Sunday, February 22nd, 2009

Chicago: Reconnecting the Hinterland 2A – Onshore Outsourcing

This the third installment of my four part series about ideas to create competitive advantage through reconnecting Chicago with its traditional greater Midwestern city-region. (Essential background reading is in Chicago: A Declaration of Independence. Part 1a is on Metropolitan Connections. Part 1b is on High Speed Rail).

To refresh, in my kickoff of the year of celebrating the 100th anniversary of the Burnham Plan in Chicago, I argued that while Chicago was performing well in a globalized world, it was only riding the wave of globalization and wasn’t defining its own uniquely successful future, one where it first and most fully grasped the implications of our new world. I also promised ideas on where to look to do that, starting with re-embracing its own unique culture and identity, resisting homogenization. My second idea was around re-engaging with the greater Midwest. It’s been widely noted that globalization has worked to separate global cities from their traditional city-regions. Indeed, Chicago and others have almost deliberately turned their back on their past in this manner to focus exclusively on the global conversation. With most global cities doing that, the question immediately comes to mind: is there overlooked opportunity in the hinterland?

There’s no doubt that globalization has hit the Midwest hard, putting a big dent in its traditional agricultural and manufacturing industries. What’s more, now services businesses are often made up of tradeable commodities that can be sent off shore too. This includes anything from answering phones to writing computer software to interpreting X-rays. We’ve seen the rise of agriculture in Brazil, IT and BPO in India, and manufacturing in China and to date the flow has largely been one way: from the United States and other high wage nations to low wage nations.

However, every action provokes a reaction. Any self-reinforcing trend like offshoring often contains within it the seeds of, if not its own destruction, at least structural weakness that leaves it vulnerable to competitors that figure out how to adapt to the new world. We’re already seeing signs of some slow down and indeed even occasional reversals of the offshore trend. I believe that there may be opportunities to leverage more onshore delivery of outsources services and that the Midwest is well positioned to take advantage of this. What’s more, if the structures emerge the right way, we could indeed see some possibility for competitive advantage for Chicago and its Midwest eco-system. Again, I’m not giving “The Answer” here, only exploring the problem and solution space.

Let’s put aside for the moment asking why people outsource, but restrict our inquiry only to why they do it offshore. One reason is access to talent. Countries like India have huge pools of highly skilled, highly educated workers. Access to that talent is important in certain industries. However, I think this has only limited applicability and that the bulk of the rationale for offshoring is based on labor and regulatory arbitrage.

The bottom line is that the Midwest is in competition with labor overseas that makes a fraction of the domestic rate. That problem is obvious. But the regulatory arbitrage point is less commonly thought about. As we got richer as a country, we were able to afford things that in previous generations might have been considered unobtainable luxuries: clean air and water, safe workplaces, protections from labor exploitation, ensuring that heavy industries and other uses don’t harm our neighborhoods. These have all brought enormous improvements in the environment of the United States and the quality of life that we have here.

The problem is that since there is greater global tradeability of goods and services, there is a choice between a highly regulated system like that of the United States and Europe and places like China, which is less the Far East than the Wild West. They want a freeway, airport or new building? Just sieze the land, kick out the current occupants, and build it. Belch fumes into the air and poison the water. Borderline enslave your workers in terrible conditions. Corruption is rampant. It’s easy to criticize these developing nations for doing this, though we should keep in mind that we ourselves did all of this during our industrialization and development phase.

All of our regulations have benefits, but also impose enormous costs. That’s to some extent ok when you are only competiting within the club of people with similar regulations, but when you are competing against people without the same regard for the benefits of regulation and thus don’t have them, this obviously puts the domestic market at a disadvantage. Again, it’s easy to criticize companies for doing this, but realistically they would soon find themselves out of business if they did not because of competitive pressures. Only laws restricting tradeability or some type of cartel or collusion could prevent this.

Ironically, as we’ve put in place rules to protect things we value, the result of it has been to push production to places with few if any rules, actually creating a net negative result. This has interesting moral dimensions. Is it right for us to effectively export huge amounts of pollution and labor exploitation to other countries simply because we aren’t willing to put up with slightly dirtier air here?

It’s an interesting question but not one I’m going to explore here. I will however point you at a must-read article in this quarter’s City Journal (the magazine of the center-right, free market think tank the Manhattan Institute). Harvard economist Ed Glaeser has another one of his masterworks. He calculates the carbon footpoint of various cities and cities versus suburbs. What he finds is that California cities have nearly the lowest carbon footprints out there. Part of that is due to favorable climate, but some of it to green policies. However, this same spirit leads them to put the nation’s toughest restrictions on development. This leads to the again the paradoxical result that pro-environment rules lead to an anti-environmental result because it forces development to places with higher carbon footprints. Per Glaeser, we should be building skyscrapers in California, not sprawl elsewhere. But watch residents rail against the “Manhattanization” of San Francisco. The fact is, to reduce carbon emissions, we should take a very pro-growth stance in a place like California. And we should be encouraging more urban growth generally since cities usualy have smaller carbon footprints than suburbs. (Interestingly, Chicago has a slightly higher carbon footprint than its suburbs).

I think a similar thing is at work in the outsourcing space. To create a better environmental result, we should be seeking to do more outsourcing close to home. This would also provide jobs at home. I believe that means having the courage to re-evaluate our regulatory systems. It is very clear that we can never and should never go back to the ways of the past. But we can definitely start taking a more realistic look at things and go forward with a pro-business mindset. Because if we want to do the right thing by the planet as a whole, we’d do more production at home where we know the worst abuses will be prevented.

Others suggest that we should seek to write environmental and labor rules into international trade agreements. While there may be scope for including some basic minimum conditions here, writing US level rules into trade agreements is simply the institution of non-tariff barriers to trade.

Let me be very clear on my own view, especially since I am very concerned about things like what globalization has done to our communities, the environment, worker rights, etc. Namely, I believe free trade is the best policy. The answer is not to cut off trade, which has enormous benefits for us as a society.

One serious problem is that few of the advocates for free market or new economy type economic policies ever make an argument about why it is good for the average joe. It’s always couched in purely theoretical terms, often by a smarmy, smart alecky guy in a suit on TV who talks a good game of creative destruction but doesn’t appear to have any concern that it will affect him personally. Similarly for things like “creative class” policies and talent acquisition strategies. It’s pretty clear they are great for the people who are pushing them, for the creative elite and others like them, but how does it benefit everyone else?

People without college degrees in rural areas, small manufacturing cities or are urban areas never seem to directly factor into these equations. And I’m here to tell you that there is serious desperation time going on out there for people in many of these places. I grew up in a rural community with no money. My Indianapolis residence is in a primarily low income area. I’ve seen it up close. I know that for many folks in these places things are tight even when times are good. And there are a lot of people right now on the brink of losing everything. This economy is only bringing into relief what’s been going on in slow motion in many communities for a really long time. So when I see people like that meltdown guy at the Merc on You Tube I want to punch him in the mouth. He’s Exhibit A in what I’m talking about. That guy has no idea what tough times are. And while many of the folks out there watching on TV at home may not be that highly educated, may not have refined food palates or sophisticated cultural tastes, I can tell you this, they ain’t dumb. Richard Longworth said it best in his book when he noted that they are well aware that globalization’s winners never spend a minute thinking about its losers.

Hey, the poor we will always have with us. There will always be individual winners and losers. We’re never going to have perfect society. But we’ve got to have a true American commonwealth, one where we all believe we are basically in this thing together, with prosperity broadly shared and costs broadly borne. I believe we are failing on both of those fronts, which is not a recipe for a stable society.

What’s desperately needed today is a new approach to policy and positioning. We’ve got to find a way to promote policies that are rooted in sound economics (e.g., free trade) yet are infused with a progressive ethos and a true, genuine passion for the welfare of the average and not so well off Americans, not just the elite. People who are able to think hard about the very real challenges we face to which we don’t have all the answers yet, and can make the case for good policy through how it affects a broad base positively in a more tangible and real way than we are doing now.

I’m inspired for this by 19th century social reformer Henry George. He’s best known for his belief in land value taxation. But he was also one of the most passionate defenders of free trade and free markets out there. His book Protection or Free Trade is still one of the all time greats on the topic. However, unlike the vast bulk of free traders, he defended it based on how it benefitted the common man, showing how almost all trade restrictions of his day mostly benefitted the wealthy and robber barons at the expense of everyone else. I also continue to be inspired by socialist Eugene V. Debs. I’m no socialist, but I can appreciate anyone who acts with such genuine regard uplifting the rank and file.

This doesn’t mean we have to avoid unpleasant facts. Far from it. We have to be willing to tell the truth and deliver bad news. The small town is probably not coming back. Small manufacturing cities that are hoping for the next Honda plant to arrive probably hope in vain. Many places need to shrink significantly and people have to be willing to move in search of economic opportunity.

But I also think that there’s scope to think of new ways to link these traditional labor forces to jobs in the new economy. That is the subject of this posting. And we have to make the case to people in a very tangible in real way they can connect to about why they should support it. Sorry for such a long warm up.

Going back to our offshore situation, labor arbitrage is a big part of the equation. However, low cost labor isn’t always what it is cracked up to be. For one thing, as there has been a great surge of offshoring, this has unsurprisingly raised market pay for many of the jobs in the target countries. We’ll see what the economy does, but double digit wage inflation is a fact of life. Also, especially for many entry level type tasks in the BPO world such as call centers, finance and accounting processing, etc., we see in an offshore environment that despite cheap labor, there continue to be significant non-labor costs such as buildings. And there are a ton of intangible costs such as currency risk to manage, time zone challenges and the strain that puts on workers, uncertain political and legal environments, poor infrastructure, the high cost of physical transportation or telecommunications, the high cost of travel, etc. Add them up and these are substantial. So a domestic operation competiting in this environment does not need to pay the exact same wages to win the work. If it can eliminate many of these other costs and risks, it might be able to get away with paying a bit more for people.

Indeed, we are already seeing some pull back on offshoring, especially in the call center space. I’m sure some of this is a bit of cultural bias, but clearly the language issue and the fact that the people answering the phones sometimes don’t have any personal experience with the products and services they are supporting makes this legitimately frustrating. I know that both AT&T and Dell have pulled some call center ops back onshore for example. Also, I’ve seen other examples. IBM recently announced a center in Dubuque, Iowa that will employ 1,300 people, for example.

I believe the Midwest is well positioned to compete for these type of operations, particularly in the BPO space. Why? Low labor costs and low costs of doing business. While I don’t believe that the Midwest will ever be able to compete purely a race to the bottom in costs, clearly its relative position domestically here is a good thing. There are lots of places in the Midwest like Dubuque where people have deep roots and want to stay and so will probably be willing to work for relatively less pay if it means they don’t have to move. Let’s not overstate the case, since the South is also very cheap, indeed cheaper in some respects. But it certainly puts the Midwest in the game.

If I were a Midwest state, one of the strategies I would be working on is how to focus on luring BPO processing centers. Indeed, this might be one area for pan-Midwest collaboration in marketing the region as they place to do outsourcing on a domestic basis.

You might be wondering by now where Chicago fits into all this. The answer is that I believe that there may be opportunity for Chicago’s companies to take advantage of that re-created hierarchical subdivion of labor that I talked about in part one and extend it to the next level. This exploits one of the interesting things about Chicago, namely that the “cost gradient” plunges dramatically at the end of the Chicago metro area.

I would be interested in seeing academic research modeled on central place theory that tracked the cost of living, wages, cost of doing business or some other interesting metrics in various radiuses around the central point of various cities. This could be mapped into a 3D topology like one of Richard Florida’s “spike charts”. My hypothesis that I’d like to test is that Chicago has an extremely steep slope to this, and that indeed, once you hit the edge of the metro region, cost falls of the cliff. Where else can you go from relatively pricey (though still not bad compared to the coasts) operations in one of the world’s most elite global cities (Chicago) to the least expensive major city in America to live (Indianapolis) in just three hours by car? If there are some tasks to which there is some level of intermediate benefit between total face to face and total virtualization, then this cost gradient could be a source of competitive advantage for business in Chicago.

I will give one example. There is a Fortune 500 company in Chicago that has long maintained an F&A operations center in Danville, Illinois. This center provides very needed jobs for that community as well as allowing the company to operate at extremely competitive rates. (Presumably they would have offshored it by now if not). Danville is 2.5 hours from Chicago. This lets Chicago based and ops-center based management shuttle back and forth regulary at very low cost and low investment of time. It’s an easy day trip. So you get some of the benefits of the face to face interaction, such as in person relationship building and knowing first hand how things work while maintaining cost competitiveness. And your operations are time zone advantaged, there’s no currency risk, etc. A possible win-win for the Midwest?

Again, it’s a hypothesis to test and an idea to try, but not a guarantee. I can see why it has some prima facie reason for success however.

What I described was what you might call a “two tier” model, with a Chicago hub and a satellite elsewhere. I can see some of this, but it is probably restricted to places within 3.5 to 4 hours drive. Another model is what I call the “three tier” model, and involves extending the hierarchical subdivision I talked about earlier to another level.

The idea I gave was in legal services where a Chicago firm would take the lead and do the orchestration and most complex work, while regional firms in Milwaukee or Indianapolis handled some more routine components of the work at a much lower price point, enabling the combined team to offer a lower blended rate to the client. This generalizes to “most high value, complex work in the Chicago Loop where the high costs are justified; lower-value but still work requiring significant creativity and skill done in a secondary market; with face to face interaction providing advantages and enabled by high speed rail.” The high speed rail part is conceivably secondary for Milwaukee and Indy, where day trips by car are feasibly if unpleasant, but it is probably a requirement elsewhere unless air service radically changes.

The extension of the model goes something like this. You add in a BPO center in a smaller satellite city within commute distance of the secondary city like Milwaukee or Indy. This could either be directly a two-tier arragement with that city, or part of a three tier arrangement with Chicago.

Again, I’ll use Indianapolis as an example. It’s conveniently ringed with small manfacturing cities that are hurting but are nevertheless within commuting distance. Imagine a company based in Chicago or with a Midwest HQ there. It also has an Indianapolis operation that services the local Indiana market and also does some of the high skill but lower value added work I mentioned previously. And there is some type of BPO operation – call center, HR, F&A, etc – in, say, Anderson, a small manufacturing city that has been hard it by the decline of the auto industry.

Now, Anderson is a very low cost place to do business. There are a lot of people who live there and love it and don’t want to leave. So the jobs would be welcome. However, some of the management positions might involve recruiting people from outside the community with specialized skills. As we know, people with that profile today more often prefer a major urban environment, which is why we see such differentials in educational attainment between these types of places. The beauty of Anderson, however, is that these management recruits can easily live in suburban Fishers or even the city of Indianapolis and commute to Anderson. Indeed, I know people who do it today. This gives Anderson an ability to tap into that management talent for the facility in a way that a more remote city far from a metro area would not. I saw previously some comments from leaders in Anderson that they were unhappy that some employees at a new local Nestle plant had chosen to live in Fishers. But the proximity to Fishers is a source of advantage, not of loss. Anderson can potentially attract employers partially because the workers have access to a more suburban environment if that is what they want. It broadens the potential labor pool and makes Anderson more attractive as a location.

So now you’ve got your HQ and top value added in Chicago. You’ve got secondary ops in Indy. And tertiary ops in Anderson. People can regularly travel back and forth between Indy and Chicago (via HSR, plane, or car) for the important face to face interaction. Plus, the Indy office can oversee the BPO operations in Anderson, and provide the urban environment that allows you to recruit specialized management talent to that facility. The BPO center management can travel to or stay in Indy easily to meet with people from the HQ operation. So it is very easy for people for all three people to get together in person at low cost.

If, and this is a big if, that geographic proximity and potential for frequent but not daily face to face interaction means something, this could give Chicago a competitive advantage through a cost structure, access to talent, and organizational simplification that you can’t get elsewhere. Plus, of course, Indy and Anderson both benefit too. That’s the key, to me, and why I would love to be able to see something like this work. It links the fortunes of the knowledge workers in the global city of Chicago with those of the knowledge workers in the regional city of Indianapolis and the people working in BPO centers in Anderson.

This is the linkage we need to be able to draw for people. Even without this hierarchical relationship, we can give some examples. I will pick one. Medco is locating America’s largest mail order pharmacy facility in Whitestown, Indiana outside of Indianapolis. Why did this company locate there? Two reasons were cited in the paper as to why Indy got the facility. One was it’s ability to accommodate the required regulatory changes rapidly. Two was the fact that Medco thought Indianapolis wasn’t just a cheap place to locate, but had a fun downtown where Medco could bring customers and entertain them at night after giving them tours of the facility during the day.

If you think about an operation like Medco, it will employ a lot of six figure pharamcists. You need to be in a major metro for that. But for every pharmacist, there are also lots of other technician jobs that carry decent wages but are accessible to people with a basic education. The pharamcists in Whitestown might mostly choose to live in Boone County or closer into the city. But I can see the technician jobs – and shipping/receiving and other jobs – appealing to people in a broad radius of the facility, often into areas where people need work badly.

That’s the link – and why it is important not just for the fortunate few but for the whole greater Central Indiana community that the Indianapolis life sciences strategy succeed, that the city succeed in luring the highly educated, and that the urban core prosper. Many people see swanky steakhouses downtown and wonder why the ability to wine and dine fat cat corporate executives is important. Well, if you are a single mother with a high school education in Clinton County and can get a good job as a technician at Medco, it matters to you. Now clearly Medco will be a highly automated facility and I don’t know how many non-pharmacist jobs there will be. But with a reported average salary of $53,000, that’s probably a leverage ratio of 3 or 4 to one.

Now of course none of this might work in real life. I’m just thinking out loud and throwing out ideas. However, it is notable that Business Week magazine just listed Indianapolis as one of 21 hot spots for outsourcing, one of only ten in the Americas, along with places like Curitiba and Buenos Aires.

So how would we action this? Good question. One way would be for various Chicago corporate networking or trade associations to hold discussions on the possibilities with their counterparts in secondary markets, academics, and economic development people from the states. Yes, this might be one of those conferences I like to make fun of at times. Explore the issue and see if there is a way to make it work. One way for states to promote it is through requiring “offsets” as part of government contracts that focus on this area. Indiana again provides an example here. When the state privatized FSSA operations, IBM agreed to create a 500 person call center in Delaware County.

Again, to me the real advantage somes not from just having some centers here and there with jobs because the Midwest is cheap. It is about exploiting the cost gradient and finding niches where you can have jobs that aren’t in the Loop, but nevertheless benefit from frequent though not daily face to face interaction. The potential for using high speed rail to enable this is an interesting thought, but potentially it could work for closer in places like Milwaukee and Indianapolis without it. The idea is to create a structural competitive advantage through exploiting this for Chicago and its “ecosystem” of nearby cities in a reinvigorated hierarchical subdivision of work.

As always, I welcome your reactions. My goal is to provoke thought and discussion.

My final installment will focus on one of the interesting implications of labor arbitrage as a value creation strategy and how it opens the door for a competitive response based on innovation.

11 Comments
Topics: Economic Development, Public Policy, Strategic Planning
Cities: Chicago, Indianapolis, Milwaukee

11 Responses to “Chicago: Reconnecting the Hinterland 2A – Onshore Outsourcing”

  1. Alon Levy says:

    First, the Glaeser study is misleading, because it only considers highway and residential emissions. The article says they account for “1.2 billion tons of carbon dioxide emissions each year, out of total U.S. emissions of 6 billion tons. So these sources together reflect about 40 percent [sic] of America’s carbon footprint.” Since 1.2/6 = 20%, what Glaeser says applies to only a small fraction of US emissions.

    Second, the conditions you describe in the third world, where the government just evicts people whenever it wants to build things, aren’t very common outside China. Even within China, the government has been doing it less and less ever since Hu took over from Jiang and the Shanghai boosters.

  2. thundermutt says:

    Aaron, this is an excellent post.

    These concepts seem to have their best application in two worlds: management consultantcy and LEDOs in the region. Alas, the LEDO guys are all busy chasing gazelles and/or trying to hit home runs (Medco, Nestle, Honda, etc.). I view your concepts as more a “hit a lot of singles” strategy for economic development.

    So…who’s going to get these ideas in front of corporate strategy consultants?

  3. cwk says:

    Some companies are starting to think this way. I don’t know if you’re familiar with Lifeline Datacenters (they bought the old Eastgate Mall), but they’re trying to market themselves as a cheaper datacenter to Chicago-based companies. Makes sense. Your high-value programmers and so forth can certainly work remotely from Chicago, and you can pay Lifeline a lot less money to have a tech go replace a hard drive than what that tech would cost you in Chicago, while still letting you maintain some physical proximity to your servers.

    There’s a lot of untapped potential here. Chicago-based firms can gain a competitive advantage being so close to cheaper talent pools. Where can a NYC or SF based company go that’s as close and as cheap?

  4. CoryWilson says:

    Terrific post. One of the better recently (not that the others suck).

    I wonder who this person is you know that commutes from Indy to Anderson…hmmmmm?

  5. Boofer says:

    This is a very interesting and somewhat brave concept. The politicos and econ-dev folks are always touting that Our City Can Be A World-Class Hub for (insert industry here). It takes some guts and a down-to-earth perspective for someone in power to look at his/her city and say “look – we aren’t going to be Chicago. We’ll always play second fiddle to Chicago. But let’s play second fiddle all the way to the bank.” The question becomes – how to move the debate away from grandiose plans to be The Greatest Hub In The World For Industry X to one more focused on the specific strengths of the local economy. How do we get people in power to set realistic, achievable goals and stop promising the world?

  6. thundermutt says:

    That might actually be a strength of Indianapolis’ current mayor. Unfortunately, he gets banged a lot for lacking “vision” (i.e. grandiose plans).

  7. Anon 7:41 says:

    In your mention of a Shared Commonwealth, two things came to mind:

    The Frontier Thesis
    and

    Enclosure/ The Inclosure Acts

    wiki:

    http://en.wikipedia.org/wiki/Frontier_thesis
    http://en.wikipedia.org/wiki/Enclosure

  8. The Urbanophile says:

    cwk, that’s a great example of what I’m talking about. The tech space is one area it is feasible, but probably only in major moetr proper. And the size of the skill base will limit what can be done there for a while, but that can inflate over time.

  9. The Urbanophile says:

    Boofer, thanks for the note. One thing I’d like to be clear on is that I’m not suggesting any cities abandon what they are doing today in the econdev space. Everything here is in addition to current efforts. A place like Indy is probably no worse positioned than Chicago in industries like life sciences or logistics. However, what this approach does is let you tap into other things that maybe you couldn’t do before in a more powerful way.

    Cory, thanks for serving as blog fodder.

  10. The Urbanophile says:

    anon 6:41, thanks for the links. There’s probably something to what you say. It’s notable that Henry George lived at the time of the closing of the American frontier. There is no doubt this shaped his thinking, since prior to that era any American who wanted it could more or less get free land on the frontier provided he was willing to live there and farm it.

  11. thundermutt says:

    Indy as IT outsource center

    See: http://newstalk.ibj.com/blogshell.asp?p=292

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