What can economics contribute to decisions on the further conduct of the war in Iraq? I set to one side all issues concerning the initiation of the war, the adequacy of intelligence and planning, the mistakes made in the conduct of the war since the invasion of Iraq in March 2003, and the costs that have already been incurred. (See Becker's and my postings of March 19, 2006, concerning the costs and benefits of the war up to that date.) All those are bygones and should not be allowed to influence current decision making. The correct perspective is an ex ante one.
Rational decision making has the general form of cost-benefit analysis. That is, one compares alternatives and picks the one that offers the greatest surplus of anticipated benefits over anticipated costs. This requires monetizing benefits and costs and discounting (multiplying) them by the probability that they would actually be realized if the particular alternative were chosen. The challenge to the application of cost-benefit analysis to the question of what the United States should do in Iraq lies in the difficulty of monetizing many of the relevant costs and benefits and of estimating the probabilities that they will be realized by particular courses of action that should be considered and thus compared.
An initial distinction should be drawn between monetized and monetizable costs. Our expenditures on military and civilian operations in Iraq are of course monetized, but not the deaths and injuries that our troops sustain. They are, however, monetizable. The greater the risk of death or injury, the higher the wage that is demanded to enlist or re-enlist. That wage premium (as discussed in my post of June 4 of this year), to the extent that it has risen as a result of the Iraq war, provides a basis for estimating the cost of anticipated deaths and injuries to our troops from continued involvement in Iraq. In effect, those costs are impounded in the wage premium. The very slow pace at which the army is being expanded is widely considered a sign of inefficiency, but an alternative possibility is that the expansion is being deliberately slowed out of concern that the wage premium necessary for a rapid expansion would be staggering.
Another important monetizable cost of the war is, if experience with the war in Vietnam is a reliable guide, the tendency to conceal the full costs of an unpopular war by deferring maintenance and replacement of equipment, drawing down reserve stocks of equipment and supplies, and cannibalizing spare parts from equipment not in use. There is also the present cost of long-run medical and disability benefits for the thousands of permanently injured veterans of the war. When the readily monetizable costs of the war are added to the monetized costs now running at some $140 billion a year, the total monetized and monetizable costs could be twice that amount.
There are also nonmonetizable costs, of course, such as the contribution that continuing the war makes to recruitment and training of Muslim extremists who may want to attack the United States either directly, or indirectly by destroying regimes friendly to the United States or by disrupting the production or transportation of Middle Eastern oil. The presence of U.S. troops anywhere in the Middle East apparently acts as a provocation to many Muslims. Against this it is argued by the Bush Administration that if we withdraw from Iraq, the terrorists who are attacking our troops there will as it were follow us to the United States. That is possible, but there are two contrary arguments. The first is that al Qaeda is Sunni, and if we leave Iraq the Sunnis there will find themselves hard pressed by the Shiites, who control the government; so al Qaeda may continue to be preoccupied with Iraq for years. Second, if our presence in Iraq endangers us by fostering recruitment and training of Islamic terrorists, it seems contradictory to claim that our absence would act as a similar provocation.
Another possible nonmonetizable cost is the boost to the terrorists that would be given by our acknowledging defeat in Iraq. Terrorist recruiters would argue that Islamic extremism was winning its global struggle with the West and that this was proof that God is on the side of the extremists. There is also a natural attraction to being on the winning team--the winning side in history. Again, though, there is an element of paradox in arguing that our invading Iraq was a provocation and that our withdrawing from Iraq would be an equal or (the position of the Administration) a greater provocation.
The cost most emphasized by the Administration is the possibility of chaos in Iraq if we leave--an intensified civil war with interventions by Iraq, Saudi Arabia, Turkey, and possibly other countries as well. Interventions by foreign countries in civil wars are common. Another possibility would be a partition of Iraq into Shiite, Sunni, and Kurdish states, on the model of the Yugoslav brakeup, which was accompanied by great violence. The United States would be blamed, and this might well increase Muslim hostility to the United States. Against this it can be argued, first, that withdrawal of U.S. troops might induce the contending factions in Iraq to settle their differences rather than inviting intervention by the neighboring countries, and, second, that whenever we leave, there will be anarchy in our wake because we are unprepared to commit the forces that would be required to pacify such a populous, violent, and fissiparous nation as Iraq.
If the nonmonetizable costs of continuing the war are ignored, either on the ground that the best guess is that they are likely to be a wash or that they are unquantifiable because no one can predict the consequences of our withdrawal, then the case for withdrawal becomes compelling: on one side would be costs probably in excess of $200 billion a year and on the other side no calculable or even probable benefits. Moreover, there are nonmonetizable costs to our continued involvement in Iraq, in particular the distraction of our government from other foreign policy problems and perhaps domestic problems as well.
The benefits of our staying in Iraq seem in current thinking to be limited to averting the costs I have mentioned. There is little expectation of a victory that would transform Iraq and the Middle East and weaken the terrorist threat to the United States.
An intermediate approach to valuing our continued involvement in Iraq would exploit the notion of option value, an important concept of decision theory. An option is a device for deferring a transaction until more is known about its value. We can think of the many billions of dollars that the United States is currently spending on the war in Iraq as the purchase of an option to delay a decision on whether to leave until we have more information about the likely consequences of leaving. That is a prudent course when potentially very large consequences cannot be evaluated at present but may be evaluatable in six months or a year. That seems to be the thinking of the Administration.
The objection is that there is no indication that waiting is producing any information. The optimal strategy for the strongest Iraqi factions, which is to say the Shiites and the Kurds, is simply to lie low until the United States withdraws. The Sunnis have less grounds for optimism concerning their position when the U.S. withdraws, and so they are showing signs of willingness to cooperate with us. But it is unclear how that willingness translates into a forecast of what the future holds for Iraq whether we withdraw in the near term or persist indefinitely. The Yugoslav precedent suggests that when the lid on a cauldron of smoldering ethnic hatred is lifted, civil war ensues. That process is already well under way in Iraq.
A critical variable that receives insufficient attention by the media is the condition of the Iraq armed forces and police. Is it improving? At what rate? What is the desertion rate from the armed forces (a very good measure of effectiveness)? The great failure in Vietnam was the failure to create a South Vietnamese security structure that could stand up against the North Vietnamese without U.S. aid. No matter how successful the United States is in suppressing violence in Iraq, our departure will be followed by collapse if we leave a security vacuum. Since the current emphasis appears to be on quelling violence rather than on creating a viable Iraqi security structure (which may be impossible), the option value of our continued involvement seems slight.
Costs are usually easier to measure in modern wars than benefits. Two estimates of the past and expected future cost of the Iraq war to the United States by Davis, Murphy, and Topel, and by Bilmes and Stiglitz are discussed in my blog entry for March 19, 2006. They quantity the cost of materials and equipment used and destroyed during the war, the higher cost of attracting volunteers to the American armed forces, the cost of the many injuries to military personnel, and the cost of reconstruction aid to Iraq. They also use modern economic research on the amounts necessary to compensate individuals for taking life-threatening risks to value the cost of the number of American lives lost in the war.
The cost estimated by these two studies differs to some extent, as analyzed in my post referred to above. However, a total cost of the war to Americans in the range of $700 billion- $1.2 trillion overlaps both studies. For the purposes of my discussion, I assume the total American cost of the war will amount to $1 trillion. As Posner well discusses, some potential costs are extremely difficult to quantify, and hence they are ignored by both these studies. Such hard to quantify costs include any increased alienation of Muslims toward the United States, the experience gained by the insurgents in fighting American military power, and a potential widespread conflict between Sunnis and Shiites.
Benefits of the war are even hardier to quantify than the costs. Possible benefits would include increased skill of the American armed forces at fighting insurgencies in cities that use suicide bombers, car bombs, and other modern tactics, preventing Saddam Hussein from using the international weapons black market to acquire weapons of mass destruction, perhaps a weakening of terrorist organizations like Al-Qadda, the stabilization of the Middle East, and possibly other benefits. Since difficulties in quantifying such benefits apply to other modern wars and also to many other large-scale activities, it might seem that benefit-cost analysis is useless when applied to these kinds of issues.
Obviously it would be much easier to assess wars and other big events if benefits also could be readily quantified; maybe that will become possible some day as economists continue to make progress in finding ways to quantify various intangible benefits and costs. I say, "continue" because not that long ago economist believed that the value of life to individuals was unquantifiable. Yet advances in the theory of risk-bearing showed how the statistical value of a life could be estimated from choices individuals make in situations that increase their probability of dying, such as driving fast, or working as civilians in war zones such as Baghdad.
Still, even without direct estimates of benefits, the costs estimated for the Iraq war can be used to make a benefit-cost assessment of the war. Given a cost of the Iraq war of say $1 trillion, how big would benefits from the war have to be to exceed this amount, and is that likely? For example, $1 trillion is equivalent to a payment of a little over $10,000 by every single American family, or about twenty per cent of average family income. Would the typical family be willing to pay that much to finance the war in Iraq because they believe that they will get at least that much in benefits from the war? Almost surely the answer would be an overwhelming "no" in any poll taken about Americans' willingness to pay this amount for the war, although some people might not appreciate some long term benefits (or costs), like a possible regional stabilization or serious harm to a terrorist organization.
The estimated cost of the war can be translated into other measures that may help in determining whether or not the war is considered a success or failure. For example, if the statistical value of life is taken to be $5 million for the average young American- this magnitude is in the center of various estimates of such a value- then a $1 trillion cost of the war is equivalent to a loss of 200,000 young men and women. Since this is far greater than the actual loss of lives even in most major wars, like the Vietnam war, it is hard to believe that Americans would be willing to pay that much for the Iraq war, even if Hussein had or was likely to acquire weapons of mass destruction. To be sure, a complete translation of the total cost into a lives-lost equivalent is extreme and possibly misleading, but it does provide a way of gauging the benefits necessary to justify the huge cost of the Iraqi war.
Individuals and groups support government regulation of energy use either because they are concerned about the negative effects of oil, gas, and other fossil fuels on the environment, or about the impact of demand for these fuels on national security. Prospects for political consensus on energy policies are dim for the many approaches that further one of these causes at the expense of the other.
Environmental-driven energy policies try to reduce pollution from cars, the generation of electric power, and other industrial and household activities. An obvious example is the current efforts to reduce CO2 emissions from the use of fossil fuels, especially oil and coal. National security energy policies may try to reduce the vulnerability of energy sources to hostile acts, such as interference with oil or gas imports, or to disruptions at the source, such as with Middle Eastern oil supplies, or the supply of natural gas from Russia. National security also depends on how much revenue is received by oil and gas producing countries that may support terrorism, or are vulnerable to potential takeover by terrorist organizations.
Many ways to make the supply of energy sources more reliable in order to promote national security conflict with the goal of reducing pollution from the use of energy in the economy. For example, China and the United States have abundant supplies of coal, and their further development and use would make the energy used by both countries less dependent on foreign supply. However, coal fired power plants emit large amounts of CO2 that are thought by many to be an important contributor to global warming. The burning of coal also contributes significantly to local pollution, mainly through the emission of sulphur dioxide gases. These local emissions can be greatly reduced through known technologies that involve installing expensive scrubbers that may not be used by poorer countries.
Some security specialists advocate that the United States shift more of its demand for oil and natural gas to friendly sources in the Western Hemisphere, such as Canada and Mexico, in order to reduce the vulnerability of its energy imports to hostile acts. Such a shift, however, would not improve the environmental impact of America's use of oil and gas, nor would it do anything to reduce the revenue from the sale of oil and gas by Middle Eastern and other potentially unfriendly states. For the world price of these fuels should not be affected by much, if at all, by shifts of U.S. demand to nearby friendly nations. Countries that would have bought oil and gas from say Canada and Mexico would now have to buy more of these fuels from Middle Eastern or other potentially unfriendly producers to make up for the shortfalls in available supply from these countries.
Fortunately, various governmental policies contribute to both environmental and national security goals. A tax on carbon emissions from business and household production would not only help reduce global warming-by how much is still controversial- but it would also lower the world prices of these fuels through reducing the demand for fossil fuels. Lower prices would cut the revenues received by Middle Eastern states from the sale of oil and natural gas. This is why a carbon tax receives support from many environmentalists and national security advocates.
Nuclear power also gets high marks on national security grounds (although as we will see, not necessarily on international security grounds) as well as on many environmental issues. Nuclear power is clean and does not emit CO2, SO2, or other gases that contribute to global or local pollution. Accidents and natural events that release radioactive materials from nuclear power plants are a risk, such as in the recent earthquake in Nigata prefecture in Northwestern Japan that caused a leak of apparently low level radiation from a nuclear power plant located there. But serious accidents have been very rare because so many precautions are taken in state of the art plants-the worse accident occurred at Cherynobyl in a plant that had minimal and primitive safety measures. Although safety is not much of an issue in nuclear power plants in economically advanced countries, it may well be for some of the many plants currently under construction in China and India.
The disposal of nuclear waste, either through reuse, or burial deeply in former mines or far under oceans, may also present major environmental challenges. Clearly, reuse of much of the waste is feasible-France, a major producer of nuclear power, reuses most of its waste. My conclusion from reading some of the literature on disposal is that safe burial is also feasible, especially for large countries like the United States and China, but that view is not universally accepted.
Nuclear power has many advantages on national security grounds. The supply of uranium, unlike oil, is widespread and abundant, and there is little risk that any single or small number of uranium producing countries can blackmail other countries by withholding supplies. The international security issues from nuclear power relate to countries that as yet do not have arsenals of nuclear weapons. If these countries develop nuclear power they will automatically generate the plutonium necessary to construct nuclear bombs. If some of that plutonium fell into the hands of rogue states or terrorist groups, the risk of possibly millions of deaths from nuclear attacks becomes scary.
Driven by environmental and security concerns, more extensive government intervention in the supply and demand for energy are to be expected during the next few years in all economically important countries. Policies that meet both these concerns are feasible, and clearly would have greater political support than the many approaches that advance one of these goals at the expense of the other.
I agree with Becker's excellent piece and have little to add. He is certainly correct that the political saleability of a carbon tax aimed at reducing carbon dioxide emissions that contribute significantly to global warming would be greatly enhanced by emphasizing the national-security benefits. That way both environmentalists, who tend to be liberals, and national-security hawks, who are almost always conservatives, might be induced to join in supporting such a tax.
It is an important detail to note that a carbon tax and a tax on gasoline or other fuels are not identical. A tax on gasoline would have a direct effect in reducing demand for oil, thus reducing, as Becker points out, the oil revenues of oil-producing nations. The tax would reduce demand, and since oil is produced with the usual upward-sloping supply curve, the price of oil is equal to the supply cost of the marginal output and thus generates enormous revenues for low-cost producers. But a gasoline tax would be inferior to a carbon tax from the standpoint of limiting global warming, because producers of oil, refiners of gasoline, and producers of cars and other products that burn fossil fuels would have no incentive to adopt processes that would reduce the amount of carbon dioxide emissions per barrel of oil, gallon of gasoline, etc. A carbon tax would create such an incentive and would also have a strong indirect negative effect on the demand for fossil fuels.
I would put greater weight on the environmental issue than on the national-security benefits of reduced demand for oil. I would thus be disinclined to encourage the substitution of coal for oil, as that would do nothing to reduce carbon-dioxide emissions though it would reduce our dependence on oil. If as I believe our greatest national-security threat is from terrorism, the benefits of reducing the world's demand for oil would be modest. The expense of terrorist attacks is small relative to the aggregate resources of countries that finance or permit their citizens to finance terrorism, and would still be small relative to those resources after the wealth of some of those countries declined somewhat as a result of a reduced worldwide demand for oil.
A separate concern is worldwide (and hence our) dependence on unstable sources of oil in countries like Venezuela, Iraq, Nigeria, Iran, and potentially Saudi Arabia. Coupled with growing demand for oil by China, India, and other developing countries, an uncertain supply could cause the price of oil to spike. That would not be altogether a bad thing because it would limit demand and thus reduce carbon dioxide emissions. Moreover, the spike would be a politically appealing occasion for the imposition of a stiff carbon tax that would reduce the revenues of the producing countries and (to the extent the tax did not reduce demand in the United States) transfer some of those revenues to the U.S. Treasury. The tax might not increase the price of oil to consumers significantly, because laid on top of the price spike it might so reduce the demand for oil that the cost of production fell steeply, assuming an inelastic supply.
A point Becker does not touch on is the importance of international cooperation to deal with environmental problems. Although the United States is about a quarter of the world's economy, even a 10 percent decline (at present unforeseeable) in our carbon-dioxide emissions and our burning of fossil fuels would have only a modest effect on global warming and on the overall demand for oil. Indeed the entire effect might be offset by soaring demand (and concomitant increases in carbon dioxide emissions) by China and other developing countries. There are very serious free-rider problems involved in reining in the use of fossil fuels by developing countries. Yet in other areas of global conflict, such as intellectual property (consuming countries in the developing world do not want to pay royalties to the producers of intellectual property), it has proved possible to overcome free-rider problems to a considerable extent through aggressive efforts to achieve international cooperation. The Administration seems not to have exerted such efforts with respect to environmental matters, and in national security too has generally preferred to go it alone.
The limits of unilateralism were underscored in an article in the Wall Street Journal on July 20 explaining how smog in San Francisco and Los Angeles is being exacerbated by enormous plumes of polluted air ("rivers of polluted air," the author called them) blown eastward over the Pacific Ocean from China. Of course we cannot order China to stop polluting. But there is much that China wants from us that we should be able to give the Chinese at relatively low cost in exchange for better environmental controls. One would like to see the Administration more active in this area, but one of the casualties of the war in Iraq is distraction from other urgent global problems.
The economist Robert H. Frank, in an article in the New York Times on July 5 entitled "A Career in Hedge Funds and the Price of Overcrowding," argues that the immense incomes of the most successful hedge-fund managers and private-equity entrepreneurs are drawing excessive resources into those activities. I believe that this is possible, but much less certain than Frank suggests.
An English economist named Arnold Plant argued long ago that patent and copyright laws could have the effect of attracting excessive resources into the production of patented or copyrighted products. The reason was that patent and copyright protection, by excluding competition, enables the patentee and the copyright holder to obtain monopoly profits. Equally productive activities in competitive markets would not generate such profits, and therefore resources would flow from them into the monopolized markets until the profits were equalized in the two sectors. From an overall efficiency standpoint resources would be flowing to a less socially valuable use; they would be socially more valuable in the competitive markets.
This problem is real (though it might of course be offset by the role of patent and copyright protection in enabling external benefits to be internalized) and is dramatized by the phenomenon of the "patent race." Suppose that for an investment of $1 million a product having a commercial value of $4 million can be invented and brought to market in three years, but that for an investment of $2 million it can be invented and brought to market in two years and eleven months. The extra month of output would be unlikely to have a value to society equal to or greater than the extra $1 million spent to get it to market a month sooner, yet if that investment would enable the investor to obtain a patent because he was the first to invent, it would yield him a net of $2 million ($4 million minus $2 million). The problem is not that the successful inventor obtains a return in excess of his cost; this is essential to motivate invention because of the risk of failure. The problem is that he may carry his investment beyond the point at which an additional dollar in investment would yield a dollar in additional value to society.
I am skeptical that the situation in the financial management market is the same. No doubt, as Frank argues, there are diminishing returns to financial management because there are only so many underexplored financial opportunities. But suppose, plausibly, that there is enormous uncertainty concerning the design and implementation of investment strategies. The higher the rewards for success, the more people (as Frank emphasizes) will be attracted to a career in financial management, and the likelier therefore that stars will emerge. If these winners create enormous social values, this may "pay" for the losers, who were lured by the prospect of becoming winners from alternative career prospects in which their social product would have been greater.
It is not like a race for buried treasure or to exhaust a coal mine or an oil field, because there is no fixed quantity of financial opportunities. New ones keep opening up all the time.
So it seems that Frank has really posed an empirical question rather than being able to offer (as he thinks he has done) a theoretical answer. One empirical dimension is the actual social value added of star financial managers. Here one might be tempted to distinguish between hedge funds, which invest but do not manage, and private equity firms, which restructure the companies they acquire in order to increase the companies' value. It is easier to see the contribution of restructuring to social value, and harder to see the contribution of trading in securities. But to the extent that hedge funds invest in new enterprises or buy stock or other securities issued by enterprises, they contribute directly to production. And even when just buying securities owned by investors rather than issued by companies to raise capital, hedge funds and other investment companies contribute to a more accurate valuation of securities, which plays a vital role in directing economic resources to their most valuable uses and users. A company whose stock price rises because investors have correctly determined it to be undervalued can raise capital at lower cost and thus attract resources to an activity in which the resources will be worth more than they are worth in their present use.
But there is no economic law that says that the reward of a financial manager is always equal to the contribution that his management makes to the efficiency of the economy. It may be much greater. This is most easily seen by supposing that luck plays a large role in investment success. Then a career in financial management might attract substantial resources (in the form mainly of the opportunity costs of the time of the financial managers) that produced private rather than social value--private value in the form of large rewards that were the product of luck rather than skill. That would support Frank's conclusion.
Frank points to overconfidence bias as a factor in attracting people to the hedge funds and private equity firms irrespective of the social value of such careers. That bias has been well documented, but so has a force that tugs in the opposite direction--risk aversion. Kenneth Arrow long ago argued that because of risk aversion, there is underinvestment in risky but socially productive activities; his example was innovation. Overconfidence bias, to the extent it offsets risk aversion, may actually improve economic efficiency, a possibility that Frank ignores.
Most people do not object if others make a fortune producing tangible products, such as Bill Gates' wealth from Microsoft, or the wealth Bill Marriott received from his hotel chain. There is much greater uneasiness about wealth that results from financial activities, such as that accruing to successful hedge fund and private equity managers. Financial-based wealth does not seem to many persons to be "earned" to the same extent as wealth based on a tangible product whose contribution to human needs is easily identified.
Although this differentiation between financial-based and product-based wealth is understandable, it is not justified. Hedge and private equity funds, and other modern asset management companies, provide a highly valuable service by discovering ways to separate, allocate, and manage risk. Developments in the theory of modern finance that began a half century ago made possible a sophisticated treatment of risk in ways that were unavailable even a few decades ago. Homeowners can hedge their housing risks with housing futures, companies can hedge their energy costs, and banks can originate mortgages and then sell them off to companies in aggregate mortgage packages that reduce and diversify the risk from slowdowns in regional or even national housing market. This diversification obviously did not prevent the collapse of the sub prime home lending market, but it did greatly reduce any overall fallout from this collapse.
That some hedge funds have spectacular failures, such as Long Term Capital, is regrettable, but is no different from the failure of a large company with tangible products, such as many large airlines or automobile companies. To be sure, the new skills at handling risk and aggregating large financial resources has contributed to some major excesses, such as the Internet stock bubble, or the too generous expansion of mortgages to families with bad credit risks. Yet, the modern management of risk has made home ownership available to many lower income families that would never have happened in the old system where mortgages were originated and then held by banks.
Robert Frank in the op-ed article discussed by Posner does not deny that hedge and private equity funds provide valuable services, but claims that an excessive number of rather talented persons are drawn in financial investing relative to the social worth of these activities. As Posner indicates, Frank relies on two arguments: the first is overconfidence on the part of individuals entering into hedge and equity funds that leads them to exaggerate how well they would do in this field relative to other fields. This overconfidence is a particular strong pull into financial management according to Frank because of the extremely high incomes that a few money managers make.
The problem with this explanation of the hedge fund industry is that such overconfidence should lead to lower average earnings among hedge fund and private equity fund managers than they can get elsewhere. All the available evidence that I am familiar with goes the other way. For example, starting salaries of MBAs who get jobs in hedge funds and other companies in the financial sector are quite a bit above, not below, what these same persons would get if they went to work in industry. The overcrowding hypothesis based on factors like overconfidence implies that they would start with lower salaries. Although we have much less evidence on this, the growth in earnings with experience also seems more rapid among those who went into managing money than graduates who chose other fields, although it is necessary to correct for possibly much lower earnings of those who drop out of a sector. However, I know of no evidence that this affects average earnings of those who pursue a financial career more than others.
Some hedge funds may earn more than they deserve because it is so difficult with a limited time series on asset returns to determine whether good performance in the past was due to superior skills or good luck. Lucky funds would end up with not only more assets but also with higher fees per dollars of assets than their true performance merits. Unlucky funds would be in the opposite situation. This does not necessarily raise the overall earnings of the average fund manager, but it may increase the inequality of earnings among managers that would affect which men and women get attracted into the industry.
Frank also claims that overcrowding arises because hedge and other equity funds poach on each others' opportunities. In effect, real resources are spent by funds in a socially unproductive way because they partly take opportunities away from others. This argument is not without some merit, but other considerations imply the opposite, that too few human resources go into fund management. Funds have continued to discover new ways of packaging risk and managing that add value to society, but the incentive to invest in such innovations is limited because many important discoveries are readily copied by other funds. It is not clear to me that the forces like this one that make for under entry into fund management are greater or lesser than those making for overinvestment. So it would be unwise to motivate the taxation and regulation of hedge and other equity funds under the assumption either that too many human resources have entered this industry, or that the industry needs special encouragement through the tax-regulatory mechanism.
Estimates suggest that intangible capital, which is mainly skilled employees, constitutes 70 per cent of the total capital of large American companies. Attracting and retaining skilled workers is the number one priority of these companies. The fundamental cause of the great emphasis being placed on talent is that production in modern economies is much more knowledge-intensive than production was in the past. This is because modern technologies and capital require abundant supplies of skilled workers to be effective. The competition for talent has raised earnings of skilled workers relative to other workers, and has led to an international search for the best and brightest.
When outsourcing of jobs to India (and other countries) began in earnest in the early 1990s, many software engineers and other highly skilled workers in India were available at wages much below those in the United States and Western Europe. Since the number of skilled workers in countries doing the outsourcing is large relative to the supply of underutilized workers in India, before long outsourcing absorbed all the available skilled workers in countries like India. As long as salaries of Indian workers benefiting from outsourcing were still far below those in America, the competition for these workers by American and Indian companies would be intense. This competition would push up the earnings of skilled Indian workers. Companies report that what they have to pay such skilled workers is rising rapidly: 10-15 per cent per year, and perhaps at much higher rates. The easier it is to outsource skilled jobs, and the closer is the substitution between work done in India and the United States, the larger would be the induced increase in salaries of skill workers in India from the growth in outsourcing. If Indian and American highly skilled employees were considered close substitutes by American companies, competition to employ the cheapest workers of a given quality would induce the salaries of such Indian workers to rise near parity with that of American workers of the same skills.
Of course, Indian and American workers are far from close substitutes because transportation and capital costs are cheaper to companies producing and selling in the American market. Hence outsourcing becomes uneconomic considerably before Indian and American salaries become equal. A front-page article in the Wall Street Journal several days ago indicated that a few high tech companies in Silicon Valley were closing their operations in India, and shifting them back to the United States. These companies lament that salaries of Indian technical employees are rising so rapidly that it has wiped out the advantage of staying in India.
Although outsourcing has certainly accelerated as well as reflected the international hunt for talent, outsourcing is not the only factor that has invigorated the talent market. Migration of skilled workers also is part of the competition across nations for talent. It has long been recognized that educated and skilled persons within a country move more easily than other workers to cities and regions that offer better paying and more attractive work and living conditions. This explains, for example, why earnings of college-educated persons in different parts of the United States are quite similar, much more so than the earnings of persons who did not go to college.
Movement of educated and skilled persons to places with better paying jobs operates across nations as well. Of course, international movement of people is blunted by the many restrictions imposed on immigration by richer nations. However, in their hunt for talent, countries have been making it easier for doctors, professors, and others with high tech and other skills to move legally across nations (although it may be easier for the less skilled to migrate illegally since they can work underground more readily). An increasing number of countries, such as Canada, Australia, and to a lesser extent the United States, have adopted point system for immigrants and passed various laws that offer skilled individuals work permits and permanent residency.
The international movement of talented workers has also greatly increased with the globalization of many companies. Global companies employ workers in different countries from very different backgrounds, and they have little hesitation to choose a president from say Scotland, a vice-president from France, or a head of the research department from India or China. Companies actively recruit skilled workers through H-1B and other programs designed to attract skilled workers, and they lobby for more generous programs that favor the immigration of skilled workers.
The supply of educated persons willing to move across countries has also increased considerably. Television and the Internet have homogenized cultures to a much greater extent than in the past. The decline in the cost of international air travel makes it much easier to return regularly to one's country of birth to visit family and old friends. Moreover, as the number of skilled immigrants from a country grows, other skilled immigrants from that country become more willing to emigrate since the new immigrants can expect to find friends and neighbors with similar backgrounds.
Technology and physical capital are complementary with skilled workers in the production process for most modern goods and services. Therefore, the growth during the past several decades in the international movement of capital and technologies through direct foreign investment in less developed countries has also contributed to the intense competition across countries for highly skilled workers.
"Outsourcing" is a form of vertical "de-integration." "Vertical integration" refers to the form of business structure in which a firm owns a supplier or distributor rather than buying (from the seller) and selling (to the distributor). Hierarchical direction within an organization is substituted for contracting for output. The tradeoff is between the agency costs involved in directing people‚Äôs work and the transaction costs involved in arms-length contracts. As markets grow, enabling greater specialization, there is a tendency to de-integration; vertical integration is attractive when the market for an input is so limited (maybe to just a single firm) that the supplier faces monopsony, which integration overcomes. Outsourcing is famously illustrated by IBM's decision to outsource the production of the operating systems for its computers to Microsoft; previously IBM made the operating systems itself.
As this example shows, there is nothing in the definition of outsourcing to connect it to foreign commerce. But the current anxiety about outsourcing focuses on the outsourcing of software development and other high-tech services to foreign nations, particularly India, and hardship to American skilled American workers whose jobs are outsourced.
Oddly, Americans who are opposed to free trade don't mind as much when Americans buy from foreigners as when they hire them, though the effect is the same. If Microsoft purchases software from an Indian company, the effect on American jobs is no different than if it hires Indian software engineers to work for Microsoft in India--or, for that matter, in the United States. If the latter arrangement is preferred, it makes no sense for Congress to make it difficult for American companies to hire highly skilled foreigners to work in the United States. In any event, the harder it is to obtain visas for highly skilled foreigners, the greater the incentive to outsource production to those highly skilled foreigners in their native lands. So restricting visas seems a futile measure for trying to protect American high-tech jobs.
The obvious difference between outsourcing and importing labor is that the foreign immigrants would command higher wages in the United States than in their native country. But they would also be more productive, because they would be working side by side with their American colleagues. Despite sophisticated video conferencing, face to face interactions are still considered highly important to productivity. It is the low wages in countries like India that makes outsourcing so attractive, but as Becker points out, U.S. and other foreign (foreign to India, that is) demand results in bidding up the wages of highly skilled Indians in India, which acts as a brake on outsourcing.
It could be argued that outsourcing high-tech jobs creates human capital in the outsource nations, like India, and that the result may be greater competition from the high-tech sectors in those nations in the future. A U.S. company might not take this effect of its outsourcing into account in deciding whether or how much to outsource, because of free-riding problems. Its forbearance to outsource would benefits its competitors, but it would not be compensated by their for conferring the benefit. If this is a concern, it argues for relaxing visa restrictions on high-tech foreigners, since once established in the United States they are unlikely to take the skills they learn here back to their native country. Some will, but most will rapidly become assimilated Americans. However, there would be no externality if the foreign workers in their outsource jobs pay for their own training in the form of accepting lower wages.
The costs of outsourcing are concentrated on Americans who lose their jobs or are paid less because of outsourcing to foreign countries, and the benefits, though they probably exceed the costs, are diffuse. The benefits in the form of consumer surplus and greater labor demand (but not necessarily in the jobs that are outsourced) in the United States as a result of the reduction in costs that the outsourcing firms experience as a result of outsourcing--if there were no net reduction in quality-adjusted costs, there would be no outsourcing. When the costs of a policy or practice are concentrated but the benefits diffuse, there is an asymmetry of political pressure, and this may explain the visa resterictions. But from a neutral standpoint of aggregate (and average) economic welfare, there is no compelling case for limiting outsourcing--or for stinginess in granting work permits to highly skilled foreigners.