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September 13th, 2005
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Essay: Offshore Outsourcing: Perceptions and Misperceptions

by Daniel W. Drezner

The best way to understand the growth of offshoring and outsourcing is to realize that “it’s the technology, stupid.” What’s happened in the last 10 years or so is that the reduction of communication costs and standardization of software packages has fundamentally altered the way some jobs are done. Some tasks that were previously considered very complex — from office work to data analysis — have been simplified with the standardization of software packages. In addition, the growth of the Internet has made it possible to have people do tasks overseas — from anywhere. Nandan Nilekani, the chief executive of Infosys Technologies, an India-based IT firm, has said that “everything you can send down a wire is up for grabs,” and while that may be a bit of an exaggeration, it’s become at least potentially feasible to have people perform certain tasks almost anywhere, tasks that were not portable before.

This change has affected even the most hallowed of professions — journalism. In February 2004, Reuters announced it would outsource six low-level financial reporting jobs to journalists in India. Coincidentally, the number of newspaper stories that mentioned “offshoring” doubled between January and February of last year. By the end of that month, the outsourcing phenomenon was the cover story of THE ECONOMIST, TIME, BUSINESS WEEK, and WIRED. There’s an old saying: when a neighbor loses their job, it’s a downturn; when you lose your job, it’s a recession; when journalists lose theirs, it’s a depression.

There’s no question that the effects of outsourcing and offshoring on the U.S. economy and job picture have been exaggerated. Since 2004 was an election year, outsourcing made a convenient scapegoat for politicians. It’s very easy to call attention to the direct costs of a job being created in India. The benefits, on the other hand, are there, and just as real, but they are much more indirect. Also, the fact that as of 2003-2004, the job market in the United States still looked sluggish led many to think that jobs must be going elsewhere.

But these really are correspondences, not connections. According to the Bureau of Labor Statistics, less than 3 percent of mass layoffs by U.S. firms can be traced to offshore outsourcing. This is of little comfort to American workers, however: unemployment, as an issue, is a lot like crime, in the sense that people perceive that a much larger fraction of the population is affected than is actually the case. It isn’t so much what the raw numbers show, but whether you know someone — or know someone who knows someone who knows someone — who’s lost a job to outsourcing.

Another issue that intersects with offshoring is that over the past few years the distribution of gains in the economy has been going more to owners of capital than has historically been the case. One possible explanation is that offshoring has weakened the bargaining power of workers vis-à-vis CEOs, allowing management to appropriate the productivity gains reaped from offshoring. The problem with that explanation is that it can be difficult to distinguish what’s being caused by offshoring and what’s being caused by broader economic transformations, such as technological change. For example, the Bureau of Labor Statistics estimated that fewer than 5,000 workers were laid off en masse due to offshoring in the first quarter of 2004; in January of last year, Kodak announced a mass layoff of 15,000 workers — because the growth of digital photography reduced demand for film. This year Kodak announced additional layoffs of 10,000 workers. Furthermore, a lot of the jobs that are sent overseas are jobs that might not continue to exist in the United States in any case: If those jobs are not outsourced overseas, they might be automated or otherwise eliminated through technological innovation.

Overall, the net effect of outsourcing on the U.S economy is likely positive. What makes this assertion difficult to prove is that the jobs created as a result of this phenomenon are not necessarily going to be in the areas in which we’ve been outsourcing — data services, software, etc. It’s more likely that they’ll be in construction, retail, or other sectors that cater to the domestic economy. A growing U.S. economy means firms will be reinvesting their gains here, expanding and thus creating increased demand for economic goods and services across the board.

When economist N. Gregory Mankiw, the former chairman of the Council of Economic Advisors, said that outsourcing was simply another form of trade, he got beaten up politically. He was still 100 percent correct. As an economic phenomenon, the outsourcing of services is really no different than trade in manufactured goods. What’s politically different is that the people who are affected are those who had seen themselves as economic winners — people who’d never thought of themselves as competing in a global marketplace. Manufacturing workers in particular probably have quite a sense of “schadenfreude” about the whole outsourcing phenomenon, watching service workers suddenly coming to the realization, “This is how the free market works?”

CAPITAL ABROAD

From the U.S. perspective, India is often seen as the big winner from outsourcing. What’s interesting is that there are political tensions developing within India that echo what we’re experiencing in the United States. Both countries are experiencing overall economic gains, but an unequal distribution of benefits. In both cases there’s new wealth being created that wasn’t there before. India’s middle class is growing at a rate that in terms of absolute numbers looks impressive from an American perspective, but as a fraction of India’s population looks a little less so.

A massive construction site on the outskirts of Gurgaon. The once quiet suburb continues to grow as the BPO-driven economy expands.
Photo: Mitra Films

It’s certainly not the case that everyone’s gotten rich there; the Indian countryside remains terribly poor. Per capita income in India is well below the global median. In 2004, the BJP (Bharatiya Janata Party) — then India’s ruling party — called a general election under the assumption that the 8 percent growth rate would lead inevitably to their reelection. Instead, they were thrown out of office. What the BJP hadn’t counted on were the 700 million Indians reliant on the agricultural sector, who hadn’t benefited at all. If there had never been outsourcing, it isn’t the case that those 700 million people would have been better off — if anything, they would have been worse off. With offshore outsourcing, you have winners and losers in India; before offshore outsourcing, you only had losers.

Ironically, India itself now has some other pressing concerns because of the expansion of the global market for outsourcing services. Wage rates in Bangalore are starting to rise dramatically, and India has bottlenecks in its educational infrastructure that will limit the growth of the labor force. So other countries — the Philippines, Indonesia, Ghana — are beginning to compete. Nowadays you can even find Europeans and Americans working — if only temporarily — in India. Backpackers hiking through India stop off in Bangalore and work in call centers for a few weeks to pay their way.

What you’re likely to start seeing is a hierarchy of services, with India not holding on to the really basic jobs. India does have a solid leg to stand on in terms of medium-value services. But where things really are likely to take off within India is in terms of increased demand for local goods and services — a situation is developing in which the Indian economy isn’t paying attention just to what the U.S. market wants, but to what the Indian market wants. And that’s what’s driving these associated booms in construction and retail. The benefits that were initially concentrated in the IT industry are now diffusing through the rest of the Indian economy.

THE GLOBALIZED FUTURE

A mall in Gurgaon. The city’s malls — in part made possible by the incomes of BPO workers — have made it a destination for shoppers from all over the region.
Photo: Mitra Films

Technology and trade have always destroyed jobs in the United States — what Joseph Schumpeter called “creative destruction,” because along the way these twin forces created even more jobs. What is likely to happen in the future is that some U.S. jobs will continue to move overseas, but on the other hand, as other economies — like India’s — continue to grow much richer, they are going to start demanding an increasing number of U.S. products. If you examine the trade data on services classically thought of as part of IT and business services offshoring, you’ll see that the United States is running a trade surplus in most of those areas. Even the trend is encouraging. Between 1997 and 2002, annual imports of business, technical, and professional services increased by $16.3 billion — but during that same half decade, exports of those services increased by $20.5 billion. This is not surprising, since the higher-value-added services still tend to stay in the United States.

A lot of U.S. firms that looked into offshoring have now tried it, found there were a lot of hidden costs associated with it, and retrenched and moved operations closer to home; the process is known as “homeshoring” or “nearshoring.” For example, there are Silicon Valley firms that experimented with offshore call centers in Bangalore, found them too costly, and decided to outsource operations to Oklahoma instead.

The reason the United States has benefited from globalization is that labor markets here are so flexible. The McKinsey Global Institute has compared the effect of offshoring in the United States and key EU countries. They found that offshoring was a net gain for the United States, because labor markets were flexible enough for displaced workers to find new jobs. For the EU countries, labor markets are so rigid that they are net losers from offshoring.

On the policy side, the U.S. government should do everything it can to maintain that flexibility without increasing economic insecurity unreasonably. And a key measure would be to ensure portability of health care coverage, because workers are quite understandably scared about the possibility of losing their benefits if they lose their jobs. If you can create a scenario where health care is portable rather than tied to employers, that would reduce a lot of the anxiety over potential job losses due to outsourcing. Similarly, things like education and retraining programs are worthy of greater investments — but that’s true regardless of the outsourcing phenomenon.

The political future will depend fundamentally on the overall state of employment. The numbers imply that there was actually more outsourcing during the 1990s than there is now, but no one cared since overall job creation figures was so robust that nobody really lost out. If the job picture remains weak, outsourcing will continue to be a political hot button.

Economics is not a zero-sum game. The fact that a middle class is developing in India does not automatically mean the middle class in the United States is threatened. The nice thing about economics is that it’s a win-win game. As outsourcing makes Indians richer, the process should actually translate into Americans profiting — not only from Indian demand for American products but also from improved economic efficiency and greater economic growth in the United States.

Daniel W. Drezner is an assistant professor of economics at the University of Chicago. He maintains a blog on economics, globalization, and politics at http://www.danieldrezner.com.

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  • Offshore oursourcing

    Nice info. Thanks for sharing this blog.

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