20 February 2007

Outsourcing Redux

Free trade is one of those ideas that seems so great and so logical, we often forget that not everyone agrees. That is, we forget until we walk past a "fair trade" protest in Seattle or the "Fair Trade" cafe on campus at UCL. We can safely conclude that these people have never taken a basic economics course.

Today, after discussing CEO pay, Wal-Mart, free trade and other cool economic things, we did a little online research, re-watched the first volume of Milton Friedman's "Free to Choose," and found Greg Mankiw's blog. Among the many things posted was this gem, written back in 2004 about the outsourcing debate, but very readable and applicable today.

This dedication goes out to all you protectionists out there, wherever you may be. We know Valentine's Day was last week, but we hope you'll forgive our tardiness.
Adam Smith on Outsourcing

By N. Greg Mankiw

If the American Economic Association were to give an award for the Most Politically Inept Paraphrasing of Adam Smith, I would be a leading candidate. But the recent furor about outsourcing, and my injudiciously worded comments about the benefits of international trade, should not eclipse the basic lessons that economists have understood for more than two centuries.

To avoid making the same mistake twice and clinching the award, I should let Mr. Smith speak for himself. Here is what he said in his 1776 classic The Wealth of Nations: “It is maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy...What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.”

This is the basic theory of international trade. Since Smith penned these words, economists have added rigor to the analysis (thank you, David Ricardo) and have conducted numerous empirical and historical studies of the effects of trade. The verdict is in: Smith was right. Few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards. Smith’s insights are now standard fare in Econ 101.

Yet, whenever the economy goes through a difficult time, as it has in recent years, free trade comes under fire. Some people now fear that trade is responsible for recent weakness in U.S. labor markets. The concern is understandable, but it is simply not true. Over the past three years, job losses are more closely related to declines in domestic investment and weak exports than to import-competition. To the extent that the rest of the world threatens U.S. prosperity, the main problem is not rapid growth in China and India, but slow growth in Japan and Europe.

Of course, global competition has caused employment declines in some industries. The world trading system is changing along with technology. Goods that could once be produced only domestically can now be produced abroad and imported over fiber optic cable. The Internet and advances in telecommunications have meant that more Americans are competing with workers in other nations. Even if more competition is good for consumers, it can produce very understandable anxiety among some workers and their families.

These technological changes, however, have not rendered Smith’s insights obsolete. The same principles apply to offshore outsourcing of services as to traditional trade in goods. This has been confirmed in a recent study by the McKinsey Global Institute. McKinsey researchers tallied up the costs and benefits associated with outsourcing and found that for every dollar the United States sends abroad, we get back about $1.12, resulting in a net gain of $0.12. Smith would not have been surprised.

Some people fear that Americans cannot compete with low-wage workers abroad, or that global competition will mean that wages will “race to the bottom.” The truth is that we can prosper in a global economy because our workers are among the best in the world. Our real wages are ultimately determined by our productivity, and American productivity growth has been spectacular over the past three years.

So, if trade is not the problem ailing the U.S. economy, what is? Smith again has the answer. “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things." This fits perfectly with three of the President’s priorities: defending the homeland against terrorist threats, reducing the tax burden on the American people, and reforming the tort system. (If Smith overlooked the importance of ensuring a reliable energy supply and reducing the cost of health care, we can forgive his eighteenth-century myopia.)

The President, like Smith, believes in the free enterprise system. The goal of policy should be to open up markets, not to retreat behind walls or throw rocks in our harbors. Economic growth is not zero-sum. Prosperity in one country is not a threat to prosperity in another. Free and open markets can mean better jobs both for Americans and for our trading partners around the world.

It may be a mere coincidence that Smith’s great book was published the exact same year that the Declaration of Independence was signed. But the founding fathers of the United States share an intellectual bond with the founding father of economics. They both believed that liberty and prosperity go hand in hand. Our founding fathers were well aware of Smith’s work. Benjamin Franklin knew Smith personally. When Franklin quipped that “No nation was ever ruined by trade,” he likely meant it as an understatement.

Perhaps quoting Adam Smith is risky. Smith was British, so some people may accuse me of outsourcing economic advice. But import competition is not a threat. I have great confidence that President Bush’s policies will grow the economy and create a job for every American who wants one, including his politically tone-deaf economist.

Dr. Mankiw is a professor economics at Harvard and former chairman of the Council of Economic Advisors.

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