Offshoring: The Next Industrial Revolution?

Alan S. Blinder

From Foreign Affairs, March/April 2006

Summary:  Economists who insist that "offshore outsourcing" is just a routine extension of international trade are overlooking how major a transformation it will likely bring -- and how significant the consequences could be. The governments and societies of the developed world must start preparing, and fast.

Alan S. Blinder is Gordon S. Rentschler Memorial Professor of Economics at Princeton University. He served on the White House Council of Economic Advisers from 1993 to 1994 and as Vice Chairman of the Board of Governors of the Federal Reserve from 1994 to 1996.

A CONTROVERSY RECONSIDERED

In February 2004, when N. Gregory Mankiw, a Harvard professor then serving as chairman of the White House Council of Economic Advisers, caused a national uproar with a "textbook" statement about trade, economists rushed to his defense. Mankiw was commenting on the phenomenon that has been clumsily dubbed "offshoring" (or "offshore outsourcing") -- the migration of jobs, but not the people who perform them, from rich countries to poor ones. Offshoring, Mankiw said, is only "the latest manifestation of the gains from trade that economists have talked about at least since Adam Smith. ... More things are tradable than were tradable in the past, and that's a good thing." Although Democratic and Republican politicians alike excoriated Mankiw for his callous attitude toward American jobs, economists lined up to support his claim that offshoring is simply international business as usual.

Their economics were basically sound: the well-known principle of comparative advantage implies that trade in new kinds of products will bring overall improvements in productivity and well-being. But Mankiw and his defenders underestimated both the importance of offshoring and its disruptive effect on wealthy countries. Sometimes a quantitative change is so large that it brings about qualitative changes, as offshoring likely will. We have so far barely seen the tip of the offshoring iceberg, the eventual dimensions of which may be staggering.

To be sure, the furor over Mankiw's remark was grotesquely out of proportion to the current importance of offshoring, which is still largely a prospective phenomenon. Although there are no reliable national data, fragmentary studies indicate that well under a million service-sector jobs in the United States have been lost to offshoring to date. (A million seems impressive, but in the gigantic and rapidly churning U.S. labor market, a million jobs is less than two weeks' worth of normal gross job losses.) However, constant improvements in technology and global communications virtually guarantee that the future will bring much more offshoring of "impersonal services" -- that is, services that can be delivered electronically over long distances with little or no degradation in quality.

That said, we should not view the coming wave of offshoring as an impending catastrophe. Nor should we try to stop it. The normal gains from trade mean that the world as a whole cannot lose from increases in productivity, and the United States and other industrial countries have not only weathered but also benefited from comparable changes in the past. But in order to do so again, the governments and societies of the developed world must face up to the massive, complex, and multifaceted challenges that offshoring will bring. National data systems, trade policies, educational systems, social welfare programs, and politics all must adapt to new realities. Unfortunately, none of this is happening now.

MODERNIZING COMPARATIVE ADVANTAGE

Countries trade with one another for the same reasons that individuals, businesses, and regions do: to exploit their comparative advantages. Some advantages are "natural": Texas and Saudi Arabia sit atop massive deposits of oil that are entirely lacking in New York and Japan, and nature has conspired to make Hawaii a more attractive tourist destination than Greenland. There is not much anyone can do about such natural advantages.

But in modern economies, nature's whimsy is far less important than it was in the past. Today, much comparative advantage derives from human effort rather than natural conditions. The concentration of computer companies around Silicon Valley, for example, has nothing to do with bountiful natural deposits of silicon; it has to do with Xerox's fabled Palo Alto Research Center, the proximity of Stanford University, and the arrival of two young men named Hewlett and Packard. Silicon Valley could have sprouted up elsewhere.

One important aspect of this modern reality is that patterns of man-made comparative advantage can and do change over time. The economist Jagdish Bhagwati has labeled this phenomenon "kaleidoscopic comparative advantage," and it is critical to understanding offshoring. Once upon a time, the United Kingdom had a comparative advantage in textile manufacturing. Then that advantage shifted to New England, and so jobs were moved from the United Kingdom to the United States. Then the comparative advantage shifted once again -- this time to the Carolinas -- and jobs migrated south within the United States. Now the comparative advantage in textile manufacturing resides in China and other low-wage countries, and what many are wont to call "American jobs" have been moved there as a result.

Of course, not everything can be traded across long distances. At any point in time, the available technology -- especially in transportation and communications -- largely determines what can be traded internationally and what cannot. Economic theorists accordingly divide the world's goods and services into two bins: tradable and nontradable. Traditionally, any item that could be put in a box and shipped (roughly, manufactured goods) was considered tradable, and anything that could not be put in a box (such as services) or was too heavy to ship (such as houses) was thought of as nontradable. But because technology is always improving and transportation is becoming cheaper and easier, the boundary between what is tradable and what is not is constantly shifting. And unlike comparative advantage, this change is not kaleidoscopic; it moves in only one direction, with more and more items becoming tradable.