The Harsh Truth About Outsourcing

Business Week ^ | March 22, 2004 | Paul Craig Roberts

[sarcasm]

It's not a mutually beneficial trade practice -- it's outright labor arbitrage

Economists are blind to the loss of American industries and occupations because they believe these results reflect the beneficial workings of free trade. Whatever is being lost, they think, is being replaced by something as good or better. This thinking is rooted in the doctrine of comparative advantage put forth by economist David Ricardo in 1817.

It states that, even if a country is a high-cost producer of most things, it can still enjoy an advantage, since it will produce some goods at lower relative cost than its trading partners.

Today's economists can't identify what the new industries and occupations might be that will replace those that are lost, but they're certain that those jobs and sectors are out there somewhere. What does not occur to them is that the same incentive that causes the loss of one tradable good or service -- cheap, skilled foreign labor -- applies to all tradable goods and services. There is no reason that the "replacement" industry or job, if it exists, won't follow its predecessor offshore.

For comparative advantage to work, a country's labor, capital, and technology must not move offshore. This international immobility is necessary to prevent a business from seeking an absolute advantage by going abroad. The internal cost ratios that determine comparative advantage reflect the quantity and quality of the country's technology and capital. If these factors move abroad to where cheap labor makes them more productive, absolute advantage takes over from comparative advantage.

This is what is wrong with today's debate about outsourcing and offshore production. It's not really about trade but about labor arbitrage. Companies producing for U.S. markets are substituting cheap labor for expensive U.S. labor. The U.S. loses jobs and also the capital and technology that move offshore to employ the cheaper foreign labor. Economists argue that this loss of capital does not result in unemployment but rather a reduction in wages. The remaining capital is spread more thinly among workers, while the foreign workers whose country gains the money become more productive and are better paid.

Economists call this wrenching adjustment "short-run friction." But when the loss of jobs leaves people with less income but the same mortgages and debts, upward mobility collapses. Income distribution becomes more polarized, the tax base is lost, and the ability to maintain infrastructure, entitlements, and public commitments is reduced. Nor is this adjustment just short-run. The huge excess supplies of labor in India and China mean that American wages will fall a lot faster than Asian wages will rise for a long time.

Until recently, First World countries retained their capital, labor, and technology. Foreign investment occurred, but it worked differently from outsourcing. Foreign investment was confined mainly to the First World. Its purpose was to avoid shipping costs, tariffs, and quotas, and thus sell more cheaply in the foreign market. The purpose of foreign investment was not offshore production with cheap foreign labor for the home market.

When Ricardo developed the doctrine of comparative advantage, climate and geography were important variables in the economy. The assumption that factors of production were immobile internationally was realistic. Since there were inherent differences in climate and geography, the assumption that different countries would have different relative costs of producing tradable goods was also realistic.

Today, acquired knowledge is the basis for most tradable goods and services, making the Ricardian assumptions unrealistic. Indeed, it is not clear where there is a basis for comparative advantage when production rests on acquired knowledge. Modern production functions operate the same way regardless of their locations. There is no necessary reason for the relative costs of producing manufactured goods to vary from one country to another. Yet without different internal cost ratios, there is no basis for comparative advantage.

Outsourcing is driven by absolute advantage. Asia has an absolute advantage because of its vast excess supply of skilled and educated labor. With First World capital, technology, and business knowhow, this labor can be just as productive as First World labor, but workers can be hired for much less money. Thus, the capitalist incentive to seek the lowest cost and most profit will seek to substitute cheap labor for expensive labor. India and China are gaining, and the First World is losing.

Paul Craig Roberts is a former Assistant Treasury Secretary in the Reagan Administration and a former BusinessWeek columnist.

[sarcasm]

Paul Craig Roberts must be a communist.

[Batrachian]

Outsourcing and offshoring of work does help corporate earnings, and sometimes stock prices, and that's it. There is no other benefit to us. To China, yes. To India, yes. To Mexico, yes. To us, no.

[MegaSilver]

You're entitled to your opinion, but I wouldn't agree that someone who's leery of letting our capital leak out to a country run by a crazed Communist Party is a communist.

[MegaSilver]

To us, no.

Actually, we do get somewhat lower prices, but considering the labor we give up in return, I'm not sure that the difference is made up.

[sarcasm]

Note screen name.

[HarryCaul]

Or someone who was an asst tres. sec. under Reagan. Heh.

[jpthomas]

The US must have an "absolute advantage" in private services expertise, because as the Wall Street Journal reported on Monday, foreigners outsourced 53.64 billion more office work to the United States than American companies send abroad in 2003. (See More work outsourced to US than away from it)

[WilliamofCarmichael]

labor arbitrage

leakage, imported productivity, loss of consumer demand. . . .

Well, Morgan-Stanley's Stephen Roach finally has an ally. Somebody else gets it.

"David? Ricardo. I thought my economic advisors said Lucy Ricardo! Doh!" exclaimed A. Free Trader.

India and China are gaining, and the First World is losing.

"Hey! That's my job! I'm working on that." screamed Kyoto.

Well, if he doesn't understand that no American has a right to a job how can he be expected to understand that it's not fa-a-a-a-air to interfere with a corporation's right to make all the money it wants, any way it wants. All it asks is to stay out of the way -- and a little taxpayer-paid risk insurance coverage and such, that's all. Darn protectionist, racist communist.

[WilliamofCarmichael]

Durn, I'm not a subscriber to WSJ. I was hoping they'd explain how Europe and Japan can outsource to us and do Okay but our corporations have to outsource to "developing nations'" cheap labor to survive. I real mystery to me. Durn.

Well, one poster suggested that we are just a rest area as the foreign outsourcers find their way to India and China. They better hurry they'll be going out of business real soon paying American wages.

[Batrachian]

We get only slightly lower prices, because the companies keep large profit margins. Anyway, we don't build wealth by driving toward the rock-bottom of wages and costs. We build wealth by increasing wages over the years and decades and keeping the money in our economy instead of letting it flood out to other countries as it's doing now.

Slowly but surely, we're impoverishing ourselves. Of course, the situation is extremely complicated, and not to be analyzed in a sentence, but the bottom line is that there's a large net negative in outsourcing.

[LibLieSlayer]

And therein lies the simple truth.

If we turn away from free trade now, our economy will slip into recession. In the short term at least, we would suffer losses from retaliatory action taken on behalf of foreign governments. If we raise tariffs, they will raise tariffs. If we eliminate outsourcing, they will eliminate outsourcing to the US.

We just witnessed what happens when we do take action to protect US markets. President Bush went out on a limb when he imposed policies to protect the steel industry from cheap imports (over a two-year period). Damn little thanks "today" for doing this, I might add. Not only did foreign governments threaten us, they sued us in the World Court...and won!!! If President Bush had not cancelled those policies, the EU would have placed embargoes on many, if not all of our goods imported into Europe.

If we pass laws that prohibit US businesses from utilizing outsourcing, how many Korean or Japanese companies will build new factories here in the US. We have a new Nissan plant in my area that employs 12,000 Americans. Toyota, Honda, and many other foreign corporations have moved some of their production to the US. This is directly due to productivity levels of the US worker, coupled with savings from the elimination of shipping product via sea-lanes.

How many jobs do we Americans enjoy now due to foreign "outsourcing" to the US? 6.4 million of us work for foreign automakers. Sony Electronics now builds some CE products here in the US. It would be naive to assume that these jobs would NOT be affected in some way, which would likely take place in foreign response to the US pulling away from free trade.

There is so much more to this problem than the above, but this is at the core when you peel back the layers.

LLS

[Southack]

"There is no necessary reason for the relative costs of producing manufactured goods to vary from one country to another. Yet without different internal cost ratios, there is no basis for comparative advantage."

1. Infrastructure (good infrastructures move goods and services and data faster, for less money, with fewer losses)
2. Rule of Law (court costs, piracy protection, theft prevention, property rights...all factor into the cost of doing business anywhere)
3. Taxes
4. Freely exchangeable currency
5. Foreign Exchange value of currency
6. Local worker Productivity levels (some cultures value working hard for lots of hours with few days off, others don't)
7. Local regulations (red tape costs money)
8. Local corruption (paying off self-important bureaucrats is a big reason why "cheap" labor is seldom actually cheap)
9. Government stability (forget low costs, the risks are too high to invest in Zimbabwe)
10.Employee turnover (some cultures foster long employee/employer relationships, while other cultures don't breed such loyalty in any reasonable degree)

All of these things are above and beyond simple access to surplus labor or materials.

And ask yourself this: If "cheap labor" is the key to wealth, then why are the two highest-wage-paying nations in the world (e.g. the U.S. and Japan) also the two richest?

Likewise, ask yourself why the lowest wage-paying nations (e.g. Nigeria with 47% of its working population earning $100 per year...10% of China's average wages) aren't the ones with the most economic growth?!

[Southack]

"Slowly but surely, we're impoverishing ourselves."

That's the ENTIRE POINT and focus of Karl Marx's Das Capital...that every capitalistic economy will grow progressively poorer each year until the workers all inevitably rebel against the ruling class.

Of course, Marx has been proven wrong decade after decade (care to compare the U.S. living conditions in 1920 with half of our country not even having running water or electricity to today, for example)...but being proven wrong again and again hasn't stopped Marx's useful idiots from parroting his long discredited spiel over and over again...

[sarcasm]

If "cheap labor" is the key to wealth, then why are the two highest-wage-paying nations in the world (e.g. the U.S. and Japan) also the two richest?

For how much longer?

[Southack]

Bright Graduates Sink In A Flooded Chinese Labor Pool - Subtitle should be: Chinese Wages Down For Third Year In a Row

[sarcasm]

I've read that article - it doesn't answer my question.

[expat_panama]

foreigners outsourced 53.64 billion more office work to the United States than American companies send abroad

The bush-bashers strut and bellow about some mythical loss of jobs-- the job-loss is like al-Querry's so called 'foreign leaders' pure fantasy.   You show the al-Querry bush-bashers the unemployment rate and you hear 'smoke and mirrors'.  You show them the millions of new jobs -- more 'smoke and mirrors'.   

It must be a new kind of Teflon, one that reality can't stick to. 

[Southack]

"I've read that article - it doesn't answer my question."

Then you missed the article's guts which point out that China's wages have declined for the last three years in row...whereas the wages in the U.S. have continued to rise.

Your question was how much longer would U.S. and Japanese wages remain above everyone else's wages...well, if our most significant competitor's wages are declining while ours are rising, then there is no "end" in sight to our dominance.

[sarcasm]

All it means is that the world is awash in surplus labor - expect more offshoring to take advantage of the wage differential and a concomitant decline in American real wages. BTW, real wages are falling.