Business & Economics

Supply Chains Are Suffering From a Demand Shock

Governments can help by scrapping costly regulations, but the bigger fear is that Washington will make things worse by pushing Made in the U.S.A. policies

Published by
Phil Levy and Christine McDaniel
  1. I, Supply Chain
  2. Supply Chains Are Suffering From a Demand Shock
  3. To Explain What’s Wrong with the Supply Chain, Start with the Labor Shortage

How did supply chains get so out of sync? When will the situation get back to normal? Should countries cut ties to global supply chains and produce more at home? Christine McDaniel, a senior research fellow at the Mercatus Center at George Mason University who studies trade, globalization and property rights, delved into these issues with Phil Levy, chief economist at San Francisco-based freight logistics company Flexport.

CHRISTINE MCDANIEL: Phil, after a distinguished career in government, you are now chief economist at Flexport. What is Flexport? How does it fit into the supply chain?

PHIL LEVY: Thanks, Christine. Flexport is a technology company for global logistics and one of the largest providers of logistics services. That’s freight forwarding, supply chain visibility, customs and more.

MCDANIEL: For the non-supply chain expert, an analogy might be useful here. For instance, there are the ocean routes, ships and freight forwarders. They move goods around the world. Is there an analogy with airlines? Like, is a freight forwarder a travel agent?

LEVY: For freight forwarding, that’s fair. But as with travel agents, there are degrees. Some can just get you that ticket you want. Others can really try to understand what you’re looking for in travel and design something. We cover that latter spectrum while also providing a tech platform to direct it all.

MCDANIEL: From where you sit at Flexport, what is the problem? What did you see at the beginning of the pandemic, and what are you seeing now?

LEVY: Logistics is a capital-intensive industry with highly seasonal demand patterns. Given that it’s expensive to build capacity, we generally see such systems built up to just barely be able to handle peak loads. Think of airports straining to handle the number of flyers on the day before Thanksgiving.

What we have seen during the pandemic is a surge in demand for goods that has pushed us beyond traditional peak load and held us there for well over a year. This has put the system under enormous strain. So, the slow deliveries, containers stacked high, ships waiting at anchor outside LA-Long Beach—these are just symptoms of this strain. And these are the ones that receive a lot of attention.

Blame Demand for the Problem

MCDANIEL: What is the problem? Is it just one thing or many things?

LEVY: The extraordinary demand for goods is at the core of the problem, but even with normal levels of demand, there would have been issues with illness and quarantine among crews and logistics workers, as well as with things like flight cancellations. As one example, roughly 50% of pre-pandemic air cargo flew in the bellies of passenger jets. When people cut back on international air travel, those flights were canceled, and the capacity disappeared. So, there are multiple problems, with high demand for goods preeminent among them.

MCDANIEL: Why are some common toys on children’s Christmas lists not available right now? Recently, I went to the Lego website, and many of the sets were either on back order or out of stock completely. What are you seeing there, and how long do you think it will last?

LEVY: A very common problem that businesses need to tackle is how to approach inventory. If you have too much inventory, it is costly to manage and store, plus there’s an expensive lag between when you buy your goods and when you make your sales. If you have too little inventory, you risk running out and having empty shelves, or online “out of stock” notices.

Many companies had found they could do better by keeping relatively lean inventories, so long as it was possible to restock quickly through well-functioning supply chains. The recent difficulties have thrown off those calculations and left some items out of stock. The challenge is that switching back to a higher-inventory approach at this stage would require lots of shipments, and that’s what’s tough to do.

This problem will last until we’re able to get supply chains functioning well again.

Don’t Expect a Quick Resolution

MCDANIEL: What is the solution? And how long will it take to get sorted out?

LEVY: If the core problem is highly elevated demand, that’s also where we have to look for a solution. It is possible to operate the supply chain more efficiently, and there are positive efforts underway to do just that. But given elevated demand, they’re unlikely to be sufficient.

So when will demand back off? There are several things that could lead to this:

  • A pullback in incomes.
  • A pullback in the propensity to spend out of income.
  • A pullback in the propensity for direct spending toward goods rather than services.

We see no signs of any of these happening at the moment. Government fiscal or monetary measures could affect incomes and the propensity to spend now rather than later, but households saved a fair amount of the transfers they received during the pandemic. And it would seem that an improved health situation would be a necessary, but maybe not sufficient, condition for dampening the ardor for goods.

Note that when demand drops, there will be some ground to make up. If demand drops below system capacity, that will start to allow the backlog of containers to be cleared. There may also be a backlog of inventories to be rebuilt. Thus, to really get back to normal, we need demand to be below capacity for an extended period. That also requires that we avoid further interruptions, such as port closures or slowdowns through labor difficulties at ports.

At Flexport, we think it is unlikely that the situation will clear much before early 2023.

Cutting Red Tape Would Help

MCDANIEL: Is this going to fix itself? What is the right role for government? What is the wrong role for government?

LEVY: Shipping and trucking are highly regulated industries. Ports are often controlled by local governments. There are laws and regulations governing the roads near ports and the areas nearby, where containers might be parked. In all of this, there is very likely room for improvement. In global rankings of port efficiency, U.S. ports rarely come out on top, suggesting there is work to be done.

It is important to avoid regulation for its own sake, to look like one is taking action. For example, a mandate to make containers available to U.S. agricultural exporters at the old, favorable rates would be counterproductive.

MCDANIEL: As I read through [President Biden’s] Build Back Better plan, I see a big focus on American-made components, American-made steel, etc. How is this going to affect the supply chain?

LEVY: There is a misconception that the supply chain crisis demonstrates an excessive reliance on trade. Some of the most salient supply-chain failure episodes of the pandemic were domestic—such as the shortage of toilet paper early on. In fact, one of the solutions to that initial shortage was to import toilet paper! [The problem was switching from making large rolls for office buildings to small rolls for home use].

Moving Production Home Isn’t the Answer

LEVY: There has been academic research that has found that “renationalization” of supply chains does not generally make countries more resilient.

MCDANIEL: Ah! I love that paper! Michigan, Yale and UT-Austin—a great group there. The authors look at the role of global supply chains in the impact of the COVID-19 pandemic for 64 countries. They find that when you sever your ties to global supply chains and try to rely more on domestic inputs, you naturally become a lot more affected by domestic lockdowns and events. So, it works only if the domestic economy has less stringent lockdowns than its trading partners. Not to mention that the costs of those inputs are much higher without trade. So, trade can actually insulate a country in a pandemic with lockdowns happening at different times across the world—much like we are seeing now.

MCDANIEL: What would you like to see the federal government doing more of? State governments? What would you like to see them doing less of?

LEVY: This is an ongoing subject of discussion. We can and do point out areas where we think we see inefficiencies. But supply chain inefficiency is not the core of this story—it is an extraordinary, prolonged surge in the demand for goods. We should not fool ourselves into thinking that the flip of a switch will let us easily handle that surge.

MCDANIEL: So, in the meantime, policymakers in Washington should avoid calls for more reliance on domestic inputs and restricting trade. Local governments actually may have a greater role to play here by addressing the costly regulations in the shipping and trucking industry and even the laws and regulations that govern the roads around the ports. Would that be a fair takeaway?

LEVY: Yes, that’s right.

MCDANIEL: Thank you for taking the time on this, Phil. And have a wonderful holiday!

LEVY: Thank you, Christine. You, too!

Phil Levy and Christine McDaniel

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