Outsourcing latest

The outsourcing debate continues. Greg Mankiw points us to an FT article by Francesco Guerrera: Multinationals cut down on outsourcing which finds that outsourcing is slowding as companies shift to shorter and smaller contracts, and run out of projects to outsource:

...The outsourcing industry has just experienced its worst quarter in four years and is unlikely to match the $81.9bn in contracts won in 2005 by the end of this year, data from the consulting firm Technology Partners International shows. A slowdown in 2006 would mark the second consecutive yearly fall in the volume of outsourcing contracts since their $84.7bn peak reached in 2004.

The results suggest that, following the drive to curb costs and streamline operations by contracting out non-core functions, multinationals might be running out of major operations to outsource.

Although companies appear to be buying a wider range of services from a larger number of providers, their preference for shorter deals is heightening competition among outsourcing groups. The average contract length is down to four years from about 10 years in the recent past.

“In some sectors, especially information technology, companies perceive that there has been a commoditisation of services, leading them to opt for shorter-term contracts of lower overall value,” said Peter Allen, a partner at TPI. “We just don’t see enough big deals in the pipeline to cause us to believe the levels of last year will be reached”.

The trend is likely to raise concerns in countries such as India and China and among groups such as IBM, Accenture and Electronic Data Systems, which have been among the biggest beneficiaries of the outsourcing trend.

...According to TPI, which tracks worldwide deals worth more than $50m, outsourcing contracts signed between July and September totalled $13.4bn, a fall of more than 20 per cent on both the previous quarter and the same period last year. The weakness of the past three months has left the total for the year at $55.3bn, more than $26bn below the figure for the whole of 2005.

Meanwhile Thomas Palley provides a critique of IT outsourcing: Globalization and IT: Setting the record straight. Responding to an IIE report Accelerating the Globalization of America: The Role for Information Technology, Palley writes:

The IT industry provides an opportunity for observing the effects of global outsourcing on a cutting-edge “new economy” sector. A close inspection of the facts confirms the fears of the public, not the claims of corporations. The IT industry is not the apparel or shoemaking industry, which means the adverse effects of global outsourcing cannot be casually dismissed as just the inevitable shedding of outmoded industry.

The study’s thesis is that IT investment yields a high rate of return for the economy. Moreover, IT investment is very price sensitive, so that lower IT prices yield a proportionately larger increase in IT investment spending. Finally, globalization has driven down the price of IT products. Putting the three pieces together, globalization has been good for the economy by driving down IT prices, increasing IT spending, and thereby spurring growth.

Sounds very reasonable. Unfortunately, there is little evidence that globalization has caused lower IT prices, and without that the argument crumbles. IT hardware prices are driven by two factors – long-term trends and the business cycle. The long-term price trend captures the impact of technological innovation, and the trend of prices has been down for a long time. That trend is sometimes referred to as Moore’s law - after Gordon E. Moore a co-founder of Intel – and it states that the unit cost of computing power halves every eighteen months. Moore’s law was coined in 1965, long before the current period of globalization began, and there is no evidence that globalization has accelerated the trend of computing power price decline.

With regard to the business cycle, there is clear evidence that the price of computing power (DRAM or dynamic random access memory) is related to the utilization of DRAM production capacity. Prices fall when there is excess capacity, and they rise when capacity is tight. That is standard supply and demand analysis, which rests on economic principles that applied long before globalization. The only contribution of globalization is that much DRAM production capacity is now offshore because U.S. corporations have been building new capacity offshore rather than at home.

All of this casts huge doubt over the claim that globalization has benefited the economy by benefiting IT. However, whereas the benefits are in doubt, the costs are not. One clear cost is that the U.S. IT hardware industry has been significantly hollowed out.

The U.S. used to run an IT goods trade surplus. Now, it runs a huge IT trade deficit, with many U.S. companies importing products made offshore by their subsidiaries or under license by foreign producers. In 2005 the U.S. trade deficit in information and communications products was $83.2 billion. The deficit with China alone was $50.8 billion, reflecting the huge off-shoring of IT production that has taken place.

With regard to jobs, there has also been a clear contraction in the level of U.S. IT employment. In 1999 there were 4.9 million technology-related jobs, but this had fallen to 4.6 million in May 2005 – a loss of 300,000 jobs. The bulk of these job losses were for workers earning less than $30,000 per year, but there was also significant job loss of 140,000 among computer programmers who made an average of $67,400 per year.

With regard to wages, the average real wage for lower paid technology related jobs was essentially stagnant between 1999 and May 2005. For mid-level computer support specialists whose annual pay averaged $43,380 in 2005, real wages actually fell 1.3 percent annually over this six-year period. However, the real pay of higher skill tech workers rose 1.6 percent per year. The bottom line is that global outsourcing of the U.S. IT industry has not been good for workers in the bottom half of the wage distribution.

...An underlying claim is that outsourcing of IT hardware production has been a boon to the U.S. economy because it leads to lower IT prices from which the U.S. economy benefits. According to this logic, the U.S could benefit from outsourcing of its IT R&D capacity and from outsourcing its software industry. Indeed, these developments are to be encouraged, and under current globalization policy they are.

Yet, this entire way of thinking has recently been challenged by Nobel laureate in economics, Paul Samuelson. Samuelson has shown that when the U.S. off-shores those industries in which it has historically held a comparative advantage (such as IT), the U.S.’s future gains from trade and standard of living can fall.

Changes in the structure of the U.S. IT industry are being driven by corporations, which are intent on maximizing their own profits. In a nationally based economy, such as was the case in the 1950s and 1960s, profit maximization by companies tends to maximize national income. In a global economy, that is not the case. Instead, profit maximization promotes the maximization of global income rather than national income.

Companies are happy to outsource because they earn the profits on outsourced production, but that does not maximize national income. This fundamental insight is not yet appreciated within Washington policy circles.

Hat tip: Felix Salmon

Comments

[Lord]

Some industries just become outmoded faster than others and IT is chief among them. It probably does mean lower standards of living since so much was overinvested in them. Even now this overinvestment is far from being totally absorbed. The education and careers thrown away don't come cheap.

[Arthur Eckart]

I agree, giving up comparative advantages is negative for an economy. However, it's uncertain if that's really happening. IT hardware (or PC computers) has become a mature and commoditized industry. So, I doubt the U.S. still has a comparative advantage. Lower prices have become more important (except perhaps for Apple computers, Dell's low cost business model is under pressure, not sure if IBM still makes PCs, etc.). There are typically labor shortages in emerging industries, because it takes many years to acquire needed skills. Growth in those industries are dependent on its workers. The data don't suggest the U.S. is giving up comparative advantages, e.g. over the past three years, U.S. export growth is faster than U.S. import growth, U.S. export growth is faster than U.S. economic growth, U.S. terms of trade are high, unemployment is 4.6% last month, etc. The U.S. may be giving away some income growth in the global economy. However, it may also be gaining some income growth, along with consumer surplus.

[A. PERLA]

"Putting the three pieces together, globalization has been good for the economy by driving down IT prices, increasing IT spending, and thereby spurring growth."

But not creating jobs, which is the most important. The theory supposedly goes that resources are "freed" to pursue other courses more remunerative. That theory falls flat on its face. Back to the drawing boards.

What has occurred in the American economy over the past five years since the dot.com boom and bust is that job creation has stagnated (or, at the very least, that remuneration to labor has done so). In Europe, it has simply never recovered since stagnating long before that of the US.

Global growth has been strong for the past 4/5 years. Given this fact and that above, where are the jobs being created? The answer to that question is oblivious. Globally, but neither in the US nor the EU.

And, what might the consequences of that fact? That most of the jobs created globally are not skill-rich hi-tech positions but unskilled manufacturing (that is, presently). Low cost but highly skilled Indian programmers are putting a hold on IT job creation in the original demand country. And Far East low skilled workers are absorbing many if not most of the jobs being dislocated from Europe and the US.

As a consequence outsourcing is reaping benefits for the corporation and stockholders, whilst destroying the earnings capacity of the lesser skilled population - thus worsening the "social fracture" within an economy.

For stockholders, this is tantamount to "having your cake AND eat it". Shareholders cannot expect one layer of the economy to always accept the deprivation brought about by outsourcing AND expect that same social level to remain active consumers promoting the economy - whilst another benefits from stock dividends or equity appreciation sparked by better corporate profit performance.

This must lead inevitably to the pauperization of the nation.

[Arthur Eckart]

A Perla, at one point, most of the U.S. labor force worked in agriculture. However, productivity gains freed-up resources for new industries, e.g. in manufacturing. Currently, less than 3% of the U.S. labor force works in agriculture and produces more than enough food to feed the entire country. The "Creative-Destruction" process can be slow or fast. Japan had a 15-year Creative-Destruction process, because of rigidies and immobilities (e.g. lifetime employment). Consequently, the Nikkei Index is still 60% lower than in 1990. However, the U.S. had a quick and massive Creative-Destruction process mostly over a two-year period, which freed-up resources from Information-Age firms. So, U.S. productivity has been able to speed-up in the Agriculture-Industrial-Information revolutions, while freeing-up resources for the Biotech Revolution and other emerging industries. Producing more output with fewer inputs raise living standards. Should we slow the inevitable? Would it be better if 10% of the U.S. labor force (instead of 3%) still worked in agriculture (and half still worked in manufacturing instead of 15%)?

[A. PERLA]

I believe wholeheartedly in the destruction/creation process of economic development. Looking closely at history shows that it has existed since the origin of civilizations.

The western world began transitioning from the Agricultural Age to the Industrial Age about a century ago. It took Europe about 50 more years than the US to do so, but it is done. (About three percent of the work force is found on farms in the EU.)

Western societies are now transiting from the Industrial Age to the Information Age, largely sparked by the doubling of available manpower in Eastern Europe and the Far East. Had this not happened, I do not doubt for a moment that the US and the EU would have been very content to maintain an antiquated industrial sector had it been allowed to do so.

You give far too much credence to America's ability to "create" and not enough to its ability to "destroy" economic activity. (That is, allowing sectors to sink into oblivion without the slightest attempt to save them.) I cannot imagine why. Having spent an entire career in IT, I am very blasé about technological innovation. It no longer impresses me and much of it has been "commoditized" anyway. Most hi-tech generates wealth for its innovators but not jobs, since manufacturing is outsourced.

I am far more concerned about America (and to a larger extent Europe's) inability to focus on lagging industries that are ripe for destructive dislocation due to high labor factor costs or lack of productivity enhancement. In fact, few governments even give it a second thought - assuming that it is simply natural evolution. Those who lose their jobs, however, have a far different opinion of the phenomenon.

If ever there was a role of the state that was obviously an imperative it is that of the threat of job destruction due to aging industrial / commercial activities. Much can be done, from tax incentives to enhance productivity to retraining to government targeted procurement programs to sectoral consolidations.

All these fall short, thankfully, of outright state subsidization.

[MB]

While the debate over the stats on outsourcing deals continues,Offshoring IT Services continues unabated. Notice the results posted by offshore service providers?

[Lafayette]

Offshoring IT Services : "Offshore IT sourcing offers many advantages, but executing offshoring is complicated. Since the number of books on this topic is limited, Mohan Babu K, a technologist at Infosys Techlologies Ltd and an IT Strategy Thought Leader"

My, my - an "IT Strategy Thought Leader". Will the marketing hype never cease?

Seems like Infosys has learned not only IT prowess but has absorbed the marketing garbage that goes along with it. Why doesn't the guy just call himself an "IT Guru", it would be less pretentious and so much more appropriate. ; ^ )

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