By Laura D'Andrea Tyson
American companies lead the world in offshoring business services to India and other low-cost countries. But faced with stiff American competition -- due in part to the falling dollar -- more European companies, especially British ones, are starting to offshore services. Will European economies benefit from the trend? The answer turns out to be yes -- if certain conditions are met.
Even then, gains will not be evenly distributed: Workers and communities that lose jobs may suffer considerable pain.
Incentives for offshoring by European companies are huge: Services costs can drop by 50% to 60%. And the scope for offshoring is vast. By IBM (IBM ) estimates, less than 8% of the $19 trillion spent each year on sales, general, and administrative expenses has been outsourced so far. Many companies say they can offshore half or more of this work.
Offshoring services should benefit Europe's economy: Companies will become more competitive so they can raise profits and reduce prices. This will bolster demand and keep inflation in check. Companies can invest to improve existing products or introduce new ones. Greater demand will spark innovation and create jobs to replace those that have gone abroad.
With flexible labor markets and strong economic growth, countries that offshore services can shift labor to higher-value activities, boosting productivity and living standards. And countries that attract outsourced jobs will enjoy improved productivity and higher growth, so they can buy more exports from offshoring nations. Applying this logic, the McKinsey Global Institute estimates that for every dollar U.S. companies spend on offshoring work in India, the American economy gains $1.14, while India gets 33 cents. Thus, there are "win-win" returns for both high-wage and low-wage countries.
BUT A CLOSER LOOK AT THE LOGIC reveals that benefits to the offshoring nation depend on two critical assumptions: the redeployment assumption (or what percentage of workers who lose jobs find new ones); and the recapture assumption (or what percentage of the wages paid in lost jobs are recaptured by the wages paid in new ones). For example, the McKinsey calculation of gains from U.S. offshoring is based on the assumption that 69% of displaced service workers will find new jobs within one year and that these workers will earn 96% of their former wages. These assumptions are based on the U.S. economy's performance between 1979 and 1999.
More recent data from 2000-03 suggests these estimates may be overly optimistic. Even according to the McKinsey assumptions, nearly one-third of American workers who lose their jobs will not find other jobs within a year. Older workers with less education are the most vulnerable.
In Continental Europe and Japan, where employment practices are more rigid than in the U.S., redeployment of displaced workers is likely to be much lower. If low enough, this could cause an increase in the overall unemployment rate and a reduction in overall income in the offshoring country. In a recent study, McKinsey concludes this might be the case in Germany, where redeployment might reach only 40%. So German companies and shareholders could benefit from offshoring, while workers and the overall economy suffer.
By contrast, labor markets in Britain are more flexible, and offshoring is apt to generate both company-level and economywide gains. This is indeed the conclusion of the Advanced Institute of Management Research, which finds that service jobs have continued to grow strongly in Britain despite rapid growth in the offshoring of similar jobs by British companies.
Offshoring is a process of creative destruction. The challenge for governments is to develop policies that ease the pain that offshoring inflicts and speed workers' transition to new jobs. So-called wage insurance policies are a promising policy response. Such programs are designed to cover the loss of wages for displaced workers until they gain new employment or to make up the difference between the old wages lost and wages paid for new jobs. A small scheme of wage insurance was introduced in the U.S. as part of the 2002 trade legislation, but it is limited to older workers who lose manufacturing jobs to foreign imports. It is time to expand this program to workers who lose service jobs to offshoring.
The British government should introduce its own wage insurance program. Such a program would be in keeping with Labour's "Third Way" approach that values both market flexibility and social equity and that has been the foundation of Britain's strong performance over the past decade.
Laura D'Andrea Tyson is dean of London Business School (firstname.lastname@example.org).