Monday, October 18, 2004
Offshoring: Political Myths and Economic Reality
Posted by David Smith at 07:27 PM
Category: David Smith's other articles

This is a text of the Leverhulme Globalisation Lecture I gave at the University of Nottingham on October 12 2004.

If I have to dedicate this lecture to anybody it is Gregory Mankiw. He will be known to some but I suspect not all of you. For those who don’t know him, Professor Mankiw, a distinguished Harvard University economist, is chairman of George W. Bush’s Council of Economic Advisers. We’re used to hearing Karl Rove described as Bush’s brain but Mankiw can lay claim to at least a lobe.

Earlier this year, Mankiw caused a political storm when he released his Economic Report of the President. According to CBS News he was guilty of “political ineptitude” of the kind that had characterised the way the Bush Administration has “stumbled and bumbled” its way through office. Others described it as political tone deafness. Tom Daschle, the Democrat Senate Minority Leader, accused him of spouting “Alice in Wonderland” economics.

Even from Bush’s own side, the condemnation was swift. Dennis Hastert, the Republican House Speaker, said Mankiw’s theory “fails a basic test of real economics”.

So what did he say that was so outrageous? Simply this section in the Economic Report: “One facet of increased services trade is the increased use of offshore outsourcing in which a company relocates labour-intensive service industry functions to another country … Whereas imported goods might arrive by ship, outsourced services are often delivered using telephone lines or the Internet. The basic economic forces behind the transactions are the same, however. When a good or service is produced more cheaply abroad, it makes more sense to import it than to make or provide it domestically.”

Most of us, I suspect, would not disagree with much of that, although the sharp-eyed will have noticed that, put like that, Mankiw is advancing the law of absolute advantage, not comparative advantage. Economists know that there are circumstances in which it is better to produce something at home if the advantage to overseas producers is even greater in other products or services. Even so, for a general audience, the point is well made. So why so controversial?

The fact is that offshoring is a hot issue, both here and more particularly in the United States. When we write about it at The Sunday Times we get more response than on any other economics-related issue. Whether you call it offshoring or overseas outsourcing it seems to have struck a chord. People who barely blinked when manufacturing jobs were shifted abroad in the 1970s and 1980s – and right up to date (three-quarters of a million such jobs have gone in the past 10 years) have become alarmed by the loss, both actual and potential, of service-sector posts.

The most common response is that, if these jobs are going, what will be left? Unions, who once condemned the replacement of industrial jobs with call-centres, now bemoan the loss of those call-centre jobs, almost as if they were our true industrial heritage. The rejoinder to this should be easy – just because some service-sector jobs are going does not mean they all are – there is “churning” within the sector, by which I mean a constant process of job destruction and creation. But people often don’t see it that way, particularly if the new jobs, as Alan Greenspan pointed out recently, are in areas we have not really thought about, or can scarcely imagine. To give one example, it is possible that nanotechnology will be a huge employer in the future. But most of us can’t even define nanotechnology, let alone begin to predict its employment consequences.

There’s also a sensitivity about offshoring among the companies that do it. Sir Keith Whitson, until last year HSBC’s chief executive, caused controversy when he said, of Indian call-centre staff: “They’re quicker at answering the phone, highly numerate and keen to come to work every day. Staff are hugely enthusiastic about their jobs, they dress well. A lot have degrees.” Most companies, in contrast, tread a lot more carefully, because they’re worried about a backlash, either from customers or the workforce. The National Westminster Bank boasts in its television advertisements that it has “UK-only call-centres”.

The backlash is already there in America. John Kerry has toned down some of his remarks but what he said earlier in the year, about so-called Benedict Arnold CEOs who transfer jobs overseas still sticks in the mind. Indeed, this has set the tone for the way many Americans think about offshoring – that it is negative for the economy and, in some way, un-American. America, of course, has always been more of a free market than a free trade country – protectionist sentiment never being too far below the surface in Congress. There are more than words involved in this. More than 100 pieces of anti-offshoring legislation have been introduced in at least 36 US states. The effect of these is mainly to prevent government services from being outsourced overseas.

Britain is very different. There’s a lot that you can criticise this government for but it has taken a very positive and grown-up attitude on offshoring. Patricia Hewitt, the trade and industry secretary, said earlier this year: “Just as consumers can now buy products or services from around the world, investors can invest anywhere so companies can now locate themselves where they like. We can't resist this and we shouldn't want to. Globalisation means greater growth, a better quality of life and more opportunities for all countries, poor and rich alike, to share in rising prosperity.”

The interesting thing about this is that it conveys two messages. The first is that if we in Britain try to cut ourselves off from the global economy by limiting offshoring the UK economy will suffer. I’ll return to that point. The second is that there is also a positive development message. Offshoring helps economies poorer than ours, and that is a good thing. As I say, American political thinking is not nearly as enlightened although the stronger the US job market, the less negative attitudes will be.

What about the economics of offshoring? I usually like to mention Russell Crowe at some stage. Why? There aren’t many Hollywood movies about economists, and not that many economists look like Russell Crowe but we can live in hope. I’m assuming everybody has seen A Beautiful Mind, a fictionalised account of the life of John Nash, the brilliant game theorist. Nash gave us the win-win game – all players can win – as opposed to the zero sum game. We can, of course, just go back to Ricardo, and the law of comparative advantage, for proof that free trade, of which offshoring is a type, is of mutual benefit.

Let us have a look in more detail at the economic benefits:

The first benefit comes in lower costs and, to the extent that there is a flow of these jobs overseas, lower inflation. In raw terms, an Indian call-centre worker gets paid a tenth of his UK counterpart. Even adjusting for purchasing power parity, Indian IT professionals are paid about a third of their UK counterparts and a quarter of the going rate in America. These labour cost differences exaggerate the full cost saving. Even so, after allowing for relocation costs and productivity differences, few companies would shift operations overseas if they weren’t saving at least 20% to 30%.

The second gain is in real incomes. A popular view is that all the income gains go to the host country. In fact, and this is where economics has to work quite hard, all the studies suggest that most of the gains, perhaps 70% to 80% go to the offshoring country. That is hard to explain to somebody whose job has just been displaced. The real income gains, at least in the first-round, come directly from lower prices and indirectly, through the boost to corporate profits and therefore dividends.

Third, even where countries have relatively high unemployment they usually suffer from specific shortages of particular types of labour. That is not always the main motivation for outsourcing but it is certainly a significant factor. When unemployment is low that point is even more powerful. In the UK at the moment we have an estimated 660,000 job vacancies, half a million of them in the private sector.

The fourth advantage is that the shift of jobs overseas enables workers to be moved into higher value-added/higher productivity jobs. As note earlier, people seem unprepared to accept the same logic for services they were happy to do for manufacturing. This is particularly the case on this point. It has long been accepted that British industry could not compete with, say, China in the mass production of low valued-added goods, and so for survival UK manufacturing had to move up the value and technology chains, and workers into higher-productivity functions. That’s exactly the effect – and the benefit – from offshoring service-sector activities. Routine tasks can be outsourced, allowing workers to be redeployed up the value chain.

What about the potential disadvantages? Is it all plain sailing or does the anti-offshoring school have a point? It is easy to assume perfect mobility of labour, and the seamless transfer of displaced workers here into new jobs. Life is not like that. There will be mismatch and frictional problems, some serious. The ex-steelworker in Rotherham who has re-trained to become a call-centre operator may not have another career change left in him. Some of these effects can be quite serious, particularly in certain high-unemployment areas, which have not really solved the problem of permanently replacing the old mass employers.

Not only that but the microeconomic effects on the outsourcing company can be adverse. It only takes a couple of examples of poor service for things to go quite badly wrong. Customers are not, in general, sympathetic to offshoring. Offshore centres almost have to outperform the domestic alternative to achieve customer acceptance.

Why do companies move activities offshore? A survey carried out by Nirupam Bajpai of the Earth Institute at Columbia University gives some useful insights. The overwhelming motivation, mentioned by 70% of firms surveyed, is to cut costs. Other factors, such as increasing capacity, taking advantage of offshore labour, gaining access to better technology and systems and improving service levels come well down the list.

What kind of activities are offshored? This is a survey of US companies so the results might be slightly different for the UK but I suspect not dramatically so. IT development is easily the most popular activity, mentioned by more than 60% of firms, followed by customer service – this includes call-centres. Then we have a range of back-office functions, including payroll management, IT support, processing and paying-out expenses and managing transactions.

If cost saving is the motivation, how much do companies reckon to save? For most – more than three-quarters – the savings are between 10% and 50% compared with the costs of carrying out the same operations at home. For a few there are even bigger savings.

Is offshoring at the expense of quality? There is a question about whether firms, even in the privacy of a questionnaire, would admit to this, but at least in their own estimation, offshoring is not at the expense of quality, in fact it improves it. About a third says quality improves significantly, and a third that it just improves. Fewer than 10% report a decline in quality.

That does not mean firms regard this as risk-free. For those who have outsourced to overseas businesses outside the organisation there is a worry that they are losing institutional knowledge. Communication problems are a concern, as are cultural differences. There are worries about the security of databases about the financial stability of the partner company and, interestingly, about a customer backlash. That tells me that firms do not go into this lightly.

When we think of offshoring services, we always think of jobs being transferred to Mumbai or Bangalore. That certainly has been making the headlines recently. But it we look just three years ago, the most popular destination in terms of cumulative activity transferred for offshored services was Ireland and I can’t remember any backlash about that. I am not suggesting that there is anything racist about the response to India, merely that Ireland was somehow more easily handled because the cost advantages were not so enormous. But Ireland had many of the same advantages as India – educated workforce, English language, and so on.

A prime driver of offshoring, of course, is the fall in telecommunications costs and the increase in broadband capacity to places like India. Peak call rates between India and the US were 60 rupees a minute before 2001. Now they are well under 10. In the case of the UK the drop has been from 48 to about 6. Ireland was a great location for offshoring because of telecoms links within Europe and between Europe and America. But the telecoms map is being redrawn.

When it comes to the UK debate, we should recognise that offshoring is happening from a position of considerable economic strength. I never tire of pointing out that this is the longest period of economic growth since records began, largely explained by the combination of a successful macroeconomic framework and the microeconomic reforms of the 1980s.

Not only that but, unusually for Britain, that this has occurred without inflation. Inflation has averaged 2.5%, on the old RPIX measure, since we adopted an inflation target, then 1% to 4%, in the autumn of 1992. Bank of England independence has consolidated this process, its main effect being to significantly bring down inflation expectations into line with the target.

Perhaps unsurprisingly, 12 years of economic growth has meant high employment. The employment currently stands at over 28 million, a record. We have seen a strong rise in recent years, in both public and private sector employment, and an increase in workforce participation. The contrast with the 1980s when even a long period of economic growth left unemployment high, partly because of adverse demographics, is plain.

What is also interesting, although perhaps not that surprising, is that services have been responsible for this growth in employment. While manufacturing jobs have continued to shrink, service-sector employment has risen, both absolutely and as a proportion of total employment. In a decade, service sector employment has risen from just over 75% to more than 80% of total employment. The point I am making is that the threat to service sector jobs from offshoring, such as it is, comes from a very high base.

Just to complete the macro jobs picture, the contrast between the UK, close to full employment on the claimant count – roughly 5% on the internationally comparable measure – is striking. Unemployment in the euro area is roughly twice as high, and importantly has stayed high. In Europe there is a bit of a debate about service-sector offshoring. Mostly, though, they are still running with the debate over manufacturing jobs, and the threat, particularly from large German companies, to shift production to Eastern Europe.

And just to complete the macro picture for services, there are legitimate worries about UK service-sector productivity, which seems consistently and in some cases dramatically below the market leader, America. But this is not yet reflected in the trade position on services, which is healthy. The service-sector trade surplus has continued to grow. Again, I would argue that we are facing the challenge of offshoring from a position of considerable strength.

What empirical work has been done on the economic effects of offshoring? Quite a lot, although some of it comes with a little bit of a health warning attached, in that much of it is research commissioned by organisations such as NASSCOM, which represents Indian software companies, or by consultants hoping to make money out of persuading their clients to outsource. Even so, choosing selectively from this research we can put a little flesh on some of the economic benefits.

One piece of research, by Evalueserve, looked at likely labour supply and demand between now and 2010, assuming the latter would rise in line with recent experience and the former would be constrained by demography. Its conclusion was that there will be a labour gap that will only be made up by working-age immigrants and decisions by UK companies to offshore. So offshoring a cumulative 270,000 jobs is necessary to head off labour shortages. This presupposes continued strength in the labour market but seems broadly plausible. Already some offshoring is occurring because of the difficulty in recruiting and hanging onto certain workers.

Most of the detailed work has been done from America, The estimate you will see everywhere is that a cumulative 3.3m US jobs will be offshored over the next decade or so. But the estimate, from McKinsey, also came with some context attached. That was that the annual flow of jobs overseas was small in relation to the normal job market inflows and outflows. Annual flows of jobs offshore, in fact, are broadly equivalent to a good month’s employment growth.

What about some of those wider economic benefits listed earlier? To what extent will offshoring boost GDP in the country sending jobs overseas, and to what extent will inflation be kept down by outsourcing? Global Insight, a US economic consultancy, has tried to put some numbers on this. The GDP boost, which comes from higher real incomes and the shift of workers into more productive activities, is estimated by them to reach $124 billion by 2008. That sounds like a lot, but it is only around 1% of GDP.

What about inflation and interest rates? Global Insight tried to estimate this too and came up with the result that the cost-reduction effect will be worth a cumulative 2-2.5% off the level of the GDP deflator by 2008, and that other things being equal interest rates will be 0.4 per cent lower than otherwise. Again, we can debate the figures, although the direction is plausible.

This then allows the crucial third step in the economic argument. How many more jobs will be created by stronger economic growth and lower inflation? They suggest quite a lot, and certainly more than are lost due to offshoring. In this example a quarter of a million IT service jobs will have been lost by 2008, but 600,000 additional non-IT jobs created. The net effect is more employment.

That sounds pretty impressive, but it also underlines the problem that economists have in this area. The 600,000 people who have jobs as a result of offshoring-related economic growth will think their good fortune is due to happenstance, and their own efforts, and has nothing to do with the decisions by companies elsewhere in the economy to outsource service jobs. But the quarter of a million IT service sector workers will complain loudly about their plight. The economic benefits of offshoring outweigh the costs. Unfortunately they are less visible.

So on the other side of the debate there are the arguments put forward by organisations like the union-supported Economic Policy Institute in Washington. This is that the effects of offshoring are, firstly, an alarming increase in US IT imports from India, which looks as worrying, no doubt, as the rise in Japanese motorcycle imports was for UK workers in the 1960s and 1970s.

Not only that but according to them there is a direct read-across from the offshoring of US jobs to the rise in Indian employment in the sector, and the loss of IT jobs in America.

We could replicate this for other sectors in the economy subject to offshoring but it would not change my fundamental view that this kind of activity is just another aspect of free trade and that, as with all restrictions on free trade, attempts to limit it would be economically damaging.

But in conclusion, as I know from my postbag, it is unwise to tread on people’s sensitivities too hard in this area. Those who lose out from offshoring, even only temporarily, are entitled to squeal. We have to be patient in explaining that it is economically beneficial. Offshoring is good for us. Whether we in Britain have the productivity and skills to take full advantage of this new and more footloose world, and not be damaged by offshoring is a question that would need another lecture.

References

Bajpai, Nirupam, Sachs, Jeffrey, Arora, Rohit, and Khurana, Harpreet, Global Services Sourcing: Issue of Cost and Quality, CGSD Working Paper No. 16, June 2004.

Council of Economic Advisers, Economic Report of the President (February 2004).

Department of Trade & Industry, Services and Offshoring: The Impact of Increasing International Competition in Services (2003).
Economic Policy Institute, Perspectives on White-collar Offshoring (2004)

Evalueserve-Nasscom, The Impact of Global Sourcing on the UK Economy, 2003-2010 (2004).

Global Insight, The Impact of Offshore IT Software and Services Outsourcing on the U.S. Economy and the IT Industry (2004).

Comments

I thought your article on outsourcing was quite interesting, but my concern is with the Indian people. If we are to be a global economy, that has to include global responsibility. These jobs are not going to last long. I am from the US, and just as most of the service I receive is from...fake voices...not real people...so it is bound to come in India. This is a short lived industry, and while I'm all for spreading the wealth, it's being short-sighted to fail to see the future repercussions in India, the Phillipines, etc. I don't have an answer, only the question -- what to do (from a human perspective). Thank you. Connie

Posted by: Connie Daniel at December 9, 2004 11:21 PM

Offshoring IT jobs to developing countries does seem to fall into the typical economic models. However it seems to me that those doing the analysis seem to be missing the real point. IT is a glue industry; it permeates pretty much all industries and is in itself a service. Therefore there are two types of jobs we are moving: one is the Microsoft type big commercial packages, and the other is the service oriented jobs. Packages like WORD are in my opinion severely overpriced and hopefully this will deal with that. The other type of IT jobs, in the long run, affects ALL service based industries and jobs.

It would be useful if Economists look at the impact of lower communication costs and high skilled offshore workers on a developed service based economies. A commercial engineering package moved offshore is likely to result in specialists being recruited offshore too. The rolling affect of this means surely competition on any intellectual profession. Personally I don’t think barriers are in anyway the answer, however I would prefer if our Economists shone a little light into this uncertainty.

Posted by: Evan Mathias at January 21, 2005 02:15 PM

I completely agree with everything that was said in this article. Great post.

Posted by: Smith at April 10, 2012 04:29 PM