Supply Chain Risk: Is Government the Solution?

According to Kaygisiz (2019), active pharmaceutical ingredients (APIs) intended for the U.S. market are overwhelmingly manufactured outside the U.S. with India and China supplying 26% and 18%, respectively.  In addition, India is currently supplying 21% of prescription drugs in final dosage forms (FDFs) that the U.S. market consumes. This reliance on overseas production caused tremendous concern in the spring of 2020 when some API plants in China shut down for several weeks due to the coronavirus pandemic, and India restricted the export of some FDFs in anticipation of increased domestic demand for these drugs.
 
Until the 1980s, the U.S. was the world’s leading producer of rare-earth metals, but now has only one producing mine and no processing plants. China, on the other hand, has become the biggest exporter of rare-earths with its comparative advantages in cheap labor and lax environmental regulations.  In 2019, the U.S. imported 80% of its rare-earth elements from China (Subin 2021).  In September 2020, former President Donald Trump signed an executive order declaring a national emergency in the mining industry and authorizing the use of the Defense Production Act to boost domestic production of rare-earth minerals and reduce U.S. dependence on China.
 
In March 2021, the container ship Ever Given got stuck in the Suez Canal amid a sandstorm and blocked one of the world’s busiest waterways for 6 days. It has been estimated that the incident cost the Egyptian government $90 million in lost toll revenue and held up as much as $10 billion of cargo per day from moving through the canal, incurring costs to consumers and businesses around the world (Rich et al. 2021).
 
As many countries are expected to have robust economic growth post Covid-19, a world-wide shortage in computer chips is currently under way. The semiconductor market was disrupted by a combination of demand and supply factors, including a plant fire in Japan, a drought in Taiwan (a major player in the semiconductor industry), and stockpiling of chips by high-tech companies in China fearing U.S. sanctions (Jeong and Strumph 2021).
 
All of the above examples highlight a vulnerability of our interconnected world, namely the supply chain risk due to natural disasters, industrial accidents, or geopolitical conflicts. Supply chain risk has become more prominent over time as the world economy gets increasingly more integrated and as average supply chains grow longer.
 
An important question regarding supply chain risk is: Is government the solution? The question becomes even more relevant after the new administration took the reins, since President Biden and his advisers have big, expensive plans for the country – including the $1.9 trillion American Rescue Plan, the $2.3 trillion American Jobs Plan (the infrastructure plan), and the $1.8 trillion American Families Plan – that expand the reach of the federal government into the economy well beyond elderly entitlements, health care and poverty relief.   
 
Indeed, President Biden has earmarked $50 billion to boost America’s semiconductor production as part of his infrastructure plan. In addition, the Biden administration is considering subjecting various supply chains – especially those for semiconductors, critical minerals, high capacity batteries, and active pharmaceutical ingredients – to “stress tests” of hypothetical scenarios.
 
There are a few tools that the government can use to mitigate the supply chain risk with respect to a key commodity: subsidizing (or directly investing in) domestic production of the commodity, requiring companies that use the commodity as a production input to maintain a critical inventory of it, and operating a strategic reserve so that the government can draw down the reserve when the price is high and fill up the reserve when the price is low. 
 
Governments’ involvement in protecting against the supply chain risk inevitably raises the question of why private businesses cannot be relied upon to deal with such risk.  Why wouldn’t the firms and consumers operating in an environment of free market and free trade have already taken any supply chain risk into account and adequately dealt with it? Why wouldn’t the firms and consumers, in their decision on the length of a relevant supply chain, optimally balance the benefits from trade and the costs of the supply chain risk?
 
The U.S. established the strategic petroleum reserve in 1975 after oil supplies were disrupted during the 1973–1974 oil embargo.  The idea was to mitigate future oil supply risk. There is evidence that this policy is ineffective and costly. Kilian and Zhou (2020) find only modest effects on oil prices of past releases from the US Strategic Petroleum Reserve (SPR), whereas Stevens and Zhang (2021) find asymmetric impacts of the SPR on oil prices: unanticipated releases from the SPR have no measurable impact on oil prices, but unanticipated purchases for the SPR raise oil prices. Taken together, this empirical evidence suggests that the SPR has had a relatively insignificant price-stabilization role.  More troublesome, a recent report by the U.S. Government Accountability Office points out that the Department of Energy has not yet identified the optimal size of the SPR (GAO 2018), casting doubt on the rationale for having the SPR in the first place.
 
According to Taylor and Van Doren (2005), while the insurance benefits from the SPR seem to be minimal, the insurance premium is quite high.  They estimated that the SPR has cost taxpayers $64.64–$79.58 per barrel of oil deposited (in 2004 dollars). To put this in perspective, the annual average world oil prices from 1949 to 2004, again in 2004 dollars, were generally much lower than even the lower bound of this range.
 
In fact, the private oil and gas industry has maintained a considerable inventory of crude oil and petroleum products. The following table, based on data from U.S. Energy Information Administration (2021), gives a private/public sector comparison, although one in which the private sector choices are already altered by the existence of public sector reserves. As seen in the table, the total amount of crude oil and petroleum products stored in private reserves was about twice the amount in the SPR as of June 25. So, the private oil and gas sector does establish a cushion against a sudden supply disruption, and the cushion would likely become thicker without the SPR.

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As an important government policy aimed at mitigating a major supply chain risk, the SPR is ineffective and costly, and it is unnecessary given the private alternative. Generally speaking, the government lacks the information and incentive that the private sector possesses in dealing with most supply chain risks. For example, suppose that, in response to the risk in foreign supply of a certain type of computer chips, the federal government requires companies using these chips to have a minimum inventory of them so that there is a 3-month lead time. A question arises as to why the firms wouldn’t have an incentive to implement, on their own, the optimal inventory amounts, which incidentally are not likely to be the same as those mandated by the federal government.  For these types of supply chain risks, the private sector cares and knows better, they are better left for businesses and consumers to address within the market mechanism. 
 
In the relatively rare cases in which a supply chain risk has national security implications, the federal government may have a role to play in the mitigation of the risk either because the government has some relevant, but classified information about the potential risk the general public does not know or because the private sector as a whole fails to sufficiently take the risk into account. For example, relying heavily on China for rare-earth elements could endanger national security, and some form of government intervention aimed at reducing the dependence on China for rare-earth minerals may be justified.  Even in this case, however, the government should carefully compare various options and should avoid overly interfering with the market. We ceded production of rare-earth minerals to China and other countries due to our stricter environmental rules and higher labor costs.  If the government now would decide to encourage domestic production this would require direct government investment or large subsidies to private producers, likely accompanied by some degree of relaxed environmental regulations.  Such changes would likely have limited support. Alternatively, it might be more cost-efficient to impose a targeted tariff on rare-earth imports from China in an attempt to divert the foreign production of rare earths to other countries.
 
The recent disruption to the global supply chain caused by the Covid-19 pandemic has brought to the forefront the potential cost of a country relying too much on foreign suppliers for certain key products. The Biden administration has signaled a willingness to spend tax dollars mitigating various foreign supply risks. But as we argued here, the government is less efficient than the private sector in dealing with foreign supply risks except perhaps in the rare cases in which a foreign supply risk has national security implications.  Even in such cases, however, the government should avoid overly interfering with the market. 

References
 
Government Accountability Office, 2018. Strategic Petroleum Reserve: DOE Needs to Strengthen Its Approach to Planning the Future of the Emergency Stockpile. GAO-18-477, May 2018. https://www.gao.gov/assets/gao-18-477.pdf
 
Jeong, E.-Y., Strumpf, D., 2021. Why the chip shortage is so hard to overcome.  The Wall Street Journal, April 19, 2021. https://www.wsj.com/articles/why-the-chip-shortage-is-so-hard-to-overcome-11618844905
 
Kaygisiz, N. B., Shivdasani, Y., Conti, R. M., Berndt, E. R., 2019. The geography of prescription pharmaceuticals supplied to the U.S.: levels, trends and implications. NBER Working Paper # 26524.
 
Kilian, L., Zhou, X., 2020. Does drawing down the US Strategic Petroleum Reserve help stabilize oil prices? Journal of Applied Econometrics 35 (6), 673-691.
 
Rich, M., Reed, S., Ewing, J., 2021. Clearing the Suez Canal took days, figuring out the costs may take years. The New York Times, March 31, 2021. https://www.nytimes.com/2021/03/31/business/suez-canal-ship-costs.html
 
Stevens, R. B., Zhang, J. Y., 2021.Buyer beware: The asymmetric impact of the strategic petroleum reserve on crude oil prices. The Energy Journal, in press. 
 
Subin, S., 2021. The new U.S. plan to rival China and end cornering of market in rare earth metals. CNBC Evolve, April 17, 2021.
https://www.cnbc.com/2021/04/17/the-new-us-plan-to-rival-chinas-dominance-in-rare-earth-metals.html
 
Taylor, J., Van Doren, P., 2005. The case against the strategic petroleum reserve. Policy Analysis No. 555, The Cato Institute. https://www.cato.org/sites/cato.org/files/pubs/pdf/pa555.pdf
 
U.S. Energy Information Administration, 2021. DATA: Petroleum and other liquids. https://www.eia.gov/dnav/pet/PET_STOC_WSTK_DCU_NUS_W.htm

Posted: July 09, 2021 by Dennis W. Jansen, Liqun Liu, and Andrew J. Rettenmaier