Buttonwood

The fragility of perfection

When supply chains go wrong

ONLY connect. The words of the novelist E. M. Forster sum up globalisation. An international company may buy its software from California, send its data to India, purchase its electronic equipment from China and staff its canteen with workers from eastern Europe.

The theory dates back to the economist Adam Smith and the principle of specialisation. The productivity of a pin factory can be improved if production is broken down into its component parts. Similarly, companies (and countries) should specialise in fields where they have a comparative advantage. The revenues can be used to buy the other goods and services the company needs, at a cheaper cost than it could manage in-house.

But specialisation depends on one critical factor: the reliability of supply. A bicycle maker may turn out fantastic handlebars but if his supplier produces wonky wheels (or no wheels at all, because of a strike or other disruption), he will not sell a single bike.

David Bowers of Absolute Strategy Research, a consultancy, thinks this makes the global industrial system vulnerable. He draws an analogy with the boom in structured finance, which saw banks distribute risk to specialist vehicles like conduits. They worried less about the creditworthiness of borrowers as a consequence. But when the subprime crisis broke, the risks ended up back on the banks' balance sheets after all. “Just as the banks mispriced credit risk, so companies have misjudged strategic risk,” he says.

In particular, Mr Bowers thinks that loose monetary policy in America is leading, via the currency markets, to inflation in developing countries. That may end up undermining the cost advantages of outsourcing, as the prices of raw materials and labour rise.

In the long run, disruption to supply chains may be a huge strategic risk. Energy is one obvious area. Britain has just shown how a two-day strike at a Scottish refinery affected deliveries to petrol stations and, more seriously, disrupted oil output. “Just-in-time” inventory levels normally create savings—unless suppliers do not deliver just in time, when they extract a huge cost. American companies such as Mattel, a toy company, have also discovered that their brand names can be tainted if goods made by overseas suppliers (particularly from China) turn out to be bad for consumers' health.

The problem could be called the “fragility of perfection”. The greater the interdependence within the system, the wider the effects of disruption in one part of it. In finance the “originate and distribute” model of bank lending may have dispersed risk, but it also meant that a problem in the American housing market damaged banks all over the world. Similarly, a supply disruption in China, which might have been ignored ten years ago, could prove to be catastrophic in many countries today.

Globalisation has been disrupted before, of course. John Maynard Keynes wrote that, before the first world war, “the inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep.”

In a remarkably short time afterwards, Britain was attempting to blockade products to Germany and vice versa; the country's dependence on imported raw materials was one of its greatest weaknesses. Even without any sign of war, recent months have seen a number of countries either ban, or attempt to tax, food exports in an attempt to safeguard supplies for the local population.

The nationalisation of energy resources is also proving to be a global problem, given that it has dissuaded foreign investors from helping to develop new sources of supply. High energy prices also lead to potential political conflicts. European nations worry about their dependency on Russian gas, particularly in the light of previous pipeline closures. And China's desire to secure energy supplies has led it to do deals with governments that western powers consider unsavoury.

Meanwhile, displays of nationalism or religious solidarity have led to consumer boycotts in the Middle East and Asia. Such protests could conceivably turn into import bans.

Companies have made enormous gains through globalisation, which in many countries has meant that profits have risen as a share of GDP. But those benefits are potentially fragile. If they start to crack, the resulting financial and economic losses could be far greater than anything dished out by the subprime-mortgage crisis.