Corporate Finance Council of San Diego, May 6, 2004

Outsourcing: Threat or Menace?

Speech by Donald L. Luskin

It's great to be here tonight. But I want you to understand that it's a big sacrifice for me. I'm missing the season finale of "Friends."

Tonight I'm going to be talking about the controversy over "offshore outsourcing" in the context of a book I'm writing.

My book is about the intersection of the science of economics, the power of government, and the influence of the mass media. The book is called The Conspiracy to Keep You Poor and Stupid -- because that's what's happening when economics, government and media come together.

Here's an example of how the conspiracy to keep you poor and stupid works.

GDP growth has been running at a real annual rate of 4.9% over the last four quarters. That's the highest it's been in 20 years. Higher than any four quarter period during the great 1990s boom.

The unemployment rate is 5.7%. It has improved from 6.3% last June. 5.7% is statistically indistinguishable from 5.6%, which is precisely the average unemployment rate since 1948.

Over the last 12 months the stock market has gained $3 trillion in market value. Home ownership has moved to all-time highs. Overall household wealth has moved to new all-time highs.

And yet -- amazingly -- the latest CBS/New York Times poll shows that the number of Americans who approve of the way President Bush is handling the economy has gone down over the last year. A year ago 53% approved. Today 39% approve.

According to the same poll a month ago, the economy and jobs were the number one and number two most important issues for voters during the election. They were the only issues to rank in double digits. Together, they were counted as 8 times more important than terrorism.

I must point on that over the last month, with the horrific headlines from Iraq, war has displaced jobs as the number two issue.

How is it that America has become increasingly worried about the economy at the same time as the economy has so obviously and strongly recovered? It's an example of the conspiracy to keep you poor and stupid -- the power of politicians to use economics to manipulate your mind. How was this achieved? It's all about outsourcing.

Most of the negative movement on the economy in the polls happened during the first three months of this year, during the Democrats' presidential primary season. The Democratic candidates found, in outsourcing, an economic issue they could use to cast doubt on the booming economy.

The issue of outsourcing has some very special psychological properties that make it especially useful as propaganda -- perfect fodder for the conspiracy to keep you poor and stupid.

First, it is an amorphous fear about the unknowable future more than it is a realistic observation about the present. So the message is, "Yes, I know the economy is recovering and you have a good job. Today! But two years from now that job could go to China! If you don't vote for me, that is." You can't argue with that kind of non-logic. But it doesn't even have to be logical. It just has to be scary.

Second, the outsourcing issue cleverly links economic concerns to national security concerns. Of course in the wake of September 11, such concerns are never far below the surface, and they are very powerful. Especially when the story connects directly to the ability of grubby people in poor, third world countries to threaten the all-powerful United States.

The message is that our strength is actually a disadvantage. The fact that third world workers are willing to labor for a twentieth of US wages becomes a kind of economic suicide mission -- one that our own prosperity blocks us from having any effective response to. We are sitting ducks.

"Every time a new call center opens in Mumbai, American jobs go the third world. On 9/11 they stole our airplanes, and now they're stealing our jobs!"

And, of course, the message from the Democrats is they are going to "do something about it" -- while the Bush administration is said to stand by passively, or in fact even promote it.

Remember when Greg Mankiw, the head of the White House Council of Economic Advisors, published the Economic Report of the President this year? He noted in that report that outsourcing was nothing more than the latest instance of time-honored principles of economics. Mankiw, a Harvard professor and author of the most widely used college economics textbooks said,

"Outsourcing of professional services is a prominent example of a new type of trade ... When a good or service is produced at lower cost in another country, it makes sense to import it rather than to produce it domestically. This allows the United States to devote its resources to more productive purposes."

And Mankiw duly noted that in the short run there can be painful dislocations, and that people affected must be helped in various ways.

But poor Mankiw was pilloried in the media for it. The very next day the liberal Washington Post wrote that Mankiw had made "laudatory statements on the movement of U.S. jobs abroad." John Kerry said Bush wants "to export more of our jobs overseas ... What in the world are they thinking?" Tom Daschle said, "This is actually now the position of the White House that they support outsourcing of jobs, jobs going abroad, saying that that's good for our country." Pete Stark said, "Bush stands idly by as jobs continue to take flight from the U.S., and now we know why. It's part of his economic plan."

Needless to say, no one in the Bush administration or in the Republican congress had the guts to say a word in Mankiw's defense.

And since then the volume has only gone up on the issue, with John Kerry talking about "Benedict Arnold CEOs" betraying American workers. There are any number of bills in congress to slap various restrictions, prohibitions and penalties on US companies that use overseas labor.

And what's so remarkable about all this is that it's all about a crisis that may not even exist.
What, after all, do we really know about offshore outsourcing?

There's an amazing scarcity of hard evidence. All the sensational numbers that are thrown around all the time in the media are nothing more than forecasts by various consultants.
Here are the ones you seem to hear all the time in the media.=

The McKinsey Global Institute estimates that the volume of offshore outsourcing will increase by 30 to 40 percent a year for the next five years. Forrester Research estimates that 3.3 million white-collar jobs will move overseas by 2015. Gartner estimates that by the end of this year, 1 out of every 10 IT jobs will be outsourced overseas. Deloitte Research estimates the outsourcing of 2 million financial-sector jobs by 2009.

These aren't even really "estimates." They're forecasts. No, they're S.W.A.G.'s -- stupid wild-ass guesses.

Remember, these consultants are the same geniuses who said, four years ago, right about the time when the NASDAQ was at 5000, that Internet traffic would grow at 90% a year forever, and that by 2002 every American citizen would have digital video-on-demand beamed via low earth orbit satellite to his cell phone. Hey, if that were true I could be watching "Friends" right now.

Let's get real. Suppose Forrester is right, that 3.3 million white-collar jobs will move overseas by 2015. That's eleven years, folks. That's 300,000 jobs a year, or 25,000 a month. Today there are 130 million jobs in the United States.

So the cost is 2/100 of 1% of jobs each month. Don't worry about it. On average the US economy generates job growth 10 times that much every month.

But it's not just that even the wild-ass guesses are actually quite small in the grand scheme of things. The worst part of it is that these forecasts inevitably just look at costs, and never benefits.

When Forrester says that 3.3 million white-collar jobs will move overseas by 2015, not a single thought is given to any possible offsetting benefit of that in the US. The implicit assumption is that 3.3 million people who would have otherwise have jobs will instead be on food stamps. But it's hardly that simple.

Remember, those jobs would not be established overseas if there were not some compelling advantage to do it, probably cost savings. That means the employing company is more profitable. It can pay out those profits in dividends, which then get reinvested in other opportunities that create US jobs -- opportunities that wouldn't have existed otherwise.

Or it can reinvest those profits themselves in new US employment, at things that US workers do better. For example, Delta Airlines outsourced 1,000 call-center jobs to India in 2003, but the $25 million in savings allowed the airline to add 1,200 positions at home.

And if cheaper foreign labor translates into lower prices of US consumer goods, then US consumers will have money left over to buy other goods and services that they weren't buying before. And that will create new jobs.

Other offsetting advantages of outsourcing are less obvious, but just as compelling. Last time I was in San Diego, I attended a meeting with Dick Heckman, the CEO of K2, the sporting goods conglomerate that is moving most of its manufacturing to China. Heckman says that he can lower his labor costs by a factor of more than 20, compared to the US.

Okay, that's a smart arbitrage. But there's more to it than that. He's found that when labor is that much cheaper, he finds new things to do with labor that he couldn't have afforded to do before. When K2's major league baseball batters helmets were made in Missouri, labor was so expensive that all he could afford to do was pull the helmet off the injection molder, throw it in a box, and ship it to Walmart. But in China, he can afford to pay laborers to hand polish the helmet first, removing all the little mold artifacts and making it look and feel great.

Cheaper labor, then, means not only lower consumer prices and higher corporate profits back in the US, but also higher quality.

Consider this. China is currently building a steel factory that will be the largest in the world. When it is complete in two years, it will be the largest steel factory in the world. This single facility will be able to produce all the steel currently used in the United States.

When most people hear that, they become afraid. But I just think of the opportunities. It reminds me of Moore's Law -- the fact that silicon semiconductors effectively drop in price by 50% every 18 months. What if steel gets on its own version of Moore's Law?

Look at the wealth, the progress, and the jobs that have been created by silicon transistors becoming effectively free. Look at all the stuff we do with transistors that we couldn't even conceive of doing 20 years ago, but we can do now that transistors are free.

What will the world look like in 20 years when steel is free? I have no idea, but I know it will be a better world full of marvels that we can't even conceive right now. It will be a world full of US jobs in goods and services that don't even have names today.

Let's go back to what Greg Mankiw was talking about, that he took so much heat for. He was talking about a basic principle of economics that has been understood for about 200 years -- the idea of "comparative advantage." It's classic stuff, but it pays to review it because it's so relevant today.

Let's say you have an economy consisting of two self-sufficient people, and in this economy it takes a minimum of 1 pound of cheese every day in order to survive. So you spend as much time as you have to making a pound of cheese. After that, you devote your leftover time to making wine, which is a luxury.

The first guy is very productive. It takes him only a quarter of his day to make his pound of cheese, and then in the remaining three quarters he can make 12 bottles of wine.

The second guy's not so good. In fact, he's totally unskilled. It takes him half a day to make his pound of cheese, and in the leftover half day he can only make 2 bottles of wine.

Right off you wouldn't think the first guy has any reason to trade with the second guy -- he's got him beat in every way. But that's not the right way to look at it.

Suppose the second guy stops making wine altogether, and devotes his whole day to making cheese. He'll able to make 2 pounds -- one to eat, and one leftover to trade. If he trades his extra pound of cheese to the first guy, that would free up a quarter of the first guy's working day. That means the first guy would be free to make another four bottles of wine.

He gives three of those four bottles to the second guy in exchange for the cheese. So now the second guy, who started off with a pound of cheese and 2 bottles of wine every day, now ends up with a pound of cheese and 3 bottles of wine.

The first guy, who originally had a pound of cheese and 12 bottles of wine, ends up with a bottle of cheese and 13 bottles of wine. The world has become richer, on net, by two bottles of wine.

Notice that this result occurred even though the first guy enjoyed an absolute advantage over the second guy in both wine and cheese. But absolute advantage isn't as important as comparative advantage. By going entirely out of the cheese business, the first guy was able to exploit his comparative advantage in wine.

Now how does this example apply to the real world?

Obviously, the first guy is the US and the second guy is -- China, India, you name it. Steel may be a necessity of our life -- like cheese in the example. But we're going out of the steel business, even though we are the best at making steel, or at least could be if we wanted to be. But we don't want to be. Because we're even better at designing fiber optic networks or figuring out financial derivatives or making blockbuster action-hero movies -- or something.

But of course it's not that simple. A nation is not a single individual who does two things -- and as soon as he stops doing one, he just does more of the other. A nation is many people who are specialized into different things. If a nation stops making cheese, its cheese makers can't just suddenly become winemakers. US steel workers can't just start designing fiber optic networks. So at least in the short term, there will be winners and losers

And any time there are losers, politics gets involved. The winners from the deal are busily reinvesting their gains -- but the losers run to their lobbyists. So we end up with things like the Bush administration's tariffs on foreign steel. Sure, it protects the domestic steel industry -- sort of. But any advantage conveyed to steel producers becomes a disadvantage to steel consumers. So this ends up being a problem from which you can run, but you can't hide.

Another consideration is that certain industries may be seen as necessary for national security, no matter how uneconomical they are for a nation to do. If cheese is strictly necessary for life, do you really dare let someone else make yours? Does America dare to not have a steel industry? What would happen if there were a major war and we needed lots of steel?

Well, what would we really do if we really believed that, anyhow? Would we have the Army operate our steel industry, just in case we ever needed one? Would we have to draft people who would otherwise be fiber optic network designers and force them to labor two years of their lives in our militarized steel industry -- all supported by tax dollars? That's where the logic takes you. Again, you can run but you can't hide.

So what can we do in terms of policy to address these issues?

You do the hardest thing of all. Nothing. And the more nothing the better.

That's because of all America's absolute and comparative advantages, the most important one we've got is freedom. And freedom consists mostly of having a government policy to do nothing. Let free individual economic actors figure it out for themselves by trial and error. Yes, it's painful. And it's hard to stand by and do nothing when a displaced steel worker goes on Lou Dobbs' show and complains about it (although I've found the answer for that -- just turn the TV off).

But it's only under a policy of do-nothing economic freedom that we can maximize our chances to find the thing we're good at doing instead of making cheese, steel, or even wine.

What if it turns out we're not good at anything? What if it turns out that China and India are better at everything? Well, if that's true, then there's no law we're going to pass that's going to save us. And we'd still be better off trading with them. If we're so bad at everything, we certainly don't want to try to make it on out own. Again, we can run, but we can't hide.

Just remember, there was a time in the 1970s when the US was afraid of competition from Europe. That's right, Europe. Can you imagine that now?

Then in the 1980s we were afraid of Japan. Can you imagine that now?

Then in the 1990s we were afraid of the giant sucking sound of NAFTA. Can you imagine that now?

What happened in all these cases was that America's politicians did pretty much nothing. We deregulated our economy, and let individual economic actors figure it out for themselves. Europe and Japan laid regulation on top of regulation on top of industrial policy on top of managed trade. We won, they lost.

We could have all won, by the way. I think that's generally how it's turned out with our NAFTA partners, so far. This isn't a zero-sum game, as the cheese-and-wine example shows.

So now we're back in the same place, déjà vu all over again. But this time it's China and India we're worried about. If it's not one thing it's another. But the answer is the same -- to do nothing.

The problem, of course, is that it's an election year -- a close one, and a nasty one. John Kerry has a presidency to win, and not all that many issues to win it with. Lou Dobbs has a show to do. Paul Krugman has columns to write. And none of those guys ever got anywhere by saying "do nothing." That has never been the agenda of the conspiracy to keep you poor and stupid.

And Bush has an election to win, too. He generally believes in free trade, but we face a very real risk that he will "do something" just to get in front of the issue. We've already seen him "do something" with steel tariffs, and that was a disaster. We've seen him try to "do something" by sending John Snow over to China to try to get them to revalue the yuan. There's six months to go till the election -- it could get worse.

The people who are supposed to "do something" are us. If that means outsourcing something your business does to China or India or anywhere else, I say go for it.

But be careful. For all the same reasons that the hype about outsourcing makes it a red-hot political issue, it's also potentially a dangerous fad. Remember, those consultants with all the big forecasts have consulting services to sell. They make money helping you do your outsourcing whether it ends up making money for you in the long run, or not.

And like all fads, the first ones in make all the money. Then it gets harder. Already wage rates in India for call center operators are rising at 20% a year. That sweet spot gets less sweet every day. But the consultants keep on consulting.

So it's a self-correcting process, like most economic processes, if we are just patient. So try to tune out the conspiracy to keep you poor and stupid. If you're a worker, don't feel afraid. If you're a manager, don't feel guilty.

That simple world of cheese and wine can be ours if we just stick patiently to the basic axioms developed by classical economics 200 years ago. If you have the courage to build a world based on trade, you'll get your daily cheese. Plus you'll get more wine.

In fact, that's what I'm going to do right now. Have some more wine.

Unless you have any questions or comments. Thank you very much.

About the Author

Mr. Luskin is chief investment officer of Trend Macrolytics LLC, and former vice chairman of Barclays Global Investors.