The politics of offshoring: all talk, no action

Key Insights (9): There are few options for developed countries to respond to this trend.

Continuing with the Key Insights list, but jumping ahead a bit. I did a guest post a week or so ago on Phil Ferst's Horses for Sources blog. Since the post is already written, I will jump ahead to Key Insight #9. Back to numbers 2, 3, and 4 in the coming days.

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Picking up on Phil’s April Fool’s day post, I wanted to share a few thoughts on why we see lots of anti-offshoring rhetoric from politicians, but (thankfully) very little actual policy.

There is certainly a heavy demand from the man on the street to “do something.” It’s easy to understand why. We have become accustomed to trade in manufactured goods and natural resources. But manufacturing accounts for only about 15% of US employment, and developing countries generally enjoy a fully-delivered cost advantage of 10-30%. This is disconcerting for developed country workers, and we frequently observe moves against trade in manufactured goods, such as spurious anti-dumping actions and “buy America” provisions in various pieces of legislation.

Services, by contrast, account for about 78% of U.S. employment, and developing countries enjoy delivered cost savings of 40-70%.

So developing countries’ advantage is much larger in services, and many more people are potentially affected. That explains the political heat and the politicians’ rhetoric, but not the lack of policy.

So, why haven’t we seen offshoring regulations? Because trade in services is incredibly difficult to regulate. Regulating trade effectively requires that two conditions exist:

1. The government can observe what actions firms are taking, and

2. Any proposed policy must be credible and enforceable.

To see why regulating offshoring is so difficult, compare the “offshoring” of auto components with that of IT services.

Auto parts -- Trade displacement in manufacturing is easy to observe. If Delphi closes a component plant in Michigan and opens one in Mexico, it is easy to see what happened. 500 Mexican workers are now doing the same tasks in the same way that the Michigan workers did. Production from the Mexican plant now goes to the customers formerly serviced by the Michigan plant. It is easy and accurate to conclude that the Mexican workers replaced the Michigan workers.

Second, if the Congress chooses to regulate this trade, it is fairly easy to do. Don’t let trucks from the plant cross the U.S. – Mexico border, or slap a tariff on auto components from Mexico. (Note that 99% of economists would recommend that Congress not do this, but most politicians are immune to the logic of comparative advantage).

Offshoring IT services -- IBM has been fairly aggressive about moving software support services offshore. In boom times, IBM is hiring many people in India and a few in the US. So, in 2006 and 2007, IBM hires SAP specialists, software testing, and wireless telecomm engineers in its India operation. These IT specialists work with other IBM teams in Australia, China, Japan, Germany, the UK, and the United States to service global customers.

Then, following the financial crisis in late 2008, IBM decides to lay off systems engineers, maintenance engineers, and COBOL programmers in the United States.

Is it in any way accurate to claim that the SAP specialists hired in India in 2006 displaced the systems engineers laid off in Philadelphia in 2009? Of course not. These are people in different functions, hired at different times.

IBM is a global firm servicing global companies. Except at the most aggregate level, the US government has almost no ability to independently observe whether IBM is “exporting jobs.” They could, of course, require that IBM report on what it’s doing. But there is no chance IBM would report in a way that indicts itself. There is simply no way a regulator could accurately observe what the firm’s 300,000 employees are doing, and who they are servicing.

Second, even if Congress wanted IBM to stop hiring people in India, what could it do? Would the Congress threaten to cut IBM off from the Internet? Or from communications satellites? Would Congress be willing to impose fines that are massive enough to cause IBM to withdraw from international markets, where it realizes 68% of its revenues? Unlike trucks crossing the US-Mexico border, regulators have no ability to monitor the bits and bytes zipping around the Internet, knitting various work teams together and allowing the firm to service global clients.

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The bottom line is that politicians are nearly helpless in the face of offshoring. Firms have a tremendous incentive to locate service activities in low-cost, good quality locations. Doing so cuts costs, increases capabilities, and creates competitive advantage. Politicians would like to regulate this activity, but they can neither accurately observe what firms are doing, nor come up with regulations that can be credibly enforced.

So, expect lots more rhetoric and, perhaps, some efforts to require new reporting by firms. But the offshore trend will continue unabated, despite politician’s hopes. In the short run, offshoring will cause more dislocation and pushback. In the medium and long-run, it will continue to raise productivity and living standards in both the developing and developed countries.

Key Insights (1): Offshoring is not reversing anytime soon

My post of April 14 laid out nine key insights developed in The Services Shift.

Today, I tackle Key Insight #1: The move toward offshoring is not reversing anytime soon. I will cover the other eight insights as time permits in the next few weeks.

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There has been a fair amount of announcements lately about firms bringing work back from offshore. Examples include:

• Student Loan firm Sallie Mae will shift around 2,000 positions from its offshore facilities in India to US cities (story)
• Delta Airlines is no longer sending reservation calls to India (story)
• Florida stops offshoring call center support for its Food Stamp program to India (story)
• UC San Diego Medical Center is bringing several activities back in-house (story; registration required)

Sounds like good news for offshoring opponents, and for job creation in the US economy. But does this herald a reversal of the Services Shift? Most likely, no.

To get an accurate view of offshoring prosepcts going forward, it is important to disentangle three distinct phenomena.

1. There are always some mid-course corrections that occur as firms work to optimize their delivery mix. Recall the famous Dell "reversal" of a few years ago (2005 I believe). At that point, Dell had moved more than 10,000 customer care positions to India. It found that some of its largest customers preferred US-based support and were willing to pay for it. So the company brought 500 positions back. The move was widely covered as a "failure" or offshoring, but it was merely a mid-course correction. The UCSD story sounds a lot like this -- normal adjustments, but why not get some good PR out of it.
2. Temporary effects from the economic downturn. As anyone who works in this field knows, jobs are a radioactive topic these days. Firms can get some easy PR and political goodwill by making a big announcement about bringing jobs home. The Sallie Mae and Delta Airlines stories have this flavor. Congress is considering whether to change the regulations governing student loans and Sallie Mae is in danger of losing its core business. Delta has big union problems resulting from its merger with NWA. Announcments like this provide some cover for tough decisions elsewhere.
3. The underlying trends that are driving the Services Shift. As discussed in Chapters 1 and 2 of The Services Shift,there are five fundamental shifts driving the globalization of service activities. These are:

• Economic liberalization in countries around the world. Since 1985, the share of global population living in countries that are "open" to global trade and investment has risen from 23% to 78%. That doesn't mean all those people in India and China are exporting to the US and EU. But if they want to consume the things we make (airplanes, movies, higher education), they have to export something. And the activity they have the largest advantage in is services.
• The digitization of business processes. As business data and correspondence becomes digitized, location becomes irrelevant. There has been a tremendous shift toward digital records (think SAP and Oracle ERP systems). This faculitates global sourcing.
• Improvements in the cost and capabilities of computing and telecom. The relentless progress of technology opens up new opportunities for move work abroad.
• Growing capabilities around the globe. The number of people receiving both basic and elite educations has skyrocketed in recent years. Many of the top business, technology, and engineering schools are now located in developing countries. Visa restrictions in the US mean that talented young people are staying at home, and serving global markets from there.
  
• The rise of a global business culture. 25 years ago, doing business in a developing country meant doing business like the locals. Today, business culture is converging on the western norm (English, lots of MBAs, entrepreneurship and equity market allocation of growth capital). In the old days, sourcing from India, China or Brazil was difficult, today it's a snap. Chances are, there are plenty of graduates from US/EU graduate programs, potential suppliers use the same software packages, and they read the same books and watch the same movies. In short, cultural distance has declined remarkable.

So what does this all mean for the future of offshoring? If we attempt to sort out the transient vs. the structural trends, we see that item 1 above is clear transient. When you look into it, most of the "bringing jobs back" stories have lots of caveats and contingencies. Many are either PR moves or small adjusments.

Item 2, almost by definition, is transitory. The economic downturn makes offshoring polticially radioactive. That means firms don't like to talk about it. But the flip side of that coin is that margins pressures are creating more and more pressure to go offshore -- both to cut costs and as a catalyst for restructuring. So there is a divergence between political and economic logis (what else is new!!).

Finally, the structural drivers (#3 above) are here to stay. The only one of the three with the potential to reverse is policy liberalization (see Zimbabwe, Venezuela, and Bolivia). But those cases are isolated and generally lead to economic downturns. Drivers 2-5 are here to stay.

All this means that the megatrend toward the globalization of services (i.e. offshoring) will continue to move forward. There will be periodic corrections, but I would be willing to bet that offshore sourcing from developing countries will be at least twice as high five years from now as in 2008 (implying a 15% growth rate). My best guess is far higher.

Any takers?