Why the Bullwhip Effect ..

8/10/2019 Why the Bullwhip Effect ..

1/10

GUEST EDITION Login Re gis te r Enr ollNew user? Start here.

Search

Blog Insider Featured Voices Daily Digest Today's Markets

THE CRASH COURSE LEARN TAKE ACTION DISCUSS PREPARE FOLLOW US

Home

Why the Bullwhip Effect All ButGuarantees Another Poorly-Handled Liquidity Crisis

Complex systems break under stress

by Adam Taggart

Monday, July 1, 2013, 11:54 AM

Wikimedia commons

BLOG

Tags: beer, bullwhip effect, complexity, crisis, Feder al Rese rve, MIT, risk

I'm about to connect the Federal Reserve to beer. You ready?

The Bullwhip Ef fect

One of my more memorable moments in business school came during an Operations class. The topic for the

day was the Bullwhip Effect, a very real and vexing phenomenon that occurs in forecast-driven distribution

systems.

Essentially, when there are multiple parties in a distribution system, the imperfections in each player's forecasts

(no forecast is consistently perfect) compound to wreak increasing havoc over time, even if demand stays

relatively stable.

Grasping how this works is somewhat non-intuitive. So the professor had us play a game developed by MIT back

in the 1960s that uses beer to make the point (thus guaranteeing our full attention).

The Beer Game

The Beer Distribution Gamedivided us into groups of 4 people each. Each person was assigned a role

(factory, distributor, wholesaler, retailer). Our task was to meet downstream demand while trying to avoid costly

inventory overages or backorders.

The game was played in rounds, and communication was limited to exchanging pieces of paper via which we

either fulfilled downstream demand from our inventories (if we could) or placed orders with our upstream supplier

(our forecasts).

As the rounds progressed, the swings in inventory overages and outages became more frequent and moreextreme. We each did our best to adjust, but that just s eemed to make the volatility worse.

At the end of the exercise, I remember the professor asked a member of each group to go up to the front of the

room and draw a chart of the demand curve their team saw during the game. Each group's chart looked wildly

different. All were chaotic, and there was no discernible pattern among them.

Then the prof dropped his surprise: You all had the exact same demand from the market throughout the game.

In fact, the level of market demand was constant for the first several rounds, increased once, and then stayed at

that new level for the rest of the game.

Despite a remarkably simple and stable demand structure, the sys tem spun out of control relatively quickly.

With every team.

Of course, that's the point of the exercise: complexity breeds risk .Where there is uncertainty in a sys tem (e.g.,

when making forecasts about the future), there are both operational and behavioral foibles that must be tightly

managed lest they compound to introduce real and non-intuitive instabilities.

Recommend 34 TweetTweet 8 ShareShare 5

INSIDER

The New Education Models Offering New Hope

More effective, cheaper, faster & poss ible today

6

Off the Cuff: The Government Shutdown is a

"Fiscal Suicide Mission"

A "one-s ize-hurts-al l" outcome

33

More

Off the Cuff: Yellin'

About the Debt Ceiling

The future is looking like'more of the sam e'

6

COMMENTS

preventing crime

Daily Digest 10/9 - Shutdown Costs $160M

Per Day, T-Bill Tensions Mount

davefairtex: 30 min 5 secago

Sheep and Sheepdogs



MOST RECENT MOST POPULAR

More


2/10

The takeaways from the exercise are: simplify processes wherever possible, optimize visibility and

communications across the system, align incentives -- and appreciate that even wi th all t hese precautions, you'll

likely never have a perfect system. So remain vigilant for the emergence of bullwhip volatility in order to reset

things before they get out of hand.

The Monetary Supply Chain

All right, so what does this have to do with the Federal Reserve?

Well, the Fed also operates a "forecast-driven distribution channel." It makes forecasts about the health of the

U.S. economy and determines how much money should be in supply to best meet its goals for price stability,

financial system health, and employment.

With the lessons of the Bullwhip Effect fresh in your mind, you might be wondering: How simple is the system

that the Federal Reserve uses to manage the money supply?

Well, the Fed would like you to think it 's as s imple as can be. Look at this easy-to-understand schematic:

(Source)

The Fed gives money to banks to then lend to people. Pretty darn straightforward. What could go wrong?

Oops, but wait a minute. It turns out it's a litt le more complicated than that. If we dig a little deeper, we see that

the U.S. Treasury plays a role in "conduiting money" into and out of the system, and that the Fed (via the

FOMC) also interacts with corporations, in addition to banks:

(Source)

Hmmm. Okay. So there are a few more folks in the pool than we originally realized. Still, the players all fit nicely

onto a single chart. It's probably all very tightly coordinated and finely controlled, right?

But wait; each of those boxes in the above chart is actually a vast organization (or collection of organizations).

Let's look at each briefly:

Rector: 1 hour 4 minago

deposit taxe s: because tha t's where the

money is

PM End of Week Mar ket Commentary -

10/12/2013

davefairtex: 2 hours 56 minago

"Put your gun back in its place..."



HughK: 5 hours 12 minago

Where would you put this thing?NASA: Our Technology-Dependent Lifestyle

is Vulnerable to Solar Flares

Arthur Robey: 6 hours 26 minago

MoveToHigherGround.yolasite.com

James Wes ley Rawles: Homesteading,

Relocation & Resilience

Cker: 7 hours 38 minago

the carnie crowd

Bud Conrad: The Bursting of the Bond

Bubble Is Now Upon Us

ao: 11 hours 49 minago

At the Carnival.

Bud Conrad: The Bursting of the Bond

Bubble Is Now Upon UsArthur Robey: 13 hours 11 minago


3/10

The Federal Reserve

The Fed is actually a confederation of private banks, headed by a board of governors composed of both banking

executives and political appointees (not the most efficient or effective of combinations):

(Source)

Treasury

The U.S. Treasury has more than 100,000 employees. Of course, they don't all interface with the Fed, but

multiple departments within the Treasury do.

(Source)

Member Banks

More than one third of all U.S. commercial banks are members of the Federal Reserve System. That's

thousands of banks. They are managed by the 12 Federal Reserve Banks, each of which has oversight of its

district.


4/10

(Source)

Complexity vs. Resiliency

So, the "simple" structure of the Fed providing banks wi th money actually encompasses the coordination ofvarious departments within the Federal Reserve system, its thousands of member banks, and at least some part

of the U.S. Treasury behemoth. Oh, and private corporations, too.

In this context, the near-death experience that the financial system experienced in 2008 due to liquidity issues

comes as li ttle surprise. When things begin to get volatile, with this many parties involved, the Bullwhip Effect

tells us that those responsible for forecasting are almost guaranteed to be wrong. Especially when additional

parties, such as Congress and the Executive Branch, get involved as they do in crises like we saw in 2008.

It doesn't help that even during times of relative stability, the Fed's forecasts are poor at best:

(Source)

As central banks around the world conduct the greatest monetary experiment in human history in real-time

around us, it 's important to keep the Bullwhip Effect in mind. The mathematical odds that the world's many

central planners, with their manifold partners in distributing fiat liquidity, are going to have the finesse to

successfully steer their ships to safety through the shoals of inflation and deflation that threaten on either side,

are very low. And that's before taking into account the unintended consequences of their more extreme

measures.


5/10

Mon, Jul 1, 2013 - 4:16pm #1

Login or Register to post comments

Tue, Jul 2, 2013 - 4:17pm #2

11 Comments

Ken CStatus: Platinum Member (Offline)

Joined: Feb 13 2009

Posts: 753

+ 1 Bullwhip

Mark CochraneStatus: Gold Member (Offline)

Joined: May 24 2011

Posts: 428

Bottom line: If another liquidity crisis hits (which Chris is warningmay be at our doorstep), the one thing we

can count on is that the response from our leaders will be ill fitting to the s ituation. Prepare accordingly.

~Adam Taggart

SHARE

MoreRELATED CONTENT

Live Blogging the Casey Summit 2013 Confere nce (Day 2)

More of what Chris & Adam are hearing

Live Blogging the Casey Summit 2013 Confere nce (Day 1)

Here's what Chris and Adam are hearing

The (Needed) Revolution Emerging in Education

The cartel-controlled college education model is failing

Automatic Spell-Check is Here!

A long time in coming

Expanding Our Reach

Assessing the challenges that come along with opportunity

Fed Shocker: No Taper

As we've long said, the Fed has put itself in a box

Abenomics' Dismal Annive rsary

Why we need to care about Japan's continued decline

Returning to the 'Real'

The virtual is not an adequate substitute for the authentic

The Periphe ry is Failing

The next big economic dislocation might be only weeks away

Why We All Lose If the Fed Wins

Fighting the wrong battles

Follow Comme nts on this Article

JOIN THE DISCUSSION

Adam - Well done. Nice description for us non economis ts.


6/10


Wed, Jul 3, 2013 - 11:46am #3


Sat, Jul 6, 2013 - 2:57am #4

+ 5 Climate Change And Beer Tabs (2)

charleshughsmithStatus: Silver Member (Offline)

Joined: Aug 15 2010

Posts: 134

+ 7 Uncertainty And Blown Forecasts

Arthur RobeyStatus: Diamond Member (Offline)

Joined: Feb 4 2010

Posts: 1697

(cross posted on the Climate thread)

Just following on Adams excellent exampleof the bullwhip effect on m anaging the beer dis tribution system, Id liketo point out the other side of the equation. The example given shows the chaos induced within a complex systemfrom imperfect forecasting of demand signals but the same uncertainty and ramifications exist for supply dynamicstoo.

I am frequently asked about how climate change is likely to show up in our lives. In the context of the BeerDistribution Game, this would show up in the forecast accuracy for supply availability/costs. For the whole beerdistribution process to work you need to have a reasonable expectation of being able to estimate the amount andprice of a given product (beer) with som e level of precision to ensure a profit margin.

Climate change m ess es with the predictabilityof costs for both production and dis tribution. There are num erousimplicit or explicit models being used that assum e climate stability. For example, grain prices are anticipated to betied closely to the amount of planted acres (hectares) in any given year. There are always some regional droughtsand floods to contend with along with localized hail storms , locust swarms etc., but within a global comm oditysystem the premis e is that these perturbations will even out over space and time. A heat-wave that decimatesRussian wheat could be made up by a bumper crop in Canada, for example, or a down year for global production in2012 migh t be made up in 2013 if global grain stocks can take up the slack for a year.

Changing climate though increases the uncertainty implicit in the assum ptions of local, regional and global levelproduction. It doesnt create new problems ; it just multiplies the frequency, extent and se verity of existing problems.For example, if the likelihood of having back-to-back down years of global production, or having both Canada andRussia experiencing simul taneous crop losses is increasing, and that increase is nt in the current modeled orassumed probability then the supply chain is going to have problems. Globally, we have gone from s o-calledthousand year heat events (meaning conditions that you expect to happen by chance once in millennium)happening on 1/1000 (0.1%) of the planets surface every year for June-August, which makes sense, to annuallyexperiencing such events at 4-13% of locations between 2006-2011, which makes no sens e if climate has notchanged (link).

Supply models can and do ignore thousand-year phenomena but they cannot reliably ignore things that happen

every decade. Put another way, you can handle extreme uncertainty for 0.1% of your production stream but youcannot have a reliable system that is consis tentlywrong about overestimating 10% of global production.

Back to the beer distribution example, climate change can induce supply problems that are slow, say wateravailability for a bottling plant, and m anageable, erratic and costly, for example global wheat or barleycops, or

serious to catastrophic, like loss o f the hops crop in Germany for a year (about 45% o f global s upply). Throw into themix periodic inabili ty to navigate the Missi ssippi due to drought, more frequent supply issues in ports like NewOrleans (Katrina) or New York (Sandy), and you can see instability in comm odity availability and pricing is likely toincrease the chaos inherent in the Bullwhip effect of uncertainty for complex pricing systems in the coming years.

Globally we have run up qu ite tab already and the bills are going to be com ing due in unexpected ways.

Mark

P.S. It is in teresting that the schemat ic of the Federal Reserveshows that the Federal Open Market Committee getsmultiple inputs but has abs olutely no indicated outputs. It makes one wonder what purpose it serves and how theyactually influence the complex monetary system.

Excellent intro to a key topic going forward, Adam, i.e. systemic fragility. I wonder if there isn't a second-orderdynamic in play here: the Fed's forecasts are notoriousl y inaccurate (what housing bubble?), as are all the other govtforecasts which never anticipate recess ion. What sort of faith can markets place in these forecasts? Obviously verylittle, but the m arkets seem ever hopeful that the Fed's controls are magically better than its forecasts--meanwhile,

the efforts at control and the bogus forecasts are feeding back into each other.

Great commentary, Mark--those 500-year floods and other anomalies happening every 5 years or so add s ome nicesnap to the bullwhip.


7/10


Sat, Jul 6, 2013 - 5:17am #5


#6Sat, Jul 6, 2013 - 8:51am


Sat, Jul 6, 2013 - 9:43am #7

+ 2 The Double Pendulum

yogiismyheroStatus: Silver Member (Offline)

Joined: Jun 28 2013

Posts: 173

+ 5 Arthur, If Your Thread Was An Olympic Event...

ScottTStatus: Bronze Member (Offline)

Joined: Nov 2 2009

Posts: 28

0 Are Corporate Earning Way Above The Mean?

Arthur RobeyStatus: Diamond Member (Offline)

Joined: Feb 4 2010

Posts: 1697

Chaos.

I would give it a 10. I am waiting for the dis mount though as my determinant, because from the point of the releaseis where all the trouble begi ns and OH Boy!, could the fall really be spectacular. I don't fear it so m uch but I am justterribly anxious for the point where we catch our footing again. Is anything irreparably broken? We shall see.

This Bullwhip thread by Adam has me on high alert and it is painfully clear his thread is as relevant as any threadwritten even though it didn't get much ink spilled from the commenters. Nice Adam. Just wait until margin calls aredemanded to rein in speculation as this perhaps gets the downward rock a really rolling. Will Gold go muchlower...We'll see. Who cares, you just gotta have it. Why? Please see Arthurs thread again. Nice Arthur. Corporateearnings are near and forward guidance seems a bit on the negative side, and if I have learned anything, corporateprofits returning to the mean will just be plain ugly.

(Reply to #5)

I work for a chemical com pany and for the mos t part our division is doi ng well and has been for the last five years.After we revised our m ethods for passing through directly the costs of increases and decreases of our primary rawmaterials to customers (all crude oil derivatives) the company realized stable and predicatable earnings and profits.Since we are few layers removed from the retail customer those pas s-through costs us ually are delayed by a fewmonths - further cushioning the downs ide risks to customers. So long as we don't see a spike in the oil price fromsay the current 95-100$/bbl to say 150$/bbl or m ore I believe we will s ee the econom y hum along happily for awhileyet and corporate earnings will surpris e by staying about where they've been for past few years.

Corporate earnings are near and forward guidance seems a bit on the negative side, and if I havelearned anything, corporate profits returning to the m ean will jus t be plain ugly.


8/10


#8Sat, Jul 6, 2013 - 11:33am

+ 2 Spells

davefairtexStatus: Gold Member (Online)

Joined: Sep 3 2008

Posts: 455

I was hoping not to have to spell i t out.

Very sim ple systems lead to chaotic behaviour as illustrated in the verysimple double pendulum. Notice how the tipof the pendulum is constrained. It cannot go beyond a certain point. That is becaus e in this system there is only oneStrange Attractor. There are other Chaos examples with two or more s trange attractors. Here is an example with two.

and here is an attractive visualization of a Strange Attractor operating in 3 Space.

Wiki.

Being a mathematical construct they can inhabit nSpace. Where n is any number.

Chaos is an important discovery. To me it illustrates yet another Limi t to what we can comprehend. Where in Adam'smodel above is Chaos hiding?

Thus endeth the tale.

(Reply to #6)


9/10


#9Sat, Jul 6, 2013 - 2:27pm


#10Sat, Jul 6, 2013 - 4:08pm

+ 1 Corporate Profits - What's "Normal"?

ScottTStatus: Bronze Member (Offline)

Joined: Nov 2 2009

Posts: 28

0 Financialization Follies

yogiismyheroStatus: Silver Member (Offline)

Joined: Jun 28 2013

Posts: 173

0 Hussman Has Corporate Earnings At 70% Above M ean...

I only have visibility at the 30,000 ft level. There are two types of corporations in the data I have - financial, andnonfinancial. Red line: Finance companies, Black line: Nonfinance companies. You can see that the financecompanies s hare of GDP (red line) has just gone nuts the past few decades. It is absu rdly higher than normal -from 1% in 1950 to 5% now. If we call 2% "normal", then 5% is 150% higher than normal.

The other compan ies, m aking "real s tuff", have a slice of GDP that's de finitelyhigher than norma l; right now its 6%,and perhaps throughout history it was around 4.5%. Perhaps that increase comes becaus e US compani es areselling products overseas, outsourcing work, they have low US wage pressures , low interest rates - let's call it 33-50% higher than normal.

(Reply to #8)

Thanks for sharing the data and your perspective from the 30,000 ft level as I agree this is really what is

fundamentally underpinning the macro econom y. My purpose for sharing m y experience at the micro level wasmeant to convey that things are quite Ok for som e - at the mom ent. Of course this can change in an instant as wesaw in 2008. Moreover as you point out the absurd financialization of the markets are s erious caus e for concern.The chart presents a boringly flat red line for about 50 years then kaboom all hell breaks loos e and the banker'sparty has been raging ever since! Looking at this chart I would expect a "correction" seems in order for both s ectorssometime bu tthe more painful and ugly one will be in the area of finance since they appear to be s till a bit bloatedand not adding much value to our econom y or lives.

absurdly higher than normal - from 1% in 1950 to 5% now.

(Reply to #9)

http://www.hussmanfunds.com/weeklyMarketComment.html

...take a look see at the analysis of this fine Doctor. A must read every Monday. IMHO


10/10


Tue, Jul 23, 2013 - 4:30pm #11


AmeetStatus: Member (Offline)

Joined: Mar 18 2011

Posts: 8

+ 1 Thanks

COMM ENT VIEWING OPTIONS

Flat list - expanded Date - oldest first SAVE SETTINGS

Select your prefer red w ay to display the c omments and click "Save settings" to activate your changes.

Good article - thanks.

or to post comments

ABOU T

Our Mission

Chris Martenson

The Team

Press and Media

Advertising

INTERACT

Contact Us

Get Help

Register

Enroll

Submit Payment

Volunteer

FOLLOW US

Facebook

Twitter

Google+

LinkedIn

YouTube

RSS

Email

Copyright 2013 Whitney Peak Ventures, LLC. All rights reserved. Registration on or use of this site constitutes acceptance of our Terms of Service and Privacy Policy.

Date post:	02-Jun-2018
Category:	Documents
Upload:	gaurav-aggarwal
View:	221 times
Download:	0 times

Why the Bullwhip Effect ..

Documents