The global supply chain is broken and the falacy of "just-in-time" inventory control has revealed itself. Welcome to the Recession of 2011. Historians will date the cause of this to the earthquake and tsunami in Japan a couple of weeks ago but it will be dated by the economists as starting in the April-June quarter of 2011.
When one piece of a global supply chain goes down, it takes down the rest of the chain and it is all because of a really stupid idea called "just-in-time" inventory, a concept trumpeted by neoclassical economists as being the ultimate in allocative efficiency but which should cause them to go back and reevaluate their theories in light of this calamity.
The problem is that neoclassical economics has no proper conception of time. Oh, for certain, there is a conception of time but it is a logical time that concerns itself with sequencing rather than the temporal distance between sequences. It is one that allows for the "short-run" and the "long-run" and which treats technology as a non-stochastic process that marches on from one "period" to the next without defining how long a period actually is.
It is a theory that explains how competitive industries (perfectly or otherwise) operate and how monopolies operate but cannot explain how competitive industries turn into monopolies or vice versa.
Yet the world is wrought with stochastic processes, such as the earthquake in Japan and those stochastic processes end up wrecking havoc with the models. After all, whenever you introduce a random shock into a model, it is important to determine how long that shock will last, the 'persistence' of it, if you will.
The problem is that since random shocks are just that - random - companies that use economic theory to help decide on how to maximize profit tend to ignore them. Yet the random shock may reverb for a longer period of time with some decisions than with others. This earthquake is just one such example.
By attempting to excise all "inefficiency" from the system, we create inefficiency. Engineers fundamentally understand that, as do systems designers. Neoclassical economists often do not. Redundancy in engineering is not inefficient; it is a mechanism to reduce overall failure. Tolerance is not efficient; it is a mechanism to ensure reliability. Yet the global supply chain exhibits neither of these two important characteristics and it is especially problematic when we are dealing with high-value parts that take a long time to fabricate (in some cases, months--and even a brief interruption in power can send you back to step 1).
The irony is that many of the actual plants where these parts are made have redundancy and tolerance build in to them -- it is the global supply chain itself that lacks these characteristics. That is because the plants were build by engineers, while the global supply chain was created by neoclassical economists.
When we ignore redundancy and tolerance, we end up maximizing returns in the short-period, but end up sacrificing the long-run. Of course, as Keynes said, in the long-run, we are all dead. However, I would add that we all live in the long-run, not the short-run and that should be the lesson that the great Japan earthquake and tsunami of 2011 teaches us.
Unfortunately, what it will take for us to learn is another recession and that is exactly what will happen. This will be the first "made in Japan" global recession for two critical reasons.
First, all because that country is the hub of activity for the world's high-tech needs and because everything is high-tech these days. Automobiles will be the first to drop in terms of their productive capacity but the ramifications will be felt in other industries as well: computers, video game consoles, televisions, kitchen appliances--if it has a Japanese part in it, it is affected.
Second, and perhaps more importantly for the US, Japan's need for funds to rebuild will cause pressure on US interest rates as Japanese savers stop investing in our bonds and start repatriating funds home. It will also cause a large exodus by insurance companies from various investments as they must liquidate positions to pay claims. To the extent that these investments are in US treasuries, it will also cause a rise in US interest rates.
Third, although US construction companies are salivating at the prospect of rebuiling, much of the expenditure will be in Japan and, to the extent that they must delay or scrap building projects in the United States, this activity will lower construction spending in this country.
We have met the enemy -- and it is us. Just as I urged back in 1995 when the Great Hanshin earthquake hit Kobe and first exposed cracks in the global supply chain, I am going to urge this again: we must build in redundancy and tolerance into our supply chains before it is too late.
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