Thursday, April 5, 2007

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Score one for the Blinder-Friedman hypothesis

Let it be noted that Anand Giridharadas had a story in yesterday's New York Times that offers some support for the Alan Blinder-Thomas Friedman view of offshore outsourcing:

Outsourcing is breaking out of the back office.

For years, most service industry jobs that were moved to countries like India were considered relatively low-skill tasks like answering customer inquiries. But that has been changing in recent years, and increasingly the jobs of Western white-collar elites in fields as diverse as investment banking, aircraft engineering and pharmaceutical research have begun flowing to India and a few other developing countries.

In the view of most specialists on the phenomenon, the kinds of jobs that cannot be outsourced are slowly evaporating.

Boeing and Airbus now employ hundreds of Indians in challenging tasks like writing software for next-generation cockpits and building systems to prevent airborne collisions. Investment banks like Morgan Stanley are hiring Indians to analyze American stocks, jobs that commonly pay six-figure salaries on Wall Street.

The drug maker Eli Lilly recently handed over a molecule it discovered to an Indian company, which will be paid $500,000 to $1.5 million a year per scientist to ready the drug for commercial use — work that would be significantly more costly if carried out by Americans.

With multinationals employing tens of thousands of Indians, some are beginning to treat the country like a second headquarters, sending senior executives with global responsibilities to work there. For example, Cisco Systems, the leading maker of communications equipment, has decided that 20 percent of its top talent should be in India within five years; it recently moved one of its highest-ranking executives, Wim Elfrink, to Bangalore, the center of the Indian industry, as chief globalization officer.

Accenture, the global consulting giant, has its worldwide head of business-process outsourcing in Bangalore; by December it expects to have more employees in India than in the United States.

This is not a zero-sum game, in which every job added in India comes at the expense of an American or European one.

In many ways, the shift reflects a changing view at multinational companies as they find it easier to meet growing demand by taking advantage of the improved skills of newly educated people in the developing world. And some companies are returning certain jobs to the United States, finding that the work in India and elsewhere is not up to snuff.

But there are trade-offs as well. As Indian back offices become more sophisticated, Western companies are finding that large parts of their work, even high-end tasks, can also be done from India. From the consumer perspective, India has emerged as a pool of 1.1 billion potential customers for companies seeking faster growth. And so many companies are shifting their energy to where they see their futures being written.

“India is at the epicenter of the flat world,” said Michael J. Cannon-Brookes, vice president for business development in India and China at I.B.M., which has reduced its American work force by 31,000 since 1992 even as its Indian staff mushroomed to 52,000 from zero....

Still, specialists warned that a continued flow of work to India required drastic improvements in its educational system and basic facilities. Water and power shortages are endemic, and industry experts predict that India could lack 500,000 engineers by 2010. Yet the country has already tapped a deep well of English-speaking engineers, attracting more outsourced work than any other country.

Meawhile, Tom Friedman looks at call centers opening up in Kenya by a firm named KenCall.

UPDATE: Friedman's column prompts a bizarre comment from Matthew Yglesias:

The reason KenCall works is that its wages are so low. Its wages, in turn, are low because in Kenya at the moment the IT infrastructure necessary to operate a call center is very scarce relative to the level of English competency necessary to work in one. If an undersea cable makes it significantly easier to start up call centers, that may change. It all depends on how large Kenya's "large pool of educated, English-speaking talent" really is.
I think Matt's point is that offfshoring jobs are constrained in their ability to generate sustainable growth in the developing world. That's wrong -- India has had pretty sustainable growth even though their talent pool is a small percentage of the population.

What would be more accurate to say is that if the education picture remained constant, the returns to being an offshoring magnet are a) limited to the upper tier of the popilation, and b) decline over time as wages would go up for (relatively) skilled labor.

On the latter point -- so what? Offshoring flows would decline as wages rise -- and rising wages are a good thing. On the former point, here's the question you have to ask -- what's better, a society that has a relatively even distribution of income or a society where the poorest are not made worse off but the educated earn much higher returns for their education?

I suspect Matt would say the latter but not be happy about it. Over the long haul, however, market signals about the increasing returns to education would encourage an expansion of educated individuals -- which counters the effect that concerns Yglesias, and happens to be a good thing in and of itself.

UPDATE: Yglesias clarifies his position here:

Friedman is portraying the issue as one in which Kenya needs to build better broadband access, and then the IT jobs would come. The counterpoint I meant to make was that the real chokepoint here seemed to me to be the Kenyan education system. Only a very small proportion of Kenyans are qualified for KenCall-style jobs. At the moment, only a small proportion of the qualified people can get KenCall-style jobs precisely because the physical infrastructure to easily set up competing firms isn't there, which makes wages low by world standards which makes Kenya an attractive outsourcing destination. Build more infrastructure, you'll get more firms, the labor market will tighten, wages will go up, and then growth will slow down as future outsourcers look to other, cheaper countries.

That's all fine as far as it goes. My only observation was that insofar as only a very small proportion of Kenyans are qualified for these sort of jobs, it won't actually go very far. Kenya not only needs more infrastructure, it needs more workers qualified for these sort of jobs. Dan Drezner writes that "market signals about the increasing returns to education would encourage an expansion of educated individuals."

This, to me, seems slightly backwards. As I see it, improving school systems is hard and education levels often don't improve even when market incentives to do so exist. Increasing internet connectivity is, by contrast, relatively easy to accomplish and relatively more responsive to market signals. I have no doubt that countries that produce large pools of workers well-suited to IT work that market signals will cause companies to invest in expanding the IT infrastructure necessary to employ those workers profitably. I'm not by any means certain that the mere existence of remunerative labor market opportunities for well-educated Kenyans will cause the number of such Kenyans to spontaneously increase.

posted by Dan on 04.05.07 at 08:16 AM


Ah, the evil of competition!

One thing that I have trouble with is that the unemployment rate in the U.S. is so low, and that more people than ever are employed. Outsourcing is perhaps restraining that growth level in total employment, or unduly keeping the level of unemployment higher than it might otherwise be, but the levels they are at seem perfectly satisfactory.

Lower labor costs are good for consumers, by restraining prices of goods and services, and good for employers, who can use the capital freed up by lower costs to expand their business and create more jobs--here in the U.S. as well as overseas.

posted by: JohnF on 04.05.07 at 08:16 AM [permalink]

I'm taking Yglesias as:
"Actual size of 'English-speaking talent pool' is not as important as its size compared to opportunities, which are constrained by technological capabilities" - in this case anyway. I don't interpret this as a knock on off-shoring, only on the debacle of the East Africa Internet Cable, which is really what's keeping wages low. For some details on this (EASSY), check out Ethan Zuckerman's overview and analysis:

posted by: Drew on 04.05.07 at 08:16 AM [permalink]

Fer cryin' out loud, Daniel, use a spell checker. 'woyld secline'. Is that some arcane economics terminology?

Keep up the great work.

posted by: Jim Esten on 04.05.07 at 08:16 AM [permalink]

There are a couple of things wrong with the libertarian-tinged arguments of our gracious host and JohnF

First, we have long known that private gain does not equal public good, or even optimal private good (see Nash equilibrium).

How might this apply in India. Well, lets assume a limited amount of human talent, and a limited amount of capital to educate that raw talent. If India puts its time and treasure into educating a relative few for the outsourcing market, it will ignore the need (which from what I've read is vast) for civil engineers, sanitation engineers, and so on. Given an existing propensity toward caste, I would guess we will in fact see increasing salaries for a relatively thin segment of Indian society, and continuing misery for the masses.

Second, developed countries might in fact be surrendering the basic level jobs that provide a training ground for higher-value jobs. If the wages for starting US engineers are depressed due to outsourcing, college kids are going to look towards non-outsourceable careers. These might be protected by guild-like structures (lawyer, college prof) or might be something that cannot be physically outsourced (physical therapist?). In either case, it does not bode well for a national economy to provide disincentives for kids to go into tech fields, while maintaining protection for the auxiliary service industries.

We won't all be flipping hamburgers, we'll all be suing each other or teaching courses on the benefits of free trade, even as the country grows poorer.

posted by: Mitchell Young on 04.05.07 at 08:16 AM [permalink]

Mitchell Young concludes with "even as the country grows poorer." Hmm?

The free traders make an effort to total up the gains and losses from free trade in such a way that they can show that the gains are larger. The analysis can be expressed various ways; I tend to think of it as "if the win were not larger, wouldn't there be incentives for individuals spontaneously to stop trading, or at least change prices so that others stop trading?" (That is, rather the way that my class on pricing derivative securities taught me to look for risk-free arbitrage.) For example, if vanadium imports cause the price of vanadium to drop, a local mine might shut down some of its production or keep producing while lowering its prices to keep in business. Why would it do the first unless its marginal costs were so close to the market price that running it isn't much of a win for the economy anyway, so that they gains to some buyer from low prices exceed the losses from the mine shutting down?

Now, it is quite possible to find serious answers for that question. It is also possible to argue that the question is the wrong question because the gain as measured in prices isn't important, because you hardly care at all about gross economic prosperity, only about vastly more important things like equality of income. But fundamentally that question is a pretty stable argument for why the huge gross benefit number tends to be consistently larger than huge gross cost, so that the large (but relatively small) gain strongly tends to be positive in a sense that most people consider very important (and is very nearly the direct opposite of the usual meaning of "the country grows poorer"). In order to logically justify "the country grows poorer" (as opposed to, say, just basing it on rhetorical appeals to natural xenophobia and conservatism and existing special interests) you need both to discredit this stable argument and to come up with your own line of argument for why when everybody acts within the price system the huge gain tends to be smaller than the huge loss.

Arguments which just list off huge parts of the cost don't do it. It is absolutely uncontroversial that the gross cost is huge (and it's a cliche to compare it to the huge gross cost of tens of percent of the country's population being driven out of agricultural work).

Appeals to "see Nash equilibrium" don't say much. (If someone wanted to quibble with you on that, how would they know where to start?)

Well-developed arguments do exist, but they tend to be special cases, and/or rest on iffy implicit assumptions like government officials and voters being consistently shrewder than businessmen, customers, and workers. To my knowledge there's no standard model of broad protectionism that you can be proud to implicitly appeal to. Thus, if you want to claim the "country grows poorer" conclusion, I think you should either appeal to one or more competing serious but not-entirely-standard arguments ("as shown by the analysis of Alice B. Clever and her school") or risk being binned with "clueless hysterics" since they, not careful economists, are the dominant source of sweeping claims about free exchange making an economy poorer.

posted by: William Newman on 04.05.07 at 08:16 AM [permalink]

Well, I don't know where to start in reply, William Newman, except to say that policies dealing with commodities and products are fundamentally different from policies dealing with human factors.

If you want a protectionist 'model' just look to Hamilton, the founder of the American economic order

And here is a not too far fetched Nash equilibrium for you.

Two companies are competing for a series of contracts. Each would like to employ young American engineers for some of the more basic elements of the projects under bid. This would allow them to train the new generation, give them experience , etc. It would be good for the long-term health of each company.

Unfortunately, each knows the other will be underbid by its competitor if it employes the young Americans, as the labor costs will be hire than in the off-shored the work. Not off-shoring is suicidal in the short term, so they both submit bids assuming that the 'grunt' engineering work will be done offshore. What each company will lose is a pool of experienced younger engineers here. Eventually, as perhaps evidenced in the main post, this process will 'eat its way up' -- the offshore contractor will gain more and more experience, the domestic companies having forgone that experience because they were in a sub-optimal Nash equilibrium. Neither could be the 'first mover' to get to the optimal equilibrium (and of course collusion would invite the Federal authorities to the party)

The overall effect, of course, is that fewer America engineers are hired, college kids go into poly sci and then law, and America starts lagging technologically.

posted by: Mitchell Young on 04.05.07 at 08:16 AM [permalink]

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