Wednesday, August 04, 2004

Outsourcing: A theoretical argument against,

While a lot of people tell stories about how outsourcing hurts them, nobody has argued the theoretical point that it might be creating wealth. There is reason to believe from the first principles of economics that this might be the case, that offshoring and the capital flight it represents might be actually impoverishing rather than enriching the general system.

Before delving into this, let's begin with the CSM story about China and textiles:

American importers are calling it the "big bang" of clothing - the scheduled end of a worldwide system of nation-based quotas on imports of textiles and apparel.

Implications of this change in the global trade system are huge - so big, in fact, that some nations standing to lose from the deal appealed Tuesday to the World Trade Organization (WTO) in Geneva to launch an emergency process to stop or delay the removal of quotas.

The change, slated to take effect Jan. 1, is already spreading something close to panic in dozens of poor countries, especially in the Caribbean, Central America, northern Africa, and Southeast Asia. Millions of workers could be laid off, the bulk of them women who sit before sewing machines hour after hour, stitching together the jeans, the blouses and shirts, the underwear, and other garments bought by Americans and Europeans. In China, perhaps in India as well, millions could win new jobs as their garment business picks up.

The removal of quotas amounts to a massive transfer of jobs and wealth in the developing world over the next few years.

In Bangladesh, concern is especially strong. Some 300,000 to 800,000 garment workers could end up losing their jobs, estimates Fazlul Hoque, president of the Bangladesh Knitwear Manufacturers and Exporters Association.

"We have to face a big problem," he says. Chinese garmentmakers, he charges, are playing "unethical games." So, without the protection of the existing quota system, Bangladeshi firms, including his own, are likely to lose many contracts for the production of clothing.

So what are the theoretical objections against outsourcing? The first one is the classical economics principle of specialization of labor. Specializing in services and production is important because it allows people to create wealth - to create more to enjoy. Specialization in production is also important because it underlies the argument of trade, that countries by specializing can create overall more net wealth to share. That was the essence of Ricardo's idea.

This is the logic that underlies mergers and consolidation, along with economies of scale. It is possible for companies with large market share to erect barriers against competition, but the reason why large companies come to exist in the first place is that when one orders bulk and can standardize mass production or service delivery and can build a brand on that then greater efficiencies of specialization and scale can be achieved. When two companies merge, they sell it to Wall Street by noting that one purchasing can do the work of two, that one human resource department will no longer compete and waste money competing with another human resource department over the same worker, or for advertising and marketing the same customer, etc., etc. It rarely works out exactly that way, but that's the idea and as an idea it's quite sound though execution cannot be taken for granted.

That's why on a purely theoretical basis outsourcing is worrisome. It speaks more of squeezed revenue or profit margins than it does prosperity. When you take a position normally filled by a full time employee, and instead fill it with an outside contractor you are doing the reverse of employing economies of scale and specialization. Instead of a succession of employees vested in your company, you get a cycle of outsiders whom you must waste time picking and choosing among - as well as forcing a skilled service or production supplier to also pick up self-administration costs, marketing costs, work sourcing costs, overhead, etc.

I'm not arguing that if a function must be performed irregular it is more inefficient to outsource, but we're not talking about outsourcing periphial or extended functions at this point in the American economy. Why would someone do something that wasteful? Because even though the overall cost is undoubtedly higher, the split share to the original employer is smaller.

So when employers excessively outsource they are in fact driving costs up and reducing wealth, but they profit by it by passing these costs on to others. Well for a while now these costs have been passed on to labor, and since nobody really gives a **** about labor this has gone unnoticed even though as I've said it must through simple logic and the first principles of economics be more inefficient for the economy as a whole.

Let's talk about the detrimental effect upon wealth of the dilution of capitalism. The sheer definition of capitalism is that by allowing inequalities of wealth, one increases net production and services and therefore can increase overall consumption. This is the famous "trickle down" or "rising tide lifts all boats" philosophy behind Say's maxim and other supply-side economic observations.

The reason why this happens is that the very fact of the concentration of wealth creates through economies of scale greater productivity. Now it would be nice if it were true that this also implied that the concentration implied a greater efficiency of using that capital, but that's not necessary. What's necessary is that if we have two persons A and B then if A has more wealth then the fact that A has more wealth is itself sufficient to increase net productivity than if that wealth were evenly distributed between A and B.

Do you see the difference? Capitalism works not because A has a greater productivity with the same amount of wealth than B, but because the fact that the greater wealth itself creates opportunities for greater productivity. B in fact if given the chance to have his shot at such wealth, might be even more productive than A was. However capitalism does not require that the best person win out, simply that having more money wins out more than having less loses investment returns of productivity.

Some economists speak of it as if capitalism implies that wealth inequality goes to those more deserving. That's a way to flatter the wealthy and powerful. It's simply sufficient for the system that wealth make those who have it more capable of getting better returns, and in such a degree that it outweighs the losses in returns from those who now have less. Even if those others if the situations were reversed would have done even better with that concentration of wealth.

Some might say that this is unfair or cruel, but that is the way capitalism works. But offshoring by it's very nature contradicts this formulation of capitalism. Why? Because it spreads the wealth around. Instead of seeing that wealth concentrated in relatively few hands, ironically, it invests it all around the world seeker ever lower structural costs. As a consequence overall productivity and returns on investment are lowered for the system. Again this is done because the short term profit motive - pushing down overall productivity while enhancing one's short term profits - is advantageous to the individuals pursuing this course of action.

It is made further pernicious because this is a Nash equilibrium of the type called the "tragedy of the commons". Each individual acts for their own interests, and in doing so degrades the overall common good so that in the future they all with draw smaller and smaller returns. This is what has happened in the fishing industry. Everyone was out to get the biggest catch they could, because if they didn't then someone else would. However this has depleted one fishing stock population after another. Cod, etc.

In the same way, by making investments in Bangladesh and then chasing better short term profit margins in China all the built up relationships, work, time investments, etc. are lost. Yes the assets are liquidated, but as they are liquidated again and again over shorter and shorter time frames any ordinary CPA will tell you that they have less and less time to earn back their investment costs and along the way you are accruing the "turnover" or transaction costs of each move. Every time you have to start over training a new labor population, maybe you save in nominal costs but you lose overall productivity as any manager can tell you because you have to train and retrain the new people and reacclimate them to your standards and get them up to speed. This is why managers dislike high turnover.

How can numbers such as stock markets and currency supply be going up if in fact wealth is being destroyed in an anti-capitalistic manner? Well there is one classic economic situation that corresponds to decreased wealth and increased nominal prices. It is called 'inflation'. The Keynesians of the past have been overly fixated on labor-inflation because that was a major driver of Western inflation for several decades.

However there are various kinds of inflation. One of them is speculative asset inflation, another is monetized inflation, etc. Inflation can come in different manners and sizes. The one I'm talking about is anti-capitalistic inflation. It comes from running an economy in such a way that you are reversing specialization of labor, disincentivizing the development of specialized knowledge or experience, diluting capital concentration faster than its net return productivity, and increasing the turnover of assets and labor faster than its return on investment cycle.

Most people today consider free markets and market-driven behavior to be synonymous with capitalism, but they are not the same thing. Even if we had truly free markets, markets exist as a group pricing phenomena coordinating in a distributed manner many buyers and seller's information in order to bring about a convergent "efficient" price for a product given a certain regulatory, supply, and demand situation. If the information that is available to buyers or sellers is through ommission or bias prejudiced then the pricing will be prejudiced as well. In fact, it is quite possible to have a perfectly functioning market inefficiently invest capital. This is because other factors than return considerations on capital direct the pricing of ownership shares in capital ventures. If return considerations really were the drivers then cash flow, P/E ratio,s and price to book ratios would tell the whole story. But they don't.

They do tell a large part of the story, but not all of it. And in this manner the whole western system of capitalism has been subverted because of the increasing breakdown of incentives for the specialization of labor and the concentration of capital - two of the bedrock principles of capitalism itself. However people don't notice it because of the inflation, because prices haven't fallen.

So I don't feel sorry for the Bangladeshis. They're in pretty much the same boat as the Mexicans. Or the Americans. They're being caught up in a whirlwind of permanent capital flight, of increased turn-over and dilution of the concentration of capital. There are many indicators that it is something like a Ponzi scheme. People are enriched today, but only by borrowing against the tomorrow.

While the debts are serviced, this seems like an excellent idea. When the bill comes due however, there are going to not just be a lot of people but capitalistic systems themselves that will founder and perhaps go under. The average person in this country has something like $10,000 dollars of consumer debt. If you were to go around your place and take all the various things you own, could you get $10,000 for them? If you sold your bed, your furniture, your electronic game machines, etc.?

I know I couldn't. Especially if everyone else tried to sell them at the same time. Yet there are people who continue to count the prevelance of ordinary consumer goods as a form of wealth. Consumer goods have never been considered a significant form of wealth, any more than you would expect a garage sale to be a significant form of asset liquidation return or income.

So yes people have more things common to their households, but in stark terms of wealth and assets they're the poorer for it and when the debts are called in then it will become obvious overnight how truly impoverished people have become.


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