The Governance of Outsourcing

Stephen Boyko

In this presidential election year, job outsourcing has become a political wedge issue for both Democrats and Republicans. Demagoguery and passion have replaced analysis and reason. Proponents of outsourcing advocate that it is to America’s advantage to avail itself of those services and products that can be acquired more cheaply overseas. Opponents of outsourcing argue that these bargain goods and services benefit only the highly skilled and highly paid Americans. Many Americans believe that outsourcing is a threat to their economic well-being.

America seems to be at cross-purposes. Notwithstanding that most southern textile manufacturers were once based in New England, southern conservative politicians who normally claim that the U.S. should compete with trade not tariffs, now argue for protectionism. This is tantamount to arguing in favor of national health care since protecting the medically uninsurable and protecting unprofitable jobs is comparable. At some level, protecting "buggy whip" jobs limits a prospective entrepreneur's opportunity to start a new venture. Likewise, champions of choice, advocate that America should never enter into a trade agreement that allows corporations to leave for another country in order to employ cheap child labor. This “economic morality” begets commercial censorship, a key operational component of class warfare.

There is little argument that global realities have altered the scale, scope, and span of modern commerce. Change is happening to a greater degree at a greater frequency. Whereas it took radio 38 years to reach critical mass of 50 million users, it took television merely twelve years, and e-commerce only four. This degree of change is frightening to some Americans, who are faced with the prospects of wage stagnation and the loss of health care. Yet would those same citizens trade their uncertainty for the predictability experienced in the former Soviet Union, which proved unable to address effectively the hierarchical complexity required by a global society?

To this point, we address the following questions concerning:

•       What is outsourcing?

•       What preconditions must be present for outsourcing to occur?

•       What can be done to ensure that outsourcing provides a net societal benefit?

The answers to these questions have profound implications for both America and our trading partners.

What is outsourcing?

The economic factors of production are land, labor, and capital. Outsourcing is the transfer of all or a portion the labor component of production to an external location.[1] The three types of outsourcing are: sovereign, surrogate, and structural.

Sovereign outsourcing occurs when production is transferred to another country.  Those who rail against outsourcing should consider that a significant number of American jobs rely on foreign firms “insourcing” jobs to the U.S. For example, Toyota Motor, the large Japanese automaker that currently sells more cars in the U.S. than any domestic automaker, has 35,000 U.S. employees and $14 billion invested. A cynic will argue that Toyota’s investment in the U.S. is not altruism. Every MBA student knows manufacturing your product close to your customer base is a good business decision. Outsourcing occurs because it represents a sound business practice. If U.S. companies are prevented from outsourcing, then foreign companies who are able to insource will have a competitive advantage.  Toyota recognized that its investment in the U.S. insulated Toyota from Japanese protectionism.

A close parallel can be made between protectionism and those advocating an end to outsourcing. Both argue in favor of “buy American” – whether labor, or products.  While “buy American” sounds patriotic, the associated lack of competitiveness reduces quality.  Imagine the consequences if steel and automaker lobbyists had been successful in sponsoring protectionism. The $20,000 price of a Chevrolet Malibu[2] would be closer to the $320,000 of a Rolls Royce, and the 2003 North American automobile production of 16 million cars would be closer to the 200 cars produced by Rolls Royce for the American market.  Foreign competition forced U.S. automakers to increase the quality of their product (as demonstrated by fuel efficiency standards) while being price competitive, proving that the best strategy for protecting one’s job is a superior product financed by ever-increasing amounts of per capita capital investment.

Surrogate outsourcing occurs when production is transferred among political subdivisions within the same country. Dick Kovacevich, chairman and CEO of San Francisco-based Wells Fargo and chairman of the California Business Roundtable, recently commissioned Boston-based consulting firm Bain & Company to conduct a study to determine why “business as usual” was not working in California. The study identified Texas as the destination of choice for the nearly forty percent of companies in California planning to move jobs out of state. It cited Texas' favorable regulatory climate as the prime reason for a potential move. Companies interviewed included a range of businesses with as little as $1.5 million in revenue to corporations with as much as $90 billion. Those companies represent more than 95 percent of the state's industry sectors and employ nearly 500,000 workers in California. The study concludes that California must improve its competitiveness to keep high-value jobs in the state. The policy question is whether the cost of consumer information is less costly than the estimated embedded regulatory cost of more than $5 per labor hour?

Structural outsourcing occurs when innovation causes existing production to become obsolete resulting from a shift in skill sets. Improving comparative advantages and core competencies begins by redesigning products and re-training people. The old corporate culture must be replaced. Otherwise the “iron law of oligarchy” will centralize power, ossify operational components, and stagnate the thought processes in an attempt to retain control.  To this point, it is instructive to review the restructuring experiences of IBM. To maintain its corporate dominance, IBM made a big bet on the OS₂ operating system. It lost. IBM’s stock, which had peaked at $200 per share in the mid-1980s, began a prolonged ten-year slide. During this retrenchment, IBM was restructured numerous times. Each time, unfortunately, the new CEO was promoted from within IBM’s management and owed his allegiance to the IBM OS2 operating system and corporate cronyism. When the stock fell below $20 per share, the institutional investors asserted themselves, selecting a non-technician, Louis Gerstner, to be the new CEO. Gerstner barely knew how to operate a computer – he was a retailer, but he knew how to operate a company. He broke IBM’s corporate culture, redesigned its products, and returned the company to profitability. The stock recently traded as high as $100 per share. IBM totally redesigned its product line and now describes itself as an “advanced information technology company providing: technologies, information systems, products, services, software, and financing.”

What preconditions must be present for outsourcing to occur?

Economic policy is a reflexive process that manages the dynamic tension among and between normative governance structures and non-normative externalities. The accompanying 2x2-governance matrix illustrates the process by which economies organize their normative commercial activity. The model combines constructs that analyze ranges of economic activity relative to transparency and profitability. The transparency construct addresses the treatment of information. Markets tend to be “open” and develop disclosure regimes for information requirements; whereas, firms are inclined to be “closed” and to guard trade secrets through intellectual property protection (i.e., patents, trademarks, and copyrights). The prime determinant for the transparency benchmark is whether “open” investment banks or “closed” commercial banks are the dominant source of financing, while the prime determinant for the profitability benchmark is determined by a political preference for either maximizing profits in the commercially viable private sector or maximizing participation in the self-sustainable public sector. Commercially viable enterprises tend to employ a marginal-cost model (profits are maximized where marginal revenues equal the marginal cost of the nth product sold). Self-sustainable entities are inclined to use an average-cost model; that is, an industrial policy enterprise such as the post office delivers a letter for the same rate, irrespective of whether the letter is to be delivered across the street or across the country. These constructs with their binary benchmarks are combined to design a robust model for governance.

Policymakers must establish commands appropriate for the set of incentives available in the economy. Incentives are the potential for net benefit, in terms of economic profit. Commands are a package of standards and rules, while standards and rules are divergent concepts. Standards are prospective societal policies, such as “fairness”, that enable the realization of norms relative to cultural values. Rules, however, are the retrospective codification of best-practice procedures that should theoretically optimize operational efficiency. Rules and standards can be perceived as alternative mechanisms through which the objectives and principles of policymakers are satisfied.

Economies consist of normative and non-normative sectors. Economic externalities of controlled, balkanized, underground, or offshore market alternatives occur due to:

•       Misspecification of the initial condition resulting in a false construct (i.e., using market remedies of infrastructure and/or regulation to cure firm maladies caused by poor training of people or design of products),

•       Mischaracterization of commercial activity creating a disproportionate level of commands to incentives, and

•       Misapplication of tactics using retrospective rules to plan.

Specifically, offshore markets result from standards that are “too high” interacting with “too few” best-practice operating rules for a given level of economic activity. Offshore markets result from an amalgamation of circumstances[3]. For example, Bain and Company’s consulting report for the State of California cited a favorable regulatory climate in Texas where best-practice approval of residential projects took only eight weeks compared to 33 weeks in California. The combination of exclusionary pricing (property tax[4]) and operational uncertainty (date of permit approval) encouraged migration to Texas’ surrogate offshore market. This occurred because the cost of domestic compliance is greater than the benefits derived from the “Law of Comparative Advantage.” Every financial income tax and/or regulatory operational tax imposed on the normative market that is excessive relative to the level of commercial incentive serves as a subsidy to economic externalities.

What can be done to ensure that outsourcing provides a net societal benefit?

The GAAMA model[5] is a diagnostic methodology which analyzes the amount of commerce conducted in the normative economy, as compared to the amount of commerce conducted in the economic externalities of controlled, balkanized, underground, and offshore markets. GAAMA is an acronym for:

•       Global: widespread in terms of mass and materiality;

•       Asynchronous: not timely information;

•       Asymmetrical: unequal access to or incorrect information;

•       Market: economic / financial system; and

•       Activity: researching, pricing, transacting, clearing/settling, and taking inventory.

The GAAMA Model is a three-dimensional, non-linear, dynamic paradigm. The x-axis depicts the volume function. It delineates commercial activity resulting from too many rules that cause confusion (i.e. the tax code) and/or too few rules or best practices that cause uncertainty (i.e. a computer problem without the help desk). The x-axis resolves bad trade practices. The y-axis determines the pricing function. Standards that are too high are exclusionary operational supports that direct order flow, while standards that are too low are indiscriminate price controls that act as a disincentive to commercial activity. By way of illustration, the tax code has specific rules applicable to the depreciation expense deductible for personal computers. Each rule in the tax code is held to the societal standard that it be assessed “fairly” and held to the cultural standard of “progressivity”. The GAAMA Model’s z-axis represents a ratio of commands-to-incentives for a given level of commerce. The z-axis posits that the smaller the ratio of commands-to-incentives, the larger the areas of normative market activity to provide a societal net benefit. The model analyzes incentives and commands to ensure their balance and proportionality with the current level of commercial activity.  

The “shadow economy” is a combination of offshore and underground markets.[6] It is a multi-trillion dollar laboratory for economic development. For a large percentage of the world’s population, it is an economic sanctuary from the taxman and the policeman that provides a living from either illegal commerce and/or corruption. The shadow economy may act as either a complement to, or a substitute for, the real goods and services sector of normative commerce, depending on the nature and the extent of government-induced distortions that are the result of inappropriate and/or inefficient policies. The shadow economy will, however, serve as a low-multiple surrogate for the capital market sector of normative commerce to constrain wealth creation.

Current outsourcing-related unemployment[7] is less a function of job migration as the lack of job creation resulting from the disproportionate regulatory redlining of small-to-medium enterprises (SMEs)—the engine of employment.[8] Consider the following facts: in 1999, although fierce competition cost an astounding 32.9 million U.S. jobs, it also helped create 35.6 million, resulting in a net creation of 2.7 million jobs. At the same time, unemployment fell to its lowest level in 30 years and poverty to its lowest level since 1979. … In 2002, there were 500,000 fewer jobs destroyed in the United States than the average number of jobs destroyed for the years 1998, 1999, and 2000.[9]

SMEs around the world face a common problem: obtaining a "sliver of equity" to enable their operations to achieve growth and positive cash flow. The core difficulty that SMEs face in their pursuit of equity financing is not investor indisposition to SMEs, but rather a fundamental failure of the one-size-fits-all approach to regulating equity securities. To correct this shortcoming, the formation of the Entrepreneurial Exchange[10] is proposed. The Entrepreneurial Exchange is a micro-cap marketplace with a governance approach that is specifically tailored for Main Street SMEs.

The United States has the only micro-cap market that is able to fund SMEs to any substantial degree. But while the bull market at the end of the previous century witnessed the globalization of capital markets, much of the wealth creation was primarily confined to the top-tier U.S. markets, such as NYSE and NASDAQ. This, in part, was due to the absence of a proportionate regulatory regime to govern the micro-cap market. Markets correct more quickly than regulators. Not only does the continuing development of regulatory proposals designed for top-tier market risk management become disproportionate when applied to the uncertainty inherent in the micro-cap market, but they also codify the chaos of the previous bubble.  Systemic change is necessary to ensure that commands supporting shareholder rights are proportionate to incentives for shareholder responsibilities. Separate regulatory regimes are required to mobilize capital for:

•       Government securities “bought” for savings accounts,

•       Top-tier issues “bought” for investment accounts, and

•       Micro-cap SME stocks “sold” to venture accounts.

In the absence of exemptive relief, costs for legal, accounting, and other top-tier-driven requirements are often greater than the benefits derived from the “sliver of equity” that micro-cap issuers seek. The cost and time required to obtain a safe harbor exemption is well beyond the means of most SME issuers. This frustrates economic development and limits job creation, innovation, and investment opportunities. The potential for dynamic increase in the percentage of wealth created by EntEx’s governance process and financial infrastructure is similar to the economic transformation that occurred when the United States changed its form of government from the Articles of Confederation to the Constitution.

Stephen A. Boyko is president of Global Market Thoughtware, Inc., an international consulting company that specializes in economic governance issues.