Order Code RL32484
CRS Report for Congress
Received through the CRS Web
Foreign Outsourcing: Economic Implications
and Policy Responses
Updated August 5, 2004
Craig K. Elwell
Specialist in Macroeconomics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Foreign Outsourcing: Economic Implications and
Policy Responses
Summary
Foreign outsourcing, the importing of some intermediate product (i.e., a portion
of a final product or some good or service needed to produce a final product) that was
once produced domestically, is not a new phenomenon, nor is it one that is
economically distinct from other types of imports in terms of its basic economic
consequences. A steadily rising level of trade in intermediate products is one of the
salient characteristics of U.S. trade and world trade for the last 30 years. It has been
estimated that as much as a third of the growth of world trade since 1970 has been
the result of such outsourcing worldwide. While foreign outsourcing may seem
different from traditional notions of trade in that it involves exchange of a productive
resource (capital or labor) rather than an exchange of a final good and service, the
ultimate economic outcome is exactly the same: a net increase in economic efficiency
through the elimination of economic inefficiencies that occur when countries use
only the productive resources found within their borders. This gain is not likely to
be achieved, however, without causing costly disruptions for the particular workers
and sectors tied to the now-imported good.
Foreign outsourcing, trade in general, and trade deficits tend to change the
composition of total output and the composition of total employment, but it is
unlikely that economy-wide they lead to any change in the overall level of either.
In some areas of the economy output falls and jobs are destroyed, but in other areas
output is increased and jobs are created. There are two complementary reasons for
this. First, the Federal Reserve using monetary policy can set the overall level of
spending in the economy to a level consistent with full employment. With aggregate
spending at the right level, full employment is possible with or without outsourcing,
trade deficits, or trade in general. Second, according to basic economic principles
any increase in the demand for an import will also lead to adjustments in the foreign
exchange market that will induce an equal increase in the demand for the country’s
exports of goods or assets. The positive stimulus to employment of the increased
export of goods is direct, that of the increased export of assets is indirect, but both
tend to create jobs in other parts of the economy. Indirect evidence of this inherent
“two-way” nature of trade and that increased outsourcing over the last 30 years has
not likely led to a significant net diversion of employment or output abroad is found
in the relatively stable patterns of employment and output between the domestic
parent and foreign affiliates of U.S. multinational corporations. In addition, there is
evidence of sizable foreign outsourcing to and job creation in the United States.
The destructive aspects of foreign outsourcing are costly and distressing to
those whose jobs are lost to increased imports. Therefore, matters of efficiency and
equity are intertwined and one of the principal challenges for policymakers in the
face of foreign outsourcing (and trade in general) is to find ways to ameliorate the
associated harm, without sacrificing the economy-wide gains that such trade
generates. Compensation for loss and adjustment assistance is thought by economists
to offer the best chance for securing higher economic efficiency along with
distributional equity. This report will be updated as events warrant.

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Lost Jobs? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Evidence from U.S. Multinational Companies . . . . . . . . . . . . . . . . . . . . . . . 5
Evidence from International Investment Flows . . . . . . . . . . . . . . . . . . . . . . . 6
Evidence from Employment Trends in the IT Sector . . . . . . . . . . . . . . . . . . 7
Trade, Outsourcing, and Wages
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
A Rising Level of Trade and Economic Well-Being . . . . . . . . . . . . . . . . . . . . . . 10
Effects on the Export Side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Effects on the Import Side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Gains from Trade Over Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
The Gains from Trade, Outsourcing, and the “Product Cycle” . . . . . . 14
Are Services Different? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Implications for Economic Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Is Protection Appropriate? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
The Sectoral Burden of the Trade Deficit . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Under-Investment in the Economy’s Creative Powers . . . . . . . . . . . . . . . . 21
Ameliorating Outsourcing’s Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

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Foreign Outsourcing: Economic Implications
and Policy Responses
Introduction
Foreign outsourcing, the importing of some intermediate product (i.e., a portion
of a final product or some good or service needed to produce a final product) that was
once produced domestically, is not a new phenomenon, nor is it one that is
economically distinct from other types of imports in terms of its basic economic
impact. A steadily rising level of trade in intermediate products is one of the salient
characteristics of U.S. trade and world trade for the last 30 years. Lower
transportation costs, improved international communication, and the reduction of
government barriers to trade have helped propel the transformation to an ever more
internationally fragmented production process in many industries. An obvious
example of this is the automobile: no matter what the nameplate, the raw materials
are produced in many different places and parts are manufactured all over the world
for final assembly often, but not always, in the destination country. It has been
estimated that as much as a third of the growth of world trade since 1970 has been
the result of such outsourcing worldwide.1 In the United States, large shares of both
exports and imports are intermediate products. In the recent years, just the capital
goods category by itself has accounted for about 50% of nonagricultural goods
exports and around 30% of nonpetroleum goods imports. And the greatest change,
for the United States has occurred on the import side. Using capital goods as an
example again, in 1970 such exports were about 40% of total exports, while imports
had a share of only 11%.2
Outsourcing may seem different from traditional notions of trade in that it
involves exchange of a productive resource (capital or labor) rather than an exchange
of a final good and service, but it can be analyzed within the same framework as
increased importing of a final product or increased trade in general. The central
economic question to be answered is whether increased foreign outsourcing
increases or decreases overall economic well-being. To answer that question will
certainly require an accounting of the deleterious effects of foreign outsourcing on
domestic workers and industries who once produced the now outsourced product, but
it will also require an accounting of the gains to domestic consumers of the now
imported product as well as any induced benefits to exporting industries. If benefits
exceed costs, then measures to constrain outsourcing will tend to reduce overall
1 David Hummels, Jun Ishii, and Kei Mu Yi, “The Nature and Growth of Vertical
Specialization in World Trade,” Journal of International Economics, vol. 54 (June 2001),
pp. 75-96.
2 Presidents Council of Economic Advisors, Economic Report of The President (Feb. 2004),
p. 404.

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CRS-2
economic well-being. But even if it is clearly a “net gain” foreign outsourcing brings
into conflict the goals of increasing economic efficiency and maintaining an equitable
distribution of those gains. This intertwining of economic efficiency and
distributional equity will mean that policymakers may find it difficult to take
advantage of the increase in economic efficiency that foreign outsourcing affords
without also establishing policies to assure equitable treatment of those whose jobs
are lost and whose lives are disrupted by this market churning force.
What economic analysis also highlights is the inherent “two-way” nature of
trade, including foreign outsourcing. Something is given up and something is gained.
More imports tend to beget more exports. If there are economic reasons for U.S.
firms to outsource abroad, there are likely similar reasons for foreign firms to
outsource to the United States. Jobs are created and destroyed. What is produced
and what is traded for will not be determined just by relative wages, but rather the
relative efficiency in the production of traded products. Low wages will likely attract
certain types of production. However, because of differences among countries in
their capacity for innovation, in their technical prowess, and in their workers’ skills
and productivity, there will be many things that can be produced more efficiently in
high-wage economies such as the United States. Over time an economy’s relative
advantages may change but there need be no general deterioration in what it gains
from trade.
Perhaps foreign outsourcing is now more noticed because it is occurring with
rising frequency in the service sector and adversely effecting a strata of the labor
force that heretofore was more insulated than goods producing industries from the
pressures of international competition. But the nature of the process is the same
whether it is trade between individuals, regions, or countries; or trade of final goods
or services; or trade of intermediate goods and services: increased economic well-
being results from producing what one does best and trading for the rest. In this
economic framework it follows that, for the nation, trade is ultimately not about
competition, rather it is a process of mutually beneficial exchange.
As noted above and developed more fully below, the overall macroeconomic
impact of foreign outsourcing will be a net effect, involving negative and positive
impulses. Unfortunately, there are no public data series that allows a ready tallying
of the net impact of foreign oursourcing on the economy. (In January 2004, the
Bureau of Labor Statistics (BLS) began to collect data on layoffs related to the
transfer of work outside of the United States. But only one quarter of data is currently
available and the series is a measure of gross job loss rather than net job loss.)3
Therefore, beyond the predictions of economic theory, analysis of this phenomenon
must use indirect evidence. Since foreign outsourcing has already occurred on a
relatively large scale in the goods-producing sector of the U.S. economy, this report
takes the approach that this experience will be the best predictor of the economic
effects of outsourcing’s spread to the service sector. Further, it is assumed that the
3 It is interesting to note that only 2.0% (4,633 out of 239,361) of the layoffs in that quarter
where the result of a transfer of work outside of the United States. For further discussion of
layoffs see CRS Report RL30799, Unemployment Through Layoffs: What are the
Underlying Reasons, by Linda Levine.

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CRS-3
tools of economic analysis used to isolate and evaluate these past economic effects
are appropriate for judging the probable economic effects of current and future
outsourcing, wherever in the economy they might occur.
Lost Jobs?

Foreign outsourcing destroys jobs in those parts of the economy that once
produced the now imported product, but economic analysis tells us that due to off-
setting employment effects in other parts of the economy, foreign outsourcing (or
imports in general) is unlikely to cause a net loss of jobs economy-wide. A steady
churning of labor markets is a normal characteristic of a dynamic market economy
like the United States. Foreign outsourcing and increased imports can contribute to
that “churning,” and in doing that can be expected to change the composition of total
output and the composition of total employment, but they are unlikely to permanently
change the level of either.

There are two complementary reasons for the relative steadiness of total
employment and output in the face of foreign outsourcing and other disruptive
market forces. First, the Federal Reserve, using monetary policy, can set the overall
level of spending in the economy to a level consistent with full employment.4 While
deviations from full employment can occur, a well run monetary policy will
minimize the incidence and duration of such episodes and help keep the total level
of employment high in most years with or without outsourcing, trade deficits, or trade
in general. To give some perspective on the relation between “job loss”and total
employment, as well as the potential significance of foreign outsourcing in this
dynamic process, consider that in any quarter of 2000, at the peak of the last
economic expansion, with total employment at about 111 million, gross job losses
tallied between 8.5 and 9.0 million. Nevertheless, the economy at that time was
operating at the lowest rate of unemployment in 40 years. Over the whole course of
that expansion gross job loss actually rose as the unemployment rate steadily fell.
But with adequate economy-wide spending, it was possible to create job gains that
more than offset job losses. In the far weaker labor market of 2003, gross job losses
per quarter measured 7.2 to 7.8 million. Gross job gains in 2003 were at about the
same as losses leaving total employment steady. In either time period gross job losses
4 Economies always have some amount of unemployment. Each economy will tend to have
a natural rate of unemployment around which the actual unemployment rate fluctuates. This
natural rate will also represent the rate at which the economy is effectively at full
employment because a lower rate of unemployment would not be sustainable due to the
inducement of higher a rate of inflation. The natural rate is not zero because at any point in
time there will be some people who are changing jobs and other people who normal market
forces have temporarily displaced. More fluid the economy’s labor markets the lower its
natural rate of unemployment is likely to be. For most of the last 30 years, the United States
economy’s natural rate was judged to be in the 5.5% to 6.0% range. Since the mid-1990s the
natural rate has likely fallen to the 4.5% to 5.0% range. Most often an appropriate level of
aggregate spending is that consistent with employment at the natural rate.

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CRS-4
occurred on a scale well beyond what is currently attributed to foreign outsourcing
alone.5
Second, against the economic backdrop of adequate aggregate spending, any
increase in the purchase of imports will tend to generate an equal increase in the sale
of the country’s exports of goods or assets. This outcome follows from the
fundamental economic requirement that imports must be paid for and exports are the
only means for making that payment. The export sold does not have to be a currently
produced good or service, it can also be the sale of an asset such as a deposits in a
bank account, shares of stock, bonds, or real property, but in the end when tallied
across transactions in goods and assets, a nation’s trade is always in balance in the
sense that any imbalance in goods trade must be offset by a compensating imbalance
in asset trade. Both types of export sales will have a positive effect on domestic
output and employment, countering across the whole economy the negative effect of
increased imports. In short, the U.S. deficit in trade is offset by the surplus in capital
flows.
Consider, for example, a situation where a service once provided domestically
is now imported from a country such as India. Since foreign suppliers do not spend
dollars, the U.S. importer will have to buy the foreign currency needed from its
foreign exchange market or pay in dollars and let the foreign supplier buy local
currency from its foreign exchange market. Either way, to generate the foreign
exchange the United States must export something. It can sell U.S. goods or
services, or it can sell U.S. assets (i.e., bank deposits, stocks, bonds, real property,
etc.). The positive stimulus of the increased export of goods is direct. When
foreigners purchase U.S. goods, U.S. output and employment rise to offset the loss
of service jobs to India. If exports increase less than the amount needed to offset jobs
lost, the United States then must, in effect, borrow the money needed to pay for the
increased imports through the sale of an asset. The stimulus from an increased
export of assets is indirect. Because the sale of an asset is equivalent to an increase
in the flow of saving available to the U.S., it exerts a downward push on domestic
interest rates, stimulating interest-sensitive activities such as spending on consumer
durables and residential construction, and raising output and employment in these
sectors.6 Therefore, whatever negative effects increased imports have on output7 and
5 U.S. Department of Labor, Bureau of Labor Statistics, Business Employment Dynamics,
various issues.
6 Of course, asset sales represent borrowing to sustain current domestic spending by
transferring to foreigners a claim on some amount of the future output of the United States.
The repayment of the loan will manifest as a future trade surplus and a net outflow of U.S.
exports of goods and services and, thereby, lead to reduction of future domestic spending
below what it otherwise would be.
7 The focus of this discussion is the circumstance when an import is a direct substitute for
domestic output. Imports, however, are not always substitutes for domestic output. An
import can be seen by consumers as a distinct product and primarily generate an increase
in total demand rather than a substitute for some domestic product. An imported good can
be an essential component necessary for the expansion of domestic output. An import can
satisfy a domestic demand that can not be readily supplied by domestic producers due to
(continued...)

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CRS-5
employment are offset by the positive economic effects of increased exports of goods
or assets.8 The composition of output and employment will change in response to
these changed demands, but so long as the Federal Reserve can maintain aggregate
spending at the an appropriate level, total output and employment will not change.
(As already highlighted above, the ultimate steadiness of total employment in the
face of increased imports does not mean that there are not likely to be important
short-run disruptions as displaced workers adjust to the new market conditions; and
the manner of that adjustment is likely to be an area of pivotal importance to workers
and policymakers.)
Given the typical high incidence of intermediate products in export and import
flows, we will probably find that outsourcing into and out of the United States both
rise as trade increases. But this is not a necessary condition because while all foreign
outsourcing are imports not all imports are foreign outsourcing. We might import an
intermediate product and pay for it by exporting a final product. The general impact
on employment and output are the same in either case, however.
Evidence from U.S. Multinational Companies
Multinational companies (MNCs) account for a very large share of the U.S.
economy. In 2001, the MNC’s domestic parents produced about 25% of U.S. gross
domestic product (GDP) and employed over 23 million workers or about 20% of the
nonbank work force. MNCs are even more important in U.S. international trade,
being involved in nearly 60% of total goods exports and about 40% of total goods
imports. Because of their central economic role, if a rising level of international
trade and foreign outsourcing were diverting a large number of domestic jobs
overseas, it would be evident in the pattern of employment between the MNC’s
domestic parents and foreign affiliates. No large scale diversion of employment has
occurred, however.9
For the period that stretches from 1977 through 1993, MNC employment
declined in both parents and foreign affiliates and the rate of decline was faster in the
latter. From 1994 to 2001, MNC employment rose in both the parents and the
foreign affiliates. This time employment in the affiliates grew slightly faster, but not
so much faster as to indicate any major shift. Be mindful that a foreign affiliate’s
employment share can increase for reasons unrelated to outsourcing and may not
7 (...continued)
capacity constraints. And imports from one country can be a substitute for imports formerly
obtained from another country.
8 Export related jobs generally pay on average 7% to 13% higher wages than jobs in input-
competing industries. So, most often, better jobs are being created than those that are being
destroyed. However, the new jobs are not necessarily going to be filled by those whose jobs
were destroyed. See Andrew B. Bernard and J. Bradford Jensen, “Exporters, Jobs, and
Wages in U.S. Manufacturing,” Brookings Papers on Economic Activity: Microeconomics
no. 47, 1995, pp. 67-112.
9 Raymond J. Mataloni Jr., “A Note on Patterns of Production and Employment by U.S
Multinational Companies,” Survey of Current Business, vol. 84, no. 3 (Mar. 2004), pp. 52-
56.

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CRS-6
reduce U.S. employment. Reasons for this would include expanding foreign markets
not easily serviced by exports, faster economic growth abroad, or lower productivity
in the foreign affiliate. That the parents in this time period were also increasing their
output share suggests that the differences in the rates of employment growth largely
reflected slower productivity growth in the affiliates.10
The natural “two-way” nature of trade suggests that for a complete view of
trade’s employment effects we also consider the behavior of foreign MNCs in the
United States. A U.S. company can destroy jobs by diverting production abroad, but
a foreign company can create jobs by diverting production to the United States.
Economic reasoning tells us that if it is more efficient to produce some products
abroad, it is also likely that it is more efficient to produce other products in the
United States. Therefore, we might expect there to be outsourcing into and out of the
U.S. economy. What we observe is that over the 1977-2001 period, employment in
the U.S. by foreign MNCs grew by 4.7 million, exceeding the 2.8 million increase
in employment in the foreign affiliates of U.S. MNCs.11 Again, employment shifts
can occur for reasons other than outsourcing, but if outsourcing is a phenomenon of
some significance for foreign and domestic companies, then these data could indicate
that the United States was more likely to be the destination than the departure point
for foreign outsourcing.
Evidence from International Investment Flows
The flow of investment spending on plant and equipment between the United
States and other economies could also be an indirect indicator of a pattern of
diversion of capacity and jobs to foreign locations. If, because of lower labor costs
or other factors, foreign locations are increasingly the preferred site for the
production of many goods and services, then we might expect that there would also
be a pronounced tendency for American companies to expand productive capacity
abroad so as to take advantage of these situations. For reasons similar to those
outlined above, foreign investment does not have to lead to a diversion of domestic
employment, but if foreign outsourcing by U.S. companies was occurring on a large
scale there might also be a skewing of foreign investment flows in the same direction.
The evidence in this regard points to a pattern of balance, not a net diversion to
foreign locations.
While the image of the American company destroying jobs by closing its
domestic operations in favor of some offshore location comes quickly to mind for
many people, it is an incomplete image of what has been occurring in the U.S.
economy for many years now. A more accurate image and one wholly consistent
with the typical “two-way” nature of international economic exchange is one that also
includes large inflows of foreign investment into the United States.
10 See Robert Lawrence, Globalization and Trilateral Labor Markets (New York: The
Trilateral Commission, 1996); and “Summary Estimates for Multinational Companies,” BEA
News, Apr. 2004.
11 See Mataloni op cid. For a closer look at the nature and extent of outsourcing, see CRS
Report RL32292, Offshoring (a.k.a. Offshore Outsourcing) and Job Insecurity Among U.S.
Workers, by Linda Levine.

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CRS-7
These types of investment flows are termed “direct investment” and their level
and direction are tallied by the U.S. Commerce Department each year.12 The data
reveal that over the course of the 1992-2000 economic expansion, the United States
increased its direct investment in the rest of the world by $885 billion, while foreign
investors increased their direct investment into this country by $926 billion. The
similar size of these flows suggests that in this time period to the extent that such
flows correlate with foreign outsourcing into and out of the United States, this
country has been as likely to be the destination of foreign outsourcing as it is the
departure point. In addition, data for capital expenditures by U.S. multinational
companies show that the shares of such spending between the parent and the foreign
affiliates have been relatively steady suggesting no increase in preference for foreign
over domestic locations for expansion of production capacity.13
Evidence from Employment Trends in the IT Sector
A widely cited study by Forrester Resources projects that 3.3 million U.S. sector
jobs will have moved offshore by 2015. Yet, Jacob Kirkegaard of the Institute for
International Economics (IIE) has done a close examination of the employment
trends since 1999 in those occupations deemed at risk of moving offshore in the
Forester study. Some of the findings of the IIE study are as follows:
! The vast majority of the jobs lost from 2000 to 2002 in the “at risk”
occupational categories were in the manufacturing sector and losses
were, therefore, more likely the consequence of recession and
productivity advance than foreign outsourcing.
! The majority of those occupations affected by foreign outsourcing
pay less than the average U.S. wage and are as likely to face
elimination through technological advance as outsourcing.
! The IT occupations that have seen declines are concentrated in low-
skill occupations.
! High paying IT occupations have generally expanded since 1999.
! More than 70,000 computer programers have lost their jobs since
1999, but more than 115,000 higher paid software engineers have
gotten jobs since 1999.
These findings again suggest that to the extent that foreign outsourcing has
affected these “at risk” occupations, it is part of a “two-way” process involving job
12 For a more extensive examination of these patterns, see CRS Report RL32461,
Outsourcing and Insourcing of Jobs in the U. S. Economy: Evidence Based on Foreign
Investment Data, by James Jackson; and CRS Report RS21857, Foreign Direct Investment
in the United States: An Economic Analysis, by James Jackson.
13 Direct investment is part of the net international invest position of the United States and
the data are available from U.S. Department of Commerce, Bureau of Economic Analysis,
Survey of Current Business (July 2003).

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CRS-8
destruction and job creation and that the jobs created may be better jobs than those
destroyed. Therefore, while some are hurt, it is not clear that the overall impact is a
negative one.14
Trade, Outsourcing, and Wages
Another common concern with a rising level of trade and the foreign
outsourcing that accompanies it, is the belief that it must put downward pressure on
the wages of domestic workers. Outsourcing is commonly seen as a process driven
by the search by companies for low-wage environments, that ultimately places
American workers in effective competition with a vast pool of lower-wage foreign
labor, and exerts downward pressure on worker wages. This competition, it is
argued, will result in the so-called “race to the bottom” between domestic and foreign
workers.
For many, the reality of the deleterious effect of trade on wages was given
credence by the observed slowdown in the growth of real wages and the widening
wage inequality between skilled and less-skilled workers that occurred concurrently
with the growth of trade over the last 25 years. Further, there are credible economic
reasons that increased trade and foreign outsourcing could have an adverse effect on
the distribution of income. The adverse distributional effect could manifest itself as
a deterioration of the position of labor relative to capital and a falling average wage,
or as a deterioration of the position of one class of labor (less skilled) relative to
another (more skilled) and increased inequality of wages.
The effect of trade on wages in the U.S. economy has been the focus of
numerous studies over the last 10 years, and the conclusions that may be drawn from
these efforts are as follows:
! As regards the slow growth of the average real wage from the
mid1970s to the late 1990s, increased trade is not seen as being the
cause of that sluggish performance, rather the identified reason was
slow productivity growth. Labor’s share of the economic pie was not
getting smaller; the economic pie just was not growing as fast.15
That the level of wages is most often reflective of the level of worker
productivity also explains why higher wage American workers are
not necessarily at a disadvantage to lower wage foreign workers.
The critical comparison is of unit labor costs, not of the level of
wages. The high productivity that is the basis of a high wage means
that unit labor costs can be lower in the high-wage economy than in
the low-wage economy because productivity in low-wage economies
is commensurately low as well.
14 John F. Kirkegaard, “Outsourcing — Stains on the White Collar” photocopy, Institute for
International Economics, 2003.
15 This conclusion is also confirmed by the absence of any deterioration in labor’s share of
national income, which has remained at about 70% throughout the post-World War II era.

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CRS-9
! As regards trade and increased wage inequality, the research
indicates that trade was a contributing factor, but a minor one,
accounting for perhaps 10% to 20% of the observed increase in wage
inequality. It would seem then that from the standpoint of the
economy as a whole, trade with low-wage economies has not
triggered a “race to the bottom.”
A likely important reason for the small effect of trade on wages for the U.S.
economy was that trade with low-wage countries was still relatively small, amounting
to less than 2% of GDP in 2000. In fact, among U.S. trade partners the average wage
level in manufacturing relative to the U.S. manufacturing wage level grew from 60%
in 1975 to 76% of the U.S. level in 200016. This has occurred because many trading
partners who were once low-wage economies have, with open trade and steady
economic growth, become high-wage economies. As the once poor have moved up
the income ladder, they have also withdrawn from the production of goods that use
low-skill and low-wage labor intensively and these products are then imported from
the newer emerging economies. China has picked up this task, as other East Asian
economies have withdrawn, and, in turn, as these economies did when Japan shifted
away from this type of production. So U.S. trade with low-wage economies is not
rising to a significant degree; rather, it is shifting location.
Economies of scale are also a factor that likely helps hold up industrial wages
in the face of low-wage foreign competition. Scale effects are thought to be a
significant force in many industries and, when present, would tend to increase worker
productivity and decrease unit labor costs. It is also possible that the increase of
competition itself spurs companies to higher levels of efficiency that also lowers unit
labor costs and helps preserve a higher wage level.
Another reason for the small impact of trade on wages in the United States is
that as the once low-wage economies transform to high-wage economies, two events
occur: one, they tend to produce less of the goods typically produced by low-wage
workers; and two, they tend to increase there demand for the products produced by
low-wage workers. The two effects exert upward pressure on the wages of these
workers, including any producing similar products in the United States. This
outcome is consistent with the evidence that for the United States the relative price
of unskilled, labor-intensive, import competing goods rose in the 1980s and 1990s.17
Of course, it cannot be ruled out that if trade with relatively low-wage
economies does grow in importance, the negative effects on U.S. worker wages of
such trade would grow in significance. Yet, there is probably an upper bound to this
effect, for it is possible that in the future with only relatively moderate differences
between home and foreign production costs, complete specialization would occur.
16 U.S. Department of Labor, Bureau of Labor Statistics, “A Perspective on U.S. and Foreign
Compensation Costs in Manufacturing,” Monthly Labor Review, vol. 125, no. 6 (June 2002),
pp. 36-49.
17 Jagdish Bhagwati and Vivek Dehejia, “Freer Trade and Wages — Is Marx Striking
Again,” in Jagdish Bhagwati and Marvin Kosters, eds., Trade and Wages:Leveling Wages
Down? (Washington: AEI Press, 1995), pp. 36-75.

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That is, the United States would no longer produce much of what is imported from
low-wage foreign economies. Since the United States would then no longer have
industries that use low-wage labor intensively, there would be no downward pressure
on domestic wages caused by such trade. To the extent that this pattern of trade
allows for a fuller realization of economies of scale and lowers product prices,
domestic workers’ real wages could be increased. The change in the location of U.S.
imports from low-wage economies noted above suggests that a sizable amount of
such specialization may have already occurred. Reviewing the period 1994 through
2003, the Council of Economic Advisors concludes that for United States the
increase in share of total U.S. imports accounted for by imports of goods from China
has been largely offset by a decrease in the share of goods imports from other Pacific
Rim countries. The value of imports from both sources has increased considerably.
Still, many of the export jobs in non-China Asia are migrating to China, so the
distributional effects of this change fell on workers in China and the Pacific Rim
economies rather than workers in the United States.18
Also we know that industries that export pay wages that are, on average, higher
wages than industries that compete with imports. Therefore, as a rising level of trade
and outsourcing creates jobs in exporting industries, and destroys jobs in import-
competing industries there is a tendency for the average industrial wage to rise. It is
also useful to keep in mind that the U.S. economy is still largely domestic in
orientation, with perhaps as much as two-thirds of the labor force working and
having wages determined in activities largely unaffected by trade.
A Rising Level of Trade and
Economic Well-Being
For the economist, the central economic question to be answered in regard to
foreign outsourcing, or increased international trade in general, is not its particular
impacts on employment or wages. Those effects are not to be ignored, but they are
symptoms of a larger process. The answer economic analysis attempts to provide is
whether that larger process ultimately makes the United States richer or poorer. As
economic growth abroad expands the number of competitive sources of production,
will substituting foreign for domestic output generate gains from trade and raise
overall economic well-being? Whether such foreign outsourcing is occurring in the
service producing sector or the goods producing sector, there will be the same array
of possible positive and negative effects on the economy. Because importing must
be accompanied by exporting, the possible effects on the economy can be grouped
into two general categories: economic effects related to exporting and economic
effects related to importing.
18 This also suggests any restriction placed on China’s imports to the United States would
not increase domestic output, rather it would increase the output of the Pacific Rim
economies whose exports to the United States would increase as they become a replacement
for restricted Chinese goods. For a discussion of this and other aspects of trade with China,
see The Economic Report of the President (Washington: GPO, 2004), pp. 65-68 and CRS
Report RL32165, China’s Exchange Rate Peg : Economic Issues and Options for U.S. Trade
Policy, by Wayne M. Morrison and Marc Labonte.

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Effects on the Export Side
! If increased foreign production is of goods that the United States
also exports then domestic exporters will face more competition and
their product prices will fall. A fall of export prices raises the
effective cost of imports and decreases our gains from trade.
! Rising foreign production also raises income of foreign producers
and workers. Higher income increases the demand for U.S. exports
(goods or assets) and pushes up their price. A rise of export prices
lowers the effective cost of U.S. imports and increases our gains
from trade.
Effects on the Import Side
! Domestic households get foreign goods at a lower price. Lower
prices also raise the real income of households allowing them to
purchase more of all goods. Lower import prices increase the gains
from trade.
! Domestic businesses get foreign-produced inputs at a lower price,
reducing production costs and increasing profitability. If the good
the domestic firm produces is an intermediate good itself, this effect
will reverberate to other domestic companies that use it as an input.
The real income of stock-holders increases and is a gain from trade.
Increased capital inflows from increased export of assets allows
companies to undertake higher levels of investment raising output,
employment and wages. This is also a gain from trade.
! Domestic import-competing products will face more competition
and their product price will fall. Output and employment along with
wages and profits in the affected industry will likely fall. This is a
cost of increased trade (and what popular concern about foreign
outsourcing most often focuses on).

The net effect of these several impacts of increased trade or outsourcing can, in
theory, be positive or negative. In most circumstances, however, the strong
expectation of economists is that gains outweigh losses and that trade’s disruptive
reshuffling of the economy’s productive resources does ultimately result in an
increase in overall economic well-being.19 That increased trade, whether for
intermediate or final products, will likely raise economic well-being is confirmed by
the preponderance of evidence.20
19 The gains from trade can emerge from comparative advantage, economies of scale, and
inducements to innovation and the generation of faster economic growth. See for example,
Max W. Corden, “The Normative Theory Of International Trade,” in The Handbook of
International Economics, vol.1 (Amsterdam: North Holland, 1984).
20 See for example, Edward E. Leamer and James Levinsohn,”International Trade Theory:
(continued...)

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CRS-12
The gains from trade are, however, most often a net gain, because some will be
hurt by this process. Trade, like other market forces, generates increased wealth
through a process of “creative-destruction” which entails what is most often a
disruptive re-shuffling of workers and capital. New opportunities for enrichment are
created and resources are drawn towards them. But other activities that are less
efficient are destroyed and resources are pulled away from them. Because there are
net gains, it is also in principle possible for the losers to be compensated and still
leave the winners better off than they were prior to the increased trade. In practice,
however, there may be reason to question how equitable the compensation
forthcoming is. It is likely that a general acceptability of increased trade will hinge
on this equity issue.
In most instances the crux of debates about trade are not about the value of
trade to the overall economy, but over who will receive the benefits and who will
bear the costs of trade. If a U.S. worker, without his employer’s knowledge, were
able to sub-contract (out-source) his work to a foreign worker for a fraction of his
own wage he would likely do so. While still earning his full wage, the use of his
freed time in other endeavors would make him better off. His employer and the
ultimate consumers of the final product bear the cost in the form of lower profits and
higher product prices than would be the case if the most efficient way of production
was used directly. Of course, if his employer learned of the relative efficiency
advantage of the foreign worker, she would most likely contract directly with that
foreign worker (outsource) and lay off the domestic employee. The gains and costs
of trade are still the same as in the first circumstance, but now they have been
redistributed to the benefit of the domestic employer and her customers and to the
detriment of the displaced employee. Economics cannot tell us which distributional
outcome is preferred, but it does tell us that outsourcing the task increases overall
economic well-being.
Equity concerns notwithstanding, the expectation of enrichment though trade
has propelled successive rounds of trade liberalization in the post-war era, a process
the United States has consistently played a leadership role in sustaining. Trade has
expanded rapidly as has economic well-being of most trading nations, and the
increase in well-being is found to increase with a country’s degree of openness — the
more open to trade, the greater the gain.21 The gains from trade are mutual, occurring
even if the trading partners have an absolute advantage or disadvantage in the
production of all traded goods and services. As such, a country does not compete
with its trading partners, it engages in mutually beneficial exchange with them.
Increased foreign outsourcing is a symptom of these expanded opportunities for trade
and mutual enrichment. As the United States has benefitted from increased trade and
outsourcing associated with the post-war industrial resurgence of Europe and Japan,
20 (...continued)
The Evidence,” in The Handbook of International Economics, vol. 3 (Amsterdam: North
Holland, 1995); and Jeffery Frankel and David Romer, Does Trade Cause Growth?,
National Bureau of Economic Research, Working Paper no. 5476, June 1999.
21 See for example, Charles I. Jones, Introduction to Economic Growth (New York: Norton,
1998), pp.134-138.

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so would it likely benefit through increased trade associated with the ongoing
economic development of China, India and other emerging economies.
Gains from Trade Over Time
The gains from trade are not a static phenomenon, however. While at any point
in time an increase in trade (outsourcing) increases economic well-being, over time
the size of the gain could rise or fall as the relative economic circumstances of
trading partners change. Therefore, it can be telling of the economy’s international
trade performance and its view of how it is faring from increased trade to consider
whether there has been any long-term trend in the nation’s share of the gains from
trade. More specifically, this is a question about whether, over time, the U.S.
economy’s terms of trade has tended to rise or fall as economic growth has occurred
in the rest of the world, and foreign outsourcing has grown in significance.
The terms of trade is a ratio of average export price to average import price and
as such is a measure of the export cost of acquiring imports. An increase in this ratio
— an improving terms of trade — means that any given volume of export sales will
now exchange for a larger volume of imports, indicating an increase in the gains from
trade. A rising trend would indicate that a country’s trade performance has
improved relative to other trading countries, reaping an increasing share of the gains
from trade, and real income benefits for the economy. Similarly, a decrease in the
ratio of export prices to import prices — deteriorating terms of trade — raises the
export cost of acquiring imports and reduces the gains from trade. A falling trend
would be indicative of deteriorating trade performance, decreasing share of the gains
from trade, and decrements to real income.22
Over time it is likely that economic growth, at home and abroad, will tend to
show either a bias towards the production of goods a country exports or a bias
towards production of the goods a country imports. If export biased, there is a more
then a proportionate increase in the worldwide supply of goods that compete with
U.S. exports, inducing a deterioration of the U.S. terms of trade over time, to the
benefit of our trading partners. In contrast, if growth in the rest of the world is import
biased, there is a more than proportionate increase in the worldwide supply of the
22 A deteriorating terms of trade does not mean that trade is harmful and that we would be
better off without trade. It has merely become less beneficial. In most circumstances there
will be no absolute decline in real income, rather the rate of growth of income will be
slower than it otherwise would have been. Also, the terms of trade will not fully reflect
the gains from trade that come from the realization of economies of scale. This is of some
significance for trade between mature economies that have similar factor proportions (i.e.,
the United States, Europe, Japan, and Canada) and has most likely steadily risen in
importance for such economies. This can be taken as, at least, a partial offset to any loss in
the gains from trade indicated by a falling terms of trade. Nevertheless, movement in the
terms of trade would still be indicative of changes in the gains from trade coming from
rising trade with low wage economies that would still have very different resource
endowments (i.e., relatively large supplies of low-skill labor and relatively small supplies
of capital and high skill labor). Nor will the terms of trade fully reflect the benefit to
consumers that come from access to, not just more goods, but a wider variety of goods.

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goods the U.S. imports, inducing an improvement in the U.S. terms of trade over
time, to the detriment of our trading partners.
Increased foreign outsourcing is clearly a manifestation of economic growth in
the rest of the world and in recent years this has included the expanded participation
of lower income developing economies in the internationally fragmented production
processes that now propel a large and growing share of international trade. As was
discussed in the “Introduction” section of this report, foreign outsourcing is not a
new phenomenon, but one that is occurring with a steadily rising incidence in goods
producing industries for the last three decades. At the peak of the last business cycle
in 2000, it is likely that a very large share of total U.S. non-agricultural merchandise
trade, exports plus imports, is of some form of intermediate product and represents
some form of foreign outsourcing.23
Has this increase in foreign outsourcing affected the U.S. economy’s terms of
trade? Has there been any tendency for the U.S. share of the gains from trade rise or
fall as a result of outsourcing? Relative to its peak in the mid-1960s, the terms of
trade declined at about 1.0% per year through 1980. But while significant, this fall
was moderate in scale. This deterioration most likely reflects the recovery and return
to competitive posture of the many high-income economies from the devastation of
World War II. These are largely economies that have resource endowments similar
to that of the United States and who with economic recovery from the war could be
expected to increasingly compete against U.S. exports in world markets. This growth
was certainly export biased and accordingly has pushed down the average price of
U.S. exports. Since the 1980s the U.S. terms of trade has fluctuated, but, overall, has
not shown a trend, up or down: up in the early 1980s, down in the late 1980s and
early 1990s, and then up again through the late 1990s to the present. It is, of course,
in this more recent trendless period that use of foreign outsourcing was steadily
climbing and the period when trade with low-income, low-wage economies was also
on the rise. Yet, the trendless path of the U.S. terms of trade over this period
suggests that these events were not inducing any significant persistent effect on the
economy’s gains from trade. Growth in the rest of the world and the outsourcing that
went with it in this period was, on balance, without a bias towards the goods the
United States exports or imports. At this point there does not seem to be a strong
reason to expect the spread of outsourcing to the service sector to change this
outcome.
The Gains from Trade, Outsourcing, and the “Product Cycle”. The
idea of the product cycle provides a useful way of understanding how an economy’s
gains from trade over time emerges from a continually changing industrial landscape
and how foreign outsourcing may influence that outcome. It has been long observed
by economists that the production of many tradable products will move from country
23 Due to a lack of a comprehensive data series, the size of trade in intermediate goods is
judged from data on merchandise trade by end-use category which does identify trade in
capital goods and industrial supplies. Because other types of intermediate products, such
as automotive parts and components, are not picked up in these two categories, it is most
likely that such an estimate will understate the scale of trade in intermediate products. See
table B-104 in Economic Report of the President, February 2004.

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to country over the life of the product.24 Innovations have their greatest value and
are more likely to occur in high-wage economies, for the reason that labor in these
countries is relatively scarce and costly and innovations most often offer a means to
economize on this expensive resource. In the early life of a product, production
occurs on a small scale using relatively high skill workers. The relatively high price
of the new product will also offer relatively high returns to the specialized capital
stock needed to produce the new product. At this stage the factor endowments of
high-income countries such as the United States will make them the most efficient
location for production. As the product matures, with expanding foreign and
domestic sales, a settled technology, the capability for standardized production, and
a falling market price, it will become possible and more efficient to produce the
product or significant portions of the product on a mass scale using relatively low
wage labor. At this stage in the product’s life it is likely that production will be
pulled toward economies that have resource endowments relatively rich in low-wage
labor, such as China.
Foreign outsourcing, therefore, can be seen as a manifestation of this process
of technological diffusion to other economies. This process is not only relevant to
the production of goods. As a portion or all of the production of a service lends itself
to standardization and international exchange, the incentives to capture efficiency
gains by moving the site of production towards lower wage economies will increase.
In the framework of the “product cycle,” the United States is most likely to be
operating at the innovation stage of this cycle. Therefore, to a significant degree its
gains from trade will be determined by the dynamic balance between the economy’s
rate of innovation and the rate of technological diffusion. While not a necessary
outcome, the rate of innovation will likely be correlated with the growth of new ideas
for products and processes in the United States, and the rate of technical diffusion
correlated with the growth of cost reducing incentives afforded by foreign
outsourcing. Unless the economy can generate a pace of innovation to match the
pace of diffusion, its terms of trade will fall, and its share of the gains from trade will
decline. (Such a decline would not be an argument for not engaging in trade as that
would reduce the gains from trade altogether, but it would be an erosion of economic
well-being and explain a perception by some that the economy is getting less out of
trade then it once did. As observed above, there has been no trend decline in the
terms of trade over the last twenty years.)
It can be argued that the advance of globalization has accelerated the rate of
diffusion, the seeming rise in foreign outsourcing is a symptom of that acceleration,
and the spread of outsourcing to services is the most recent manifestation of this
process. What this suggests is that preserving or increasing the economy’s gains
from trade in the face of globalization will require an acceleration of the pace of
innovation in goods and service producing activities. While market forces may
respond positively to the incentives for innovation offered by expanding trade, a case
can be made that this is an area subject to substantial market failure, and because of
that the optimal amount of innovation will not be forthcoming.
24 Raymond Vernon, “International Investment and International Trade in the Product
Cycle,” Quarterly Journal of Economics, vol. 80 (1966), pp. 190-207.

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The creation of innovations is largely a process of generating new ideas. To
the extent that new ideas lead to profitable outcomes and those profits can be secured
by a private enterprise, the market economy will generate new ideas and foster
technological change. An inherent attribute of ideas, however, is that they are non-
rival, as in, my using the idea does not preclude someone else from using it. Further,
ideas will often have the attribute of limited excludability, meaning the owner of the
idea will find it difficult or impossible to charge a fee for its use. These attributes
will likely cause a divergence of private benefit and social benefit in the idea
production process. (What the creator of the idea can expect to gain will be less than
what the overall economy can expect to gain.) In this situation, less than the socially
desirable level of idea generation will occur. In this circumstance public policy can
improve on the free market outcome if it can foster more idea production.
Are Services Different?
Trade in services is nothing new to the U.S. economy. In 2003, $300 billion in
services were exported, a doubling of sales since 1990. Service exports now account
for about 30% of the value of all U.S. exports. And the United States has
consistently run a trade surplus in services.25 That surplus stood at $60 billion in
2003, about where it was at this stage of the last economic expansion, but it can be
expected to grow in response to faster economic growth abroad and a significantly
more favorable exchange rate than has prevailed in recent years. For example,
Global Insight projects a U.S. services trade surplus of over $120 billion by 2008,
occurring along with a steady rise in the level (exports and imports) of U.S. trade in
services.26
In the business, professional, and technical services sub-component of U.S.
services trade, an area where outsourcing could be expected to be most likely, the
U.S. had exports of nearly $31 billion against imports of about $12 billion, yielding
a surplus in 2003 of about $19 billion, up from about $16 billion in 2000. This
pattern of trade makes clear the “two-way” nature of services trade and that if the
incidence of foreign outsourcing, in both directions, is proportional to the size of
export and import flows, then the U.S. is likely to have more often been the
destination rather than the departure point for the foreign outsourcing of services.
This would also suggest that the United States has a large economic stake in the
rising level of services trade.
Employment data for the service sector also suggest significant economic
viability. Unlike the hard hit goods producing sector where recession and a laggard
recovery have since 2000 caused substantial employment losses, employment in
service producing industries held up far better. In that sector employment fell only
about 1.0% in the 2001 recession and in contrast to the goods producing sector, has
25 Services trade data can be found in U.S. Department of Commerce, The Survey of Current
Business, various issues.
26 U.S. Economic Outlook, Global Insight (Lexington: April 2004), pp. 60-66.

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increased employment since then so that by early 2004 the level exceeded the
previous peak.27

It is also clear, however, that until recently services had not faced the degree of
international competition that has prevailed in the goods-producing sectors. The
need for more person-to-person interaction and the relatively high cost of
international communication made many services difficult to trade. Now, however,
because of the increasing ease, quality, and ever lower cost of international
communication afforded by information technology advances, the possibilities for the
trade of services have greatly expanded, and in response the level of international
competition in services is rising fast.
In this expanding arena for trade, it is likely that the United States, being the
world’s largest producer of services, will have a comparative advantage in many
areas of service production, but not all areas, and not in all aspects of the production
of any given service. Therefore, more foreign competition is likely to change the
structure of many services industries. We can expect to see a substantial increase in
the share of what was once done in-house being outsourced (and becoming a service
import), as firms exploit more and more the efficiency advantages afforded by
foreign production of many standardized tasks. Likely many other tasks will be
outsourced to the United States. Again, trade and foreign outsourcing in services will,
as it seems to have been in the wider economy, likely be a “two-way”process.
What the service sector can expect from increased foreign outsourcing has
already been experienced by the manufacturing sector over the last 30 years. That
sector has certainly been greatly transformed, nevertheless manufacturing has
maintained a healthy presence in the U.S. economy. Despite increased foreign
outsourcing, through the last business cycle peak in 2000, the manufacturing sector
had
! increased real output 144% since 1970.
! maintained a relatively steady share (17%) of real final demand since
the 1980s.
! Despite a declining share of the civilian workforce, maintained a
relatively steady level of employment (17 million) since the 1980s.
! Received large net inflows of foreign investment.
! Increased export sales $400 billion (about 125%) between 1990 and
2000, despite an unfavorable exchange rate.
Most of the negative effects the U.S. manufacturing sector has endured,
particularly since 2000, are seen by economists to be the consequence of economic
forces other than foreign outsourcing and a rising level of trade. Of greatest
significance are changes in consumer expenditure patterns that place a rising
27 See Bureau of Labor Statistics, monthly national employment survey.

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importance on the consumption of services relative to goods (a change common to
most industrial economies), rapidly rising productivity (something unambiguously
good for the overall economy), and the burden of trade deficits on goods producing
industries (distinct from the rising level of trade).28
Implications for Economic Policy
The substantive economic conclusion of this report is that foreign outsourcing
is international trade in a somewhat different guise. Like other market forces, it
causes disruptions that are costly to some, but its ultimate effect on the economy is
the same as any type of trade — an increase in overall economic well-being. Because
foreign outsourcing has already occurred on a large scale in the goods producing
sectors of the economy over the last 30 years, its impacts are reasonably evident and
seem to confirm this judgement. What often seems to be missing in popular concern
over foreign outsourcing is an appreciation for the mutual or “two-way” nature of the
process. The U.S. economy outsources to foreign economies and foreign economies
outsource to the U.S. economy, jobs are created and destroyed, and overall economic
welfare increases through this exchange.
If foreign outsourcing on balance raises economic well-being, policies aimed
at arresting that activity would have a net economic cost. There are, however, other
avenues for policy response that most economists think could be generally beneficial.
One avenue is to work to expand overseas markets through further removal of
foreign trade barriers against American exports. A second avenue would be to use
policy to boost the benefits of trade by correcting deficiencies in the economy’s
ability to create new products and processes that could become attractive exports.
A third avenue is to use economic policy to remove any unwarranted bias against the
economy’s tradeable goods sector caused by an elevation of the incentives toward
foreign outsourcing that arise from the economic forces generating the trade deficit.
A fourth avenue would be to use policy to address the hardships and inequities
arising from trade and foreign outsourcing by extending compensation and more
effective tools for adjustment to those who are hurt by the disruptive effects of
foreign outsourcing and other market forces.
Is Protection Appropriate?
If international trade, including outsourcing, is economically enriching, using
policy to arrest the phenomenon by imposing barriers to such exchanges will prevent
the nation from fully realizing the economic gains from trade and, therefore, must
reduce economic welfare. Economics has long taught that protection of import-
competing industries with tariffs, subsidies, or other devices to shelter a domestic
activity from international competition leads to an over-allocation of the nation’s
scarce resources in the protected sectors and an under-allocation of resources in the
unprotected tradeable goods industries. Standard economic theory indicates that
28 See CRS Report RL32350, Deindustrialization of the U.S. Economy: The Roles of Trade,
Productivity, and Recession, by Craig K. Elwell and CRS Report RL32179, Manufacturing
Output, Productivity and Employment: Implications for U.S. Policy, by Stephen Cooney.

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reducing the flow of imports will also reduce the flow of exports because fewer
exports are needed to pay for fewer imports. Clearly, the exporting sector must lose
as the protected import-competing (outsource- competing) activities gain.
But more importantly, the overall economy that consumed the imported goods
would suffer because the more efficient production process — available through
international trade — would not be used to the optimal degree. This would increase
the price and reduce the array of goods available to the consumer from what they
would otherwise be. Therefore, economic analysis indicates that the ultimate cost of
the trade barrier is not a transfer of well-being between sectors, but a permanent net
loss to the whole economy arising from the barrier’s distortion toward the less
efficient use of the economy’s scarce resources. These costs would be magnified if
the trading partners disadvantaged by these actions retaliated against U.S. exports.
There is ample evidence that the economic cost of protection is high. The U.S.
International Trade Commission has estimated the economy-wide cost of existing
U.S. trade barriers to be about $12.4 billion. And this is probably a conservative
estimate, because it is difficult to fully account for the costs associated with lost
product variety and productivity. Therefore the full cost of protection is thought by
economists to likely be significantly higher than that estimate.29 A study by Hufbauer
and Eliott found that across 21 industries the economic cost per protected job ranged
from $100,000 to more than $1million and averaged about $170,000. In each case the
cost of protection was far higher than the protected workers average annual earnings
and far higher than what any likely worker adjustment program would cost.30
The argument may be made that some form of protection is needed to counter
the unfair trade practices of some trading partners. Such practices do occur and in
those instances some form of retaliatory policy may be appropriate.31 But it is very
unlikely that such unfair trade practices are the principal force driving the ongoing
expansion of world trade and the associated growth of foreign outsourcing. If most
unfair trade practices were gone tomorrow, it is likely that trade would still be rapidly
rising and most of its associated pressures and problems would still be with us.
A more credible explanation is that the expansion of world trade is propelled
by the prospect of economic enrichment and enabled by an increasingly open world
trading system that allows each nation to use its resource endowments in more
efficient ways. It is differences in those endowments and how they are used that
makes trade mutually beneficial. Yet, it is often those differences that give rise to
perceptions of unfairness. What is an acceptable or unacceptable practice will not be
considered here. But is probably unreasonable to expect our trading partners to be
identical to the United States in their economic and social practices. From an
economic perspective it makes sense that the level of labor and environmental
standards would be correlated with a nation’s level of income. At their current stage
29 See U.S. International Trade Commission, The Effects of Significant U.S. Import
Restraints, Publication 3201(Washington: 1999).
30 See Gary Clyde Hufbauer and Kimberly Ann Eliott, Measuring the Costs of Protection
in the United States (Washington: Institute for International Economics, 1997).
31 For a discussion of the options available, see CRS Report RL32371, Trade Remedies: A
Primer, by Vivian C. Jones.

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of development, many poor countries, with very low levels of productivity, simply
can not afford the economic and social practices and institutions of a rich economy
like the United States. With economic growth, that trade helps achieve, they may
be able to. This is certainly the path that today’s rich nations followed.32
The clear direction of U.S. trade policy in the post World War II era has been
to reduce trade barriers, not erect them. And it is widely recognized that this process
has been beneficial to the U.S. and the world economy.
With that gain will likely also come more foreign outsourcing, but we can
reasonably expect that outsourcing to the United States would also rise as exporting
opportunities improve along with importing opportunities. If you also consider that
existing foreign barriers are most often higher then existing U.S. barriers, removing
those barriers is likely to have a relatively stronger beneficial effect on the United
States, particularly since many of the remaining barriers are against trade in services,
an area where the United States is likely to be very competitive.
The Sectoral Burden of the Trade Deficit
Analysis indicates that trade deficits do not cause a net loss of output or
employment for the overall economy, but they do shift the composition of output and
employment and that shift in composition will have an adverse effect on some
domestic industries that produce tradeable goods or services. This bias could tend
to raise the incidence of foreign outsourcing.
Trade deficits are a macroeconomic phenomenon that reflects a short-fall of
domestic saving relative to the domestic investment that needs to be financed. (This
is precisely the same thing as the economy spending beyond current output.) This
imbalance can be reconciled by a net inflow of foreign capital that acts to augment
the flow of saving available and allows the higher level of investment to occur. The
capital inflow pushes up the exchange rate which induces a like sized net inflow of
goods and services — a trade deficit. The rising exchange rate has induced this net
inflow of goods by making imports more attractive to domestic buyers and the
economy’s exports less attractive to foreign buyers. Domestic exporting and import
competing industries will find themselves somewhat worse off as a result. In the
current context, job-creating export industries will do less of that, and a rising tide
of imports will mean more outsourcing is occurring.33 This is a distributional effect,
however, for as some sectors lose others gain. The capital inflow that is the
necessary counterpart of a trade deficit serves to increase the flow of saving available
to the economy and has favorable effects on output and employment in activities
32 Some industries, or at least components of some industries, are vital to national security
and possibly may need to be insulated from the vicissitudes of international market forces.
This determination is best made on a case-by-case basis since the claim is made by many
who do not meet national security criteria. Such criteria may also vary from case to case.
33 The exchange rate induced bias is likely to be particularly relevant when the decision to
produce at home or abroad is not constrained by the need for large scale capital investments
that are less likely to be influenced by the more near-term effects of the exchange rate, and
hinges largely on relative labor costs.

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CRS-21
typically financed by saving flows such as business investment and residential
construction.

Therefore, removing this bias against the tradeable goods sectors should be
judged against the benefit to the overall economy of the capital inflow that animates
this process. Most recently, the trade deficits of the 1993 — 2000 period allowed
the U.S. economy to undertake rates of investment that otherwise could not have
occurred. The payoff is faster economic growth. In the 1980s, however, large U.S.
trade deficits were used to support public and private consumption and arose in part
from public policies that increased the federal budget deficit. In this case there is no
payoff from faster growth. It also raises the issue of whether the public policies
involved were on balance good or bad. At present, an expanding economy along
with large federal budget deficits may be a recipe for perpetuating large trade deficits
more along the lines of the 1980s experience then that of the 1990s.
If a smaller trade deficit is judged the appropriate goal, economic policy can be
used to reach it. If it is also judged prudent not to achieve this reduction at the
expense of domestic investment, then the economy’s rate of saving will have to be
raised. (This is the same thing as saying the economy’s rate of consumption will
have to be reduced.) Economic policy’s ability to affect the private saving rate is
problematic, but macroeconomic policy can certainly change the public saving rate.
Government budget deficits are a subtraction from the nation’s saving and budget
surpluses are an addition to the nation’s saving. Therefore policies that move the
budget away from deficit and toward surplus, other things unchanged, will tend to
reduce the trade deficit. This will occur, of course, as a depreciating exchange rate
works to change the composition of domestic output, stimulates export sales and
dampens import spending, and in the process likely boosts the output and
employment of the U.S. tradable goods sectors.34 This will not stop the rise in the
level of trade, nor eliminate outsourcing, but it can remove some of the bite of that
process on the tradeable goods industries.
Under-Investment in the Economy’s Creative Powers
The presence of a market failure in idea production can be corrected by an
appropriate amount of public support for the idea creation process. Such support
could include public funding of research and development (R&D), both basic
scientific research (where the prospect of market failure is the greatest) and
34 The trade deficit would be reduced if foreign lenders curtailed their accumulation of U.S.
assets. In this case, however, there would be no increase in U.S. saving. So in this
circumstance the adjustment must occur through higher domestic interest rates and lower
domestic investment. The favorable effect of the smaller trade deficit on trade sensitive
sectors would be counterbalanced by the adverse effect on domestic interest sensitive
sectors. The dollar depreciation seen since early 2002 is most likely being driven by a shift
away from dollar denominated assets by foreign investors. Because the economy is now
operating with considerable slack, the adverse effects of this capital outflow have been
negligible. For a fuller discussion, see CRS Report RL31032, The U.S. Trade Deficit:
Causes, Consequences, and Cures, by Craig K. Elwell.

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enterprise-specific research; public funding for investment in human capital,35
particularly education in the sciences and engineering; and public support for
mechanisms to establish and enforce property rights, such as patent and copyright
administration. The intent would be that these actions would boost the economy’s
ability to create new products and better jobs and produce a more appealing
counterweight to the destructive effects of technological diffusion and increased
imports and foreign outsourcing. As jobs are destroyed by foreign outsourcing in one
part of the economy, it is hoped that the boost to the idea production process would
improve the attractiveness of U.S. exports on the world market, leading to an
acceleration of the flow of exports and foreign outsourcing into the United States,
and boosting the rate of creation of better jobs in other parts of the economy.
Of course, these are activities that the U.S. government supports now.36 But the
open question is whether such support is well targeted and undertaken at an adequate
scale. This is not an easy question to answer. As regards spending on R&D, there
is a considerable amount of economic evidence that the social rate of return to R&D
for a variety of research projects often greatly exceeds the private rate of return,
suggesting that too little research is being undertaken. (At optimal scale research
projects would be undertaken to the point where the social rate of return has been
pushed down to the level of private return.) By some estimates, the level of
investment undertaken by firms could be as little as 25% of the level what is
economically optimal.37 This said, we also observe that total R&D spending by
industry and government as a percent of GDP has hovered around 2.5% of GDP for
nearly 30 years. The overall steadiness of this share, however, masks divergent paths
for industry and government R&D spending. While the dollar spending levels by
industry and government have both increased, since the 1980s as a percent of GDP
industries share has risen and that of government has fallen. It is government
spending on R&D that largely provides support to basic research and this is an area
where the incidence market failure in idea production is probably the great.
Ameliorating Outsourcing’s Costs
Labor market disruptions are not new problems and most advanced industrial
economies have developed policies to provide some degree of support for those
displaced by recession or the ever present churning of market forces including trade.
Because equity goals are as likely to be of as much concern to citizens and
policymakers as are efficiency goals, an economic response of foreign outsourcing
35 Raising the skill level of workers would also improve the flexibility of the labor force.
Carrying with them more than just job specific skills would facilitate a quicker adjustment
of workers to economic change.
36 For a discussion of current federal programs, see CRS Issue Brief IB10088, Federal
Research and Development: Budgeting and Priority Setting Issues, 108th Congress, by
Genevieve Knezo.
37 See Zvi Griliches, “The Search for R&D Spillovers,” Scandinavian Journal of Economics,
(1991), pp. 29-47; Bruce Smith and Claude Barfield, Technology, R&D , and the Economy
(Washington: Brookings Institution, 1996); and Charles I. Jones and John C. Williams.
“Measuring the Social Return to R&D,” The Quarterly Journal of Economics, vol. 63, no.4
(Nov. 1998), pp. 1119-1136.

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can not be easily separated from consideration how those hurt in this process will be
treated. To the economist the policy challenge is to craft initiatives that equitably
compensate and assist those who are displaced, while also securing the efficiency
gains from increased trade. At the most general level, the economist would argue for
a transfer of some of the gains from trade from the “winners” to the “losers.”
Because increased trade generates benefits in excess of costs such a transfer can, in
principle, compensate those hurt by trade and still leave the wider economy better off
then it would be without trade and outsourcing. Finding and implementing policies
to affect such a transfer remains an area of controversy.
It can be argued that in the United States and other industrial economies, the
post World War II economic order was built upon an explicit or implicit “social
bargain.” Workers would accept the periodic disruptions associated with the market
economy’s cyclical and destructive traits that are inherent to its rapid creation of
wealth and rising economic well-being, if those disruptions were cushioned by
government provision of various types of economic support to see them through
these rough spots. Public support rather than workers themselves buying insurance
against the risk of job loss is thought the preferred method because the “market
failure” caused by the problem of “adverse selection” will prevent the private market
from providing an adequate level of coverage.38 While the social policies may have
changed in form and extent over the years, these worker support policies remain an
integral piece of the modern industrial economy.39
The level of economic support an unemployed or displaced worker receives can
be seen as a form of social insurance against the “risk” of job loss and its associated
costs that a fluctuating and ever churning market economy exposes workers to.40 The
argument can be made that if the velocity of market “churning” has increased in
recent years due to the combined or individual effects of a rapidly rising level of
international trade, accelerating productivity advance, or more quickly shifting
consumer demand, then the volatility of the labor market and the risk of
unemployment that each worker faces have also increased.
Some argue that higher level of risk would warrant a higher level of economic
support. This does seem to be the case among Organization for Economic
Cooperation and Development (OECD) countries for exposure to the risk associated
38 For further discussion of the issue of public versus private provision of unemployment
insurance, see CRS Report RL32194, Job Loss: Causes and Policy Implications, by Marc
Labonte.
39 For current legislative issues about unemployment insurance, see CRS Report 95-742,
Unemployment Benefits: Legislative Issues in the 108th Congress, by Celinda Franco. For
more information on adjustment assistance and retraining programs, see CRS Electronic
Briefing Book, Trade, page on “Trade Adjustment Assistance for Workers,” by Paul Graney
and Celinda Franco, at [http://www.congress.gov/brbk/html/ebtra85.html]; CRS Report
RL31250, The Worker Adjustment and Retraining Notification Act (WARN), by Linda
Levine; and CRS Report 97-536, Job Training Under the Workforce Investment Act (WIA):
An Overview, by Ann Lordeman.
40 This concept of risk encompasses both the likely incidence job loss, the duration of
unemployment, and the level of possible adjustment costs.

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with international trade, where there is a fairly strong correlation between market
openness and levels of government support expenditures.41 In addition to the level
of support, consideration of the form of that support, particularly the incentives for
quick re-employment, may be important. In this regard, policy areas that might merit
closer examination include wage-insurance, portability of health and retirement
benefits, and incentives for ongoing enhancement of worker skills that could have
value to a wider spectrum of employers.
41 See Dani Rodrik, Has Globalization Gone too Far? (Washington: Institute for
International Economics, 1998), pp. 49-66.

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