Does economics need a new theory of offshoring?

A good question. It is posed in this week's Economist Economics Focus piece, The great unbundling. Let's enter the world of 'high resolution globalisation':

Globalisation is a big word but an old idea, most economists will say, with a jaded air. The phenomenon has kept the profession's number-crunchers busy, counting the spoils and how they are divided. But it has left the blackboard theorists with relatively little to do. They are confident their traditional models of trade can handle it, even in its latest manifestations. For example, Greg Mankiw, of Harvard University, has concluded that “services offshoring fits comfortably within the intellectual framework of comparative advantage built on the insights of Adam Smith and David Ricardo.”

Ricardo illustrated his insights with the example of Portuguese wine trading for English cloth. But some trade theorists think this metaphor will no longer do. Indeed, two of them—Gene Grossman and Esteban Rossi-Hansberg, of Princeton University—published a paper* last year subtitled “It's not wine for cloth anymore” (see “On the hiking trail”, August 31st 2006).                                         

Ricardo, it seems, did only half the job. He described the first of two “great unbundlings”—as Richard Baldwin, of the Graduate Institute of International Studies in Geneva, has put it in a recent guide†. Trade in wine, cloth and other goods allows production to be distanced from consumption. Countries do not need to grow grapes to enjoy the fruit of the vine; thanks to trade, they can transform cloth into wine instead.

But in Ricardo's world, a country must still take care of all of the separate tasks required to finish the goods it makes. In a country of pinmakers, to take Adam Smith's seminal example, someone must still cut, draw and straighten the wire; fashion and affix the head; then whiten and sheath the finished product, if any pins are to be made at all.

In the second great unbundling, production is spliced and diced into separate fragments that can be spread around the globe. Pin-whitening is done in one country; wire-cutting in another. Some theorists call this the “vertical disintegration of production across borders”. Thankfully, Messrs Grossman and Rossi-Hansberg have a more felicitous phrase: “trade in tasks”.

...As globalisation has advanced, it has become easier to move some of these tasks offshore. For the workers who once carried them out, this has three possible consequences, two bad, one good. Start with the good news. Offshoring makes firms more productive. The tasks that are best kept close to home remain onshore; other tasks can be taken care of in cheaper places abroad. Everyone benefits from this gain in productivity, including the workers who have fewer tasks to perform. For example, Japanese electronics companies continue to flourish in American markets precisely because they have moved their assembly lines to China. 

The second potential consequence of offshoring might be called the “Lou Dobbs effect”, after America's most prominent television mercantilist. When some tasks are taken overseas, that leaves less work for patriotic Americans to do, right? Well, maybe. If a whole industry leaves America's shores, demand for labour will ebb, and wages will fall. But in less extreme cases, relieving workers of some of their tasks (wire-cutting for example), allows the domestic industry to expand—and a bigger industry might find room for the displaced wire-cutters, at the same wage, albeit on different tasks.

...Offshoring, it is clear, enables companies to make more stuff. But this can be a mixed blessing. If the home industry makes too much, it will depress the price of its exports on world markets, damaging the country's terms of trade, and hurting workers. This result is sometimes called the “terms of trade effect”.

Messrs Grossman and Rossi-Hansberg describe this as a “new paradigm”, a phrase guaranteed to raise the hackles of more cautious scholars. Their model may not be quite that, but nor does it sit altogether comfortably within trade economists' established way of thinking. That tradition painted in bold strokes, and identified clear winners and losers from globalisation. Economists felt sure they could predict what would be traded and who would get hurt. As Mr Baldwin points out, they made pronouncements about entire “sectors” of the economy (heralding the dawn of some industries; the twilight of others) and whole classes of workers (the college-educated versus the rest) whose fortunes were tied to them.

A bundle of results

The new breed of models paint globalisation with a much finer brush. (It is high-resolution globalisation, Mr Baldwin says.) International competition plays out not just at the level of the industry, or even the firm, but right down at the level of individual tasks—assembly, packaging, data entry—that cut across whole sectors of the economy. Moreover, in a break with most traditional models, the new theories do not take the tradability of things as a given.

For Messrs Grossman and Rossi-Hansberg, the ease of trading a particular task is a matter of degree not kind; and it is a variable, not a constant. Hence tasks that seem safe from foreign competition today may not be so tomorrow. Finally, the tradability of a task might bear no relation to the amount of skill it requires. As a result, the victims of globalisation are harder to identify and the salves harder to apply.

So is globalisation to blame for the rich world's recent anxieties or not? Unfortunately, the new theories of offshoring can deliver opposite verdicts depending on precisely how they are set up. As James Markusen, of the University of Colorado, mischievously puts it, “I am confident that I can concoct a model to generate any result desired by a reader with a deep pocketbook.” If only every worker were as versatile.

* “The Rise of Offshoring”

† “Globalisation: The Great Unbundling(s)”

Comments

[Arthur Eckart]

Labor is abundant and capital is scarce. So, labor supply needs fall or capital creation needs to rise. Scandinavian countries control the labor supply by restricting immigration and providing social progams (generally to less productive workers) to lower the labor participation rate. China controlled its fertility rate. However, the U.S. focuses on capital creation, which lowers the cost of capital e.g. for entreprenuership. Consequently, the U.S. has an advantage in the global economy, where labor is abundant.

[Lafayette]

AE: "Consequently, the U.S. has an advantage in the global economy, where labor is abundant."

Claptrap clairvoyance, AE.

Go tell it to the 30,000 that GM laid off over the past year.

You know how to run fast?

[Arthur Eckart]

Lafayette, GM has lagged in capital creation and has destroyed capital recently. So, it makes sense to layoff workers to increase capital. The U.S. automobile industry is too large, since it's becoming obsolete. Laying off more U.S. autoworkers will help the U.S. economy run faster, because more resources can be shifted into the U.S. Information Revolution (where U.S. firms lead the rest of the world combined) and the U.S. Biotech Revolution (where U.S. firms account for over two-thirds of the world's revenue). Also, U.S. capital will flow into other high-skilled jobs. The U.S. creates and attracts the most capital, which gives the U.S. a huge advantage in the global economy, since labor is relatively abundant and capital is relatively scarce.

[Lafayette]

Baldwin: "It is high-resolution globalisation,"

Globalisation has two components, on being the production/exportation of low-tech consumer gadgets and the second of high-tech modern technology.

The first is dependent upon low wage costs to assemble products of commoditized technology. Some of the components come from advanced countries and are of the second category.

For instance, a CPU-chip from a hi-tech wafer plant in Germany will be exported to China to be incorporated on a motherboard with semiconductor memory from South Korea and other PC components to create a finished computer (which is then sold in Germany). This is indeed high-resolution globalization. But, is it a major percentage of the total.

Or, is the major percentage home or hobby gadgets like battery powered drills?

Low-tech is a major source of the job threat. Globalization of this kind is menacing both Europe and the US, since it is characterized by unskilled or semi-skilled labor input. Unfortunately, there are probably as many people employed in this sort of manufacturing as there are engineers employed in high-tech production of sophisticate products - if not more.

Who is suffering most? Today, the former employed in low-tech jobs. Tomorrow, who knows where it will stop? Only a serious deflation of wages will counter competition from the bottom, or very high productivity at present rates. The former is socially unacceptable, so the latter is worth thinking about. And changing fiscal policy towards allowing companies to amortize more quickly investments in productivity enhancement.

China is opening engineering centers in Germany to understand the magic of its machine-tool industry. One day German will engineers be joining the unskilled unemployed that once worked on the assembly line at Volkswagen? Quite possibly.

Regardless of all the knee-jerk reverence for "high-tech" stateside, of the entrepreneurship and venture capital that drives it, I doubt that high-tech contributes the majority of manufacturing jobs. Low-tech is, to my mind, much more of an employer. High-tech grabs a lot of headlines and TV reporting. Anyone reading current newsmagazine is likely to think it runs the economy. I can’t help but wonder if that is true.

Low tech, let’s remember, are industries like construction, building cars, or appliances, or sunglasses, etc., etc., etc. Low tech is the production of goods that we employ almost daily and in a repeated fashion. How many iPods does one buy in a year?

And, with the exception of construction, it is fertile ground for dislocation to the Far East. Where the iPod is made.

[Arthur Eckart]

Also, I may add, GM should produce fewer models and focus only on its high-quality autos, trucks, and SUVs, following other U.S. producers e.g. Paccar (commercial vehicles), Harley Davidson (motorycles), Caterpillar (tractors), Boeing (aircraft), Winnebago (motor homes), etc. GM is also making progress with electric/hybrid cars. The U.S. auto industry needs to be leaner with more emphasis on quality than quantity.

[Lafayette]

AE: "Also, I may add, GM should produce fewer models "

And, it should have been imposed emission standards on its SUVs instead of building cars that it was obvious would one day fall to the inevitability of higher petroleum prices.

Why wasn't it (or others, or even a national laboratory) leading the research on fuel cells? Where was a "moon project" effort by the government when the need was truly evident? On the planet Crawford?

But, of course, what is important are, not the air that American's breathe, but corporate profits, Wall Street P/E ratios and management stock-options.

Deeply flawed reasoning; all short-term myopia in the quest for lucre. And the environment be damned.

[Arthur Eckart]

Lafayette, the U.S. produces many big high-quality products. The U.S. can afford big vehicles, to go along with big houses and other big products, while meeting strict pollution standards. The U.S. takes into account the cost of negative externalities. So, there's no "flawed reasoning." Also, I may add, there's a shortage of labor for high-tech jobs and a surplus of labor for low-tech jobs. Any country can reverse engineer. It's inevitable developing countries will improve quality. Developed countries will also improve quality, and create new products. However, developing countries need to improve every industry by large margins to reach the levels of developed countries, which is not an easy task.

[Lafayette]

You work for an New York advertising agency, Arthur, with a contract for trumpeting the greatness of America?

America is the worst polluter per capita in the world. You are not in hi-tech or you would know how much Silicon Valley jobs have suffered by outsourcing to India.

China is not reverse engineering. India does reverse engineering of software.

China is doing very little hi-tech engineering per se. It is following the Japanese business strategy that worked. It is doing copy cat manufacturing, just like the Japanese did in the 50s and 60s - only to become, today, a lead technology developer in, for instance, home entertainment products.

They are learning and bettering themselves every day. Those kids I went to engineering school with in the US are now teaching engineering classes to a new generation in China. Sooner or later, this newer generation will start professional careers and China will start to roll out a fierce competition to confront Europe and America. (NB: Just look what it did recently in blowing one of its own satellites out of the heavens. That must have impressed the hell out of the Pentagon.)

All that you say gives a sense of hubris and of complacency, the two worst attributes of any country just before its demise.

China has an oriental long-term strategy, just like Japan. Its role model, in fact, is not America or Europe. It is Singapore and Hong Kong where the Chinese, under free market systems, learned to cope within and even dominate certain markets.

China was once a great country. It did it before and it thinks it can do it again. I figure it has a pretty good chance.

[Arthur Eckart]

Lafayette, the U.S. with less than 5% of the world's population produces one-third of the world's output and utilizes one-fourth of the world's oil. So, the rest of the world combined produces two-thirds of the world's output and utilizes three-fourths of the world's oil. I'm sure Japan, for example, is more energy efficient. However, Japanese live in small houses, drive small vehicles, etc. The U.S. is also efficient in outsourcing to add value at lower costs. So, the U.S. creates more capital for entreprenuership. Lower cost of capital is one mechanism to raise living standards. It's invevitable, China's education will continue to improve. However, China lags U.S. education by a huge margin. I wouldn't say the U.S. is complacent. The U.S. is a dynamic economy where change takes place quickly. The Soviet Union and the U.S. had some real military competition. However, I wouldn't place China near the same level. Competition makes a country stronger. However, at this point, China is generally not a direct U.S. competitor.

[Lafayette]

"So, the U.S. creates more capital for entreprenuership."

And, entrepreneurship adds what to the economy? To the American economy it adds stock options for the top directors and to the Far East economies it adds jobs.

'Lower cost of capital is one mechanism to raise living standards."

Right, and if you are unemployed, do you really care what the cost of money is? You can't afford to buy anything anyway.

"China lags U.S. education by a huge margin."

In fact, you may be finally right about something.

It is graduating thousands of university graduates every year. It'll catch up.

"I wouldn't place China near the same level (militarily)."

Right again. But China does not NEED a large military. What country is menacing China? Taiwan?

The US needs a large army. For two reasons,
1) The military-industrial-complex has some fine lobbyists in Washington that helped its lead-head PotUS open the spigot once again to provide "toys-for-boys", and
2) Too many nations around the globe can be categorized as a menace to America's vested interests in some way or another. But, first and foremost is oil. Get America unhooked from the carbon-molecule and America will no longer need the world to supply it.

Besides, had America spent money on this, in terms of a massive mission-critical development project, instead of wasting the money on a fly-by-wire Pentagon, it is quite likely that America would not only be polluting less from coal/oil fired electricity generating plants but from cars running on fuel cells as well.

Also, renewing America’s energy infrastructure with non-polluting renewable resources (as well as nuclear energy and scrubbing pollution from oil/coal burning plants) as well as a modern efficiently managed electricity grid would provide jobs that are greatly needed. This would make a great idea for the next presidential election.

PS: Good debate, AE. Thanks.

[Arthur Eckart]

Lafayette, everything I've stated is supported by data and economic models. Entreprenuership adds jobs and facilitates growth, e.g. in emerging industries. Most of the jobs created are in small businesses. Capital creation provides opportunties for entreprenuers. Every country depends on oil. The U.S. is less dependent on foreign oil than many other countries, since it's the world's third largest oil producer. However, the U.S. has an interest being the largest economy and consumer market. It's a misperception to suggest the U.S. is a heavy polluter. The U.S. takes into account negative externalities. The U.S. had a "peace dividend" for 10 years, since the end of the Cold War. Another peace dividend will accelerate U.S. growth.

[Lafayette]

AE: "Lafayette, everything I've stated is supported by data and economic models."

Take off your academic bifocals and look at what is happening around you.

Both America and Europe, at the bottom, are hurting. Where does that hurt come up in your model? For example:
- New Orleans is expected never again to reach its population level before Katrina. It must settle for half that number of residents.
- An Iraq war is absorbing needlessly huge quantities of tax revenues that could be better spent elsewhere. All the while those revenues go to a selected few whilst income inequality in America goes to hell in a hand basket.
- At any given moment one sixth of American workers have NO medical coverage.
- A university diploma in America costs as much as an apartment or a small house. Why should the young need to become indebted to obtain an education because their parents cant afford the cost? Why should they have to die in Iraq because they were attracted by the army’s tantalizing promise to pay that education for military service?
- American corporations far too easily seek to protect profits by exporting unskilled or semi-skilled jobs. Where is the corporate responsibility that says, "Well, if we create the jobless, who is going to have the income to purchase our products?" Which model is telling you that the economy at present is a "zero sum game"?
- Inflationary pressures have risen such that even modest middle-income families require a dual source of income to make ends meet. (Yes, that is because Americans/Europeans, both within archly consumerist societies, have failed to distinguish between their “needs” and their “desires”. But, that is the fault of who? Themselves.)
- etc., etc., etc.

PS: A little known event (outside of France) happened this week. A small man, called "Abbé Pierre" died. In 1947, when Paris became iced-over by a month-long cold spell, he was the only one who rattled the cages to get help for the poor who (at a time also of economic recession, were being expulsed from the homes into the cold). He became a national hero and, a bit like Mother Teresa, he never left his vocation of helping those who needed help most. France new subsequently, from the sixties up to the mid-nineties, an economic expansion that brought it relative prosperity. But, Abbé Pierre's work, from his foundation Emmaüs, never faltered and continues to work providing shelter for those who could not afford to even rent one. These people exist. They are real. They wash your windscreen at stoplights ...

[Arthur Eckart]

Lafayette, the data weren't created in academia and you haven't disputed the logic of mathematics used in economic models. Anyone can pick and choose to create distortions using subsets of aggregate data. Of course, you failed to mention the Iraq War is a relatively cheap war (compared to other wars or a percentage of GDP). Four-fifths (actually over four-fifths) of Americans are covered by medical insurance, which is a remarkable achievement given coverage is not mandatory. Much of the U.S. middle class has moved into the "upper" middle class. The U.S. provides not only low-interest loans for education, but also generous grants and scholorships. I think most Americans who join the volunteer U.S. military know it's not the boy scouts or girl scouts. American corporations also have a responsibility to shareholders to remain financially sound in a competitive global economy. U.S. inflation fell to 2.5% in 2006, along with an unemployment rate of 4.5%. There are structural problems e.g. U.S. income inequality has increased, some regions of the U.S. remain poor, and cheap foreign goods have induced U.S. consumption creating greater household debt. Nonetheless, by and large, U.S. economic policies have been beneficial.

[Nietz1950]

AE, the US is among the less efficient than the developed world when it comes to greenhouse gas emissions. CO2 productive relative to GDP near the bottom, next to the other big polluters - Canada and Australia.

You were intentionally being misleading by comparing US productivity to the entire world, which includes developing nations. Of course the US can produce more with oil than a developing country - but why can't we seem to keep up with the rest of the developed world?

[Lafayette]

N1950: "but why can't we seem to keep up with the rest of the developed world?"

What do you mean by "keep up"?

If one looks at the rate of capital accumulation and its distribution, then America is the world's leader in economic unfairness. Yup, a world class player in that matter.

Also, world class when it comes to neonatal deaths and (health-care) uninsured workforce. Completely mediocre when it comes to accomplishment in maths and reading ability.

If ever there was a modern country that has gone awry from its founding principles it’s the US. So, no wonder that, after 250 years, it should stray.

The issue is this: It is not that difficult to get back on track. It is a matter of political leadership and government expenditures wisely selected in certain areas. However, for that to exist, a nation must elect that leadership.

There's the hurdle. American's simply do not understand that they are NOT a world class player in terms of social services. Why? Because of an addle-headed notion that America is a nation of individualistic pioneers who need ask no one for nothing.

A pioneering America was once, perhaps, the norm. But that was more than a century ago, since when it is now a developed nation in which economic fairness and not individualism is a paramount objective.

Then, of course, there's the matter that for whatever psychological reason (perhaps envy), Americans elect a rich politicians who haven't the foggiest notion of how classes below them live and cope with life.

Ask a great many Congressmen or Senators how much the Metro-ticket (local DC subway system) costs and you be faced with a blank stare for an answer.

I get tired of repeating this, but it seems universally true: In a democracy, a people elect the government they deserve. If you want to change leadership in the US, you will have to change political mentalities first. And, that aint gonna be easy.

Every American aspires to being a billionaire. It takes most a lifetime to understand that such a notion is incredibly naive.

[Nietz1950]

Lafayette, I agree that Americans do seem more apt to believe they will one day become wealthy even though class mobility is now one of the lowest in the developed world. It seems to be a relic of the era when wealth mobility was the highest in America. It's actually the Nordics (yes, them again) who have the highest mobility rates now.

I also agree we would do better with proper investment in health, education, and infrastructure.

My original post was poorly worded, but I was pointing out that the US is not particularly efficient with its oil-use, relative to developed countries. We are along the bottom, around 29th in GDP per ton of CO2. AE seemed to be suggesting the US was quite efficient, only conceding Japan may be a little better. The truth is that pretty much everyone in the developed world does better and we have plenty of room to grow.

I guess I should add the Nordics are again the best in this measure too. Some produce almost 5 times the wealth per unit of CO2 as the US.

[Arthur Eckart]

One reason the U.S. has become more energy efficient is the U.S. economy has become lighter. Most of the products produced by Information and Biotech Revolution firms (where the U.S. leads the rest of the world combined) weigh almost nothing. Also, U.S. productivity in older core industries are higher than the aggregate economy. Of course, those energy gains are offset by higher American living standards, e.g. larger houses and vehicles.

[Nietz1950]

A GDP / CO2 unit measure already accounts for high living standards. Americans simply produce less wealth for the amount emissions we produce.

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