New Economist

Consultants don't come cheap

Are consultants milking the UK government for billions for very little result? Brian Appleyard has a provocative piece in the Sunday Times Magazine which argues that they are: Blair's barmy army. While he exaggerates the failures of consultancy and largely ignores the succeses, there are some telling blows. He summarises the problem thus:

Everybody agrees, the MCA included, that consultants can be useful if – and only if – their task is tightly defined and controlled. But, overwhelmingly, government contracts have been vague and subject to constant change. Like your local builder, consultants quietly add on huge costs every time anybody makes a remark about what must be done. Furthermore, they have so far done so with an almost complete lack of accountability.

...The whole thing has simply been the result of a collective delusion: that there are quasi-scientific, objective ways of managing human affairs that transcend all considerations of culture, ethos and environment. Consultants sold this lie, government bought it, and we’re paying for it.

And the solution?

What we need, say some, is our equivalent of America’s Clinger-Cohen Act. This was introduced by two Republican senators in 1996 after a series of cases in which consultancies ripped off the federal government. The act forced all departments to monitor and control every project, effectively imposing a proper management structure where none had existed before. There is no prospect of that happening here and, seemingly, little political will to shake off the burden of the deals already done.

...But there are hopeful signs. Richard Granger is now imposing more stringent controls on contracts for the NHS computer. The failure of the NHS to show anything like the signs of improvement to be expected from Brown’s billions is starting to sink in. Mark Serwotka’s union is threatening a strike ballot in January. There can be no doubt that a project like the NHS computer would be a fantastic idea if it can be made to work, which, sadly, it can’t.

Germany: Outsourcing and job security

Another paper from last week's conference on The Impact of International Competition on Firms and Workers was by Ingo Geishecker from Freie Universität, Berlin. Using a large panel of individual monthly employment spell data from German manufacturing, he finds that international outsourcing, when narrowly defined, has "a marked impact on individual employment security". Here is the abstract for The Impact of International Outsourcing on Individual Employment Security: A Micro-Level Analysis (PDF):

The paper analyzes how international outsourcing affected individual employment security in German manufacturing industri es between 1991 and 2000. The analysis is carried out at the micro-level, combining monthly spell data from the German Socio-Economic Panel and industry-level outsourcing measures. By utilizing micro-level data, problems such as aggregation and potential endogeneity bias, as well as crude skill approximations that regularly hamper industry level displacement studies, can be reduced considerably.

The main finding is that international outsourcing significantly lowers individual employment security. Interestingly, the effect does not differ between high-, medium-, and low-skilled workers. With regard to the observed skill upgrading and high relative unemployment rate of low-skilled workers in Germany the impact of international outsourcing is therefore not related to skill biased displacement but to reduced chances for reentering employment.

France: Unions, jobs and outsourcing

This week I will be citing a few recent papers on outsourcing. The first, by senior INSEE researcher Francis Kramarz, examines the French experience. The paper shows that French unions who flex their muscles in the face of greater trade competition make things worse, by encouraging firms to oursource more jobs. Here is the abstract for Outsourcing, Unions, and Wages: Evidence from data matching imports, firms, and workers (PDF), delivered at the University of Nottingham's recent conference on The Impact of International Competition on Firms and Workers:

How are wages and employment of manufacturing workers affected by trade competition? In particular, how are wages and employment affected by the sourcing strategies of their employing firm and those of their competitors? What is the role of unions in this process? I attempt to answer these questions using unique French data that matches firm-level information on imports, value-added, employment, firm-level data on unions and negotiations, with individual worker data; at a unique moment - the first years of implementation of the Single Market Program (SMP) within the European Community.

A simple bargaining model, particularly well-suited to the French institutional setup, allows me to capture the mechanisms by which changes in competition can directly affect wages: changes in the firm's ability to pay (as measured by the quasi-rent, the total pie shared between the workers and the firm) as well as changes in trade competition and sourcing strategies that potentially affect the bargaining process by altering both the firm's and the workers' threat points. I use an IV strategy where export prices of American firms act as instruments for trade competition and outsourcing. First, trade competition affected the size of the quasi-rents, most particularly in large firms where these rents were large. Because workers received in average 20% of the quasi-rent but also because wages declined with competitive pressure induced outsourcing, trade competition has negatively impacted wages.

To see how unions potentially entered the process, I re- examine my results when information on firm-level negotiations between firms and unions is added. As expected, in firms with strong unions (those able to impose bargaining on both employment and wages) workers were able to capture a large share of the declining quasi-rent (about 50%). However, the presence of strong unions has apparently led these, mostly large, firms to increase outsourcing with an associated decline in employment. As a result, unions' fight for workers' wages and employment appears to have backfired.

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.

Outsourcing US volatility to Mexico

Outsourcing has grown to become an important part of the trade relationship between the US and Mexico. It counts for more than 20% of Mexican value added and nearly half of the country’s exports. While Mexican officials have hailed outsourcing as a source of growth for their country, some have also complained that it is highly fickle, being a source of excessive volatility.

A new paper by Paul Bergin and Robert Feenstra from University of California, Davis, and Gordon H. Hanson, UC San Diego, look at this issue: Outsourcing and Volatility (PDF).

We begin by documenting a new stylized fact: the maquiladora outsourcing industries in Mexico experience fluctuations in value added that are roughly twice as volatile as the corresponding industries in the U.S. A difference-in-difference method adapted to second moments is used to verify that this finding is specific to the outsourcing sector and is statistically significant. We then develop two theoretical models of outsourcing that can explain this stylized fact. Both models rely on a continuum of products and many varieties of each product. In the first model, firms can enter into outsourcing relationships via new products and new product varieties, with CES preferences.

In the second model, firms enter into outsourcing only via new product varieties, and the degree of entry is modulated by a novel mechanism of endogenous markups obtained from translog preferences. Stochastic simulations show that both models can replicate many of the second moment properties in the data. In particular, domestic demand shocks in the U.S. are transmitted in an amplified manner to Mexican outsourcing industries.

It seems clear from this paper that domestic demand shocks in the US are, as the authors put it, "transmitted in an amplified manner to Mexican outsourcing industries". A related question is whether this in turn is reducing output volatility in the corresponding industries in the US?

Outsourcing fraud

With money comes opportunity for corruption. Saritha Rai reports in the New York Times (and IHT) today report that Fraud worries Indian outsourcing firms:

BANGALORE - India's outsourcing industry, flourishing with business from an expanding base of American and European customers, is facing greater criticism after a series of security breaches.

Industry executives and officials at Nasscom, the trade group of the Indian outsourcing industry, say they are worried that exposés of recent incidents of fraud are damaging India's reputation as a high-skilled, low-cost location.

India's $23.6 billion outsourcing industry has a lot at stake. It is growing at an annual pace of more than 30 percent, and back-office services like call centers and online technology support made $6.3 billion last year. That is forecast to grow to $8.5 billion this year.

The Indian companies fear that Western business clients will hesitate to outsource here if India is repeatedly depicted as a market susceptible to fraud. "India is not immune but fraud here is limited," Nasscom said. "Less than 10 cases of security breaches have been reported so far."

Nasscom said the record in India was much better than those of companies in the West. In the last 18 months, 148 data breaches were reported in the United States. The compromised data ranged from a few records lost as a result of mail theft to more than 26 million records of military veterans that were on a laptop stolen from the Department of Veterans Affairs.

Nevertheless, the industry in India has suffered from a succession of security scandals. Last year, a few employees in the Pune office of a company called Mphasis were arrested after being accused of defrauding several Citibank customers in New York of thousands of dollars by cajoling them into disclosing their Internet banking passwords.

Later, a British tabloid, The Sun, reported that it was able to purchase confidential data on more than 1,000 Britons from an employee of an outsourcing company based in the New Delhi suburbs.

Early this year, an employee of HSBC's call center in Bangalore was accused of selling customers' credit card details to people in Britain, who then skimmed thousands of pounds from the customers' accounts.

And a new documentary on Channel 4 Television in Britain says that during a 12-month investigation, undercover operatives "infiltrated criminal networks that trade British consumers' bank and other confidential information for huge profits in India, the world's call-center capital."

The industry's rapid growth - it added 100,000 employees last year - is confronted by other challenges. Talent is harder to find and employee turnover is rising, prompting some companies to hire workers without completing background checks.

Executives in India suggest that the exposés unfairly take aim at the outsourcing industry. Such reports have "tried to crucify India's back-office industry," said Raman Roy, chairman of Quatrro BPO Solutions, a company in New Delhi that offers back-office financial, legal, technology and call-center services to British and U.S. clients.

Globalisation: The great unbundling(s)

Yesterday I mentioned a new series of papers on globalisation published by the Economic Council of Finland: The challenges of globalisation for Europe. The central paper is by Richard Baldwin of Graduate Institute of International Studies, Geneva: Globalisation: the great unbundling(s) (PDF). It's a thought provoking read, tackling the key isue of whether we are just experiencing 'more of the same' (old globalisation paradigm), or something fundamentally different (new paradigm):

The new and old globalisation paradigms fit together most naturally when thinking of globalisation as two great unbundlings. The cost of moving goods, people and ideas has, since the dawn of human civilisation, tended to result in the geographic clustering of production and people. Rapidly falling transportation costs - a trend which has been going on since the late 19th century - caused the first unbundling, namely the end of the necessity of making goods close to the point of consumption. More recently, rapidly falling communication and coordination costs have fostered a second unbundling - the  end of the need to perform most manufacturing stages near each other. Even more recently, the second unbundling has spread from factories to offices with the result being the offshoring of service-sector jobs.

In a nutshell, the first unbundling allowed the spatial separation of factories and consumers. The second unbundling spatially unpacked the factories and offices themselves. The old paradigm - essentially traditional trade economics - was useful for understanding the impact of the first unbundling. Understanding the second unbundling (which has variously been called fragmentation, offshoring, vertical specialisation, and slicing up the value-added chain) may require a new paradigm, especially when it comes to the offshoring of services.

Before the second unbundling, firms and sectors were the finest level at which globalisation’s impact was felt. More open trade spurred the fortunes of some firms while spiking the fortunes of others but the firm was the finest level of disaggregation worth looking at. Since most firms in a sector stood or fell together, the type of labour used most intensively in the sector typically shared the fortune of the firms and thus labour groups were a useful aggregate for analytic purposes. In the EU, the first unbundling systematically spiked the fortunes of unskilled-labour-intensive industries and spurred the fortunes of skill-intensive sectors, so unskilled labour found the first round impacts of globalisation to be highly negative while skilled workers found them to be  favourable.

As the second unbundling opened up firms - viewed as black-box package of ’tasks’ in the old paradigm - global competition came directly into factories and offices; global competition occurred on a task-by-task basis rather than firm-by-firm or sector-by-sector basis. The new paradigm helps us understand the impact of globalisation when international competition plays itself out at the level of tasks within firms. This trade-in-tasks versus trade-in-goods has subtle but important implications for policy.

US offshoring boosts blue collar wages

Gene Grossman and Esteban Rossi-Hansberg from Princeton University gave an interesting paper to the Jackson Hole symposium. It argued that outsourcing has increased productivity and real wages for low-skilled US workers since 1997: The Rise of Offshoring: It's Not Wine for Cloth Anymore (PDF).

See also the debate at Greg Mankiw's post: Another one for the "I told you so" file

UPDATE: Brad Setser comments on the paper in his post Wages, Walmart and the debate about the Global Economy:

I have only skimmed the Grossman paper.  But it hardly paints a wonderful picture of that state of working America. Real wages of the least skilled manufacturing workers increased by 3.7% since 1997, while total factor productivity is up by 11.8%. Real wage growth for low skilled blue-collar manufacturing workers has been flat 1998 (Figure 5, p. 24) -- most of the 3.7% growth came in 1997.  Real wage growth for average blue-collar workers has been flat since 2002 (Figure 6, p. 25).

Why aren’t wages rising in line with total factor productivity? Because the price of the goods produced by low-skilled workers is falling. Grossman and his co-author’s don’t claim that things are good, only that without the higher productivity from offshoring, things would be worse:

“Real wage growth for low-skilled workers in the US has been far from exceptional (and some might say “far from acceptable”), the experience has not been as bad as one might have expected based on the sharp improvement in the United States terms of trade.”

Not as bad as might be expected isn’t exactly an upbeat account, at least in my book -- even if cheap imported goods are good for those in sectors insulated from global competition.

Political Tribalism

by Mark Thoma

Chris Dillow at Stumbling and Mumbling is disappointed at the state of political debate:

Deepak Lal's Reviving the Invisible Hand: a review, Chris Dillow: There's very little political debate these days. Most people merely talk to their own tribe of converts. If they recognize an opposing position at all, it's only as a target of cheap abuse.

Deepak Lal has fallen into this bad practice in his Reviving the Invisible Hand. His aim is a noble one - to restate the case for classical Smithian liberalism against the anti-globalization movement. The trouble is, he fails.

The challenge for classical liberals is to justify free markets to those who fear they will lose from them. And - contrary to Tim's claim - markets do create losers, if only temporarily, simply because ... they throw people out of work. What does Lal say to these? This (p232):

As the northern losers in the new liberal interational economic order are the unskilled, there is a simple means for them to maintain and raise their incomes: go to school.

This is great advice for a 10 year old. But it's just ridiculous for a 50-year-old. Lal also opposes redistribution to maintain the incomes of the poor (p189):

Unless the coercive power [to levy redistributive taxes] is voluntarily and unanimously given by free agents to the State, its exercise would be unjust.

He's speaking here of justice in the sense of ensuring people have liberties (Lal is dismissive of "rights") to do as they will. What he never answers is the question which the poor might ask: "why should your conception of justice - which is only one of many - trump my need to continue living?"

And why are the poor poor? Lal has the decency to acknowledge that in some (many?) cases, it's because they are victims of past thefts of land. But he denies - as Robert Nozick did not - that they are entitled to rectification (p186):

Though the claim may be morally just, ... most societies throughout history have recognized the chaos that would be caused by seeking to redress any fault in the historical descent of every current title to property...

Well, this is a good game, isn't it? When the poor claim an income on grounds of expediency, justice triumphs. And when they claim it on the grounds of justice, expediency wins. Cynics will say Lal is merely defending existing inequalities and speaking only to the winners. And they've other evidence for this...

What Lal seems to be doing here is speaking only to the converted. This will get him an appreciative audience. But it will not advance the classical liberal case one jot.

I find all this tribalism especially depressing because Lal makes so many good points. His analysis of the gains from trade, the misuse of global poverty statistics, climate change and the influence of NGOs are all valuable. Sadly, though, liberalism's opponents will regard these not on their own merits, but merely as defences of existing inequalities.

If liberalism is to triumph - and I hope it does - its advocates will have to convince egalitarians. Lal fails to do this.

I'd be curious to know if you feel the "state of political debate" is better in the UK than in the US. Also, to follow up on the point that globalization produces both winners and losers, see Baumol's "Errors in Economics and Their Consequences" posted here a couple of weeks ago.

Europe: why offshore when you can nearshore?

In Europe, the main threat of job loss comes not from China or India, but Central and Eastern Europe, which has skilled but cheap labour - and most of it now within the European single market. in the past the main impact has been on manufacturing. But what about services? A new Deutsche Bank publication by Thomas Meyer, Offshoring to new shores: Nearshoring to Central and Eastern Europe (PDF), tells us quite a lot about this phenomenon. Here's the executive summmary:

Central and Eastern Europe (CEE) is an important region for services offshoring. The imports of IT-based services from Central and Eastern Europe into the EU-15 rose by an average of 13% per year between 1992 and 2004. Imports from India, by comparison, increased only slightly faster during the same period at 14% per year.

Close cultural and geographical ties make suppliers from CEE an attractive option. The close ties – in terms of culture, geography and partly language – between the CEE countries and the key Western European markets, the low wages, the high standard of education and stable macroeconomic and institutional environment constitute some of the strengths of the region.

However, CEE cannot boast any IT specialisation in exports or education. IT-based services account for less than 4% of total exports in CEE, whereas the share in India is 17% (see chart). Also, the share of graduates gaining information technology degrees – a key qualification for IT offshoring – is lower in CEE than the Western European and Indian averages. It is therefore unlikely that offshore production of standard IT services will become as important for CEE as is the case for India.

The comparative strength of CEE lies in more complex back-office processes. The cultural background shared by providers and their clients in CEE is particularly important for more complex business processes. Clients from outside English-speaking countries also appreciate the widespread language skills in CEE. Moreover, the lack of IT specialisation in CEE is less significant for typical back-office processes – such as bookkeeping.

Well worth dippping into for anyone seeking a better understanding of what's going on in Eastern Europe. The discussion on educational and science qualifications, for example, is an eye-opener. Who would have thought that the pool of suitable skilled engineers, mathematicians, statisticians and physicists in the CEE-3 (Czech Republic, Hungary and Poland) is on a par with Russia, which has far more scientists? (Figure 14).