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2007 Annual Report—Federal Reserve Bank of DallasOpportunity Knocks: Selling Our Services to the World
Globalization may require us to revise our operating manuals, but we do ourselves a disservice when we accentuate the negative. An increasingly integrated world economy promotes efficient production, lowers costs, speeds growth and fosters better economic policies. It gives U.S. consumers more access to foreign products and U.S. producers more access to foreign consumers. Therein lies one of the dangers in the downbeat view: It ignores the opportunity globalization offers America to sell our services to the world. Over the past century, the U.S. has developed a deep, diverse pool of skilled, productive and well-paid service providers. They're part of a sprawling service sector—fully four-fifths of our economy—that incorporates skills and talents honed in the highly competitive U.S. market. We're world-class providers of financial, legal, medical, construction and industrial engineering services. We excel in supplying entertainment, education and information management. We lead in telecommunications, management and consulting, travel services and tourism. Thanks to fundamental shifts in the global marketplace, America's services expertise can now exert itself worldwide. The Internet, satellites and fiber-optic transmission lines have bound economies together by making it cheaper and easier to collect, process and distribute information, a key component in supplying sophisticated services. Many services, once limited to domestic markets, now trade internationally. These new technologies have arrived at a time of explosive growth in global demand. In the past two decades, China, India and other big, fast-growing countries have thrown open their economies, giving the rest of the world billions of potential new customers. As these emerging nations grow richer in coming decades, they'll spend more of their incomes on the kinds of services U.S. companies can deliver. We hear a lot about American businesses and workers facing growing competition from low-cost rivals around the world—call center operators in the Philippines, computer programmers in China, accountants in India, back-office workers in Brazil. We hear little about U.S. service companies that create jobs and grow profits by expanding their businesses overseas. Yet examples are everywhere. Foreign audiences accounted for almost 60 percent of Hollywood's box-office revenues from movies released in 2007. McDonald's and KFC serve fast food at more stores abroad than here at home. A quarter of the lawyers at the 15 largest U.S.-based firms work in foreign outposts. U.S. architects design office towers, airports and stadiums in China, Dubai, Canada and other foreign locales. American forensic experts investigate accidents and crimes around the globe. Our programmers create video games, our professors teach classes, our financial advisors manage money—for both foreign and domestic customers. Services are often dismissed as the province of dead-end jobs and low wages. Nothing could be more wrong. Many of our service workers are well-educated, commanding high pay because of their ability to add value to what they produce. Our economy's transition to services has brought higher incomes and better jobs, making this sector our best hope for prospering in the era of globalization. Opportunity knocks. The U.S. has been sharpening its service skills for decades. We have what it takes to be a world-beater in the services that provide well-paying jobs. Opening the door to the expansion in services trade will lead to faster economic growth and rising incomes. Turning away from globalization's call risks squandering a golden opportunity. Services AscendantA century and a half ago, German economist Ernst Engel documented the differences in how poor and rich families spend their money. Those with low incomes tend to allocate relatively more to basic needs—food, clothing and shelter. Higher-income consumers spend more on entertainment, travel, personal care and other wants.
Engel's observations are fundamental and still hold today. Demand grows slower than income for needs and faster than income for wants. Economists analyze spending patterns with a concept called income elasticity of demand—the growth in demand relative to the growth in income. Elasticities below 0 indicate inferior goods and services. Spending on them declines as income rises. Intercity bus service is one example, but inferior goods and services are rare. Necessities have elasticities of 0 to 1 because consumption increases more slowly than income. Demand grows faster than income for superior goods, which have elasticities above 1. Using economists James Seale, Anita Regmi and Jason Bernstein's work on world consumption patterns, we calculated 2006 elasticities for nine categories of goods and services in 116 countries. Demand patterns change markedly from low-income countries to higher income ones (Exhibit 1 Start with the most basic item—food, a necessity for most countries but an inferior good for a few. For each 10 percent increase in income, spending on food for home consumption rises 6.1 percent in China and 7.1 percent in India. In the U.S., spending drops 1.1 percent, partly because Americans eat out more as their earnings rise. Clothing and footwear are necessities, but poor and rich countries have roughly the same elasticities. The measures decline only slightly—from 0.93 in Madagascar, where per capita income averages less than $1,000 a year, to 0.90 in far wealthier nations, such as Japan and Canada. As incomes move up from low levels, spending on housing and utilities rises sharply at first, then more slowly as consumers shift to other goods and services. Elasticities fall from a high of 1.34 at the lowest income levels to 1.15 for nations like Norway, where per capita income averages $40,000 a year. A nearly identical pattern is found for other household operations, a category that includes expenditures on furnishings and maintenance. The richer families become, the larger the portion of their budget spent on medicine and health care, with some of the money paying for elective procedures. For every 10 percent increase in income, medical spending goes up 13.4 percent in Brazil, 13.1 in Russia and 12.3 in Australia. In the poorest nations, the increase is 24 percent.
The data for the 116 countries don't allow us to separate communications and transportation. Looking at spending patterns for U.S. consumers only, however, we find relatively high elasticities for cell phone service and air travel. This suggests the category's overall elasticity is probably being pulled up by the services it embodies. Recreation spending exhibits the highest elasticity at all income levels , indicating households worldwide are especially eager to consume more of it. The types of recreation, of course, vary along the income scale—from buying playing cards and dominoes in poor countries, to attending soccer games in developing nations, to enjoying Broadway plays in the U.S. In many poor households, children drop out of school to work. As families earn more money, they can afford to allow their children more years in the classroom. Education is a superior good, with income elasticities that range from 1.07 to 1.09, not as high as the medical, recreation and communications categories. Education is a priority because it holds the key to higher incomes, but its measured elasticity may be held down because spending decisions are often made by governments, not households. Consumption rises faster than income for the catchall category “other.” Made up largely of services not captured elsewhere, it includes lawyers drafting wills, CPAs filing tax returns and geeks fixing computers. The category also covers many of the personal services consumers regularly use—from haircuts to dry cleaning. Overall, services exhibit a high degree of income elasticity. Countries with rising per capita incomes will likely follow the path trod by U.S. consumers and allot a growing portion of their spending to services. Wealthier households will want more food, energy and factory goods, but global demand will gradually skew toward maids, hairdressers, entertainers, insurance agents, financial advisors, doctors and other service providers. Increased consumption of services is a hallmark of societies growing richer (Exhibit 2 Per capita incomes have been rising in many countries—Spain and Poland in Europe, Brazil and Chile in South America, Thailand and Vietnam in East Asia. Their demand for services will continue to increase, but China and India may be the biggest potential consumers. Although still poor by U.S. standards, these two nations have moved up rapidly in recent years. Combined, they have 2.4 billion people—eight times the U.S. population—and they, too, will want even more services. The emerging giants we sometimes fear may offer our greatest opportunity. With its large population and fast growth, China will contribute more to the rise in global demand than any other country in 2008. The nation's spending increases alone should reach $151 billion for communications and transportation, $116 billion for medical services, $87 billion for education and $79 billion for recreation (Exhibit 3 India won't match the incremental demand from China and the U.S., but it should add $37 billion for communications and transportation, $25 billion for medical services, $24 billion for education and $16 billion for recreation. Spending increases will become even larger as China and India continue to grow. A big chunk of this demand will no doubt be filled by domestic service providers, but consumers and businesses in China, India and elsewhere will also shop the world market. This will mean potential new business for companies that deliver quality and value in services exports—business for the U.S. and, yes, for other countries as well. In 2006, our largest markets for services exports were countries with long-standing economic ties to the U.S.—the United Kingdom, Japan, Canada, Mexico and Germany. American companies have had decades to build up business in these markets, and our services exports to them are still growing (Exhibit 4 China and India, largely closed to outsiders before market-friendly reforms in the 1980s and '90s, have been the fastest growing markets for U.S. services exports in the past 15 years. Sales to China are up 500 percent and to India, 450 percent. By 2006, China was already among the top 10 U.S. export markets in eight service categories—freight; port services; management, consulting and public relations; legal services; construction, engineering, architectural and mining services; equipment installation and maintenance; operational leasing; and other business and professional services. India joined China in the top 10 in construction, engineering, architectural and mining services, and other business and professional services, plus it ranked high in travel and passenger transport. India was first and China second in using U.S. educational services. Our Services EdgeThe price of services relative to goods has more than doubled since returning veterans set off on a spending spree after World War II. We've been willing to pay more for services because our incomes have risen, services elasticities are high and the quality of services has improved relative to goods. It wasn't until the early 1980s, however, that prices for services exports started gaining on goods (Exhibit 5
Services differ from goods in fundamental ways. Most goods can be mass-produced, crated, warehoused and shipped; production and consumption may be widely separated in time and space. They're easily traded, even over long distances. Most services, on the other hand, are created for specific customers, delivered directly to them and consumed when produced. They were difficult to trade until technology reduced the barriers imposed by distance. Goods still account for the bulk of U.S. exports, but services have gained ground, rising from 19.6 percent of total exports in 1980 to 29.8 percent in 2007 (Exhibit 6 Breaking it down by industry, we find U.S. services exports exceeded imports in 15 of the 20 categories tracked by the Commerce Department—often by a large margin (Exhibit 7
Media reports have focused on Americans traveling abroad in search of affordable health care, but foreigners spent 10 times more on U.S. medical services than we spent overseas in 2006. The United States leads the world in medical research, helping doctors and hospitals offer patients advanced care they may be unable to find in their home countries. Foreigners are employing U.S. firms for infrastructure and exploration projects. In construction, engineering, architectural and mining services, our exports were nearly 10 times our imports. The next largest U.S. export-to-import ratios were in database and other information services and installation, repair and maintenance of equipment. U.S. experts are being hired to make foreign companies more efficient. Our law firms have polished their skills in a highly sophisticated legal system. This wealth of talent helped give the U.S. a 5 to 1 edge in legal services. Our industrial might began making us rich more than a century ago, providing an impetus for developing the financial expertise needed to manage the money. This legacy explains why our financial services exports were four times imports in 2006. Many American colleges and universities rank among the best in the world. The educational services we sell foreigners are three times greater than what we buy abroad. U.S. companies have developed a deep reservoir of profitable copyrights and patents. Taking this intellectual property to the global marketplace earns them royalties and licensing fees. What we receive from foreigners exceeds what we pay to other countries by better than 2 to 1. The U.S. ran a slight services surplus in travel and tourism, the largest service category in international trade. Our exports also exceeded imports in port services, telecommunications, computer and data processing, and management, consulting and public relations. We ran significant trade deficits in just two categories of services—freight and insurance. We had smaller deficits in three other areas—passenger fares, advertising, and research, development and testing. Broad trade patterns show the U.S. is globally competitive in a wide range of industries that employ skilled services professionals capable of complex and sophisticated work. The services we trade involve embedded knowledge. We're more likely to sell foreigners cancer treatments than cold remedies, merger and acquisition advice than patent searches, computer system design than basic programming. Exporting KnowledgeSome of Americans' anxiety over globalization arises from a gut-level question: How will we maintain our high standard of living in this new economic environment? Services exports are a big part of the answer. China, India and other low-wage nations compete at the low end of services trade with call centers, back-office operations and the like. U.S. service exporters do business at the other end of the skills spectrum. We provide high-value-added services—those worth more to customers because they embody the skills and talents of highly educated professionals. Workers who add the most value earn the highest incomes. The United States has been expanding its value-added production for generations—within jobs, firms and industries, and across the economy as a whole. Farms have shifted from labor- to capital-intensive production. Factories have moved from making textiles and toys to producing aircraft, pharmaceuticals and microchips. The services hierarchy isn't any different. It started with seamstresses, launderers, clerks, telephone operators and low-end personal services and steadily climbed upward to jobs as medical specialists, forensic accountants, industrial psychologists and environmental architects. At the macroeconomic level, agriculture gave way to the growth of industry; in time, industry has given way to the expansion of services. This pattern has been repeated in most other nations as income growth shifts consumer demand and the relative quality of services improves. Nations with 30 percent or more of their labor in agriculture usually have incomes below $6,000 a year (Exhibit 8, top
Growth tends to reach a natural limit as industry approaches 30 percent of employment. Above that, the share of jobs in industry falls as incomes rise. In the United States, manufacturing, mining and construction jobs topped out at a third of employment in the early 1950s and have ebbed ever since, falling below 20 percent. Labor resources no longer needed by industry find their way into services. Per capita incomes rise quickly once services constitute more than 50 percent of jobs, indicating that economies have shifted to a new model for success, one centered on educating their workers for high-end services jobs (Exhibit 8, bottom High incomes and large service sectors go hand in hand, belying the old criticism of services as a sector of low-wage, dead-end jobs. The record shows that services are the path to prosperity, not poverty. America's service-dominated economy trails only tiny Luxembourg's in per capita income. Right behind us are Norway, Ireland, Switzerland and other nations far along in the transition to services. These economies couldn't thrive unless services jobs paid well. U.S. wages have been rising faster in services industries than in manufacturing. Since 1990, the gains have been particularly strong in finance, insurance and real estate; education and health; information; and professional and business services (Exhibit 9, top In 2007, average hourly manufacturing earnings, excluding overtime, stood at $16.40, but a typical worker earned $27.93 in utilities, $23.92 in information, $20.14 in professional and business services, and $19.66 in finance, insurance and real estate. Retail trade and leisure and hospitality, however, didn't pay as much as manufacturing in 2007. High pay in services is due to human capital—workers' know-how. Their education, acquired skills and innate talents allow U.S. service workers to generate average annual output of nearly $80,000, a figure that makes them among the most productive in the world (Exhibit 9, bottom Workers' wages derive from their productivity, and their productivity derives from the availability of the capital needed to do their jobs. In goods production, firms provide nearly all the capital that makes workers more productive—machinery, equipment and training. The intellectual capital that dominates services, however, derives largely from investments by the workers themselves, who make decisions on schooling. Knowledge acquired on the job embeds itself in workers, and they take it with them when they change employers. In short, service workers take in and out the door the knowledge-intensive capital that makes them valuable. Human capital explains the vast differences in service-sector pay. Service workers with the most education and training command the highest hourly pay—$88.53 for surgeons, $67.76 for dentists, $54.65 for lawyers and $48.77 for financial managers. Jobs requiring little human capital pay relatively low wages—$7.67 for fast-food cooks, $8.99 for maids, $10.62 for taxi drivers and chauffeurs, and $11.51 for retail clerks (Exhibit 10 Pay scales aren't as diverse in goods-producing industries, primarily because the educational requirements don't vary as much and firms can easily supply physical capital. Pay ranges from $48.86 for petroleum engineers, who are usually college educated, to $9.78 for sewing machine operators, a job requiring little specialized training. Services' human capital starts with formal education, especially at colleges and professional schools. More than half those in management, business and financial occupations have earned bachelor's degrees or higher. Two-thirds of workers holding professional jobs are college graduates. By contrast, only 10 percent of sales workers finished college. Human capital doesn't just come from book learning; it's not just analytical brainpower. Today, human capital increasingly reflects people skills and emotional intelligence, developed mainly through face-to-face contact. Here's where America's melting pot serves us well. We are a richly diverse nation—multiracial, multicultural and multiethnic, a composite of virtually every society on the globe.
In the 1930s, economists Eli Heckscher and Bertil Ohlin refined David Ricardo's theory of comparative advantage and showed that nations tend to export goods and services that intensely use their abundant factors of production. Countries well endowed with land and other natural resources sell food, minerals, lumber and the like. Countries with ample plants and equipment export steel, machinery and other manufactured goods. The U.S. has the world's most abundant stock of knowledge. It is, of course, one reason our country has emerged as a large exporter of sophisticated manufactured goods. But knowledge is inherent in our high-value-added services, many of which can now be more easily exported, thanks to today's technology. America's OpportunityWe live in a world of constant change, where the new and better continually roil the status quo. Firms fail, workers lose their jobs and old ways get left behind by the creation of new products, new industries and new jobs. It's the price of progress. Enduring the economy's constant churning is the only way nations climb the ladder leading to higher-value-added production and rising incomes. Poor countries stand on the lower rungs. They can move upward by adding physical capital and reallocating resources from agriculture to industry. Rich countries have already climbed to the higher rungs by shifting their economies toward services. Their best bet for rising even further lies in sharpening their ability to deliver higher-value-added services. The way to do that is through investing in human capital—more and better education, of course, but also learning through work and life experiences. Domestic demand will continue to fuel America 's services industries, but we have an epochal opportunity in the global marketplace. The ability to deliver more services to distant customers comes as global demand surges. If American service providers don't take advantage of the opportunity, others will. Globalization's critics would have us fear our times. They're looking for ways to slow the integration of the world economy—or stifle it altogether. While it might be wise to mitigate globalization's unwanted side effects, a protectionist backlash risks squandering the benefits and opportunities globalization offers. Trade surpluses in an array of service industries prove America can compete in a global marketplace. We need to become smarter and even better educated. We need to embrace globalization and recognize the bright prospects for selling our services to the world. It's time to seize the opportunity. —W. Michael Cox and Richard Alm
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Today's rapid globalization worries many Americans—and it's not hard to figure out why. We're bombarded by news of trade deficits, soaring oil prices, outsourced jobs, shrinking factory employment, a weakening dollar and hazardous imports—made all the more troubling by the rise of such new competitors as China and India. 
The shift from needs to wants shapes patterns of consumer demand at all income levels. At a per capita income of $3,700, for example, India's consumers allocate an average 46 percent of their budgets to food and 3 percent to recreation. At a per capita income of $45,000, Americans spend 12 percent on food but 8 percent on recreation. 
Elasticities show demand rising faster than income in the communications and transportation category. Communications mainly consists of telephone service, both wired and cellular. Transportation covers cars and other goods, but it also includes many services, such as auto repairs, airline flights and public transport. 
The timing, however, suggests the key factor at work was technology. Services' relative prices took off just as the revolution in information processing and communications hit its stride. The invention of the microprocessor led to computers, cell phones, the Internet and e-mail, expanding the capacity to move vast amounts of data virtually anywhere. Service producers could connect to distant customers in ways never before possible. 
In 2006, U.S. movie studios produced such box-office hits as Pirates of the Caribbean: Dead Man's Chest, helping our foreign distribution of films and TV shows exceed imports by a factor of 13. 
The adoption of more-productive farming techniques frees up rural labor, which migrates to the cities to work in manufacturing and construction. Workers fresh from the farm tend to be low skilled and less educated, but machinery and on-the-job training quickly raise their productivity. Per capita incomes rise. Step by step, industrial economies make progress—up to a point (
We also have more experience than the rest of the world in delivering services. Most of our workers are already in the sector, where they've been dealing directly with other people, not with machinery or the land. The combination of diversity and experience puts us ahead of most other countries in the ability to deliver services to a global marketplace. 
