Policy response should be well informed about the costs and benefits of offshoring

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D. Murali

AS PROFESSIONALS in the truth business, it is only but fair that we read a hot report titled Truth and consequences of offshoring' by L. Josh Bivens, posted on, the site of the Economic Policy Institute.

It examines three studies on offshoring and rebuts their claim that large benefits accrue to the US economy, and points out that costs have been ignored.

For starters, offshoring isn't the same as outsourcing.

"Outsourcing is an arrangement in which one company provides services for another company that could also be or usually have been provided in-house," defines and provides links to nearshore outsourcing, onshore outsourcing, and offshore outsourcing, as `also see' entries.

Onshore outsourcing a.k.a. `domestic outsourcing' is the contracting out of work to another company in the same country.

`Nearshore outsourcing' takes the work outside the border but only to neighbouring countries, as for instance, US companies outsourcing work to Canada and Mexico.

"Geographic proximity means that travel and communications are easier and less expensive, there are likely to be at least some commonalities between the cultures, and people are more likely to speak the same language," are the advantages as the EPI's site mentions.

In contrast, `offshore outsourcing' or `offshoring' is a type of business process outsourcing (BPO) where the work travels farther away than countries nearer to one's shore, as in the case of work coming in to India from Europe or the US.

Dynamics of Outsourcing: Offshoring, Insourcing, and a Case Study India by Lily Ho, Marcos Torres and Philipp Vu is among the `scholarly articles' listed by Google on outsourcing.

It defines `insourcing' as the practice of foreign firms investing in the US, typically in the form of FDI, to take advantage of the benefits of doing business in the US.

"The combination of offshoring and `insourcing' makes it difficult to say whether one or both practices are `good' or `bad'," wonder Ho et al, but leaving that discussion aside, let me veer back to Bivens's paper.

$1.14 benefit for $1 offshored!

McKinsey Global Institute's 2003 study is the first that Bivens takes up for attacking. MGI had argued that 58 cents can be saved in corporate costs; US exports to the country where employment is offshored would increase by 5 cents; 4 cents will get repatriated to the US multinationals from the offshored location; and workers laid-off in the US would earn 47 cents for every dollar offshored when re-employed. All adding up to $1.14, in the form of benefits for every $1 offshored, MGI had said.

But Bivens questions the implicit return of 14 per cent, saying it is `enormous'. He points out that the data were drawn from "a self-selected group of firms that have chosen to offshore their labour specifically because offshoring provides the largest economic gains."

Therefore, the numbers don't represent the average payoff that could be expected from a representative firm, declares Bivens.

A widespread practice of offshoring can result in "a loss to US income through terms of trade effects (as pointed out recently in the Journal of Economic Perspectives by Nobel Laureate Paul Samuelson)," states the briefing paper. (The phrase `terms of trade' refers to the prices foreign purchasers pay for a country's exports relative to the prices that country's residents pay for imports.)

Thus, offshoring of white-collar work may provide benefits to individual firms, but if it becomes widespread enough to lead to rapid productivity gains in sectors in which the US is a prime exporter, the US' terms of trade could deteriorate enough to cause actual income losses for the country, writes Bivens.

An interesting endnote explains this further: "This is an example of the classic fallacy of composition: assuming what is good for some parts is necessarily good for the whole.

The most clear-cut example is standing up to see better at a crowded baseball game. If no one else stands, you'll see better. But if everybody else stands up, no one's sight line is improved, and everybody is less comfortable."

To prove that the US workers are `net losers', the author attacks the MGI study with its own numbers:

"The cost savings from offshoring to low-wage locales is 58 cents, while US workers end up with only 47 cents in labour earnings after the fact.

This implies a loss of 11 cents for labour earnings from each dollar of production that is offshored, money that is a pure redistribution of income away from US workers."

Bivens argues that it may not be correct to assume that prices would decline so workers should be able to purchase things with their lower earnings. A telling graph shows that ever since 2001 corporate-sector income growth has accrued more to capital (65 per cent) and less to labour (35 per cent), almost reversing what prevailed all along!

Another chart plots CPI (consumer price index) that tracks the prices of what households consume, and GDPD (gross domestic product deflator) that tracks the prices of goods produced; "CPI has risen much more sharply than the GDPD over the past two decades, meaning that American households tend to consume goods whose prices are rising relatively rapidly".

We may need to find out how these charts look like for our data.

Global insight

The second study under the author's lens is The Impact of Offshore IT Software and Services Outsourcing on the US Economy and the IT Industry from Global Insight (GI), a consulting firm hired by the Information Technology Association of America (ITAA) to study the economic effects of offshoring information technology (IT) services on the US economy.

Drawing inputs from the MGI report, GI assumes that offshoring offers a 40 per cent reduction in the costs of producing software and other services, and therefore, equally flawed, points out Bivens.

"The most striking GI result is the forecast that offshoring of IT services will cut the growth of IT employment in the US by 50 per cent over the next five years. In the aggregate, the economy will more than make up this loss through expansion in sectors like construction, transportation and utilities, and health and education services," states the briefing paper before dissecting the shortcomings of the `macroeconometric model'.

Transparent accounting of potential benefits

Third in the list is the work of Catherine Mann, a 2003 report titled Globalisation of IT Services and White Collar Jobs: The Next Wave of Productivity Growth prepared as a policy brief for the Institute for International Economics (IIE). The report concludes that globalisation of IT hardware production since 1995 has raised US' GDP by $230 billion; and that globalisation of software will have the same substantial effect. Bivens lists the imperfections in the report such as overestimating the effect of globalisation, and exaggerating the effect of hardware on GDP.

On the latter, don't skip the section titled `standard growth accounting', where Bivens writes, "Multiplying the per cent price decline times the elasticity of investment yields only the change in IT investment, not its contribution to productivity growth," and goes on to suggest an alternative formula to compute `average annual contribution', the standard way of most growth accounting studies.

In conclusion, the author appeals for policy response to be "well informed about the costs and benefits of offshoring". And more important, "Policy should also not be driven by studies that mask the costs of offshoring while providing inflated estimates of its benefits."

Conversely, on this side of the shore, shouldn't we also study if we're falling into the trap of overstating benefits and ignoring costs?

(This article was published in the Business Line print edition dated August 4, 2005)
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