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What Matters: August 2004

Offshoring Conflicts with National Interests

By Michael Sarfatti '76, SM '78

Editor's Note: In a statement at the White House on February 9, 2004, N. Gregory Mankiw PhD '84, Chairman of the Council of Economic Advisers, stated:

"I think outsourcing is a growing phenomenon, but it's something that we should realize is probably a plus for the economy in the long run. Economists have talked for years about trade, free international trade, being a positive for economies around the world, both at home and abroad. Outsourcing is just a new way of doing international trade."

What Matters asked Michael Sarfatti '76, SM '78 if the trend of outsourcing/offshoring jobs should be of economic interest to the United States. Below is his response.

The benefits of offshoring, are justified on a dated 19th century economic concept: "comparative advantage."1 The benefits often largely accrue to investors and management elites; the costs are increasingly borne by workers and middle class professionals. In the geopolitical realm, a world power that loses it manufacturing capacity no longer is a world power. Unrestricted use of outsourcing conflicts with the long-term U.S. national interests. Gregory Mankiw2 drew a chorus of criticism from Congress and quickly backpedaled. Searching the web3, it seems the economics profession supported Prof. Mankiw's position. But why is the general public (April 2004 Harris Poll4) skeptical about the benefits of outsourcing, a facet of "free" trade?

Free trade

"Free" trade means5: Trade or commerce carried on without such restrictions as import duties, export bounties, domestic production subsidies, trade quotas or import licenses. The basic argument for free trade is based on the economic theory of comparative advantage: each region should concentrate on what it can produce most cheaply and efficiently and should exchange its products for those it is less able to produce economically.

Does the U.S. engage in "free" trade? Yes and no. While a leading exponent of "free" trade, the U.S. nevertheless subsidizes agriculture, lumber (cheap leases of publicly owned forests), occasionally protects steel production (in key steel industry states) and regulates some financial industries. Other countries (e.g., Korea and China) with which the U.S. runs massive trade deficits, are based on the "Export-Led Growth Model"6 invented by Japan, the world's second largest economy, one not operated on the supposed universal laws of western economics. Hence, realists see "free" trade as an idealization, often honored in the breach. So public chariness about "free" trade may be as much prudence as protectionism (the dreaded tag-word). Public opinion notwithstanding, Mankiw's views are particularly important since he has the ear of the President.

Prof. Mankiw lectured at the Stanford Institute of Economic Policy Research7 in late April 2004. Obtaining a videotape of his talk, I viewed it carefully. He addressed the outsourcing/"free" trade issue that gained him notoriety; about one third of the questions related to outsourcing. To summarize, "free" trade is good for everyone although the induced economic changes produce "painful dislocations." The basis for this belief is David Ricardo's comparative advantage theory (1817), a concept that is "true without being obvious." He noted, "Economists are reasonably unanimous on 'free' trade and that is why George Bush sends Bob Zeollick (U.S. Trade Representative) around the world to do trade agreements...George Bush is convinced about 'free' markets and he is a 'free' trader." Prof. Mankiw duly observed, "Admittedly, not everyone is as convinced (of the benefits of 'free' trade) as the economics profession." Why not?

First, who was David Ricardo8? He could be described as the George Soros of the age (1795 to 1815) of Britain's struggles with Napoleon. He became immensely richer by betting correctly on the outcome of the Battle of Waterloo. He promptly retired and began a second career. His Book, "Political Economy and Taxation" (1817) contained novel concepts including "comparative advantage" (how Portugal and England were better off specializing in production of wine and cloth respectively with trade rather than both producing both these commodities). But other dated concepts of that age have been abandoned or modified (e.g., unfettered laissez faire of Adam Smith, population economics of Malthus, etc.) but not comparative advantage, which still motivates key economic policy makers. Why?

One explanation is an uncritical spiritual belief in Ricardo's comparative advantage, regardless of practical consequence to society or the economy. Heretic Nobelist and economist (and MIT PhD '66) Joseph Stiglitz9 argues that belief in globalization (AKA, "free" international trade) amounts to "market fundamentalism" (that is, a "free" market solves all problems flawlessly). Agnostic economist, Paul Craig Roberts (Treasury official during the Reagan Administration) argues10 the underlying assumptions of Ricardo are wrong in the modern context. Ricardo assumed that a country's labor, capital and technology must not move offshore. But the factors of production now can, so comparative advantage ceases to be as meaningful. Outsourcing then, a feature of "free" trade per Prof. Mankiw, is driven in some Asian countries by "an absolute advantage because of a vast excess supply of skilled and educated labor." Hence, outsourcing is largely "labor arbitrage" that leaves many workers in the First World at a loss. Continued pursuit of comparative advantage in a world where absolute advantage primarily matters, risks leading this nation to "Brazilianize" (per author Michael Lind11), to become a nation with a small class of extreme wealth and a huge underclass and greatly reduced middle class. Few economists would endorse Brazilianization, but they endorse Ricardo theory, which seems to allow this outcome.

Returning to Mankiw's talk, he suggests that First World economies will maintain themselves by continual "innovation." As work moves offshore, "U.S. Ingenuity will bring new jobs as market forces respond." When asked what these new jobs or industries might be, he demurred. He felt that "public policy makers should not make such determinations." He did mention federal funds for retraining. But again questions arose: in what field, biotechnology, nanotechnology etc.? He didn't know. Also can't most of the jobs, for which workers retrain, also be outsourced? Why not? So, where is the comparative advantage?

Key to the use of the Ricardian theory is the creation of "new and better jobs" to fill the outsourcing void (which isn't clearly happening). This often leads defenders of outsourcing to hit the "R&D Button," or to call for more government funding of research and development. Or it can also lead them to hitting the "Education Button" to encourage more U.S. college students, skeptical about employment prospects, to major in science and engineering in spite the outsourcing risk12. Craig Roberts points out13, it has been years since the U.S. economy has created any "net new" jobs in export/import-competitive industries. The projected job growth over the next decade, per February 2004 Bureau of Labor Statistics (BLS)14 for seven of the top 10 occupations, lies largely in menial areas that can be learned without a college degree. So the government's own projections suggest the creation of largely low-tech rather than high-tech jobs over the next decade. (Recent U.S. job growth in February thru April 2004 has indeed been concentrated in these low-end service occupations15.) So innovate we must.

The "innovate" gambit, however, poses intellectual property (IP) issues when the manufacturing is outsourced offshore. Two key domiciles for outsourced U.S. production, India (IT) and China (low cost manufacturing), do not follow patent and copyright treaties. The struggle over intellectual property is a significant trade issue between the U.S. and China16. Intel declined to ship its Wi-Fi chipset for use in China. One stated reason was the Chinese use of its Wired Authentication and Privacy Infrastructure (WAPI) standard (vs. global IEEE 802.11i standard). Were Intel to adopt China's (WAPI) standard, they would be obligated to share their IP with Chinese companies. Deborah Wince-Smith, President, Council on Competitiveness notes17, "There's been a tremendous amount of outright theft, where a U.S. design has actually showed up in a competing Chinese product." So, running faster with more innovation (Prof. Mankiw's nostrum) is a risky game as the U.S. innovators have little IP protection to earn a long-term return.

Ms. Wince-Smith further observes, as have other economists and technologists18, offshoring is accelerating the emergence of China and India as first-tier competitors in many of the most advanced, high value economic activities. In the process of outsourcing, U.S. companies may be creating their own competition. But such "externalities" seem to be excluded from the traditional economic analysis.

Geopolitical realism

In Ricardo's day, economics was known as the "political economy" with good reason, as many economic issues have political or national interest dimensions. Often modern practitioners of economics neglect the political dimension. Turning to a prominent political scientist, Prof. John Mearsheimer (University of Chicago), who accurately forecast many trends following the dissolution of the Soviet Union, now posits that China and the U.S. are destined to engage in an intense security competition reminiscent of the Cold War19. Similar thoughts emanate from Prof. Samuel Huntington at Harvard20. Therefore, the "precautionary principle" alone argues, for geopolitical reasons, against a policy that risks losing a substantial part of the U.S. manufacturing capacity, especially to countries where the U.S. interests will most likely conflict.

But haven't numerous studies forecast significant economic benefits to the U.S. from outsourcing? Of course, but astute readers must wonder to whose advantage was each study produced? The McKinsey Global Institute21 finds that "Every dollar a U.S. company spends on offshoring to India, the U.S. economy gains $1.12 to $1.14."22 Really? The problems with this study were articualted by Prof. Ronil Hira of the Rochester Institute of Technology and the IEEE-USA's Chair on the Career and Workforce Policy Committee23. First, the report fails to disclose that McKinsey has had NASSOM (Indian Software Services Industry Association) as a long-standing customer and that McKinsey sells offshoring consulting services. The study itself is drawn from case studies done by McKinsey consultants; the data are unavailable for review. Most importantly the study assumes that workers, displaced by offshore outsourcing, will be "redeployed" soon at substantially the same wages. Such redeployment (Exhibit 6 of the MGI study) accounts for about $0.45 of the $1.12 to $1.14. Without re-employment in "new" industries, much of $1.12 to 1.14 benefit for $1.00 cost goes away!

Another prominent study commissioned by the Information Technology Association of America24 reports, "Outsourcing may create U.S. jobs." A review of the ITAA study by U.C. Davis Professor of Computer Science, Norman Matloff, points out25 the report says explicitly that IT jobs will decline as a result of offshoring, while jobs in construction and financial services (low tech) will increase. Fine, but a Ph.D. in EE or CS isn't necessary for those occupations.

One occasionally hears of "insourcing" (countervailing source of jobs to the U.S) but deconstruction of these numbers shows few really net new jobs since foreign companies insourcing to the U.S., often grew by acquisition26. Some authors attribute the massive loss of U.S. manufacturing jobs since 2001 primarily to productivity growth27. But other periods of high-productivity growth (say the 60's, or late 90's) have coincided with robust U.S. job growth. Why isn't this pattern happening now?

The first attempt of the Bureau of Labor Statistics28 to measure outsourcing by looking at mass layoffs suggests only a few thousand jobs were due to outsourcing (2.5 percent of the 182,456 layoffs in 2004 QI). The BLS admits an undercount. It further fails to address jobs created offshore by American companies without any corresponding U.S. layoffs. A number of other researchers produce much higher estimates29. U.C. Berkeley's Fisher Center for Real Estate and Urban Economics released a more comprehensive report30 that estimated about one in ten jobs in the U.S. is at risk for outsourcing, and the jobs are concentrated in certain industries.

"Face-Off on Offshoring" appeared in the May 10, 2004 Wall Street Journal31, pitting Dr. Paul Roberts (Ricardo agnostic) against Prof. Jagdish Bhagwati PhD '67 of Columbia University. The latter32 generally agrees with the Mankiw position. Roberts however, argues Bhagwati should temper his optimism with realism, because if offshoring becomes big, the U.S. risks losing jobs requiring higher levels of education and intellectual power, and only gaining in jobs requiring much lesser levels. Dr. John Steadman, President of IEEE-USA lays out the position33 of this engineering society. Both Roberts and Steadman posit the outsourcing issue will peak if deterioration continues in the U.S. labor market and will ultimately be settled by political action rather than economic debates.

Conclusion

Prof. Mankiw's comment that "outsourcing is just a new way of doing international trade" has deeper implications than he appreciated. The bigger question is, what in total are we trading away and getting in return? While a majority of the economics profession may assure us of net benefits, I recommend Mark Twain's aphorism: "Whenever you find that you are on the side of the majority, it's time to pause and reflect."

Footnotes

  1. See any economics text
  2. Harvard Professor of Economics, expert on macroeconomics, author of two popular textbooks and MIT Ph.D.
  3. http://angry-economist.russnelson.com/mankiw.html
  4. http://sanjose.bizjournals.com
  5. A definition found via a websearch.
  6. MIT economist Lester Thurow in Fortune Favors the Bold, HarperCollins, 2003, p. 238 ff.
  7. http://siepr.stanford.edu
  8. http://cepa.newschool.edu/
  9. Author of Globalization and Its Discontents, Norton, 2002
  10. Business Week, March 22, 2004, p.48
  11. The Next American Nation, Free Press Paperback, 1996 or Atlantic Monthly, Jan/Feb. 2004.
  12. Editorial "Protect American Jobs by winning at global R&D" in Electronic Design, March 2004.
  13. http://www.vdare.com/roberts/occupational_hazard.htm
  14. http://www.bls.gov/news.release/ecopro.toc.htm
  15. New York Times, June 5, 2004 , p. B-14.
  16. IEEE Spectrum, June 2004, p.16 ff.
  17. Technology Review, April 2004, pp. 74-75
  18. For example, Dr. Ralph Gomory and Prof. William Baumol in Global Trade and Conflicting National Interest, MIT Press, 2000.
  19. www.itsyourworld.org/program.php?page=915 (India and the U.S., which were soft adversaries during the Cold War, have moved closer together due to a perception of a common threat of China.)
  20. The Clash of Civilizations and the Remaking of the World Order, Simon & Schuster, 1996, p. 218 ff.
  21. http://www.mckinsey.com/knowledge/mgi/index.asp
  22. See MGI report "Offshoring: Is it a Win-Win Game?" p. 12.
  23. Search www.ieeeusa.org; see http://online.nvtc.org/calendar/geteventinfo.cfm?event=INTER-6 or http://www.washingtonpost.com/wp-dyn/articles/A36379-2004Mar30.html.
  24. ITAA is an industry group known of lobbying Congress to raise the H-1B and L-1 visa limits to solve the IT professional shortage.
  25. http://heather.cs.ucdavis.edu/Archive/ITAAOffshore.txt and related documents on Prof. Matloff's website discussing the abuse of H-1B and L-1 visa programs to displace workers in the U.S.
  26. "Insourcing myths: jobs and insourcing," Economic Snapshots, April 6, 2004. http://www.esrresearch.com
  27. Business Week, March 22, 2004 p. 38 ff.
  28. Reported in New York Times June 11, 2004, p. C1 ff
  29. Ibid, NYT.
  30. http://groups.haas.berkeley.edu/realestate/Research/staff.asp
  31. "The Journal Report" supplement (p. R6)
  32. MIT PhD, a convert to globalization and author of In Defense of Globalization, Oxford, 2004
  33. http://www.ieeeusa.org/forum/POSITIONS/offshoring.html
Related Articles

"Offshoring is not a Choice, It's a Reality," by Satwik Seshasai '01, MNG '02, SM '05

About the Author

Michael Sarfatti '76, SM '78

Michael Sarfatti '76, SM '78 (Course 2) is the treasurer/director of the MIT Club of Northern California and he has a "studious interest" in economics and national policy.



 

What Matters is a guest opinion column written by a different MIT alumnus or alumna. The views expressed are entirely those of the author and do not necessarily represent the views of the Alumni Association or MIT. Interested in writing a column? Email whatmatters@mit.edu.