The New
Face of
Globalization:

Lessons From History

Michael M. Knetter joined the UW-Madison School of Business as dean in 2002. This spring, he taught Global Economics for Executives in the Executive MBA program. Prior to coming to Wisconsin, he was associate dean of the MBA program and professor of international economics in the Amos Tuck School of Business at Dartmouth College. Knetter served as a senior staff economist for the President’s Council of Economic Advisors for former presidents George H.W. Bush and Bill Clinton, working on macroeconomic policy issues. The following article represents his position as an economist and is not intended to reflect an official position of the School of Business.

Capitalist economies have long grappled with a variety of sources of job displacement such as the mechanization of both agriculture and manufacturing and the growth of international trade. Today, a new challenge has emerged: international outsourcing of service functions. Discourse on this topic is likely to become even more politicized as the election draws near. Already, the patriotism of firms employing foreign labor to deliver services more efficiently is being questioned. Respected commentators on the economy are asserting that the principles of free trade no longer apply when jobs can be outsourced. Is this really true? And how should we deal with the pain of job displacement?

It is difficult to get to the bottom of this debate in normal media accounts, which are prone to sound bites and anecdotes. Since this entry in the debate is coming from the Ivory Tower, let’s start with some history. It is often said history repeats itself, and I am hopeful that will be the case here.

The scale and nature of “employment disruption” that has occurred at various points in U.S. history is quite stunning. A great case study in this regard is the mechanization of agriculture that began in the United States in the mid-1800s and continued well into the last century. Prior to early mechanization, estimates suggest that up to 65 percent of the U.S. labor force worked on farms. That share began to fall dramatically, until by 1940 only about 20 percent of U.S. employment was on farms. By 1970 that share had plummeted to just 4.4 percent. Although the displacement of agricultural workers is not a front-burner policy issue in many parts of the nation today, when agriculture was still employing a significant share of the workforce, it prompted great concern. Would workers displaced from the farm find alternative employment? If so, where?

In retrospect, most people view the mechanization of agriculture as a great economic achievement. The explosion in agricultural productivity enabled us to feed more people with less labor. Doing more with less is usually a good thing. The labor that was no longer needed in farming ultimately fueled the industrial revolution in this country. No one foresaw or directed the reallocation of workers from agriculture to manufacturing, it just happened through market forces. Average real income per person increased significantly. This average increase, however, most certainly masked variation around that average. There are winners and losers in any period of economic change.

More recently, we have seen increased mechanization of manufacturing in this country. Since 1970, output of manufactured goods, adjusted for inflation, has maintained a steady share of gross domestic product, while the share of workers in manufacturing has fallen sharply. Some of this is explained by “domestic outsourcing” of certain service functions that were once counted in manufacturing employment (e.g., maintenance workers in a auto plant). But mostly, this is a consequence of the rapid growth in manufacturing productivity due to the use of computing and robotics.

International trade has had similar qualitative effects on productivity and the mix of employment, although the scale of impact is much smaller than the mechanization of agriculture or manufacturing. Despite the smaller scale of impact, international trade generates much more controversy because it appears that foreign workers are displacing domestic workers. While no one accused the machines of ulterior motives during the mechanization of agriculture or manufacturing, many suspect that foreign countries are conspiring against us.

Economists have a fun parable that puts things in perspective. Suppose that an entrepreneurial farmer in Iowa (who had gained considerable experience with combustion engines by doing his own maintenance) discovered a new technology for automobile production. The secret technology used the same factors of production that the big firms in Detroit used—namely, labor, capital and land—but in different proportions. He decided to risk it all and launched his production facility in the remote fields of Iowa. After some initial quality problems, the Iowa firm was able to produce cars that were cheaper, more efficient and ultimately more appealing to consumers than those produced in Detroit.

Is this a good thing or a bad thing for the U.S.? The answer seems obvious. The consumers benefit from lower prices, the producers in Detroit lose and the producers in Iowa win. The last two cancel each other out, so the consumer gains, making this a no-brainer. It is just good, clean competition.

Ah, but there is a twist. The Iowa entrepreneur’s “new technology” is actually increased production of corn, shipped to Japan, and exchanged for autos of equivalent value. Should we now feel differently about this? Economists believe the answer is a resounding “no.” If we can make cars more efficiently by making corn and trading it, then that is how we should make cars. It is just another way to “build a better mousetrap.”

Although there have been episodes during which international trade has come under attack here, the U.S. has largely continued to reduce barriers to trade over the years. Ross Perot’s insurgent presidential campaign was largely founded on opposition to free trade with Mexico. Perot is remembered for his prediction that there would be a “giant sucking sound” of jobs going south of the U.S. border in the wake of the North American Free Trade Agreement (NAFTA). The unemployment rate fell precipitously throughout the 1990s after the signing of the NAFTA in 1993. The only giant sucking sound was the increased consumption by U.S. households made possible by efficiency gains from trade and technology.

The strong labor market conditions that coincided with the rapid expansion of trade in the 1990s helped persuade most people—particularly white-collar workers who were not threatened by trade with Mexico but benefited from lower prices—that freer trade would lead to expansion of relatively “high-wage” jobs in the U.S., while relatively “low-wage” jobs moved elsewhere. We appeared to reach peace with the labor market churning that accompanied trade.

Now the spotlight has shifted to a new form of displacement: trade in services and the “offshoring” of services jobs. Advances in communications and information technology have made it possible for U.S. firms to set up call centers in India to handle many customer service functions. Engineering and medical firms are able to set up virtual workplaces for projects and have professionals across the globe work around the clock on a project. This not only reduces time to completion on projects, but allows certain services to be performed at lower cost.

How does this differ from trade in goods? In spite of the claims of some pundits, there is no fundamental difference in the logic of comparative advantage. Exchanging investment banking and higher education services for call center and engineering services is no different than exchanging corn for cars. There is, however, one important difference: Certain professional services are facing direct international competition for the first time. Many services have faced indirect competition through trade in goods for years (i.e., engineers in Detroit certainly competed against engineers in Tokyo and Munich through international trade in autos).

Will the new opportunities for services trade increase the displacement rates that are part of the background noise in our economy to unprec-edented levels? Will our high-priced IT professionals and radiologists be put out of work? Will we need new national policies to deal with white-collar unemployment? Should we penalize firms that hire foreign workers to perform services jobs previously done here?

The job displacement that accompanies economy-wide restructurings, whatever the source, is real. The unemployment insurance system was created to mitigate the adverse effects of job displacement in a market economy. A variety of government programs provide subsidies for continuing education and retraining for workers who have been displaced. If displacement is becoming a quantitatively larger problem, we should consider whether the current support levels ought to be increased for these programs. But the evidence so far suggests that outsourcing of service functions is only a small part of labor market turnover.

Penalizing firms that hire foreign workers to perform services would be pure protectionism. The argument that services outsourcing is conceptually different than trade in manufactured goods is bogus. Why is it different to use foreign labor in a U.S.-headquartered call center than it is to have foreign labor produce a component of a U.S. automobile? It isn’t. The burden of proof of this argument—that trade in services requires us to erect special barriers to protect certain jobs—is squarely on the skeptics. Their intellectual predecessors were wrong about the perils of the mechanization of agriculture and international trade in goods. If we were able to accept competition when it affected blue-collar workers, it is hard to justify curtailing competition that affects higher-earning white-collar workers.

The U.S. economy has thrived relative to our counterparts in Europe and Japan in the last decade. A major reason is that globalization and technology change have provided many new opportunities to boost productivity for creative and innovative companies. U.S. firms have seized these opportunities in part because our system places fewer barriers in front of them.

Providing support for workers in transition, whatever the cause of their transition, makes sense. We should debate whether that support should be increased. But we should not back away from competition or opportunity. Let’s hope our history of relying on markets to adapt to mechanization and the challenge of international competition is repeated once again. A nation of bright, creative people with freedom to engage in commercial activity that is valued by others—wherever the others are located—will do just fine in this brave new world.

Now the spotlight has shifted to a new form of displacement: trade in services and the “offshoring” of services jobs.