A colleague sent me an article from McKinsey called ‘Power Curves’: What natural and economic disasters have in common by Michele Zanini. Coincidently, I read a different article that made similar points (“Too Complex to Exist” by Duncan Watts, the chief scientist at Yahoo! Research). I found both articles interesting because they explain to senior executives why risk management is still important, even if this recession is winding down, and why it needs to be applied in broader ways than many companies are currently doing.
Power curve analysis, as applied to economics, has grown out of complexity theory. This is how Zanini describes these tools: “If, for instance, you plot the frequency of banking crises around the world from 1970 to 2007, as well as their magnitude as measured by four-year losses of GDP for each affected country, you get a typical power curve pattern, with a short head of almost 70 crises, each with accumulated losses of less than 15 percent of GDP, quickly falling off to a long tail of very few-but massive-crises.” You can see what this curve looks like by going to the article, but you’ll need to register first.
The article continues: “Earthquakes, forest fires, and blackouts yield a similar power curve pattern… The curve highlights a key property of the power law: extremely large outcomes are more likely than they are in a normal, bell-shaped distribution.” Power law patterns – “with their small, frequent outcomes mixed with rare, hard-to-predict extreme ones” – exist in many parts of the economy. “This suggests that the economy, like other complex systems characterized by power law behavior, is inherently unstable and prone to occasional huge failures.”
Watts makes similar points in his article, citing the following example: “On August 10, 1996, a single power line in western Oregon brushed a tree and shorted out, triggering a massive cascade of power outages that spread across the western United States. Frantic engineers watched helplessly as the crisis unfolded, leaving nearly 10 million people without electricity. Even after power was restored, they were unable to explain adequately why it had happened, or how they could prevent a similar cascade from happening again – which it did, in the Northeast on Aug. 14, 2003.”
Watts goes on to say, “Over the past year we have experienced something similar in the financial system: a dramatic and unpredictable cascade of events that has produced the economic equivalent of a global blackout…Experts have weighed in on the causes of the meltdown…Although these explanations can help account for how individual banks, insurers, and so on got themselves into trouble, they gloss over a larger question: how these institutions collectively managed to put trillions of dollars at risk without being detected. Ultimately, therefore, they fail to address the all-important issue of what can be done to avoid a repeat disaster.”
Watts argues that ‘systemic risk’ is at the heart of this issue, and that the risk of the entire financial system failing (with all of its moving parts) is not related in any simple way to the risk profiles of its individual parts. “Like a downed tree,” says Watts, “the failure of one part of the system can trigger an unpredictable cascade that can propagate throughout the entire system.” It may be that “globally interconnected and integrated financial networks just may be too complex to prevent crises like the current one from reoccurring.”
In good supply chain risk management, we put in place contingency plans for highly unlikely events, such as an earthquake knocking out a factory. What if, for example, a massive earthquake occurs in China where you source a key component? You’d likely require your supplier to have a disaster recovery plan in place, as well as store safety stock outside the earthquake zone, and you’d look for alternate component suppliers in different parts of the world.
In short, we should think of the economy in the same way we think about natural disasters. Major systemic imbalances and corrections are not uncommon, and everyone should be wary of new economic theories that claim otherwise. Companies with robust strategic planning processes are better prepared to handle this kind of turbulence, as I highlighted in my recent posting “Integrating Strategic and Supply Chain Planning at Emerson“.
