Interesting Business Week article on the potential costs of free trade
Source Michael Perelman
Date 04/12/11/02:21

DECEMBER 6, 2004


Shaking Up Trade Theory
For decades economists have insisted that the U.S. wins from
globalization. Now they're not so sure

Ever since Americans began fretting about globalization nearly three
decades ago, economists have patiently explained why, on balance, it's a
boon to the U.S. Yes, some Americans lose their jobs, either to imports
or because factories move to cheap-labor countries such as China or
India. But the bulk of this work is labor-intensive and lower skilled
and can be done more efficiently by countries that have an abundance of
less-educated workers. In return, those countries buy more of our
higher-value goods made by skilled workers -- for which the U.S. has a
comparative advantage. The lost jobs and lower wages in the U.S.,
economists say, are more than offset when countries specialize like
this, leading to more robust exports and lower prices on imported goods.

Now this long-held consensus is beginning to crack. True, China is
emerging as a global powerhouse, realigning many economic relationships.
But in the long run a more disruptive trend may be the fast-rising tide
of white-collar jobs shifting to cheap-labor countries. The fact that
programming, engineering, and other high-skilled jobs are jumping to
places such as China and India seems to conflict head-on with the
200-year-old doctrine of comparative advantage. With these countries now
graduating more college students than the U.S. every year, economists
are increasingly uncertain about just where the U.S. has an advantage
anymore -- or whether the standard framework for understanding
globalization still applies in the face of so-called white-collar
offshoring. "Now we've got trade patterns that challenge the common view
of trade theory, which might not be so true anymore," says Gary C.
Hufbauer, a senior fellow at the Institute for International Economics
(IIE), a Washington (D.C.) think tank. A leading advocate of free-trade
pacts, he still thinks white-collar job shifts are good for the U.S.

The great debate percolating among the country's top trade economists
gained new prominence with a recent article by Nobel laureate Paul A.
Samuelson in the Journal of Economic Perspectives (JEP). In the piece,
the 89-year-old professor emeritus at Massachusetts Institute of
Technology, who largely invented much of modern-day economics, questions
whether rising skills in China and India necessarily will benefit the U.S.

The reaction was swift. Experts such as Columbia University trade
economist Jagdish N. Bhagwati, who countered Samuelson in the next JEP
issue, resist the notion that the new offshoring could lower U.S. wages
or slow growth of gross domestic product. After all, these economists
have spent their professional lives ridiculing such conclusions as so
much protectionist nonsense. Nevertheless, they aren't yet able to
reconcile what's happening on the ground with the ideas they have so
passionately defended. "This is a whole unexplored question that is very
controversial, and nobody has a clue about what the numbers are," says
Robert C. Feenstra, a prominent trade economist at the University of
California at Davis.

*Global Labor Pool*
The central question Samuelson and others raise is whether unfettered
trade is always still as good for the U.S. as they have long believed.
Ever since British economist David Ricardo spelled out the theory of
comparative advantage in the early 1800s, most economists have concluded
that countries gain more than they lose when they trade with each other
and specialize in what they do best. Today, however, advances in
telecommunications such as broadband and the Internet have led to a new
type of trade that doesn't fit neatly into the theory. Now that
brainpower can zip around the world at low cost, a global labor market
for skilled workers seems to be emerging for the first time -- and has
the potential to upset traditional notions of national specialization.

There are three ways this new development could disrupt the U.S.
economy. If enough cheap, high-skilled workers become available around
the world, competition may drive down U.S. wages for a wide swath of
white-collar workers. Even economists who still see overall net gains
agree that this is a potential problem. "For the first time,
high-skilled U.S. workers are going to be exposed to international
competition, though it's not clear how much it will hurt their wages,"
says Bhagwati.

A second concern is how much of the gains from trade will flow through
to U.S. consumers. Until now the pain of globalization has been borne by
less than a quarter of the workforce, mostly lower-skilled workers,
whose wage cuts outweighed the cheaper-priced goods globalization
brings. But the other three-quarters of American workers still came out
ahead, since they weren't affected by foreign wage competition. If blue-
and white-collar employees alike are thrown into the global labor pool,
a majority of workers could end up losing more than they gain in lower
prices. Then the benefits of increased trade would go primarily to
employers. "It's entirely possible that all workers will lose and
shareholders will gain; you have to be concerned about that," says
Harvard University trade economist Dani Rodrik.

Even that wouldn't be enough to completely derail comparative-advantage
theory, which holds that higher profits from trade should more than
offset the lower wages. But again, for the first time, economists see
another factor at play. As skill levels improve in cheap-labor countries
-- for example, the new engineering class in India -- competition is
coming on in the very products for which the U.S. has had a global
advantage, such as software. If the new competition drives down prices
too much, U.S. export earnings will suffer, and the entire U.S. economy
could end up worse off.

While experts such as Hufbauer and Bhagwati doubt it will ever come to
this, the fact that they're even entertaining such concepts is an
intellectual sea change on a subject long considered settled. When
countries such as China can perform tasks in which the U.S. previously
had a clear edge, "comparative advantage cannot be counted on to gains greater than the net losses," Samuelson asserts in
his new paper.

The rethinking among economists could soon spill over into the policy
arena. No one is advocating new trade barriers, which could be a cure
that's worse than the disease. Nonetheless, the shaken views of so many
prominent economists could prove to be critical. Throughout the 1990s,
Washington embraced new trade deals in large part because of the virtual
unanimity among experts that trade always benefits the U.S. If they're
not so sure anymore, the public consensus that was unsteady to begin
with could start to unravel.

Two tests will come next year when U.S. membership in the World Trade
Organization comes up for review, as does the President's so-called
fast-track authority to negotiate trade agreements. "I'm worried that
rising anxiety among higher-skilled workers will erode support for
continued globalization in the U.S.," says Dartmouth University
economics professor Matthew J. Slaughter.

*"A Right to Be Scared"*
How large might the white-collar offshoring trend become? The more jobs
that go, the greater the impact on U.S. wages. Consultant Forrester
Research Inc. (FORR ) in
Cambridge, Mass., was among the first to spot the white-collar job
shifts and has done the most detailed projections so far. It sees the
pace of U.S. job flows abroad averaging 300,000 a year through 2015.
This is probably conservative since Forrester has also found that the
number of U.S. companies among the 1,000 largest that engage in some
level of white-collar offshoring will rise sharply -- from 37% today to
54% by 2008. Already, some 14 million white-collar jobs involve work
that can be shipped electronically and thus in theory could be moved
offshore, according to a study by economists Ashok D. Bardhan and
Cynthia A. Kroll at the University of California at Berkeley's Haas
School of Business.

The hit to wages could be powerful if that happens. Forrester analyst
John C. McCarthy identified 242 service jobs as likely to be affected
among the 500-plus major occupations tracked by the Bureau of Labor
Statistics (BLS). He ranked each by the share of jobs employers are
likely to shift abroad by 2015. His conclusion: The cumulative job
outflow will total 3.4 million over that period. That comes to 6% of the
57 million people who work in these 242 occupations today.

If that's in the ballpark, U.S. white-collar wages would get whacked,
says Harvard University labor economist Lawrence F. Katz. Every 1% drop
in employment due to imports or factories gone abroad shaves 0.5% off
pay for remaining workers, he found in a study with Harvard colleagues
Richard B. Freeman and George J. Borjas. So if job losses rise to 6% of
the white-collar total, these workers' pay could be depressed by 2% to
3% through 2015, figures Katz. While a few percentage points over a
decade or so may not sound dire, it's roughly as much as blue-collar
workers lost to globalization in recent decades. "White-collar workers
have a right to be scared," says Katz.

Another way economists gauge the potential wage impact is to look at
examples of how people fare when they lose a job and extrapolate for
those who might get displaced by offshoring. Turns out that just 30% of
laid-off workers earn the same or more after three years, according to a
study of 22 years of BLS data by economics professor Lori G. Kletzer of
the University of California at Santa Cruz. Only 68% even hold a job at
that point, while the rest are unemployed, retired, or perhaps at home
with children. On average, those reemployed earn 10% less than before,
Kletzer found. "Clearly, offshoring will be bad for U.S. wages, given
what the job displacement numbers tell us," says Princeton University
economics professor Henry S. Farber, who has written extensively about
displaced workers.

But even if the incomes of more U.S. workers fall, won't the rest of
American consumers benefit from the lower-priced goods and services
globalization brings? Not necessarily, some economists now believe. Most
studies of trade's impact on pay, including Katz's, assume that
factory-job losses simply shift the demand for labor from one kind of
worker to another higher up the value chain. So higher-educated workers
gained much of what the less-schooled lost.

But if white-collar offshoring swells enough, the resulting job losses
could undercut a large swath of U.S. consumers. In part, this is a
question of scale. There's little doubt that globalization is likely to
continue to cut into the country's 14.5 million factory hands. Add in 57
million white-collar workers suddenly facing global competition, too,
and more than half the U.S. workforce of 130 million could feel the
impact. Then, economists conclude, the benefits of globalization would
flow mostly to companies and shareholders who profit from the cheaper
labor, with little pass-through to workers and consumers. "If a majority
of Americans have lower wages from outsourcing, then capital would be
the prime beneficiary, even if U.S. GDP goes up," says Harvard's Freeman.

*Domestic Disturbance*
Could the offshore phenomenon even dent America's overall GDP? Standard
theory suggests not, but it's now another question nagging economists.
Ricardo's insight that all countries come out ahead when they trade more
with each other was updated in the early 1900s by two Swedish
economists, Eli F. Hecksher and Bertil Olin. They showed that Ricardo's
idea holds even if high-skilled countries such as the U.S. trade more
with low-skilled ones such as India, with each country specializing in
products in which they have a relative advantage. Thus, it's more
efficient for the U.S., where about 60% of the workforce has some
college education, to export products that use their skills and import
low-end ones from cheap-labor countries. Conversely, India, where just a
fraction of its 400 million-plus workers have gone to college, should
grab the low-skilled work and leave higher-end products to the U.S.

This theory doesn't square with today's outflows of programming and
other higher-skilled jobs. "According to the Heck-sher-Olin model, we
shouldn't be sending these jobs to countries with [so few skilled
workers]," says University of California at Los Angeles trade economist
Edward E. Leamer. But U.S. companies are doing just that because labor
is cheaper and the Net makes it feasible to transport work done abroad
back to the U.S.

Still, most economists think the new offshoring is an overall plus. For
one thing, they say, employers' cost savings should more than compensate
for any wage damage. And by slashing the price of software and other
goods, offshoring could power a new wave of U.S. productivity gains
similar to those triggered by falling computer-hardware prices in the
'90s, says a study by Hufbauer's colleague, IIE senior fellow Catherine
L. Mann.

She and others argue that countries will continue to specialize in what
they do best. Sure, India or China are taking high-skilled jobs in
programming, but the U.S. will still outperform them in, perhaps, drug
research or nanotechnology. Instead of thinking about comparative
advantage in broad strokes such as high-skilled and low-skilled, they
say, it makes more sense to make finer distinctions and look at areas in
which countries have industry- or occupation-specific advantages. "There
will be specialization within industries, [which will bring] a lot of
demand from India for our higher skills," says Bhagwati.

Other economists, however, such as Leamer and Rodrik, believe that in
the new global economy, advantages from these kind of micro-level
specialties will be fleeting. After all, if the U.S. is better at
aerospace research, there's no reason why China couldn't quickly ramp up
college grads in that area, too. It's already doing that in telecom and

Leamer and other trade experts say the resulting price competition from
rising stars such as China and India could overpower any economywide
gains companies get from global sourcing. They point to a famous 1968
paper by, of all people, Bhagwati, who argued that a country can be made
worse off if trade lowers the price of products in which it has a
comparative advantage. Bhagwati called it the "immiserating" effects of
trade. In discussing the idea with /BusinessWeek/, Leamer wrote a short
proof showing how a downward spiral of lower labor costs leads to lower
export prices, causing immiseration. Even Bhagwati concedes that his
insight could apply to the U.S. today, though he thinks the chances are
slim that it will. "Bhagwati showed back then that a country can grow
and get poorer, which might be this story, though I doubt it," says

Indeed, it's possible that the U.S. already has suffered immiseration.
Mann's study found that the offshore exodus of U.S. chip factories
accounted for 10% to 30% of the decline in the prices of personal
computers and memory chips in the early 1990s. These savings boosted
U.S. multinationals' net exports of these products, and by 2000 the
companies saw a $10 billion trade surplus in them.

But did the U.S. as a whole come out ahead? Mann's study also shows that
the country's overall trade deficit in these products plunged into
negative territory in 1992 and has remained there ever since. So while
large U.S. companies gained from moving chip factories abroad, the
overall U.S. economy may have lost. "This looks like immiseration to
me," says Leamer.

Globalization, say most trade economists, ultimately should benefit the
U.S. more than it hurts. But they can't yet show that to be true. Until
someone comes up with a convincing explanation for what happens when the
highest-skilled jobs move offshore, battles over globalization are
likely to rage even hotter.

By Aaron Bernstein

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