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Sunday, May 07, 2006

Outsourcing Redux


About two years ago, while I was chairman ofthe Council of Economic Advisers, I had my 15 minutes of fame overthe topic of offshore outsourcing. (I tell the story in a recentpaper with my former chief of staff Phillip Swagel.) At the time, Idrafted an op-ed on the topic. The article was never submitted, butit has been sitting on my hard drive ever since, where I recentlyran across it. I thought the readers of this blog--an elitegroup--might enjoy it.

Adam Smith on Outsourcing
By N. Gregory Mankiw
March 25, 2004

If the American Economic Association were to give an award for theMost Politically Inept Paraphrasing of Adam Smith, I would be aleading candidate. But the recent furor about outsourcing, and myinjudiciously worded comments about the benefits of internationaltrade, should not eclipse the basic lessons that economists haveunderstood for more than two centuries.

To avoid making the same mistake twice and clinching the award, Ishould let Mr. Smith speak for himself. Here is what he said in his1776 classic The Wealth of Nations: “It is maxim of every prudentmaster of a family never to attempt to make at home what it willcost him more to make than to buy...What is prudence in the conductof every private family can scarce be folly in that of a greatkingdom. If a foreign country can supply us with a commoditycheaper than we ourselves can make it, better buy it of them withsome part of the produce of our own industry employed in a way inwhich we have some advantage.”

This is the basic theory of international trade.

Since Smith penned these words, economists have added rigor to theanalysis (thank you, David Ricardo) and have conducted numerousempirical and historical studies of the effects of trade. Theverdict is in: Smith was right. Few propositions command as muchconsensus among professional economists as that open world tradeincreases economic growth and raises living standards. Smith’sinsights are now standard fare in Econ 101.

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

Of course, global competition has caused employment declines insome industries.The world trading system is changing along withtechnology. Goods that could once be produced only domestically cannow be produced abroad and imported over fiber optic cable. TheInternet and advances in telecommunications have meant that moreAmericans are competing with workers in other nations. Even if morecompetition is good for consumers, it can produce veryunderstandable anxiety among some workers and theirfamilies.

These technological changes, however, have not rendered Smith’sinsights obsolete. The same principles apply to offshoreoutsourcing of services as to traditional trade in goods. This hasbeen confirmed in a recent study by the McKinsey Global Institute.McKinsey researchers tallied up the costs and benefits associatedwith outsourcing and found that for every dollar the United Statessends 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-wageworkers abroad, or that global competition will mean that wageswill “race to the bottom.” The truth is that we can prosper in aglobal economy because our workers are among the best in the world.Our real wages are ultimately determined by our productivity, andAmerican productivity growth has been spectacular over the pastthree 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 astate to the highest degree of opulence from the lowest barbarismbut 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 taxburden on the American people, and reforming the tort system. (IfSmith overlooked the importance of ensuring a reliable energysupply and reducing the cost of health care, we can forgive hiseighteenth-century myopia.)

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

It may be a mere coincidence that Smith’s great book was publishedthe exact same year that the Declaration of Independence wassigned. But the founding fathers of the United States share anintellectual bond with the founding father of economics. They bothbelieved that liberty and prosperity go hand in hand. Our foundingfathers were well aware of Smith’s work. Benjamin Franklin knewSmith personally. When Franklin quipped that “No nation was everruined by trade,” he likely meant it as anunderstatement.

Perhaps quoting Adam Smith is risky. Smith was British, so somepeople may accuse me of outsourcing economic advice. But importcompetition is not a threat. I have great confidence that PresidentBush’s policies will grow the economy and create a job for everyAmerican who wants one, including his politically tone-deafeconomist.

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