Date: Fri, 3 Sep 2004 22:53:27 -0700 From: Norm Matloff To: Norm Matloff Subject: detailed New Yorker article on offshoring To: H-1B/L-1/offshoring e-newsletter As I mentioned recently, there have been several articles which I've been saving up for posting here, waiting until I had a good block of time to deal with each one. In this posting, I will review an article by John Cassidy in the August 2 issue of The New Yorker, with the modest title "Winners and Losers--the Truth About Free Trade," dealing in detail on the offshoring issue. Cassidy is the author of the book Dot.con (yes, that's an `n', not an `m'), which showed how big financial interests manipulated the Internet boom to artificial heights of frenzy. I highly recommend that you take the time to read the article in its entirety. It is lengthy, and not available on The New Yorker's Web page. Thus I will not post it here. However, it should be available at your local library, and the full article is (at least for the time being) on the Web at http://wilsonhellie.typepad.com/for_the_record/files/winners_and_losers.htm Now, here are some comments I have on specific statements in the article: As a senator, Kerry supported a host of free-trade initiatives, including the North American Free Trade Agreement and the extension of Most Favored Nation status to China. But once he embarked on a Presidential campaign he railed against "Benedict Arnold C.E.O.s" who transfer jobs overseas, and he proposed policies designed to limit outsourcing. As I've reported, Kerry's proposals would do virtually nothing about offshoring, and both he and his campaign officials have publicly admitted it. See http://heather.cs.ucdavis.edu/Archive/Kerry.txt More insight on Kerry's real views on offshoring come in the article here. The article leads off by citing the controversial remarks of N. Gregory Mankiw, chairman of the [Bush] White House Council of Economic Advisers, strongly supporting offshoring. There was such a negative reaction that even Republicans felt the need to object. But as Cassidy points out, ...it is left to economists to defend free trade, which they tend to do without reservation, regardless of political affiliation. For example, one of Mankiw's predecessors, Martin N. Baily, who served in the Clinton Administration, has just co-authored a paper entitled "Exploding the Myths of Offshoring," which echoes Mankiw's arguments almost word for word. Despite Kerry's tough public stance, many of his economic advisers endorse views similar to Mankiw's and Baily's, In this light, note that I have pointed out that the Clinton wing of the Democratic Party, which I believe is generally recognized as well representative of Kerry too, is also quite supportive of industry on the issues of offshoring and H-1B. See my posting on this at http://heather.cs.ucdavis.edu/Archive/DemocraticParty.txt Baily came to the Clinton adminstration from his position as a principal with the McKinsey Global Institute (and now is back there again), an organization whose purpose is to promote global trade. The McKinsey parent company advises business on how to offshore. So the Clinton people knew exactly what they were getting when they hired Baily. But at the time Clinton hired Laura D'Andrea Tyson, an economics professor at UC Berkeley to head his Council of Economic Advisors, she had been a critic of free trade. Magically, she transformed into a trade proponent during her time in the White House. After that, she became dean of the UCB business school, during which time she wrote a column for BusinessWeek in which she strongly supported the H-1B program. She then became dean of the London Business School. In other words, all kinds of goodies come from being a proponent of trade. Moreover, economists tend to overstate the theoretical case for outsourcing, arguing that trade liberalization is always and everywhere beneficial, which simply isn't true. In today's world, where multinational corporations can produce many goods and services practically anywhere, and where investment capital can move from one continent to another at the flick of a switch, there is no economic theory which guarantees that new types of trade, such as outsourcing, automatically benefit the United States. Some Americans gain: consumers, who enjoy lower prices; stockholders, who see profits rising at companies that employ cheap foreign labor. Some Americans lose: workers whose jobs are displaced; the owners of firms whose contracts are transferred to foreign suppliers. But the economists' argument that the country as a whole inevitably benefits is questionable. As Mankiw indicated, it was Adam Smith who developed the argument that the unfettered exchange of goods and services allows individuals to specialize in what they do best, thereby raising overall income and prosperity. "The taylor does not attempt to make his own shoes, but buys them of the shoemaker," Smith wrote in "The Wealth of Nations," which was published in 1776. "The shoemaker does not attempt to make his own clothes but employs a taylor." It may seem remarkable that economists still refer to the work of a Scottish radical who didn't even call himself an economist--his title at Glasgow University was professor of moral philosophy--but the division of labor, which is what Smith was talking about, lies at the heart of outsourcing and offshoring. (The two phrases once had distinct meanings, but now they are used interchangeably.) It is indeed amazing that all the current economists can do is cite this very old, highly simplistic analysis of free trade they teach in Econ 101. True, an introductory course does require that things be watered down, but that doesn't mean that the economists have to advise presidents on that unrealistic basis. Needless to say, the topic is not amenable to simple mathematical models, as the situation is not simple at all. There are just too many factors, which interact in intricate ways, to construct a model which is both realistic and mathematically tractable. Moreover, there is no obvious "objective function," a mathematical term for the quantity to be optimized. Economists are happy using Gross Domestic Product as their criterion for goodness of an economic policy, but as Cassidy says above, that criterion is woefully inadequate, as there are winners and losers. Here the author cites another problem with those simple economic models: However, some types of offshoring are not so easy to rationalize. American insurance firms are hiring workers in countries like India to process customer claims. Yet many of the Americans who are being displaced are well-educated and productive employees who could probably do the job better than their Indian counterparts. The problem here is that the models don't factor in quality of the product (in this case a service). Why, then, does this sort of trade benefit the United States? David Ricardo, another ancient British economist, answered this question in "Principles of Political Economy and Taxation," which was published in 1817, and it is his defense of free trade that Mankiw and his colleagues rely on to this day. Where Smith argued that nations gain by exporting goods which they can make more cheaply than other countries, Ricardo said that trade between countries makes sense even if one of the countries is the low-cost producer in every industry. Suppose, he said, that in Portugal it takes ninety workers to make cloth and eighty workers to make wine, whereas in England cloth production requires a hundred workers and wine production requires a hundred and twenty. Then, assuming wages are the same in both countries, Portugal has an "absolute advantage" in wine and cloth. Should it still trade with England? Yes, said Ricardo. Compared with each other, he pointed out, Portugal's vineyards are still more efficient than its textile mills. Therefore, it makes sense for the country to specialize in wine production, export what it doesn't need, and import British cloth. Portugal's "comparative advantage" lies in wine. In other words, say England has a worker making wine and Portugal has one raising sheep. It makes sense for them to trade places, because even though the Portuguese worker can do both jobs more cheaply than the Englishman, the Portuguese's cost advantage is even more pronounced for wine than sheep. Needless to say, there are all kinds of problems with this simple argument. For instance, if all that is really true, then why not have Portugal produce BOTH wine and cloth? That obviously can't work, since without trade the English couldn't pay for these things, but my point is that there is nothing in the model itself to reflect this. Nor does the model reflect things like quantity; I would guess that the population of England is substantially larger than that of Portugal, yet the model assumes an implied balance between the amounts of wine and wool produced. One of the reasons Indian programmers have such low salaries is that the country has an enormous underclass which makes the overall cost of living low. Intuitively, that would suggest that one impact of trade between the U.S. and India would be that U.S. economic structure might become somewhat like that of India. This is reminiscent of Michael Lind's term, "the Brazilianization of America." This point is addressed somewhat, in an indirect manner, by the following: But how does the rise of potential economic superpowers like China and India benefit the United States? Here, Ricardo's theory needs applying carefully. In a heretical but fascinating book, "Global Trade and Conflicting National Interests," which appeared in 2000, Ralph E. Gomory, the president of the Alfred P. Sloan Foundation, and William J. Baumol, an economist at N.Y.U., examined what happens when a low-wage economy begins competing with a high-wage economy. Unlike And even this book does not address what I consider a key point regarding offshoring: The industry's own analysis essentially says that offshoring will result in the U.S. losing jobs requiring a rigorous level of education while gaining jobs which require lesser education. You don't have to be an economist to understand the serious negative impacts of such a trend. The nearest thing to a compensation scheme is the federal Trade Adjustment Assistance program, which has recently been expanded. In 2003, this scheme provided income support and retraining grants to more than two hundred thousand displaced workers. However, a 2001 report by the General Accounting Office has shown that it is often ineffective, especially for older, less educated workers. Other ideas Moreover, programs like this tend to train workers for lower-level jobs than what they had had. Offshoring would exacerbate this problem, again because of the trend I mentioned above, in which offshoring trades high-level jobs for low-level ones. have been proposed, such as "wage insurance" for workers threatened by This is Robert Reich's favorite "solution." Obviously it is stopgap at best. Some economists privately acknowledge that the arguments about outsourcing are nuanced, but they fear that any weakening of support for free trade could do untold damage to the economy. During the Great Depression, Congress introduced the infamous Smoot-Hawley Tariff Act, which raised duties on a range of foreign goods. Other countries retaliated, and the subsequent downturn in international trade intensified the slump. The economists are right when they say protectionism isn't the answer to outsourcing. But they need to get beyond pat slogans about free trade. Yet the author later brings in quite a few pat slogans himself. First, though, he makes what I consider a key point: John Kerry has at least tried to address the issue. His outsourcing plan, which was largely drawn up by Jason Furman, a young economist who was formerly one of Mankiw's students at Harvard, would revoke tax breaks for companies that shift production overseas and redistribute some of the extra revenue in the form of subsidies to firms that expand hiring in the United States. Politically, this proposal is an astute response to popular concern about outsourcing. Practically, it is unlikely to have much impact. All too often, the cost reductions that firms enjoy by moving jobs abroad are so large that hitting them with a tax increase wouldn't make much difference to their calculations. And, as I mentioned above, Kerry and his campaign officials have ADMITTED this. See http://heather.cs.ucdavis.edu/Archive/Kerry.txt Yet, Kerry is still crassly hoodwinking many people concerned about offshoring, knowing that his famous "Benedict Arnold" comment will reach far more people than this little comment buried in a long New Yorker article. The essential point is that comparative advantage is no longer endowed by nature: through hard work and enlightened administration, countries can wrest it from each other's grasp. Ricardo was writing about economies dominated by agriculture and rudimentary manufacturing, where a favorable climate and the ready availability of raw materials were vital. These days, the keys to economic success are a well-educated workforce, technical know-how, high levels of capital investment, and entrepreneurial zeal--all of which countries can acquire with the help of supportive governments, multinational firms, and international investors. Yes, good points. Unfortunately, at this point the author, after being critical of the right people--industry lobbyists, politicians and economists (my apologies to readers of this e-newsletter from those three groups :-))--starts talking exactly like those people he has criticized. He claims that all will be saved as long as we beef up science and math education, etc. As I've said many times, none of these passes the test of common sense. Tons of people who are really good at science and math are being laid off and cannot get new technical work, yet the author thinks the solution is to produce even more of them. And worst of all--those readers who are critics of the H-1B program, brace yourselves, and don't smash your computer monitors when you read this--the author urges that we should be expanding scholarships and visas to attract able foreign students and entrepreneurs to these shores; Now, where did this come from? The industry lobbyists? Not likely for the author of a book named Dot.con. More likely he got this directly or indirectly from the intellectual movers and shakers in the Clinton-Kerry wing of the Democratic Party. Again, see the details at http://heather.cs.ucdavis.edu/Archive/DemocraticParty.txt It is rare and very disappointing to see such a thoughtful article ruined by a string of unthinking recommendations at the end. Norm