The Outsourcing Bogeyman

Daniel W Drezner. Foreign Affairs. Volume 83, Issue 3. May/June 2004.

The Truth Is Offshore

When a presidential election year coincides with an uncertain economy, campaigning politicians invariably invoke an international economic issue as a dire threat to the well-being of Americans. Speechwriters denounce the chosen scapegoat, the media provides blanket coverage of the alleged threat, and legislators scurry to introduce supposed remedies.

The cause of this year’s commotion is offshore outsourcing—the alleged migration of American jobs overseas. The depth of alarm was strikingly illustrated by the firestorm of reaction to recent testimony by N. Gregory Mankiw, the head of President George W. Bush’s Council of Economic Advisers. No economist really disputed Mankiw’s observation that “outsourcing is just a new way of doing international trade,” which makes it “a good thing.” But in the political arena, Mankiw’s comments sparked a furor on both sides of the aisle. Democratic presidential candidate John Kerry accused the Bush administration of wanting “to export more of our jobs overseas,” and Senate Minority Leader Tom Daschle quipped, “If this is the administration’s position, I think they owe an apology to every worker in America.” Speaker of the House Dennis Hastert, meanwhile, warned that “outsourcing can be a problem for American workers and the American economy.”

Critics charge that the information revolution (especially the Internet) has accelerated the decimation of U.S. manufacturing and facilitated the outsourcing of service-sector jobs once considered safe, from backroom call centers to high-level software programming. (This concern feeds into the suspicion that U.S. corporations are exploiting globalization to fatten profits at the expense of workers.) They are right that offshore outsourcing deserves attention and that some measures to assist affected workers are called for. But if their exaggerated alarmism succeeds in provoking protectionist responses from lawmakers, it will do far more harm than good, to the U.S. economy and to American workers.

Should Americans be concerned about the economic effects of outsourcing? Not particularly. Most of the numbers thrown around are vague, overhyped estimates. What hard data exist suggest that gross job losses due to offshore outsourcing have been minimal when compared to the size of the entire U.S. economy. The outsourcing phenomenon has shown that globalization can affect white-collar professions, heretofore immune to foreign competition, in the same way that it has affected manufacturing jobs for years. But Mankiw’s statements on outsourcing are absolutely correct; the law of comparative advantage does not stop working just because 401(k) plans are involved. The creation of new jobs overseas will eventually lead to more jobs and higher incomes in the United States. Because the economy—and especially job growth—is sluggish at the moment, commentators are attempting to draw a connection between offshore outsourcing and high unemployment. But believing that offshore outsourcing causes unemployment is the economic equivalent of believing that the sun revolves around the earth: intuitively compelling but clearly wrong.

Should Americans be concerned about the political backlash to outsourcing? Absolutely. Anecdotes of workers affected by outsourcing are politically powerful, and demands for government protection always increase during economic slowdowns. The short-term political appeal of protectionism is undeniable. Scapegoating foreigners for domestic business cycles is smart politics, and protecting domestic markets gives leaders the appearance of taking direct, decisive action on the economy.

Protectionism would not solve the U.S. economy’s employment problems, although it would succeed in providing massive subsidies to well-organized interest groups. In open markets, greater competition spurs the reallocation of labor and capital to more profitable sectors of the economy. The benefits of such free trade—to both consumers and producers—are significant. Cushioning this process for displaced workers makes sense. Resorting to protectionism to halt the process, however, is a recipe for decline. An open economy leads to concentrated costs (and diffuse benefits) in the short term and significant benefits in the long term. Protectionism generates pain in both the short term and the long term.

The Sky Is Falling

Outsourcing occurs when a firm subcontracts a business function to an outside supplier. This practice has been common within the U.S. economy for some time. (Witness the rise of large call centers in the rural Midwest.) The reduction of communication costs and the standardization of software packages have now made it possible to outsource business functions such as customer service, telemarketing, and document management. Other affected professions include medical transcription, tax preparation, and financial services.

The numbers that are bandied about on offshore outsourcing sound ominous. The McKinsey Global Institute estimates that the volume of offshore outsourcing will increase by 30 to 40 percent a year for the next five years. Forrester Research estimates that 3.3 million white-collar jobs will move overseas by 2015. According to projections, the hardest hit sectors will be financial services and information technology (IT). In one May 2003 survey of chief information officers, 68 percent of IT executives said that their offshore contracts would grow in the subsequent year. The Gartner research firm has estimated that by the end of this year, 1 out of every 10 IT jobs will be outsourced overseas. Deloitte Research predicts the outsourcing of 2 million financial-sector jobs by 2009.

At first glance, current macroeconomic indicators seem to support the suspicion that outsourcing is destroying jobs in the United States. The past two years have witnessed moderate growth and astonishing productivity gains, but overall job growth has been anemic. The total number of manufacturing jobs has declined for 43 consecutive months. Surely, many observers insist, this must be because the jobs created by the U.S. recovery are going to other countries. Morgan Stanley analyst Stephen Roach, for example, has pointed out that “this is the first business cycle since the advent of the Internet—the enabler of a new real-time connectivity to low-cost offshore labor pools.” He adds, “I don’t think it’s a coincidence that this jobless recovery has occurred in such an environment.” Those who agree draw on anecdotal evidence to support this assertion. CNN’s Lou Dobbs routinely harangues U.S. companies engaged in offshore outsourcing in his “Exporting America” series.

Many IT executives have themselves contributed to this perception. When IBM announced plans to outsource 3,000 jobs overseas this year, one of its executives said, “[Globalization] means shifting a lot of jobs, opening a lot of locations in places we had never dreamt of before, going where there’s low-cost labor, low-cost competition, shifting jobs offshore.” Nandan Nilekani, the chief executive of the India-based Infosys Technologies, said at this year’s World Economic Forum, “Everything you can send down a wire is up for grabs.” In January testimony before Congress, Hewlett-Packard chief Carly Fiorina warned that “there is no job that is America’s God-given right anymore.”

That last statement chills the blood of most Americans. Few support the cause of free trade for its own sake, out of pure principle. The logic underlying an open economy is that if the economy sheds jobs in uncompetitive sectors, employment in competitive sectors will grow. If hi-tech industries are no longer competitive, where will new jobs be created?

Inside the Numbers

Before answering that question, Americans need to separate fact from fiction. The predictions of job losses in the millions are driving the current outsourcing hysteria. But it is crucial to note that these predictions are of gross, not net, losses. During the 1990s, offshore outsourcing was not uncommon. (American Express, for one, set up back-office operations in India more than a decade ago.) But no one much cared because the number of jobs leaving U.S. shores was far lower than the number of jobs created in the U.S. economy.

Similarly, most current predictions are not as ominous as they first sound once the numbers are unpacked. Most jobs will remain unaffected altogether: close to 90 percent of jobs in the United States require geographic proximity. Such jobs include everything from retail and restaurants to marketing and personal care—services that have to be produced and consumed locally, so outsourcing them overseas is not an option. There is also no evidence that jobs in the high-value-added sector are migrating overseas. One thing that has made offshore outsourcing possible is the standardization of such business tasks as data entry, accounting, and IT support. The parts of production that are more complex, interactive, or innovative—including, but not limited to, marketing, research, and development—are much more difficult to shift abroad. As an International Data Corporation analysis on trends in IT services concluded, “the activities that will migrate offshore are predominantly those that can be viewed as requiring low skill since process and repeatability are key underpinnings of the work. Innovation and deep business expertise will continue to be delivered predominantly onshore.” Not coincidentally, these are also the tasks that generate high wages and large profits and drive the U.S. economy.

As for the jobs that can be sent offshore, even if the most dire-sounding forecasts come true, the impact on the economy will be negligible. The Forrester prediction of 3.3 million lost jobs, for example, is spread across 15 years. That would mean 220,000 jobs displaced per year by offshore outsourcing—a number that sounds impressive until one considers that total employment in the United States is roughly 130 million, and that about 22 million new jobs are expected to be added between now and 2010. Annually, outsourcing would affect less than .2 percent of employed Americans.

There is also reason to believe that the unemployment caused by outsourcing will be lower than expected. Gartner assumed that more than 60 percent of financial-sector employees directly affected by outsourcing would be let go by their employers. But Boston University Professor Nitin Joglekar has examined the effect of outsourcing on large financial firms and found that less than 20 percent of workers affected by outsourcing lose their jobs; the rest are repositioned within the firm. Even if the most negative projections prove to be correct, then, gross job loss would be relatively small.

Moreover, it is debatable whether actual levels of outsourcing will ever match current predictions. Despite claims that the pace of onshore and offshore outsourcing would quicken over time, there was no increase in 2003. In fact, TPI Inc., an outsourcing advisory firm, even reports that the total value of business process outsourcing deals in the United States fell by 32 percent in 2003.

There is no denying that the number of manufacturing jobs has fallen dramatically in recent years, but this has very little do with outsourcing and almost everything to do with technological innovation. As with agriculture a century ago, productivity gains have outstripped demand, so fewer and fewer workers are needed for manufacturing. If outsourcing were in fact the chief cause of manufacturing losses, one would expect corresponding increases in manufacturing employment in developing countries. An Alliance Capital Management study of global manufacturing trends from 1995 to 2002, however, shows that this was not the case: the United States saw an 11 percent decrease in manufacturing employment over the course of those seven years; meanwhile, China saw a 15 percent decrease and Brazil a 20 percent decrease. Globally, the figure for manufacturing jobs lost was identical to the U.S. figure—11 percent. The fact that global manufacturing output increased by 30 percent in that same period confirms that technology, not trade, is the primary cause for the decrease in factory jobs. A recent analysis of employment data from U.S. multinational corporations by the U.S. Department of Commerce reached the same conclusion.

What about the service sector? Again, the data contradict the popular belief that U.S. jobs are being lost to foreign countries without anything to replace them. In the case of many low-level technology jobs, the phenomenon has been somewhat exaggerated. For example, a Datamonitor study found that global call-center operations are being outsourced at a slower rate than previously thought—only five percent are expected to be located offshore by 2007. Dell and Lehman Brothers recently moved some of their call centers back to the United States from India because of customer complaints. And done properly, the offshore outsourcing of call centers creates new jobs at home. Delta Airlines outsourced 1,000 call-center jobs to India in 2003, but the $25 million in savings allowed the firm to add 1,200 reservation and sales positions in the United States.

Offshore outsourcing is similarly counterbalanced by job creation in the high-end service sector. An Institute for International Economics analysis of Bureau of Labor Statistics employment data revealed that the number of jobs in service sectors where outsourcing is likely actually increased, even though total employment decreased by 1.7 percent. According to the Bureau of Labor Statistics “Occupation Outlook Handbook,” the number of IT-related jobs is expected to grow 43 percent by 2010. The case of IBM reinforces this lesson: although critics highlight the offshore outsourcing of 3,000 IT jobs, they fail to mention the company’s plans to add 4,500 positions to its U.S. payroll. Large software companies such as Microsoft and Oracle have simultaneously increased outsourcing and domestic payrolls.

How can these figures fit with the widespread perception that IT jobs have left the United States? Too often, comparisons are made to 2000, an unusual year for the technology sector because Y2K fears and the height of the dot-com bubble had pushed employment figures to an artificially high level. When 1999 is used as the starting point, it becomes clear that offshore outsourcing has not caused a collapse in IT hiring. Between 1999 and 2003, the number of jobs in business and financial operations increased by 14 percent. Employment in computer and mathematical positions increased by 6 percent.

It is also worth remembering that many predictions come from management consultants who are eager to push the latest business fad. Many of these consulting firms are themselves reaping commissions from outsourcing contracts. Much of the perceived boom in outsourcing stems from companies’ eagerness to latch onto the latest management trends; like Dell and Lehman, many will partially reverse course once the hidden costs of offshore outsourcing become apparent.

If offshore outsourcing is not the cause of sluggish job growth, what is? A study by the Federal Reserve Bank of New York suggests that the economy is undergoing a structural transformation: jobs are disappearing from old sectors (such as manufacturing) and being created in new ones (such as mortgage brokering). In all such transformations, the creation of new jobs lags behind the destruction of old ones. In other words, the recent recession and current recovery are a more extreme version of the downturn and “jobless recovery” of the early 1990s—which eventually produced the longest economic expansion of the post-World War II era. Once the structural adjustments of the current period are complete, job growth is expected to be robust. (And indeed, current indicators are encouraging: there has been a net increase in payroll jobs and in small business employment since 2003 and a spike in IT entrepreneurial activity.)

Offshore outsourcing is undoubtedly taking place, and it will likely increase over the next decade. However, it is not the tsunami that many claim. Its effect on the U.S. economy has been exaggerated, and its effect on the U.S. employment situation has been grossly exaggerated.

The Upside of Outsourcing

To date, the media’s coverage of outsourcing has focused on its perceived costs. This leaves out more than half of the story. The benefits of offshore outsourcing should not be dismissed.

The standard case for free trade holds that countries are best off when they focus on sectors in which they have a comparative advantage—that is, sectors that have the lowest opportunity costs of production. Allowing countries to specialize accordingly increases productivity across all countries. This specialization translates into cheaper goods, and a greater variety of them, for all consumers.

The current trend of outsourcing business processes overseas is comparative advantage at work. The main driver of productivity gains over the past decade has been the spread of information technology across the economy. The commodification of simple business services allows those benefits to spread further, making growth even greater.

The data affirm this benefit. Catherine Mann of the Institute for International Economics conservatively estimates that the globalization of IT production has boosted U.S. GDP by $230 billion over the past seven years; the globalization of IT services should lead to a similar increase. As the price of IT services declines, sectors that have yet to exploit them to their fullest—such as construction and health care—will begin to do so, thus lowering their cost of production and improving the quality of their output. (For example, cheaper IT could one day save lives by reducing the number of “adverse drug events.” Mann estimates that adding bar codes to prescription drugs and instituting an electronic medical record system could reduce the annual number of such events by more than 80,000 in the United States alone.)

McKinsey Global Institute has estimated that for every dollar spent on outsourcing to India, the United States reaps between $1.12 and $1.14 in benefits. Thanks to outsourcing, U.S. firms save money and become more profitable, benefiting shareholders and increasing returns on investment. Foreign facilities boost demand for U.S. products, such as computers and telecommunications equipment, necessary for their outsourced function. And U.S. labor can be reallocated to more competitive, better-paying jobs; for example, although 70,000 computer programmers lost their jobs between 1999 and 2003, more than 115,000 computer software engineers found higher-paying jobs during that same period. Outsourcing thus enhances the competitiveness of the U.S. service sector (which accounts for 30 percent of the total value of U.S. exports). Contrary to the belief that the United States is importing massive amounts of services from low-wage countries, in 2002 it ran a $64.8 billion surplus in services.

Outsourcing also has considerable noneconomic benefits. It is clearly in the interest of the United States to reward other countries for reducing their barriers to trade and investment. Some of the countries where U.S. firms have set up outsourcing operations—including India, Poland, and the Philippines—are vital allies in the war on terrorism. Just as the North American Free Trade Agreement (NAFTA) helped Mexico deepen its democratic transition and strengthen its rule of law, the United States gains considerably from the political reorientation spurred by economic growth and interdependence.

Finally, the benefits of “insourcing” should not be overlooked. Just as U.S. firms outsource positions to developing countries, firms in other countries outsource positions to the United States. According to the Bureau of Labor Statistics, the number of outsourced jobs increased from 6.5 million in 1983 to 10 million in 2000. The number of insourced jobs increased even more in the same period, from 2.5 million to 6.5 million.

Political Economy

When it comes to trade policy, there are two iron laws of politics. The first is that the benefits of trade diffuse across the economy, but the costs of trade are concentrated. Thus, those made worse off by open borders will form the more motivated interest group. The second is that public hostility toward trade increases during economic downturns. When forced to choose between statistical evidence showing that trade is good for the economy and anecdotal evidence of job losses due to import competition, Americans go with the anecdotes.

Offshore outsourcing adds two additional political pressures. The first stems from the fact that technological innovation has converted what were thought to be nontradeable sectors into tradeable ones. Manufacturing workers have long been subject to the rigors of global competition. White-collar service-sector workers are being introduced to these pressures for the first time—and they are not happy about it. As Raghuram Rajan and Luigi Zingales point out in “Saving Capitalism From the Capitalists,” globalization and technological innovation affect professions such as law and medicine that have not changed all that much for centuries. Their political reaction to the threat of foreign competition will be fierce.

The second pressure is that the Internet has greatly facilitated political organization, making it much easier for those who blame outsourcing for their troubles to rally together. In recent years, countless organizations—with names such as Rescue American Jobs, Save U.S. Jobs, and the Coalition for National Sovereignty and Economic Patriotism—have sprouted up. Such groups have disproportionately focused on white-collar tech workers, even though the manufacturing sector has been much harder hit by the recent economic slowdown.

It should come as no surprise, then, that politicians are scrambling to get ahead of the curve. During the Democratic primary in South Carolina—a state hit hard by the loss of textile jobs—billboards asked voters, “Lost your job to free trade or offshore outsourcing yet?” Last Labor Day, President Bush pledged to appoint a manufacturing czar to get to the bottom of the outflow of manufacturing positions. In his stump speech, John Kerry bashes “Benedict Arnold CEOs [who] send American jobs overseas.”

Where presidential candidates lead, legislators are sure to follow. Senator Charles Schumer (D-N.Y.) claimed in a January “New York Times” op-ed authored with Paul Craig Roberts that because of increased capital mobility, the law of comparative advantage is now null and void. Senator Tom Daschle (D-S.D.) has observed, “George Bush says the economy is creating jobs. But let me tell you, China is one long commute. And let me tell you, I’m tired of watching jobs shift overseas.” Senator Christopher Dodd (D-Conn.) and Representative Nancy Johnson (R-Conn.) are sponsoring the USA Jobs Protection Act to prevent U.S. companies from hiring foreign workers for positions when American workers are available. In February, Senate Democrats announced their intentions to introduce the Jobs for America Act, requiring companies to give public notice three months in advance of any plan to outsource 15 or more jobs. In March, the Senate overwhelmingly approved a measure banning firms from federal contracts if they outsource any of the work overseas. In the past two years, more than 20 state legislatures have introduced bills designed to make various forms of offshore outsourcing illegal.

Splendid Isolation?

There are clear examples of jobs being sent across U.S. borders because of U.S. trade policy—but not for the reasons that critics of outsourcing believe. Consider the example of candy-cane manufacturers: despite the fact that 90 percent of the world’s candy canes are consumed in the United States, manufacturers have sent much of their production south of the border in the past five years. The attraction of moving abroad, however, has little to do with low wages and much to do with protectionism. U.S. quotas on sugar imports have, in recent years, caused the domestic price of sugar to become 350 percent higher than world market prices. As candy makers have relocated production to countries where sugar is cheaper, between 7,500 and 10,000 workers in the Midwest have lost their jobs—victims not of outsourcing but of the kind of protectionism called for by outsourcing’s critics.

A similar story can be told of the steel tariffs that the Bush administration foolishly imposed from March 2002 until December 2003 (when a ruling by the World Trade Organization prompted their cancellation). The tariffs were allegedly meant to protect steelworkers. But in the United States, steel users employ roughly 40 times more people than do steel producers. Thus, according to estimates by the Institute for International Economics, between 45,000 and 75,000 jobs were lost because higher steel prices made U.S. steel-using industries less competitive.

These examples illustrate the problem with relying on anecdotes when debating the effects of offshore outsourcing. Anecdotes are incomplete narratives that fail to capture opportunity costs. In the cases of steel and sugar, the opportunity cost of using protectionism to save jobs was the much larger number of jobs lost in sectors rendered less productive by higher input prices. Trade protectionism amounts to an inefficient subsidy for uncompetitive sectors of the economy, which leads to higher prices for consumers and a lower rate of return for investors. It preserves jobs in less competitive sectors while destroying current and future jobs in sectors that have a comparative advantage. Thus, if barriers are erected to prevent offshore outsourcing, the overall effect will not be to create jobs but to destroy them.

So if protectionism is not the answer, what is the correct response? The best piece of advice is also the most difficult for elected officials to follow: do no harm. Politicians never get credit for inaction, even when inaction is the best policy. President George H.W. Bush, for example, was pilloried for refusing to follow Japan’s lead by protecting domestic markets—even though his refusal helped pave the way for the 1990s boom by letting market forces allocate resources to industries at the technological frontier. Restraint is anathema to the political class, but it is still the most important response to the furor over offshore outsourcing. As Robert McTeer, president of the Federal Reserve Bank of Dallas, said when asked about policy responses to outsourcing, “If we are lucky, we can get through the year without doing something really, really stupid.”

The problem of offshore outsourcing is less one of economics than of psychology—people feel that their jobs are threatened. The best way to help those actually affected, and to calm the nerves of those who fear that they will be, is to expand the criteria under which the Trade Adjustment Assistance (TAA) program applies to displaced workers. Currently, workers cannot apply for TAA unless overall sales or production in their sector declines. In the case of offshore outsourcing, however, productivity increases allow for increased production and sales—making TAA out of reach for those affected by it. It makes sense to rework TAA rules to take into account workers displaced by offshore outsourcing even when their former industries or firms maintain robust levels of production.

Another option would be to help firms purchase targeted insurance policies to offset the transition costs to workers directly affected by offshore outsourcing. Because the perception of possible unemployment is considerably greater than the actual likelihood of losing a job, insurance programs would impose a very small cost on firms while relieving a great deal of employee anxiety. McKinsey Global Institute estimates that such a scheme could be created for as little as four or five cents per dollar saved from offshore outsourcing. IBM recently announced the creation of a two-year, $25 million retraining fund for its employees who fear job losses from outsourcing. Having the private sector handle the problem without extensive government intervention would be an added bonus.

The Best Defense

Until robust job growth returns, the debate over outsourcing will not go away—the political temptation to scapegoat foreigners is simply too great.

The refrain of “this time, it’s different” is not new in the debate over free trade. In the 1980s, the Japanese variety of capitalism—with its omniscient industrial policy and high nontariff barriers—was supposed to supplant the U.S. system. Fifteen years later, that prediction sounds absurd. During the 1990s, the passage of NAFTA and the Uruguay Round of trade talks were supposed to create a “giant sucking sound” as jobs left the United States. Contrary to such fears, tens of millions of new jobs were created. Once the economy improves, the political hysteria over outsourcing will also disappear.

It is easy to praise economic globalization during boom times; the challenge, however, is to defend it during the lean years of a business cycle. Offshore outsourcing is not the bogeyman that critics say it is. Their arguments, however, must be persistently refuted. Otherwise, the results will be disastrous: less growth, lower incomes—and fewer jobs for American workers.