Breaking Metcalfe's Law
Release 4.2 January 2008
by Bret Swanson*
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The power of a network grows approximately by the square of the number of connected nodes. A computer network comprising 10 nodes, for example, is thus not 10 times as powerful as a single unconnected computer but 100 times as powerful. This rough rule is called Metcalfe's Law, after Bob Metcalfe, the inventor of Ethernet. First introduced by Metcalfe in 1976 to connect office terminals, Ethernet is the networking standard that now dominates not just home, office, and wireless local area networks (LANs) but increasingly the metro and core networks of the global Internet as well.
Metcalfe's Law helps explain why the "information revolution" will rival or exceed the Industrial Revolution in scope and scale. Metcalfe's Law, however, applies not just to computer networks. It is also a powerful metaphor for that large collection of human and corporate nodes known as the global economy.
Just as the local economy of yesteryear became more than twice as powerful when the town butcher and baker traded their specialized goods, the exchange of goods, services, and knowledge among ever larger groups yields more than linear growth. A village of 100 cooperating specialists could generate far more output than 100 solitary, disconnected individuals fending for themselves. Free trade allows specialization, division of labor, and the rapid diffusion of technology across companies and countries. The best ideas, practices, and innovations rise to the top. The talents of individuals achieve worldwide exposure. Capital seeks the most productive investments. More ideas get funded. More ideas and products are generated. Supply-chains among diverse companies integrate. Collaboration among diverse people explodes. The best products gain wider markets and volumes. Products proliferate and prices fall, boosting consumer welfare. As the connected, booming world economy passes $50 trillion in output, the story of globalization is thus itself a dramatic manifestation of Metcalfe's positive-sum network law.
How ironic then that anti-trade policymakers now seek to block investment in the very company that first launched Ethernet commercially in the early 1980s -- 3Com Corporation, founded by one Robert Metcalfe. In late September, the American private equity firm Bain Capital announced its intention to buy 3Com, a maker of telecom switches and other networking gear, for $2.2 billion. Huawei, the largest telecom equipment company in China and a growing global force in communications, with sales of $11 billion in 2006, would also invest in the deal for a 17% minority stake. In the world of private equity, additional partners are often brought in to spread risk and add strategic value, in this case to gain access to China's huge market.
Despite the fact that 3Com and Huawei had worked closely together since 2003, including a high profile joint venture selling products in Asia, some U.S. policymakers and commentators exploded with anger and denounced Bain's proposed acquisition. "Huawei is up to its eyeballs with the Chinese military," an unnamed U.S. defense official told Bill Gertz of the Washington Times. "[N]ow we are proposing to sell the [People's Liberation Army] a key to our front door. This is a very dangerous trend." Sens. Jon Kyl and Jeff Sessions and Reps. Peter Hoekstra, Duncan Hunter, and Dana Rohrabacher, among other lawmakers, worried that the U.S. was giving away national security secrets. They wrote letters to the U.S. Treasury, called for Congressional hearings, and proposed a law -- HR 730 -- to block the deal.
But political hearings and interventions on each cross-boarder investment in this global economy are exactly what we don't want. Although the deal seemed fairly routine, there was no advanced technology involved, and China's Huawei would be only a minority partner, Bain voluntarily submitted the buyout for review by the Committee on Foreign Investment in the U.S. (CFIUS). By walling off lawmakers and relying on security experts, CFIUS was designed to avoid the political hyperbole and arbitrary objections that so often accompany anti-trade protectionism.
After an initial 30-day review, CFIUS is said to be moving on to an additional, and more serious, 45-day review. Although CFIUS could still approve the deal or ask Bain to make adjustments, such as divesting 3Com's Tipping Point intrusion detection products, some observers believe this extended review means the deal is "in trouble."
Opponents of the deal betray a fundamental misunderstanding of 3Com's product portfolio and erroneously conflate unrelated events. Although the Pentagon buys 3Com network gear, and although the Defense Department believes Chinese elements last year attempted to hack into Pentagon computer systems, there is no connection among the various story lines. 3Com's products are off-the-rack commercial products sold here and all over the world, including China. They do not contain sensitive national security technology. Moreover, Huawei was the majority partner in a joint venture with 3Com from 2003 to 2006, when 3Com bought the joint venture back. As far as we know, 3Com products had nothing to do with the Chinese hacking incident. But even if it were the case, fierce opponents of this pedestrian deal would confront a further hypothetical irony: If 3Com's Tipping Point intrusion detection products had failed to detect last year's Chinese cyber-intruders, then why would we worry about selling the Chinese such lousy technology?
The harassment of Bain follows a string of proposed cross-border deals that fell through after U.S. lawmakers objected. The most prominent were China CNOOC's failed bid for Unocal and the infamous Dubai Ports World fiasco. Even in cases where policymakers rightly stood up for innocuous and entirely beneficial foreign investments, voters have sometimes rebelled with knee jerk resentment. In 2005, for example, Governor Mitch Daniels leased the Indiana Toll Road, which stretches from Ohio to Chicago, to the Australian-Spanish consortium Macquarie-Cintra for $4 billion. Although Indiana was allowed to keep the 157-mile stretch of concrete, an overwhelming number of Hoosiers angrily objected to the $4 billion windfall.
America has greeted other recent high profile deals in the financial sector, such as Abu Dhabi's $7.5 billion investment in Citigroup, more hospitably. But even some capitalist stalwarts expressed skepticism at that deal. And now yet another wave of foreign investment in American financial companies, from Merrill Lynch to additional infusions at Citi, is reportedly on the way. Can America withstand this assault of dollars aimed at our shores?
The more often the U.S. blocks or merely harasses foreign investors, the stronger message we send that we don't want the world's capital. The more obstacles we lay before highly skilled visa applicants and would-be immigrants, America's status as the strongest magnet for ideas and talent erodes. As we build more robust firewalls to repel this "dangerous" knowledge and money, the more likely it is that ideas and capital will flow through other nodes of the global economic network.
At a time when the U.S. dollar has fallen to near-record lows, foreign investments are more important than ever. Pushing foreign capital away could further weaken the dollar and, in a downward spiral, signal that any new investments are likely to further depreciate in dollar terms.
Trade and investment is a two-way street. China over the coming decades presents a large opportunity for U.S. businesses and everyday American investors. If America closes off investment from China, will China block us from investing in the world's fastest growing large economy?
Over the last few decades China did not always appreciate or follow many of the established concepts, traditions, and rules of intellectual property rights. Low-end counterfeiting and piracy was rampant (and remains so), and some high-end IP violations became news as well. Cisco Systems famously sued Huawei over software code in 2003, but the suit was settled in 2004.
China, however, is no longer just an importer, consumer, exploiter, or usurper, of Western technology. It is increasingly a producer of world-leading innovations. In 2006, Huawei filed 595 patent applications under the World Intellectual Property Organization's Patent Cooperation Treaty (PCT). That was good for number 13 in the world, a ranking it will likely surpass in 2007. China as a whole in 2006 boosted its PCT patent filings 56% and rose to number 8 worldwide. Many of us have long believed that as China developed a native technology economy, its appreciation of IP would grow. Indeed, although China's practices do not yet match its impressive new laws, some American China experts confirm that within the last year there has been a "sea change" in China's embrace of IP.
Mere patent filings do not an innovative, thriving economy make. It takes entrepreneurship and business acumen to turn inventions into useful products and services. China has entrepreneurial spirit in abundance. Entrepreneurship is in its bones. China is now focused on acquiring and nurturing the latter -- management expertise -- to impose structure and discipline on its unbridled energy and new ideas.
Although China has become a highly decentralized, entrepreneurial, rising economic and technology power, it was formerly a nation dominated, top-down, by communist officials and a strong PLA. We are therefore bound to encounter lots of Chinese companies with government and military links. We should never risk divulging true national security secrets, but we had better learn to deal with these situations smartly, or we will end up cutting ourselves off from the world's fastest growing economy.
In coming years, an ever larger proportion of the world's key innovations and investment opportunities will emerge from China, India, and other non-U.S. locales. Does the U.S. want to be blocked from participating in this epochal surge of new wealth?
Metcalfe's Law works both ways. Protectionist anti-trade policies and attitudes can spin quickly out of control. Severing too many nodes in America's powerful economic network can reduce its value in exponential fashion.