Breaking Metcalfe's Law - 01.14.08 - by Bret Swanson

8/14/2019 Breaking Metcalfe's Law - 01.14.08 - by Bret Swanson

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Progress SnapshotRelease 4.2 January 2008

Breaking Metcalfes Law

Progress SnapshotRelease 4.2 January 2008

by Bret Swanson*

The power of a network grows approximately by the square of the number ofconnected nodes. A computer network comprising 10 nodes, for example, is thus not 10times as powerful as a single unconnected computer but 100 times as powerful. This

rough rule is called Metcalfes Law, after Bob Metcalfe, the inventor of Ethernet. Firstintroduced by Metcalfe in 1976 to connect office terminals, Ethernet is the networkingstandard 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.

Metcalfes Law helps explain why the information revolution will rival or exceedthe Industrial Revolution in scope and scale. Metcalfes Law, however, applies not justto computer networks. It is also a powerful metaphor for that large collection of humanand 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 ofgoods, services, and knowledge among ever larger groups yields more than lineargrowth. A village of 100 cooperating specialists could generate far more output than 100solitary, disconnected individuals fending for themselves. Free trade allowsspecialization, division of labor, and the rapid diffusion of technology across companiesand countries. The best ideas, practices, and innovations rise to the top. The talents ofindividuals achieve worldwide exposure. Capital seeks the most productive investments.More ideas get funded. More ideas and products are generated. Supply-chains amongdiverse companies integrate. Collaboration among diverse people explodes. The bestproducts gain wider markets and volumes. Products proliferate and prices fall, boostingconsumer welfare. As the connected, booming world economy passes $50 trillion in

output, the story of globalization is thus itself a dramatic manifestation of Metcalfespositive-sum network law.

* Bret Swanson is a senior fellow and director of the Center for Global Innovation at The Progress &Freedom Foundation. The views expressed in this report are his own, and are not necessarily the viewsof the PFF board, fellows or staff.

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How ironic then that anti-trade policymakers now seek to block investment in thevery company that first launched Ethernet commercially in the early 1980s3ComCorporation, founded by one Robert Metcalfe. In late September, the American privateequity firm Bain Capital announced its intention to buy 3Com, a maker of telecomswitches and other networking gear, for $2.2 billion. Huawei, the largest telecom

equipment company in China and a growing global force in communications, with salesof $11 billion in 2006, would also invest in the deal for a 17% minority stake. In the worldof private equity, additional partners are often brought in to spread risk and addstrategic value, in this case to gain access to Chinas 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. policymakersand commentators exploded with anger and denounced Bains proposed acquisition.Huawei is up to its eyeballs with the Chinese military, an unnamed U.S. defenseofficial told Bill Gertz of the Washington Times. [N]ow we are proposing to sell the[Peoples 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 DanaRohrabacher, among other lawmakers, worried that the U.S. was giving away nationalsecurity secrets. They wrote letters to the U.S. Treasury, called for Congressionalhearings, and proposed a lawHR 730to block the deal.

But political hearings and interventions on each cross-boarder investment in thisglobal economy are exactly what we dont want. Although the deal seemed fairlyroutine, there was no advanced technology involved, and Chinas Huawei would be onlya minority partner, Bain voluntarily submitted the buyout for review by the Committee onForeign Investment in the U.S. (CFIUS). By walling off lawmakers and relying onsecurity experts, CFIUS was designed to avoid the political hyperbole and arbitraryobjections that so often accompany anti-trade protectionism.

After an initial 30-day review, CFIUS is said to be moving on to an additional, andmore serious, 45-day review.1 Although CFIUS could still approve the deal or ask Bainto make adjustments, such as divesting 3Coms Tipping Point intrusion detectionproducts, some observers believe this extended review means the deal is in trouble.2

Opponents of the deal betray a fundamental misunderstanding of 3Coms

product portfolio and erroneously conflate unrelated events. Although the Pentagonbuys 3Com network gear, and although the Defense Department believes Chineseelements last year attempted to hack into Pentagon computer systems, there is noconnection among the various story lines. 3Coms products are off-the-rack commercialproducts sold here and all over the world, including China. They do not contain sensitivenational security technology. Moreover, Huawei was the majority partner in a jointventure with 3Com from 2003 to 2006, when 3Com bought the joint venture back. As far

1Tucker, Sundeep, and Stephanie Kirchgaessner. U.S. extends China-3Com probe. Financial Times.January 2, 2008. http://www.ft.com/cms/s/0/9e589684-b89d-11dc-893b-0000779fd2ac.html?nclick_check=1

2http://www.thedeal.com/dealscape/2008/01/cfius_may_pull_the_plug_on_3co.php

2
http://www.ft.com/cms/s/0/9e589684-b89d-11dc-893b-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/9e589684-b89d-11dc-893b-0000779fd2ac.html?nclick_check=1http://www.thedeal.com/dealscape/2008/01/cfius_may_pull_the_plug_on_3co.phphttp://www.ft.com/cms/s/0/9e589684-b89d-11dc-893b-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/9e589684-b89d-11dc-893b-0000779fd2ac.html?nclick_check=1http://www.thedeal.com/dealscape/2008/01/cfius_may_pull_the_plug_on_3co.php


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as we know, 3Com products had nothing to do with the Chinese hacking incident. Buteven if it were the case, fierce opponents of this pedestrian deal would confront afurther hypothetical irony: If 3Coms Tipping Point intrusion detection products hadfailedto detect last years Chinese cyber-intruders, then why would we worry about selling theChinese such lousy technology?

The harassment of Bain follows a string of proposed cross-border deals that fellthrough after U.S. lawmakers objected. The most prominent were China CNOOCsfailed bid for Unocal and the infamous Dubai Ports World fiasco. Even in cases wherepolicymakers 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 toChicago, to the Australian-Spanish consortium Macquarie-Cintra for $4 billion. AlthoughIndiana was allowed to keep the 157-mile stretch of concrete, an overwhelming numberof Hoosiers angrily objected to the $4 billion windfall.

America has greeted other recent high profile deals in the financial sector, suchas Abu Dhabis $7.5 billion investment in Citigroup, more hospitably. But even somecapitalist stalwarts expressed skepticism at that deal.3 And now yet another wave offoreign investment in American financial companies, from Merrill Lynch to additionalinfusions at Citi, is reportedly on the way.4 Can America withstand this assault of dollarsaimed at our shores?

The more often the U.S. blocks or merely harasses foreign investors, thestronger message we send that we dont want the worlds capital. The more obstacleswe lay before highly skilled visa applicants and would-be immigrants, Americas statusas the strongest magnet for ideas and talent erodes. As we build more robust firewallsto repel this dangerous knowledge and money, the more likely it is that ideas andcapital 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 investmentsare more important than ever. Pushing foreign capital away could further weaken thedollar and, in a downward spiral, signal that any new investments are likely to furtherdepreciate in dollar terms.

Trade and investment is a two-way street. China over the coming decadespresents a large opportunity for U.S. businesses and everyday American investors. IfAmerica closes off investment from China, will China block us from investing in theworlds fastest growing large economy?

Over the last few decades China did not always appreciate or follow many of theestablished concepts, traditions, and rules of intellectual property rights. Low-end

3Citi of Arabia. The Wall Street Journal. November 29, 2007. p. A18.http://online.wsj.com/article/SB119630344845307407.html

4 Enrich, David, Randall Smith, and Damian Paletta. Citigroup, Merrill Seek More Foreign Capital. TheWall Street Journal. January 10, 2008.

3
http://online.wsj.com/article/SB119630344845307407.htmlhttp://online.wsj.com/article/SB119630344845307407.html


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counterfeiting and piracy was rampant (and remains so), and some high-end IPviolations became news as well. Cisco Systems famously sued Huawei over softwarecode 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 PropertyOrganizations Patent Cooperation Treaty (PCT). That was good for number 13 in theworld, a ranking it will likely surpass in 2007. Chinaas a whole in 2006 boosted its PCTpatent filings 56% and rose to number 8 worldwide.5 Many of us have long believed thatas China developed a native technology economy, its appreciation of IP would grow.Indeed, although Chinas practices do not yet match its impressive new laws, someAmerican China experts confirm that within the last year there has been a sea changein Chinas 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 andservices. China has entrepreneurial spirit in abundance. Entrepreneurship is in itsbones. China is now focused on acquiring and nurturing the lattermanagementexpertiseto impose structure and discipline on its unbridled energy and new ideas.

Although China has become a highly decentralized, entrepreneurial, risingeconomic and technology power, it was formerly a nation dominated, top-down, bycommunist officials and a strong PLA. We are therefore bound to encounter lots ofChinese companies with government and military links. We should never risk divulgingtrue national security secrets, but we had better learn to deal with these situationssmartly, or we will end up cutting ourselves off from the worlds fastest growingeconomy.

In coming years, an ever larger proportion of the worlds key innovations andinvestment 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 newwealth?

Metcalfes Law works both ways. Protectionist anti-trade policies and attitudescan spin quickly out of control. Severing too many nodes in Americas powerfuleconomic network can reduce its value in exponential fashion.

5 WIPO. Record Year for International Patent Filings with Significant Growth from Northeast Asia.February 8, 2007. http://www.wipo.int/pressroom/en/articles/2007/article_0008.html

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http://www.wipo.int/pressroom/en/articles/2007/article_0008.htmlhttp://www.wipo.int/pressroom/en/articles/2007/article_0008.html

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Breaking Metcalfe's Law - 01.14.08 - by Bret Swanson