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The Supply Chain Crisis: How We Got Here

Summary:
Advanced economies are in the throes of what can, without exaggeration, be called a global supply chain crisis. Car makers unable to meet demand and even in many cases produce full featured cars due to chip shortages. Shipping rates spiking then collapsing due to a lack of containers and truckers at ports. Petrol and food shortages in the UK. Warnings even in the US to buy Christmas gifts now because they might not be available later. And there are also increasing reports of shortfalls of drugs and medical supplies. The original sin is optimizing businesses for efficiency at the expense of having slack to contend with unexpected developments….anything from the factory of a key supplier blowing up to the macro-level disruption of Covid. More buffers means more resilience. Having them

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Advanced economies are in the throes of what can, without exaggeration, be called a global supply chain crisis. Car makers unable to meet demand and even in many cases produce full featured cars due to chip shortages. Shipping rates spiking then collapsing due to a lack of containers and truckers at ports. Petrol and food shortages in the UK. Warnings even in the US to buy Christmas gifts now because they might not be available later. And there are also increasing reports of shortfalls of drugs and medical supplies.

The original sin is optimizing businesses for efficiency at the expense of having slack to contend with unexpected developments….anything from the factory of a key supplier blowing up to the macro-level disruption of Covid. More buffers means more resilience. Having them doesn’t mean all bad outcomes would have prevented. But we would have had fewer deficits and many would have resolved faster. In other words, companies around the world set out to increase collective tail risk in pursuit of profit.

How did this result come about? A lot of commentators want to point to mechanisms like globalization or consolidation, as opposed to why did executives decide to pursue those fads?

I went to Harvard Business School from 1979 to 1981. Managing global supply chains, outsourcing and offshoring were not yet A Thing. About 40% of the class had worked in manufacturing before coming to HBS and at least that many had undergraduate degrees in engineering. We had no Wall Street analysts (those two-year programs were just getting started). In my nearly 90 person section, there were only two bankers. Both had applied to HBS not long after completing their commercial banks’ two year credit officer program.

So having come in to the world of commerce at the tail end of the old regime, here are the management practices that produced companies with sprawling supply chains as important parts of their operations, as opposed to old industrial model of internal integration. I’ll try to lay these developments in rough time order, but they obviously overlap.

Just in time manufacturing. In the later 1970s, the business press regularly described how Japanese and German manufacturers were eating the lunch of their sclerotic American competitors. Carmakers were Exhibit 1. The experts conceded that the foreign insurgents did have the good fortune to be operating out of newer plants, but a big part of the problem was outdated practices and bad relations with workers 1 (the success of the NUMMI, where Toyota took over the management of a plant with a reputed-to-be-terrible workforce and got it performing at over the median for quality standards for Toyota operations proved the problem was much more “bad management” than “bad unions.”

Japanese “just in time” manufacturing amounted to turning a problem into a virtue. The Japanese car-makers of the 1960s couldn’t afford to carry big inventories, nor was it prudent for them to invest in larger facilities just to have inventory on site. The Japanese and Germans made deep inroads into the US market in the strong dollar period of the early 1980s, after Volcker relented in 1892 on this high interest rates, but they never gave it back when the dollar normalized.2 Japanese methods, most of all “just in time” management, were widely adopted in the West.

Outsourcing. Electronic Data Systems pioneered in outsourcing before it was even called outsourcing, acting as a “facilities manager”for big corporate and government IT departments. EDS would often buy the data center, taking on the employees, and run the operation for a fee. Even though companies had been selectively outsourcing before (for instance, the legal department hiring outside law firms for litigation or other specialized or one-off work), the EDS approach was more radical, in essence taking over an entire, usually pretty large, and usually mission critical corporate function and entrusting it to outsiders. The fact that EDS was competent and much better at optimizing the use of then very price IBM computers than their customers were meant the deals were win-wins. I don’t recall ever reading of an EDS deal going bad; one assumes they either didn’t or EDS would do what it took to make amends.

GE envy/imitation. During the Jack Welch era, the business press and management gurus held up GE a paragon of American manufacturing.3 One of the much-touted GE principles was not to be in a market unless they could be number one or number two. This rule became the fodder for many management consultant studies urging either divestitures or acquisitions to achieved the supposedly magical market position (never mind that market definitions are very fuzzy). Even though consolidation plays are hard to execute and seldom succeed (every study ever done has found that between 2/3 and 3/4 of all acquisitions fail, as in do not deliver value to the buyer), unless a deal was obvious misconceived, Wall Street would generally give a prospective buyer’s stock a pop.

In other words, the fad for consolidations can’t be attributed to LBO artists, or at least not directly. They were making financial plays in the 1980s, taking over undervalued, overly diversified conglomerates and selling the parts for more than the price of the former whole.

However, weak management sought to better defend their castles by building higher walls and deeper moats in the form of poison pills and “golden parachutes” for the executives, in theory to make taking over a company prohibitively expensive. In practice, they served to grease more deals, since the management of the seller got big payoffs, and the management of the buyer could expect raises for now running a bigger and more complicated operation.

In banking, the regulators drove consolidation. Conventional wisdom was that 16,000 banks (the number as of 1988) was way too many, and Canada needed only 5, so the US could and should shrink the number a ton. Somehow they didn’t read any of the studies that showed that banking has a negative cost curve, that banks show higher costs per dollar of assets once they pass a not very high threshold. In other words, if a bank bought another bank and cut costs in the consolidation, they could have reduced costs to the same degree if not more as separate entities.

Concentrated supply networks. By the late 1980s, if not earlier, another managerial fad for manufacturers was to greatly thin their supplier networks. The claim was that having fewer suppliers would allow the buyer to invest in their supplier and forge deeper relationships. That never seemed to be the operative truth. Someone who becomes a large, as in overly large, customer to a business can push them around. I always assumed this fashion was primarily about extracting better prices or valuable non-price terms.

Offshoring. For global manufacturers, this was hardly a new idea. Automakers had plants in foreign markets largely to serve customers in those markets. However, Mexican maquiladoras quickly became popular among American auto and parts makers and Japanese selling into the US market. From Wikipedia:

Maquiladoras date back to 1964, when the Mexican government introduced the Programa de Industrialización Fronteriza (‘Border Industrialization Program’)….

In 1989, the federal government put in place specific procedures and requirements for maquilas under the “Decree for Development and Operation of the Maquiladora Industry”.[8] After the Mexican debt crisis of 1980 (see Latin American debt crisis), the economy liberalized and foreign investment increased. Factory jobs began to leave central Mexico, and workers followed the jobs from central Mexico to the maquilas in the north and on the border.[9] In 1985, maquiladoras overtook tourism as the largest source of foreign exchange, and since 1996 they have been the second largest industry in Mexico behind the petroleum industry.

Although the plural of anecdote is not data, in 1984 I ran the numbers on a potential acquisition of a Mexican business by a US aircraft maker. The short version is the deal made no sense (buyer and seller were 10X apart and when I modeled their difference in positions, tax, union relation, and FX/country risk, the difference made sense). Needless to say, this transaction would not have benefitted from maquiladora treatment. But I did visit Monterey (the capital of maquiladora-land) and at least on a drive-through, it consisted of impressively big heaps of raw materials and awfully rough-shod, small footprint plants. It looked like the manufacture as of then was on the order of metal-bending and assembly.

Back to Wikipedia:

With the introduction of NAFTA in 1994, Northern Mexico became an export processing zone. This allowed multinational corporations from the US to produce products cheaply. Corporations could use a maquila to import materials and produce a good more cheaply than in the US by paying Mexican laborers to lower wages and paying less money in duties. Mexicans work for approximately one-sixth of the U.S. hourly rate. During the five years before NAFTA, maquila employment had grown at a rate of 47%; this figure increased to 86% in the next five years. The number of factories also increased dramatically. Between 1989 and 1994, 564 new plants opened; in the five years following, 1460 plants opened.

Wikipedia contends:

However, the maquiladora growth is largely attributable to growth in US demand and devaluation of the peso, not NAFTA itself.

Help me. The “US demand” cannot be tidily picked apart from NAFTA. However, Mexico did have a currency crisis in early 1995.

Nevertheless, the motivations for outsourcing IMHO are not properly understood. In the auto business, which is typical of a lot of US industry, direct factory labor cost is 11% to 13% of product cost. The offsets against that are greater supervisory and coordination costs (longer shipping times and financing costs, and with that, greater risk of being stuck with inventories related to products that aren’t selling well) and just plain old screw ups due to having more moving parts.

In other words, outsourcing is better understood as a transfer from factory labor to managers and executives, at the cost of greater operational risk.

This cynical take is confirmed over the years by many executives telling me privately that the case in their company for outsourcing was weak but management went ahead because reasons, the most important often being they knew Wall Street would bump the stock price up.4

Misrule by Wall Street. In the Stone Age when I attended business school, even that bastion of capitalism hewed to the belief that companies served many constituencies, including (gasp) communities, and one of the big jobs of management was to navigate sometimes conflicting demands.

By the end of the 1980s, the notion that public companies have a sole duty to serve shareholders, a theory with no legal foundation but was successfully promoted by Milton Friedman and his followers, had become well enough accepted so as to restructure executive pay around stock price performance, and not business fundamentals.

Wall Street was remarkably forgiving of executive efforts to ‘splain away risk blowups, including the sort that resulted from over-optimizing for efficiency. It became almost a joke to seem companies every five years or so engage in a writeoff purge, pretend that all that Bad Stuff was part of Discontinued Operations and thus had nothing to do with the company as of now. I can’t recall anyone serious ever suggesting that the implication of the loss dump was the prior year earnings had been overstated, and where were the fines and sanctions for accounting/securities fraud?

Planned obsolescence. Goods companies learned Silicon Valley’s evil lesson: that software can be deployed to shorten product lives. I happily drive a 2003 Buick with fads practices to the miss, but the overarching point is hopefully evident: executive practices created the fragile supply chain mess. Deregulation and favorable trade deals greased the wheels, but they came about because businessmen, pundits, the press and pols were all pumping for them to advance supposedly desirable ends, and not as ends of their own.
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1 The success of the NUMMI joint venture, where Toyota took over the management of a plant with a reputed-to-be-terrible workforce and got it performing at over the median for quality standards for Toyota operations proved the American problem was much more “bad management” than “bad unions.”

2 Many accounts back in the day described how Detroit was in denial as well as incapable. Executives drove company cars that were babied every day by company mechanics, so they had no idea how they actually performed. They also failed to embrace small cars, both due to projecting their own preferences (in snowy areas, a heavy car is a plus), and profit (they thought they’d be cannibalizing sales of bigger, pricier cars, but better they cannibalize those sales than a competitor).

3 A friend who turned around and still runs a successful mid-sized US manufacturer who worked at GE under Reg Jones and then Welch hotly disputes the popular myth. She says Jones was the architect of GE’s success, that Welch mainly but slowly ran it into the ground.

4 This is not to say that outsourcing never made sense but that it was often adopted when there wasn’t much in the way of good reasons.

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