Out-Outsourcing

One of the biggest economic stories of the past decade has been the practice of outsourcing jobs from the U.S. to India. From the start, it was an enormously profitable idea: American companies could create a “back office” halfway around the world that would work while the folks in the American “front office” slept. Rather than getting 8 or 10 hours per day of productive work, companies could be productive around the clock.

Of course, American companies couldn’t all just set up shop in India—the fixed costs are too great. So Indian entrepreneurs began founding companies to provide back-office services to American firms. One of these was Infosys Technologies. Now, the New York Times reports, Infosys and its Indian rivals are opening back offices of their own in Brazil, Chile, Uruguay, the Czech Republic, Mexico—and even the United States. The article states:

In a poetic reflection of outsourcing’s new face, Wipro’s chairman, Azim Premji, told Wall Street analysts this year that he was considering hubs in Idaho and Virginia, in addition to Georgia, to take advantage of American “states which are less developed.”

In other words, globalization has come full circle: now you can work in Georgia for an Indian company providing services for an American company.

Discussion Questions

1. Consider a company in Silicon Valley that outsources some of its work to Infosys in India, which in turn outsources some of its work to an office complex in Idaho. Suppose the project is handled by one programmer in each location, and suppose that each programmer is equally talented. In all probability, the wages earned by each programmer are different. What explains this difference?

2. Some jobs, like computer programming, are easily outsourced. Others, like providing haircuts or construction, are not. What effect do you think an increase in outsourcing would have on the wages of computer programmers, barbers, and construction workers? What about the relative prices of software, haircuts, and housing?

3. The increase in outsourcing over the past decade or so is what economists call a disequilibrium phenomenon. Disequilibrium occurs when there is a rapid change in the way things are done—for example, a rapid shift in a demand or supply curve—and prices and quantities have not yet fully adjusted to their new equilibrium levels. What do you think the new equilibrium will look like? What impact do those expectations have on the choices you need to make in college—such as what to major in, or what companies you should try to get a summer internship with?

Monetary Policy and Flexible Exchange Rates

The Federal Open Market Committee (FOMC), the monetary policy arm of the Federal Reserve, announced a 50-basis-point reduction in the target federal funds rate on Tuesday, September 18. The stock market soared in response to the rate cut because most market watchers were only expecting a 25-basis-point reduction. Read the FOMC statement for the reasons behind the rate cut. After the announcement, the U.S. dollar decreased in value against the euro, the British pound, the Japanese yen, and the Canadian dollar. This was no coincidence, and the reduction in the value of the dollar actually reinforces the Federal Reserve's goal of maintaining moderate economic growth.

The federal funds rate is a benchmark for other interest rates in the United States. For simplicity, let's imagine for a moment that the federal funds rate is the only interest rate in the United States. If this is true, then the U.S. interest rate is also the dollar rate of return for holding U.S. assets. However, the United States is not the only country in the world. The European Union has its own interest rate that represents the euro rate of return for holding EU assets. For a given amount of volatility in asset prices, investors place their savings in assets that offer the best rate of return after adjusting for the exchange rate.

A reduction in the U.S. interest rate makes U.S. financial assets relatively less attractive than before because the EU interest rate has remained unchanged. U.S. investors will want to purchase more EU assets (i.e., there will be an increase in the supply of U.S. dollars), and EU investors will want to purchase fewer U.S. assets (i.e., there will be a decrease in the demand for U.S. dollars). Figure 1 shows the subsequent changes in the market for U.S. dollars.

A depreciation of the U.S. currency will make U.S. exports relatively inexpensive for foreigners while making imports from foreign countries relatively expensive for Americans. A decrease in the interest rate causes an increase in net exports and reduces the size of the U.S. trade deficit. Figure 2 shows the relationship between the exchange rate and net exports. Since net exports are a component of total spending in the U.S. economy, the Fed's rate cut provides two boosts to aggregate spending: (1) the rate cut stimulates consumption and investment because the cost of borrowing decreases; and (2) the rate cut stimulates net exports due to U.S. dollar depreciation. By cutting the target fed funds rate, the Fed intends to prop up spending and growth at a time when tightening credit conditions threaten to slow or reverse the growth of economic output.

Discussion Questions

1. The previous analysis assumes that the United States and the European Union operate under a flexible exchange rate regime. Would the Fed be able to maintain moderate output growth after a severe shock, such as the subprime mortgage meltdown, if U.S. dollars were fixed to a currency such as the euro?

2. What if the Fed is wrong about the adverse effects of tightening credit conditions? What if growth would have continued at a moderate pace even without a rate cut? How would the decision to cut rates affect output and inflation in the short run and in the long run?

3. Suppose that at the next FOMC meeting on October 31, 2007, a jump in the inflation rate is reported. What would the FOMC do to the interest rate? How would this affect the exchange rate and net exports?

Same Problem, Different Solutions

Recently, both U.S. and British farmers have faced the problem of a labor shortage. How can a labor shortage occur when the unemployment rates of both countries have remained positive? Effectively, a labor shortage is the same as any other type of economic shortage—it occurs whenever the price (in this case, the wage) is lower than the equilibrium price, leading to a situation where the quantity of labor demanded exceeds the quantity of labor supplied. Since labor is one of the main factor costs in the agricultural industry, farmers in both countries are reluctant to raise the wages of their workers, as this would raise costs and reduce profits.

The wages of farm workers in Britain and the U.S. have been kept low by the influx of immigrant farm workers. Immigration increases the labor supply in the host country, shifting the labor supply curve to the right. As a result, the equilibrium wage for farm workers in the host country falls.

So what are the sources of the farm labor shortages in the U.S. and Britain?

According to the Department of Labor, more than half of the 2.5 million farm workers in the U.S. are illegal immigrants. The recent crackdown on employers of illegal immigrants poses a threat to many U.S. farmers who rely on immigrant workers. With a tighter immigration policy, the U.S. farmers would have to rely on domestic instead of immigrant workers. As the labor supply decreases with fewer immigrants (the supply curve shifts to the left), the farmers have to pay a higher wage. If they are reluctant to raise the wage, they will face a shortage of willing workers at the initial wage.

Britain did not tighten its immigration policy against Europeans. Nevertheless, the number of Europeans going to Britain for farm work has decreased due to better job opportunities in booming European economies. At the same time, many European workers are beginning to find other types of British jobs preferable to agricultural work. As fewer immigrant workers make the trek to Britain, and those that do choose non-agricultural jobs, the supply of farm workers in Britain declines. In Britain, as in the United States, reluctance to offer higher wages leads to a shortage of willing workers. Only when British and American farmers offer higher wages will the labor shortages disappear.

Interestingly, the farmers in these two countries have adopted completely different approaches to dealing with the problem. While some U.S. farmers chose to avoid the immigration issue by offshoring their operations to Mexico, the British farmers lobbied the government to bring in more Ukrainian workers under a special scheme. How well do these two approaches address the agricultural labor problem in the two countries?

Discussion Questions

1. As observed by Julia Preston of the International Herald Tribune, what impact does the offshoring of farm operations have on the U.S. economy as a whole?

2. According to the Economist, what is the best way to provide incentives for immigrant workers to work hard? Why?

Time Off for Procreation

William Saletan of Slate and economist Joshua Gans of the Melbourne Business School recently commented on the latest ill-advised birth encouragement policy, this time from Russia. The governor of the Ulyanovsk region in Russia declared September 12 a day off for making babies. The regional government is offering prizes in the form of cash, cars, and appliances to couples that give birth nine months after the Day of Conception. This is on top of President Putin's national proposals to entice would-be mothers with cash, extended maternity leave, and day-care subsidies. The Aplia Econ Blog has already posted here and here about Gans' extensive look at similar birth incentive programs in Australia.

Discussion Questions

1. What, according to Saletan, are the primary reasons for rapid population decline in Russia? Given the causes of depopulation, do you think birth incentive programs stand a reasonable chance of reversing the trend? What long-term policies would you recommend to deal with Russia's declining population?

2. While the effect of birth incentives on long-term population growth is highly debatable, economists Joshua Gans and Andrew Leigh have demonstrated that birth incentives have a significant impact on parental decisions about timing births and inducing labor. What do you expect maternity wards in Ulyanovsk to look like on June 12, 2008? What are the health costs associated with Ulyanovsk's birth incentive policy?

The Fed's Rate Cut

As Greg Mankiw recently pointed out and Wall Street Journal reporter David Wessel was quick to observe nearly a month ago, the actual federal funds rate has been trading below the Fed's target federal funds rate of 5.25%. The federal funds rate is the rate at which banks borrow from one another overnight, and it is the key benchmark interest rate for monetary policy. The Fed targets a relatively low, or loose, fed funds rate in order to encourage borrowing, speed up economic growth, and avoid recession. The Fed targets a neutral rate when it wants neither slower nor faster growth than the economy is currently experiencing. The Fed targets a relatively high, or tight, rate when it wants to discourage some borrowing, slow the pace of economic growth, and ensure price stability (low and stable inflation).

According to Mankiw, the actual fed funds rate averaged 5.02% during August—23 basis points lower than the target—while in the preceding 13 months, the Fed had never allowed the actual rate to deviate from the target by more than 1 basis point. Although we can't be sure until the next Federal Open Market Committee (FOMC) meeting on Tuesday, September 18, the behavior of the actual rate in August seems to suggest that the Fed will cut the target federal funds rate to at least 5.0%. A rate cut would mean that the Fed is backing away from a tighter policy stance associated with reducing inflation, and moving instead toward a more neutral monetary policy that will allow it to wait and see how the recent subprime and housing-market turmoil plays out in the broader economy.

The prospect of a rate cut raises the issue of moral hazard. Some critics feel that any loosening by the Fed will bail out borrowers who have taken on risky subprime mortgages and investors who have purchased the assets backed by such mortgages. By cutting rates, the Fed may encourage borrowers, lenders, and investors to make similar gambles in the future on the assumption that the Fed will intervene if things turn sour. Tyler Cowen's latest New York Times column argues that while the Fed should not go out of its way to help poor decision makers, the Fed's mandate—price stability and full employment—should not be sacrificed for fear of instigating moral hazard.

Discussion Questions

1. If banks become increasingly reluctant to lend to one another and to individual borrowers, what will happen to the types of consumption and investment expenditures that are typically financed by borrowing?

2. If borrowing difficulties persist for an extended period of time, what would you expect to happen to housing prices? What about economic growth? How should the Fed respond to this type of credit crunch?

3. Consider the borrowers, lenders, and investors who made poor decisions in the subprime market. Will some of them benefit from an FOMC decision to cut rates? Can the Fed prevent all moral hazard associated with monetary policy decisions? Can Fed policy provide total relief to the borrowers, lenders, and investors who made poor decisions in the subprime markets?

Interest Rates and Inflation

The central bank of China has been combating surging inflation, which recorded an 11-year high of 6.5% last month. The inflation has contributed not only to the erosion of purchasing power, but also to negative real interest rates in China. Recall that

Real Interest Rate = Nominal Interest Rate – Inflation Rate

While nominal interest rates are never negative, real interest rates will be negative if the inflation rate exceeds nominal interest rates.

Interest rates play a dual role in the economy. On the one hand, they determine the interest payments banks make to depositors; on the other, they determine the interest payments borrowers make to banks. Since the interest rate is the return on deposits, negative real interest rates imply a loss of purchasing power if people deposit money into banks. This will discourage people from saving and encourage them to withdraw their funds for current consumption and investment.

At the same time, negative real interest rates mean that the cost of borrowing is low or even negative. Because of this, negative real interest rates can boost aggregate demand, or total spending, and fuel a bubble in the stock market. As observed by Dong Zhixin of China Daily, low interest rates have played an important role in fueling the Chinese stock market, with people withdrawing or borrowing from banks to buy stocks.

In August, the People’s Bank of China raised nominal interest rates for the fourth time this year in an effort to cool the economy. This will boost real interest rates and raise the cost of borrowing at any given inflation rate. The higher cost of borrowing will hopefully curb excessive spending and ultimately reduce inflation.

Discussion Questions

1. Is it possible or even desirable for the Chinese government to fine-tune the real interest rate by adjusting the nominal interest rate? Why?

2. China's currency, the yuan, is fixed to the U.S. dollar within a narrow band in the foreign exchange market. What impact do rising interest rates in China have on the exchange rate?

Principals and Agents

The theme of accountability is present in two important debates in Washington this week. On the international front, there are serious questions of how to deal with the lack of political progress in Iraq as Ambassador Crocker and General Petraeus testify before Congress. Likewise, in domestic policy, there's the equally serious question of how to deal with failing schools, as reauthorization of the No Child Left Behind Act (NCLB) of 2001 is debated in the Senate.

While these two issues are worlds apart in scope, the basic problem is the same. In economics, it's known as the principal-agent problem. Rather than looking at how individuals respond to the incentives of market prices, principal-agent theory looks at how "principals" (governments, employers, parents) can set up a system of incentives to encourage specific behavior from "agents" (citizens, workers, children).

Suppose you ran the U.S. government. You'd like to achieve academic success for students at home and real political progress for the Iraqi government. However, you cannot do these things alone: you can only provide incentives for students and teachers on the one hand, and for Iraqi leaders on the other.

So you set "benchmarks." For example, let's focus on the school scenario. The basic strategy of NCLB is that if a certain percentage of students at a school don't pass a standardized test, most of the teachers will be fired and replaced with new ones. This is meant to give teachers an additional incentive to make sure that all their pupils are learning.

The really difficult part comes when benchmarks are not met: when a school fails to meet the standards laid out by NCLB, or when the Iraqi government fails to reach the benchmarks set by the American government. What do you do then? Do you really follow through on your threat? What if you really believe that the teachers were working hard, or that the Iraqis just needed a little more time?

Discussion Questions

1. Think of a situation from your own life in which you wanted someone to do something and were in a position to provide them with incentives to do it. What incentives did you use? Did they work? Did the person do what you wanted?

2. Recent research by Derek Neal and Diane Whitmore Schanzenbach of the University of Chicago suggests that No Child Left Behind has an unintended consequence: "...the design of NCLB almost guarantees that the most academically disadvantaged children will not benefit from its implementation and may actually be harmed." Read the summary of their research. Do their results imply that NCLB should be rescinded? How might it be changed to provide better incentives?

3. Consider the problem of addiction. The main object of rehab and groups like Alcoholics Anonymous is to provide a system of incentives to break someone of addiction. But suppose someone returns to their addiction. What should be done then? Is there a strategic value to lenience when someone doesn't meet a benchmark?

U.S. Food Aid Practices: Help or Hindrance?

A recent article in the New York Times and a subsequent editorial suggest that U.S. food aid policies are good for American farmers and charitable nongovernmental organizations, but bad for the people in low-income countries the charitable groups aim to assist. How can this be the case?

For simplicity, let's assume that U.S. agricultural price subsidies take the form of price supports. The U.S. government effectively sets a price floor for certain agricultural commodities, such as crude soybean oil. At the guaranteed price, U.S. agribusinesses produce more soybean oil than consumers wish to purchase. The U.S. government purchases the excess supply and donates it to charitable organizations operating in low-income countries like Kenya. The charitable organizations then sell the surplus crude soybean oil in Kenyan markets in order to finance anti-poverty programs aimed at Kenyans.

The charitable organizations represent additional sellers in the Kenyan market for soybean oil. The supply of soybean oil in the Kenyan market rises, leading to a reduction in soybean oil prices. The lower price of soybean oil can impact local farmers in a couple of different ways. If a local farmer produces soybeans, the decrease in price obviously reduces her profit margin and directly lowers her income. However, the impact need not be so direct. A local farmer producing a substitute for soybean oil, such as sunflower seed oil, will see the demand for his product decline as well due to the decrease in soybean oil prices.

The result is the same—lower income for Kenyan farmers producing products that somehow compete with the subsidized commodities that the charitable groups sell to raise funds. Keep in mind that the percentage of the Kenyan population employed in agriculture is much higher than in the United States.

Discussion Questions

1. At worst, food aid programs like those described in the article lead to higher food product prices in the U.S. and lower incomes for people employed in the agricultural sectors of low-income countries. Considering how the costs and benefits of the programs accrue to different parties, why do you think such programs have met with little to no political resistance in the U.S.?

2. In what way does the current system of financing aid undermine the efforts of charitable organizations that teach farmers in low-income countries to use more productive agricultural methods?

3. CARE's decision to quit the business of selling surplus U.S. commodities to raise funds is a source of controversy among charitable operators in less-developed countries. Charities that continue to endorse the practice argue that they bring food price stability to low-income countries without compromising the ability of local farmers to earn income. Even if we assume this argument is correct, what can you say about the efficiency of the current system compared to a system where the U.S. government forgoes farm subsidies and passes the cash savings directly on to the charitable organizations that currently sell subsidized U.S. farm products abroad?

4. CARE has decided to stop accepting donations of food from the U.S. government altogether. But what if they just stopped selling it, and instead gave the food away for free? What would the effects of that policy be?

Financial Contagion in Credit Markets

The ongoing U.S. subprime credit crisis has received significant attention from the domestic media and even here on the Aplia Econ Blog. However, recent developments suggest that this credit crisis might be spreading to the rest of the world. Around the globe, a credit crunch is being felt in subprime markets, as well as in safer prime mortgages and leveraged lending. The World Bank defines financial contagion as "the cross-country transmission of shocks or... general cross-country spillover effects," but notes that the term is generally used to describe the spread of financial crises. Distress in one country's financial system can be "contagious" and spread to other countries whose interests are tied to the "sick" country.

When a financial crisis begins to take hold, the old saying goes that "cash is king," leading investors to sell off securities and flock from risky positions. The result is depressed stock prices, lower Treasury yields, and higher default spreads. Default, or credit, spreads are the additional premium investors require to hold a security based upon its default risk. According to the article, many carriers of the crisis "bug" are credit hedge funds that face rising leverage due to falling collateral values, illiquid markets, and tighter lending policies from brokers. Leverage exists when investors finance their investments with borrowed funds (debt).

The effect of financial contagion is stronger the more institutions and investors in different countries have vested interests in each other's financial markets. These interests may be direct equity or fixed-income investments, or they may be complex financial arrangements (which may or may not be collateralized), such as interest or exchange-rate swaps, or arbitrage portfolios designed to profit from market imprecision.

A famous illustration of the effects of financial contagion is the case of Long-Term Capital Management (LTCM), a hedge fund founded by bond guru John Meriwether whose board of directors included Nobel laureates Myron Scholes and Robert Merton. LTCM's fixed-income arbitrage strategies provided investors with astonishing returns over its first few years, until a series of unfortunate events in 1997 and 1998 crippled the fund. The collapse of the Thailand property market spread throughout east Asia, causing panic and massive selling as market volatility soared to record heights. LTCM believed it was properly hedged to weather the storm—as long as the Asian crisis was an isolated event. Unfortunately, it wasn't: in August 1998, Russia unexpectedly refused to honor its international debt, causing investors to flock toward liquidity in the U.S. Treasury market. The real effect of these crises was to cause investors to take cover from losses and to cause markets to behave in unprecedented ways.

Discussion Questions

1. Interest rates are supposed to reflect an investment's risk. Why is it, then, that in a financial crisis (like the current subprime fiasco), Treasury yields actually go down?

2. What might be a larger concern regarding contagion if it extends beyond financial markets?

3. Why does a financial crisis that causes depressed stock prices and asset values also cause investors' and institutions' leverage to increase?

4. The effect of leverage can be quite staggering, as seen in the case of LTCM, whose ratio of assets to liquid capital reached 30 to 1 in the middle of its meltdown. Suppose you run a hedge fund that leverages a $20 million equity investment into $100 million of managed assets. If poor market conditions cause your fund's managed assets to decline in value by 5%, the new value of managed assets becomes $95 million. But what is the percentage decline in value of your fund's equity position?

5. Drawing from the previous example, imagine now that your fund is even more leveraged, and the $100 million in assets is supported by only a $10 million equity position. Now what is the percentage decline in your fund's equity position due to a 5% decline in the fund's managed assets?

The Doctor Will See You Now. Seriously. Right Now.

Where smoothly functioning markets exist, they generally do an efficient job of answering the fundamental economic questions—what gets produced, how it gets produced, and who receives it. Not everyone will be happy with those answers, but there is efficiency in the sense that to make any person better off would require making at least one other person worse off.

Such grandiose notions of efficiency may seem quaint when you're waiting, say, two months for a doctor's appointment. The market does not allocate when each patient is seen by a doctor—that scheduling is done by someone in the doctor's office, or (shudder) a bureaucrat working for the government or an HMO. No wonder, then, that scheduling nightmares are common.

But even when markets cannot be brought in to answer questions—do you really want to have to bid to see a doctor in a timely manner?—other systems can be designed to achieve better efficiency. In a recent article in Slate, Marina Krakovsky discusses innovations in the way doctor's appointments are allocated among patients. In particular, a new system called "open access" or "same-day scheduling" reserves a large chunk of each doctor's time for patients who want to come in on the same day.

If you were just starting a medical practice, using this new system would be easy. But the transition from the old system, which was plagued by weeks of waiting, is difficult. In economic terms, it means switching from an inefficient equilibrium to an efficient equilibrium. What does this mean? Well, think about the normal supply and demand model: strong market forces pull the system toward the equilibrium where supply and demand intersect. Similarly, trying to shift away from an equilibrium in which patients wait for months in advance means overcoming powerful forces. It means working overtime for several months to work down the backlog, and potentially turning away patients that would otherwise have been seen.

Discussion Questions

1. Suppose you ran a small medical practice and read this article. How would you go about deciding whether the benefits of the new, more efficient system would be worth the cost of transitioning to that system?

2. In a blog post about this article, Joshua Gans points out that "the no-waiting equilibrium is also fragile unless you have sufficient slack in the system—that is, on average more slots available than there is demand. This is because if you have a bad day, that creates a backlog, and this can feed back on itself so that waiting times slowly increase." What kind of "slack" can medical practices build into their system? How could they go about finding the optimal amount of slack?

3. The discussion of shifting from a system with a backlog to one without a backlog is somewhat applicable to the case of Social Security. The way Social Security works is that employees pay Social Security taxes, which go directly to retirees; the money isn't saved for the employee's own retirement. Many people believe that it would be more efficient to have individuals own personal retirement accounts. As in the doctor's office example, though, this would entail massive transition costs—the equivalent of all doctors working overtime to reduce their wait times, but on a much larger scale. Even if we assume that it would be better for people to have personal retirement accounts, how could we measure the benefits of increased efficiency against the transition costs?