Rebuttal to McKinsey's pro-offshoring Study

A recent McKinsey study Offshoring: Is it a Win-Win Game? claims that offshoring U.S. jobs overseas has an overall beneficial effect on the U.S. economy. The study's author, Diana Farrell, has a pro-globalization slant, as evidenced by her book, "Market Unbound: Unleashing Global Capitalism." You may view her 15-minute video "Whatever happened to the new Economy" here.

The study claims that for every "$1.00 of U.S. labor cost [offshored], the U.S. captures $1.12 to $1.14." But the study fails to disclose that, using the same measures, the U.S. economy captures far more if the jobs remain in the U.S. The study further fails to consider substantial factors such as the loss of income tax.

I challenge Diana Farrell to defend her study. This report is being widely quoted, for example:
For Kiran Karnik [Forbes "Face of the Year"], the transfer of employment from West to East is a "win win" situation. "I know it is easy to say but now we have actual data which shows that for every dollar outsourced the value created is US$1.45145, of which US$1.12 flows back to the US and a smaller benefit of just US$0.33 accrues to India."

As the following exhibit from the McKinsey study shows, the "actual data" is nothing more than biased speculation that fails to consider the full impact. A true study would take a scenario -- such as Intel terminating all 50,000 U.S. employees and transferring these operations to India, then tracking the impact on tax revenue and impact on service industries -- factors that McKinsey fails to consider.

My questions to Diana Farrell and McKinsey:

I've pasted their core argument below verbatim, and confined my commentary to boxes.

Kim Berry
Board -

The hocus-pocus in this diagram is explained in the bulleted items below. They fudge by presuming 2/3 of direct benefit remains in the U.S. - more should be better - McKinsey's theory should hold even if 100% of the company's labor is offshored.

But, is offshoring really bad for the United States?

What is the impact on employment? The evidence available to MGI suggests that fears about job losses, however reasonable they might be, tend to overplay the likely impact of offshoring. The vast majority – some 70 percent – of the economy is composed of services such as retail, restaurants and hotels, personal care services, and the like spanning very broad wage and value added ranges. These services are necessarily produced and consumed locally – and therefore cannot be offshored.

So only 30% of U.S. jobs might disappear. The study fails to consider that a key customer of rental cars and hotels is business travelers. McKinsey does not factor in this impact. If the U.S. economy is reduced to providing services to each other, how do we add value to compete in the Global market? McKinsey ignores this factor.

This is not to say that no jobs will go overseas. They will. And as with any trade related or other industry restructuring, the changes will be painful for many involved. But even if Forrester is right, and 3.3 million jobs do go offshore by 2015, the United States has been there before. It has the world’s most dynamic economy and is fully able to generate new jobs. The job losses Forrester references translate into a loss of about 200,000 jobs a year over the next decade. Even in good times, mass layoff numbers are much higher than this. In 1999, for instance, 1.15 million workers lost their jobs through mass layoffs (out of a total of 2.5 million job losses). In 1996, the number was 1.18 million. It is not only offshoring that can result in job displacement: technological change, economic recession, changes in consumer demand, business restructuring and public policy, including trade liberalization or environmental regulation all can and do play their part. The recent changes driving offshoring are not that different or radical from the changes that dynamic, competitive, technologically evolving economies have experienced for the last few decades.

This is like arguing that cancer is not a problem since people die of many other causes. Further it is flawed because historically jobs lost through layoffs are balanced by jobs created, or by rehires by the same company when profits improve. Offshoring is different: Those jobs are lost forever.

What is the impact on the economy? We would argue that not only is the United States fully able to withstand these changes, as it will be able to create jobs faster than offshoring eliminates them, but that the current debate misses the point entirely. Offshoring creates wealth for U.S. companies and consumers and therefore for the United States as a whole: that is why companies choose to follow this course. Offshoring is just one more example of the innovation that keeps U.S. companies at the leading edge of competitiveness across multiple sectors. If it did not benefit U.S. businesses, they would not offshore. The more companies innovate, the more competitive they become and the more benefits are passed on to consumers.

Without explanation McKinsey claims that the U.S. economy will create jobs faster than is loses them - then says that isn't the point. They then move to the nonsequitur that "What is good for U.S. businesses is good for the U.S. economy. This is false. Relocating IBM, Intel, HP, Oracle, Cisco, etc, might benefit those corporations. But would this benefit the U.S. economy? Two million jobs is roughly 20 BILLION is lost income tax revenue annually, and at least as much annually transferred from the U.S. to India each year in the form of foreign wages. What would India purchase from U.S. workers to balance this trade imbalance?

Moreover, while still receiving services that employees were previously engaged in, the economy could now generate additional output (and thus income) when these workers take new jobs. Thus, offshoring not only captures every bit of economic value, dollar for dollar, that exists in the U.S. economy prior to the decision to offshore, but it also creates a net additional value for the U.S. economy that did not exist before.

Their study is further flawed by presuming that the two million displaced workers will simply "take new jobs." Yet the media is full of articles of professionals who are sending out hundreds of resumes, and no U.S. employer will hire them.

The U.S. will capture economic value through several different channels: reduced costs, increased revenues, repatriated earnings, and the redeployment of additional labor (Exhibit 6).

Reduced costs. Cost savings represent the largest form of economic value capture. For every dollar of spend offshored, 58 cents are captured as net cost reduction to businesses even as they often receive an identical (or better) level of service. A more competitive cost position will lead to higher profitability, increased valuations and help keep U.S. companies highly competitive in the world economy. Initially, the savings will flow to investors, or they will be invested in innovations or new business ventures. Eventually, as offshoring becomes more prevalent, competition will yield the savings to consumers. In either case, offshoring will contribute significantly to increasing national earnings.

New revenues. For every dollar of spend offshored, offshore services providers buy an additional five cents worth of goods and services from the U.S. economy, thereby creating exports and extra revenue for the U.S. economy. Providers in low-wage countries require U.S. computers, telecommunications equipment, other hardware and software. In addition, they also procure legal, financial, and marketing services from the U.S. Already imports from the U.S. to India have grown to $3.8 billion today from less than $2.5 billion in 1990.

This is flawed because it fails to consider than onshore services likely purchase much more goods and services from the U.S. economy.

Repatriated earnings. Several providers serving U.S. offshoring market are incorporated in the United States. These companies repatriate their earnings back to the U.S., which amounts to an additional 4 cents out of every dollar of spend offshored.

And how does the remaining $0.96 ever return to the U.S.?

Redeployed labor. As low value-added service is sourced from overseas, U.S. workers previously engaged in providing those services are freed up to take other jobs. If redeployment continues at the rate it has over the past two decades, then for every dollar of spend offshored, the economy will capture an additional 45 to 47 cents per dollar of offshoring from the new jobs that are generated. This appears a reasonable assumption given the empirical evidence that services workers find employment more quickly than do manufacturing workers, and job-displacement during the last two decades – when jobs offshored were primarily in manufacturing – was at least as high as the projected job displacement in services.

Far from being bad for the United States, offshoring creates net additional value for the U.S. economy that did not exist before, a full 12-14 cents on every dollar offshored. Indeed, of the full $1.45 to $1.47 of value created globally from offshoring $1.00 of U.S. labor cost, the U.S. captures $1.12 to $1.14, while the receiving country captures, on average, just 33 cents. (Exhibit 7)

The openness of the U.S. economy and its inherent flexibility, particularly in terms of its labor market, are recognized widely as two of its great strengths. These aspects need to be reinforced, not undermined. The current danger is that policy makers will inadvertently pander to protectionism. To do so would be dangerous for America’s future well being.

Conversely McKinsey will lead us into a world of economic collapse where workers are not paid enough to be consumers. This is already the problem in India and China - multinational corporations must sell to US and EU where wages are higher. What will happen when supply and demand drives U.S. wages down to China?