How concerned should advanced countries be about the outsourcing of manufacturing to China or software development to India? Fear of jobs lost to low-wage countries strikes a populist chord, but misses a vital point: the prosperity of developed countries depends primarily on entrepreneurship.
After all, no economy can raise living standards forever through innovations that make production of existing goods more efficient. In the short run, increased efficiency reduces the cost of a good or service, so people consume more of it. But eventually, consumers refuse to buy more even if prices continue to fall. After that, further efficiencies require shedding workers.
Creating and satisfying new consumer desires keeps the system going by absorbing the labor and purchasing power released by the increasingly efficient satisfaction of old ones. At the other end of this process, producers who satisfy old desires continue economizing, because they compete for employees and consumers with producers who satisfy new desires.
Similarly, outsourcing to low-wage countries improves living standards only if the human capital released can be used to make new goods and services. Otherwise, outsourcing merely reduces demand for domestic labor, just like other efficiency gains.
For many advanced countries, expansion of markets for new goods and services facilitates - and has been facilitated by - imports from low-wage countries. More than half of all manufactured goods consumed in the US are made abroad, particularly low technology, mass-produced labor-intensive products. Virtually all the toys and shoes sold in the US are made in the Far East. China alone accounts for 86% of the US bicycle market.
Resources released by these imports fostered the growth of industries that satisfy new needs. Cheap Asian televisions gave Western households the wherewithal to purchase PC's powered by Intel microprocessors and Microsoft software, which are designed by engineering graduates who would otherwise have worked for TV manufacturers.
To be sure, the speed and magnitude of the integration of nearly a billion Chinese and Indian workers into global labor markets is unprecedented and will hurt some workers and communities in developed countries. But as long as these economies churn out new desires, outsourcing represents an opportunity for prosperity on both sides.
The problem, of course, is that producers of new goods and services do not create jobs at exactly the same rate as efficiency gains or imports reduce the demand for labor. Following the Internet boom of the late 1990's, job creation slowed, while efficiency improvements continued to reduce the labor required by the "old" goods and services.
Nor does the usual argument for free trade apply. Low-cost call centers in India or Chinese made bicycles do not reflect any "natural" comparative advantage. Rather, costs are low because for almost two centuries colonial powers and then domestic governments hobbled markets and restricted international trade, leaving a legacy of wages so low that they offset weaker productivity.
Moreover, exports to low-wage countries cannot compensate for job losses. A Chinese worker simply cannot buy the same goods and services as a worker in the EU, and workers in low-wage countries spend only a small portion of their incomes on EU products. As incomes in China grow, imports from other low or middle-income countries rise faster than imports from high-wage countries. China's trade surplus with the US exceeds $100 billion, but it runs a deficit with India.
Uncertainty about jobs breeds anxiety, and anxiety stokes protectionist sentiments. But, apart from a few industries, such as toys and bicycles, far fewer jobs are lost to imports than to efficiency improvements.
Manufacturing employment in the US fell in 2003 to its lowest level since 1964, but thanks to a tripling in output per worker, total manufacturing output was roughly three times larger. Pressure to reduce costs in the recent downturn may have accelerated the movement of jobs to low-wage locations, but this accounts for only 15-35% of the decline in employment since the downturn began.
The Austrian economist Joseph Schumpeter attributed the boom-and-bust cycles of the 19th century to periodic bursts of "creative destruction" followed by lulls in innovative activity. More effective use of counter-cyclical policies may have subsequently smoothed out the economic cycle, but this cannot explain why productivity and incomes also grew more rapidly than in the 19th century.
Standard supply-side arguments fare no better. After all, tax rates were higher in the 20th century and regulation more extensive.
A critical factor is large scale, non-destructive creation. Inventions from 1850 to 1900 may well overshadow those of the entire 20th century, but they were the result of a few inventors, such as Thomas Edison, who satisfied a small wealthy clientele. In the 20th century, many entrepreneurs, large companies, financiers, and inventors developed products and services for the masses.
Moreover, their innovations created and satisfied many new consumer desires. Airplanes, for instance, didn't reduce demand for automobiles: people fly when they would not otherwise have driven. These new mass markets sustained a steady increase in average incomes and total employment.
Simply put, the long-term prosperity of developed economies depends on their capacity to create and satisfy new consumer desires. Provided this capacity remains in good repair, job "losses" - through improvements in the efficiency of domestic production or through outsourcing to low-wage countries - will enhance standards of living. But if this capacity is impaired, neither the low road of protection nor the high road of free trade can do much good.