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ChartingTheEconomy.Com. Our goal is to post articles that represent diverse views on timely topics.
Our guest is Robert Pisani, Ph.D., the author of this article. He is a Visiting Scholar in the Department of
Statistics at the University of California at Berkeley, and co-author of the leading university-level
textbook on statistics. Dr. Pisani can be reached through his website WWW.JustAsItIs.Com
by Robert Pisani, Ph.D.
Introduction
I am not an economist. I am a mathematician with a background in
academics and in business, but I have a fair understanding of the cause
and effect relationships in the world of economics. I am bothered by the
lack of rational discourse in the media about outsourcing and
by the unproductive finger pointing and political doubletalk that I find
there.
Haas Study
A study coming out of the Haas School of Business at UC Berkeley
estimates that as many as 14 million jobs or 11 percent of the workforce will
be exported from the US in the next 10 years. This has caused some
consternation in the US, but certain optimistic economists have pointed out
that in the 1950’s there were similar concerns relating to the spread of
automation, and that in fact automation led to increased productivity and a
much more efficient US economy, which quickly became the strongest in
the world. And their feeling is that the result of outsourcing will be the
same.
Nonetheless, simple economic reasoning leads to contrary conclusions that
are, to me at least, very alarming. Of course, there are few inevitabilities
in this world but there does appear to be something missing from the
arguments of the outsourcing optimists.
Economics of Outsourcing
It is an economic tautology that, at least in a capitalist economy, companies
that do not produce at the lowest possible cost will ultimately fail or be
acquired by companies that do. This Darwinian principle is at the heart of
all capitalist systems and appears to have been acknowledged even by the
communist bosses in China. And the world economy has become almost
exclusively capitalist.
Assuming no degradation in quality, moving work to lower cost labor
markets reduces a company’s production costs and does not affect its
sales. Where a computer programmer in Silicon Valley may cost his or her
company $70,000 per year plus benefits, the same work performed by a
computer programmer in India may cost only $7,000 per year plus some
relatively minor administrative costs, leading not only to much lower
development costs for the company, but also to a lower price for the
company’s ultimate consumers and to a higher return to the company’s
stockholders or other owners. Given that such inexpensive offshore
programmers are likely being used by competing software companies
(some of which may actually be located offshore, perhaps even in India or
China), it is probably necessary for the survival of the company that it use
such a low cost resource.
Identical considerations affect companies in other industries. As an
example, almost all US clothing and fabric manufacturers have either
already closed their doors or moved their manufacturing offshore.
Because of the cost of US labor and US resources, an apparel maker
manufacturing in the United States cannot produce clothing at a price
competitive with the prices of clothing produced by foreign operations. The
lesson is, if a job can be exported profitably, it will be; and if such a job is
not exported, the job will vanish anyway when the company goes out of
business.
Benefits of Outsourcing
However, US consumers have benefited from this trend. Clothing is less
expensive today than ten years ago. And a visit to a local hardware store
will demonstrate the availability of tools produced in, for instance, China,
being sold at prices far below the prices charged ten or twenty years ago
for the same tools made by American companies. While US jobs have
been lost thereby, US consumers can now purchase clothing and tools and
other goods at prices far below the prices they used to pay. Whether the
benefits outweigh the losses is as yet unclear.
The advantages of using offshore workers are not limited to those
companies producing material goods. It is already widely observed that if
you call a telephone operator at any major bank or credit card center, you
will most likely reach someone located in India. Language difficulties
occasionally pose minor impediments to the services requested but this is
merely another friction cost, small relative to the huge savings experienced
by paying workers only a fraction of what they must be paid in the United
States. Just as the first post-WWII Japanese products were steadily
improved until Japanese products dominated some markets even in the
US, so the continued improvement in training of offshore operators will
clearly bring them to the point where their accents and language skills will
make them and their service indistinguishable from their former US
counterparts.
Automation
Exacerbating the problem facing US workers and the US economy is the
fact that if a job can be automated at low cost (for instance, using voice
recognition or artificial intelligence technology), it will be. A call to
customer service at UPS or one of the major airlines will connect you to a
computer that asks you standard questions and understands standard
answers.
Of course, certain work cannot be exported or, at least in the near future,
automated. For a few examples, work done by roofers, cleaning
personnel, bus drivers, and university professors cannot be exported or at
the present automated. However it is not only low-end jobs that can be
automated. As technology progresses, more and more human activities
become duplicated by machines, and the few activities immune to this kind
of automation reside in the areas of creative work and technical invention.
Certainly the technology needed to automate much lower-end work, such
as that of supermarket checkers, is already available and being used. And
the many untapped opportunities for profitable automation are rapidly
being explored. The economic incentive for such automation is clearly
enormous when one considers that, for instance, a human checker may
cost anywhere from $10 to $20 per hour, while a computer performing the
same work costs only pennies per hour and does not make errors.
US Workers, Foreign Workers
As a general rule, if a US worker can be replaced by a foreign worker who
is paid $x per hour or by a computer costing pennies per hour, that cost
(plus any friction or administrative expenses) becomes the value of the
labor performed by that worker. In a sector affected by outsourcing, the
cost of labor in the US must therefore decline to a level at which US labor
costs equal foreign labor costs in that sector, subject to the relevant
frictions. And for a sector affected by automation, the total income of US
workers in that sector must decline essentially to zero.
What happens to workers in a sector affected by outsourcing or
automation? Workers in an affected sector migrate to other sectors,
producing an oversupply of workers there, and their numbers and their
competition reduce the value of their services (and the cost of their labor)
in these other sectors. Because of this migration, ultimately all US low-end
sectors will be affected, and in higher-end sectors only critical jobs not
performable by lower-end workers will be unaffected. Thus it appears that
not only must the average US income suffer a possibly dramatic decline,
but also the US unemployment rate at all levels must increase.
Effects on the US Economy: Income and Expense
By how much must the average American income decrease? Equilibrium
of wages will be reached when wages in like sectors are equal throughout
the world. Considering only the two largest sources of offshore labor, India
has a population of about 1 billion and China has about 1.2 billion people,
with about half of the population in each of these countries in the 20-49
age group of greatest working potential. Annual income for a skilled Indian
worker is $7,000, average per capita income is much lower, and both are
considerably less in China. Given the combined populations of just these
two countries, an estimate of $10,000 per year for the average American
wage at equilibrium is not unrealistic (see Demographic Note below). A
question that Is unanswered by this analysis is how long it will take to reach
equilibrium.
This mass production of goods using low cost labor will naturally result is
lower costs at the local store, so that Americans will need less money to by
the same goods. However, even if the cost of goods in the US declines to
the level of the cost of goods in India and China, the outsourcing of
American jobs poses a problem. Namely, certain expenses of American
consumers will not decline. For one, oil is become more and more
expensive and may even by itself precipitate a crisis in the American
economy. And mortgage payments are at best fixed and in many cases
worse than that: variable.
A decline in the earning power of the average American worker to an
annual level of $10.000 would lead to foreclosures more widespread than
those in the 1930’s depression. Combined with the automation effects, a
level of unemployment of 30%, such as experienced by the US in the
depression of the 1930’s, does not seem an unreasonable expectation.
Further, it would become impossible to pay off the US national debt and tax
revenues would not be sufficient even to pay the interest on this debt.
It is argued that the prosperity and increased productivity of the countries
receiving outsourcing labor will cause them to purchase American
products. However, this argument begs the question of what goods or raw
materials America can produce less expensively than, for instance, India or
China. Aside from its efficiently grown food, and from unique industries like
Hollywood and TV that are peculiarly American, it is not clear that America
and Americans can offer more than a small fraction of the world’s need for
products.
One of Scotland’s major industries is the production of cashmere, but
modest quality cashmere produced in China is now available at very
ordinary stores like Target and Wal-Mart, at prices much lower than the
cashmere sold by Scotland. Scotland has managed to retain its cashmere
industry by focusing solely on cashmere of the highest quality. While
China will certain improve the quality of its exported cashmere, it may be
that it will cede the high-end cashmere market to Scotland, at least for the
foreseeable future.
Focusing on the highest quality products may be one solution to the
problems faced by American industry. However, just as Japan moved from
producing cheap low quality products to exporting products that were
among the best available anywhere, it is inevitable that the rest of the world
will catch up and sooner or later also begin producing high quality goods
for export.
How Large an Effect?
These structural changes in the world economy will certainly have an effect
on the average income of American workers, on US real estate prices, US
tax revenues, and the US GDP. The question that must be answered is:
how large an effect? It appears that their potential effect may be
catastrophic. Note also that the structural changes threatened by these
events are not limited to the United States. Certainly Canada and many
European countries will suffer similar fates.
None of the various proposed weapons to combat the trend of outsourcing
appears to be more than lame. Tax incentives or disincentives clearly
cannot compete with the difference between a $70,000 per year expense
and a $7,000 per year expense. Trade barriers such as tariffs will also not
do the trick and will have side effects perhaps more serious than the
problem. And productivity increases of a factor of ten or more, which would
be required to overcome the huge differences in the cost of onshore and
offshore labor, are clearly not possible.
One weapon the US has is inflation, which would at least provide some
temporary relief for their income problems, albeit at considerable long run
cost. Certainly if all industrialized nations agreed, either explicitly or
implicitly, to inflate their currencies, their real estate prices would be
thereby supported, and since these countries in fact house the principal
borrowers in the credit markets the interest rates that they pay could for a
time be kept at low levels. However, as soon as the majority of world
production activity has gravitated to the now-developing countries, lenders
with a choice of borrowers would no longer lend to the old countries at low
rates.
Many states now have their accounting and bookkeeping services
performed offshore. Some argue that this is un-American and that these
government agencies should not participate in such perfidy. However, the
savings that such a state enjoys are passed on to taxpayers. If the state
chose to have the work done at home at higher cost, it would be the
taxpayers who would be paying a higher cost, either in higher taxes or
fewer services, for this work.
Conclusion: See the World as it Is
If, as some economists would argue, this shows only one side of the
equation, it would be of major economic and national interest to
demonstrate the other side. The election year political grandstanding that
passes for analysis on television talk shows is not productive and in fact
distracts from the real issue of what should be done. While the outlook
may not be as grim as I have portrayed it, the US will likely suffer some
economic losses, possibly severe ones, and it is important to see as clearly
as possible what lies ahead.
Machiavelli said in one of his discourses that those to see the world as it
should be rather than as it is bring down upon their heads all manner of
woe. If you are stuck on the railway tracks and a freight train is headed
your way, it is surely foolish to deny the fact. I would like to see some
sober discussion of these matters.
Demographic Note:
The following preliminary demographic calculations
serve to illustrate the magnitude of the problem.
The US has .3 billion people, India has 1 billion people, and China has 1.2
billion people for a total population among the three countries of 2.5 (= .
3+ 1.0 + 1.2) billion people.
US average household income, accounting of course for many two income
families, is about $40,000, and per capita income is around $23,000 per
year.
Average per capita income in India is less than $3,000 and in China it is
less than $2,000.
Using these optimistically inflated figures, we can compute gross annual
income to be:
• US: 300 million times $23,000 = $6,900 billion,
• India: 1 billion times $3,000 = $3,000 billion,
• China: 1.2 billion times $2,000 = $2,400 billion,
• Total income of the three countries combined: $12,300 billion.
If the workers in these three countries earn equal wages for equal work,
assuming roughly the same work is done in each country and that the
total income remains the same (probably not realistic, since the
advancement of conditions in each country will raise the standard of living
and lead to increased wages), this total income of $12,300 billion will, in
equilibrium, be divided among 2.5 billion people, which will give an
average annual per capita income of the three countries equal to 12,300
billion/2.5 billion = $4,920.
Footnote
The above demographic analysis is admittedly simplistic. Of course
there are frictions involved in these processes: administrative costs,
transportation costs, time costs of educating an agrarian populace, etc.
And an average income of only $5,000 for American workers does seem
preposterous. But I would not underestimate the speed with which China
and India (which are merely the two largest currently competing
populations) will become competitive. China is already building yachts
and other luxury items. In the years after World War II, Japan was known
for producing only cheap and shoddy goods, watches and transistor
radios and such, but within 15 years it was competing head-on with the
US and European automobile industry, and within 20 years it had seized
a good portion of the world automobile market, as well as the world's
audio-visual market.
China is already reportedly building knock-off Chevrolets and selling
them there for $5,000; if they begin building and exporting legitimate
quality cars, I think the western automobile manufacturers, including the
Germans and other Europeans, will be driven out of business unless they
produce their vehicles in a lower wage country. Also everything happens
faster today. China may accomplish what Japan did after World War II in
far less than 15 years, especially considering their governed economy.
Because of its social problems, India seems to have a little more
resistance to this sort of evolution, but I would not underestimate the
desire of its people to have better lives.
Some might argue that American ingenuity will protect the United States
from this kind of calamity. But the US does not have a corner on
innovation (and even if it did, the real innovators are a very small
percentage of the population, and once they innovate it is easy for
others to follow in their footsteps). There is no question that the US now
has the majority of the world's scientists, engineers, writers and film
makers, artists and intellectual product, far more per capita than non-
industrialized nations and even more than many of those that are
industrialized. But that is because we are a rich nation and have more
people able to spend their time pursuing these activities rather than
fighting for survival. China already graduates ten times as many
engineers as the US each year. Once other nations achieve a level of
wealth that enables these activities, we will see much more product of all
kinds coming out of them.
.
The simplistic estimate of $5,000 for the future average annual income of
US workers is so extreme -- in statistical parlance, so many standard
errors from any figure which would not cause catastrophic adjustments to
the US economy -- that, even after considering all frictions, omissions
and other corrections to the demographic argument, the result may still
be calamitous. If comprehensive modifications to this argument cause
this $5,000 figure to be multiplied even by an unrealistic factor of four or
five, half an order of magnitude, the estimated average annual income is
still only $20,000 or $25,000, devastating to the US economy. Even a
decline to an average income of $30,000, a factor of six, would be
catastrophic.
Ultimately a state of quasi equilibrium must prevail and outsourcing will no
longer be profitable, as the labor cost in the US will have declined, and
offshore labor cost will have risen, to a point where the difference
between the costs of US labor and comparable offshore labor will not
compensate for the frictions involved. Although this quasi equilibrium
may not imply the equalization of household income among countries, it
apparently does imply an overwhelming change to American living
standards in the not very distant future.
As I said at the beginning of this article, I am not an economist. And
these are very complex times. But although the above discussion may
ignore certain factors and forces, I do not think that the basic reasoning
is incorrect or that these conclusions are undeserving of consideration
and analysis. I wrote this article not so much because I am completely
persuaded of its thesis but because I don't know what else to think. The
media provide only politically motivated discussions and I find no
reasonable analysis elsewhere. I would like to hear some smart and
objective economists discuss these issues and, as they say, finish the
equation.
And, finally, a grim comment from one reader is as follows:
"Not to belittle the outsourcing subject, it pales in the face of the real
calculations of the US's entitlement programs, whether one disagrees with
them or not. To support even modified or reduced commitments which really
become very due in the next four years will either necessitate a huge increase
in taxes or almost unimaginable repudiation across the board, or both. Of
course considering the entitlement issue, the outsourcing issue, and the
current Administration's preoccupation with war in foreign lands and the
financial waste war brings, one is really only left with a single choice in terms
of long-term investing. Go short, and hope that today's Exchanges (Bourses)
will still be able live up to their guarantee of delivery."
Final Footnote
There is an interesting counter argument to the above thesis, which
should be considered in any comprehensive analysis:
I calculate the total income from the three major populations and divide
that total by the total number of people in those countries, arriving at an
average per capita annual income under equilibrium. If the total income
from India and China remains the same, that average is, at least within
the boundaries of frictions, etc., applicable. But the total income from
India and China will not remain the same; it is rising and will definitely
continue to rise, and therefore the average income in the three countries
will rise, so that at equilibrium the average annual income will not be
$5,000 but will certainly be greater than that. If their GDP's rise
sufficiently, even at equilibrium the US average annual income could stay
the same, or even rise. And Indian and Chinese and US incomes could
even maintain the same disparity that they currently have.