner." Being lean is just business talk for using less capital and labor to produce the same amount of stuff. To achieve that companies move to just in time supply chain systems to keep inventories low thereby economizing on warehouse space and unused items. Moreover, companies will try to outsource non-critical business to subcontractors to minimize costly investments in capital goods. Better to have a dedicated company you purchase from to make those investments and absorb those costs.
Atwater rightly points out that like the alphabet soup of financial products that caused the 2008 crash, these practices are opaque. There's no one at the top of the system who actually knows everything that is going on but without stress, it all seems to work fine. Until it does not. I would go even further than on that analogy because it is fundamentally correct about how both finance and logistics work and have changed in the late-20th and early 21st centuries. Just in time is about the delivery of goods to locations without the need for large amounts of inventory or residual capacity thereby reducing costs to the company. Securitization is about the delivery of money just on time without the use of extensive and costly bank balance sheet capacity.
To understand why banking is really just a supply chain for money, we have to unpack the concept of liquidity and why it is so central to a capitalist economy. Let's imagine I own a company that owes my supplier five dollars. I have sales of six dollars coming in so I should be able to pay my debts and have a nice one-dollar profit remaining. So I am golden, right? Not so fast! My customer is picking up and paying for her order the day after tomorrow but my supplier is demanding payment tomorrow. Everything held equal, I am screwed. My business is solvent, i.e. I can eventually make the payment, but it is not liquid.
This lack of liquidity rather than solvency is what Hyman Minsky called "the survival constraint." The job of a financial system is to move that survival constraint around in time. So, fortunately for me, there is a bank that is willing to make a loan to me to cover my payment to the supplier. Because I have good credit, that loan charges a very low rate so it doesn't cut into my profit much. I repay my loan after I get payment from my customer and everyone is happy. This ability to borrow from the bank is what loosens the survival constraint. This isn't hypothetical. Supply chain finance is one of the oldest forms of finance. We can trace many of our security markets to the "bills of exchange" that merchant banks in nineteenth-century Britain lent against while merchants waited to get their cargo in.
Now, while I wait for my customer to show up, the bank has an asset on its balance sheet: its loan to me. It has quite a few of these loans, some of them good, some of them bad, and maturing at all kinds of different durations. So there are all kinds of risks to the overall balance sheet of the bank. The bank manages risk by using its own borrowing from the "money market" – that is the market for actual money i.e. everything from your bank deposit to complex overnight repurchasing agreements that we won't get into here – matches the money it lends. So, in turn, the bank also relies on the liquidity of the money market to fund the capital market asset it owns – its loan to me.
Clever bankers can sit around and make risk models of their loans and liabilities and do pretty well. However, even cleverer bankers can come up with a better solution that lets them run their balance sheet leaner by selling off these risks to other investors. In this sale, the bank gets an immediate return while the investors take various pieces of the money the bank gets paid on its loans over time. This is called securitization. It is an extremely complex process but let's use some relatively easy examples to get a grasp at it. First, the bank will take its loans and package them together into a single bond. This will combine its loan to me and my good credit with some other loans which have worse credit to mix together these heterogeneous risks into one single risk. It can then even carve those risks up further into "tranches" of better and worse slices of the bond. Even more precisely, they can carve out specific kinds of risks and sell them to investors. So for example, I can sell the default risk – the risk that a string of defaults will mean there will be missed payments on the bond – to an insurer who will get fees from an investor for insuring against this possibility but will then pay the investor upon default. This lets the insurer have an investment that it gets cash returns on and it gives the speculative investor on the other side a chance at a big win if the default happens. This is called a credit default swap (CDS). The bank, meanwhile, no longer has to care about the chances of me defaulting. It literally sold off that risk to the other players.
These instruments are called "derivatives" because they are derived from another securitized instrument. And if everything runs smoothly, chopping up risks that way greatly reduces the cost of borrowing to each individual borrower. But what is critical here is that all these financial products are dependent on cash flows getting to the buyers of the bond and its derivatives from loan payers, "just in time." In normal times, things happen some of these will go south. No big deal. There is a vast money market that all these players can go to borrow from to overcome snags in payment and to then reposition themselves. However, things can go wrong. What if the snag becomes big enough that people can't make rational risk calculations anymore. Then we are entering a world of uncertainty and, as John Maynard Keynes explained his magnum opus, that triggers a run from relatively illiquid assets like loans to the most liquid asset – cash. The worse the uncertainty, the more cash-like and "safe" the asset being held becomes perceived as less cash-like. Suddenly, even relatively low-risk investments (like my trade finance loan) find themselves unable to be refinanced by borrowing from the money market against their value.
This rush to get cash is called a bank run. In traditional banking, that means people lining up to pull out their deposits. In the modern banking system where banks use securitization, that means failures of complex money market instruments outside the banking system. This is what happened in 2008. The whole merry-go-round stops. Coming back to my example, my business can't pay its supplier anymore because it can't get a loan at a reasonable rate, and my perfectly solvent, well-operating company has to close and let go of its employees. That's how we get recessions and worse, depressions!
Bank runs are a beloved study for game theorists because it is collectively irrational for everyone to go for cash at once. If everyone holds on the bank will be able to roll over its debts and live to fight another day after some hiccups in payments. However, if you do not enter a bank run early, you might be the one holding the bag because you will find the bank can no longer pay back your deposit. Because of how devastating bank runs are for the economy, we have developed a lot of institutions to prevent them in the traditional banking system. Think FDIC deposit insurance, and most interestingly here loans from the central bank which acts as a lender of last resort. Perry Mehrling argues that with securitization, the US Federal Reserve had to step out of its traditional role of lender of last resort to banks and restore liquidity to the entire global financing ecosystem by becoming "the dealer of last resort." In other words, it became the final buyer of financial products from the wide array of actors and thereby provided liquidity to the entire financing chain thereby stemming the bank run on what he terms "the shadow banking" system.
What is happening to supply chains has a lot in common with what happens in the financial system. Since the 1980s, most major companies have implemented "just in time" (JIT) supply chains. Just-in-time production originated in Japan, and specifically at Toyota. Japan was a natural breeding ground for just-in-time production. A small chain of islands with few resources and a small population, Japanese industry traditionally emphasized a "Taylorist" approach to manufacturing that maximized efficiency through the close management of personnel in contrast to the Fordist approach of their competitors – most prominently the United States – which emphasized achieving high output through capital intensity. "
Just in time" approaches to supply chain management took off after the Second World War when Japanese industries began looking for a competitive edge against larger, richer, and more advanced American rivals. At Toyota, managers developed a system where inventory was kept to a minimum and highly skilled, motivated workers would respond at a moment's notice to new supplies incoming.
Just-in-time contrasted with American car makers' tendency to build up large inventories of supplies and products before moving on to making the next model year due to uncertainty, especially in labor relations. Tensions between the UAW and Detroit's big automakers meant that labor conflict was rampant and could shut down production at any time. Best be safe than sorry.
The saying went "Japanese firms just-in-time, American firms work just-in-case." Just-in-time stormed American industries as a response to their loss of competitiveness to foreign competition. Lower inventory costs meant Japanese automakers could carve out higher profits by keeping up a steady production rhythm without the huge, expensive fixed capital investments of the American auto giants.
It came along with two other phenomena. The breaking of the power of labor and the Volcker shock. Both contributed to the creation of a low inflation regime and to greater shareholder power. By minimizing costs, firms could begin to keep prices low and profit high. Of course, this required very pliant labor. Remember, the Toyota model of just-in-time manufacturing was about using friendly labor-management relations to compete against rivals who had advantages in deploying capital. The friendliest kind of labor-management relationship from the point of view of management is near-total victory. As time went on, just in time turned from a competitive manufacturing technique used in the auto industry to a general aversion to having large capital investments and the emphasis on "leanness" through low inventories and high labor content. No wonder then, labor productivity has been slowing! However, the pandemic upended this relationship by giving labor a bit more power. In a great Twitter thread, a line worker explains just how this works in real life and how increased labor power due to a tighter labor market has disrupted the whole system.
So Peter Atwater is right. Just-in-time has a lot in common with "financialization." Like the deregulation of financial markets, just-in-time depends on creating a lot of liquidity for physical things. Instead of warehousing inventories of loans, banks securitize to run leaner just as manufacturers and retailers do now. A larger ecosystem of actors moves both cash and material to where it is needed right on time, usually with very few problems. And there are a lot of advantages to this. Both systems lower the price of things – credit and goods – thereby reducing inflationary pressures. When things work well, no one has to think about the guts of the whole thing.
But things don't always work well. What we are seeing might be something of a bank run on the just-in-time supply chain. Some of this is just a "growing pain" related to the changing consumption patterns under COVID. The United States did a great job sustaining the ability of American households to weather an apocalyptic storm by replacing income through transfers. What could have been an event that rivaled the great depression was contained to a one-month-long recession. With that help, consumption patterns shifted from services, throttled by a global pandemic, to goods that you can use at home. At the same time, COVID led to the closing of plants around the world affecting the supply of those exact same goods. So the system was already under stress for over a year leading into the summer of 2021. It was buckling under a perfect storm of a demand schedule change and supply disruption that sucked the liquidity out of the system.
What is happening in the late summer and fall of 2021 might be more interesting. According to some analysts – and I must emphasize this is somewhat of a conjecture – one of the problems we are seeing in the ports is that companies were spooked by the last year of supply crunches and began to build up inventories for the Christmas season far earlier. This has caused a competitive run for building up inventories. In money and banking terms, for the last year, there was very little liquidity in supply chains but they struggled along because the players were still coordinating. With Christmas approaching, firms began to panic and ran on the system. Essentially, what we have is a bank run on the supply chain. Hyman Minsky famously argued that "stability is destabilizing" in regard to monetary systems. The same might be true for supply chains that look so smooth and stable in normal times that we forgot about them and their day-to-day operations. Until they are not!
And what makes it worse, we don't have the institutions to manage a bank run on the supply chain. Money is something special. First of all, it can be created out of thin air by the very groups that need it most – banks. Second, since the 19th century, governments have increasingly understood that the smooth functioning of supply chains for money is a public good. The Bank of England moved from being a financing bank for the government to a banker's bank that sustained the financial system in times of trouble by "lending freely, against good collateral at a penalty rate." But production has been a domain for the private market with little government direction – especially recently. This is ironic since production markets are actually fairly unstable. Capitalists are very good at distributing consumer goods but they aren't always good at sustaining the right kind of investment needed for them to be priced at the right level. This is the place of what my friend Alex Williams called "Kaleckian and Harrodian mysteries" and I won't go there right now. But to make matters very simple, we do not have a central bank - a lender of last resort - for physical stuff.
However, that doesn't mean we shouldn't. There are many ideas out there that could help smooth supply chain issues by building resiliency in the production process. I outline some of them in an article for Noema. But to make the point even sharper than I did in that article, we need not only action but we need institutions. Central banks work because they are, to a degree, independent and perpetual. They can intervene in the private market without much delay and have massive staffs that collect data on them and interact with them practically every day. We lack such institutions for the real economy. If this sounds a bit like calling for economic planning, then you are right. Planning might evoke the Soviet Union and certainly, as someone who started their career as a historian of the Soviet planning system, we don't want to repeat that. But practically all industrialized societies have some kind of industrial planning policy. "Indicative planning" was not only normal but very successful. Its downfall came not from specific failures as much from an inability to create the coalitions necessary to innovate them for an interdependent world. That however doesn't mean we can't begin the process of starting that process of innovation again. I'll leave that for another post...