Sovereignty in the age of scale
#35 | On what Clayton Christensen, Union Square Ventures and China have in common
I’ve had these concepts in mind for a while, but never managed to put them into a coherent framework (or at least one that seemed coherent to me…). Until now!
My buddy Chris edited this edition of Unbeaten Path after reading The FT’s deep dive titled The Trump Supremacy. Well worth the subscription alone.
The world we live in is the best that humanity has ever had - efficient, integrated, safe and cheap.
Yet the very same dynamics that made it so good, expose it to fragility. A world in which every individual can release a software product with less than $100 but half of the internet breaks if AWS US-East-1 goes down, in which EVs have become the best possible way to move around but whose supply is dictated by China.
The beauty of all of this is that both positive and negative aspects of today’s world are unplanned effects of free and interconnected markets.
However, the times they are a-changin’ and the single points of failure that we tolerated so far can’t be tolerated anymore.
I think it’s worth stopping for a second, and exploring how and why we got here and how we can go towards a better future.
The first step is understanding how markets create this fragility.
The way I rationalized this is by drawing a parallel with social networks.
“If you’re not paying for the product, you are the product” - we know this well by now, but it’s still telling. Social networks didn’t get to the current business model because someone imposed it, but because we let the market evolve towards its optimal state.
Markets always try to optimize a (often non-explicit) objective function. Participants in the market test different variables with their product positioning, until customers reveal their preference with their actions.
In the case of social networks, many different monetization strategies were tried and the “free to use + ads” model won. What participants in the market have signaled by subscribing en-masse to Facebook & co. is that in their objective function the variable “price” had a very high weight, while the variable “privacy” was not really present.
The interesting part is that nobody would take the explicit decision to sell their personal data, but they end up doing it when the transaction is presented in a different form, behind a cheaper and better product.
Something similar has happened to the world economy over the past 50 years. Not a single country would put a price tag on its sovereignty and resilience, but as a matter of fact the participants in this game voted with their action and decided to release a slice of sovereignty and resilience in exchange of a better world.
Because, just to be clear, I really do believe that an open, efficient, specialized world is a better one. Or at least just as long as everybody agrees that it’s not worth exploiting the flaws coming with it, leaving everybody worse off.
Unfortunately, we got to a point in which these flaws are being exploited, and the fragility has become unbearable.
As with social networks, the way the world works today is the result of years of optimizing non-explicit objective functions. Resilience is hard to factor in, while costs/profits/quality are easy to optimize for and thus this is the direction the world evolved into. Markets always tend to optimize what they can measure.
The defining technologies of the 21st century are extremely complex and rely on specialization and scale to increase quality and decrease costs. This is clear looking at today’s complex supply chains, as the one of semiconductors for example, that are hyper-concentrated and have near-monopolies at every step.
This was a good deal for the West as long as the East (cough…China…cough) was OK producing low-margin peripheral goods that were serving the lower end of the market. This obviously doesn’t hold true anymore, because nobody wants to play at the edge of a large market when they can see a way to eat a bigger slice of the pie.
If you look closely, this is nothing else than Christensen’s Disruptive Innovation applied to countries instead of companies.
“Entrants that prove disruptive begin by successfully targeting those overlooked segments, gaining a foothold by delivering more-suitable functionality—frequently at a lower price. Incumbents, chasing higher profitability in more-demanding segments, tend not to respond vigorously. Entrants then move upmarket, delivering the performance that incumbents’ mainstream customers require, while preserving the advantages that drove their early success. When mainstream customers start adopting the entrants’ offerings in volume, disruption has occurred.”
I know it sounds cliché for a VC, but I’m constantly amazed by this theory and by how well it explains how incumbents lose their dominant position not only in business, but also in many other unrelated fields - think of those football teams that snag up all those youngsters big teams wouldn’t let play and end up winning against all the odds.
(This is, by the way, also how Union Square Ventures became one of the best venture firms in history: investing at the edge of large markets)
If this weird mix of Facebook and disruptive innovation can explain how we got here, it probably can also explain how Europe (and more in general, the West) could stop the decline and fix their fragilities.
The first, straightforward strategy is to brute-force some changes in the cost function. This is essentially what tariffs do: they re-price resilience by penalizing certain geographies. There is plenty of literature discussing why tariffs are a good/bad means to this end, so I won’t add anything on this.
The second strategy is catalytic. Governments can decide to become the first or the best customers for the industries that matter to resilience, thus obtaining a similar end goal as tariffs. Again, this is nothing new:
“The initial growth of the chip industry from the 1950s through the early 1970s was heavily dependent on a DoD willing to pay top dollar for bleeding-edge chip technology that would offset Soviet numerical advantages in weapons systems production”
How Intel’s Innovation Problem Became a National Security Crisis
Tariffs are coercive instruments, pushing the market. Public procurement, on the other hand, pulls the market. Probably a mix of both instruments is needed, as they both tend to have a pretty short feedback loop and work well to give incumbents a new direction.
However, we need to remember that Europe today is not where China was at the end of the 1970s - we still play a role, we still have positions to defend and skills to leverage. Not all our incumbents have lost their position in the market.
Luckily, Disruptive Innovation can come to the rescue.
One of the counter-intuitive ideas Christensen introduced in his seminal work is the concept of being too close to your customers, thus missing the emergence of new needs that end up taking over industries.
Since taxes are essentially the only revenues for a country, we could define tax-payers - both corporates and private individuals - as a country’s main customers. This is why countries fail to see the emergence of new needs when these needs don’t match the needs of their established customers. If you are the US, and your customers make a lot of money selling fossil fuels, you won’t understand the needs of those that consider electricity the best form of energy.
According to Christensen, the way to get out of this dilemma is the following:
“Senior executives must first be able to spot the technologies that seem to fall into this category. Next, to commercialize and develop the new technologies, managers must protect them from the processes and incentives that are geared to serving established customers. And the only way to protect them is to create organizations that are completely independent from the mainstream business.”
What this means for Europe is that governments should employ a barbell strategy: on one side, keep supporting your best customers, the industries that still make Europe great, on the other create an environment in which you let experimentation thrive, even though your main customers don’t see an immediate need.
That is what startups are for, and this is why it is so important to nurture the venture ecosystem and to remove every barrier that introduces artificial friction.
I find it fascinating that one of the best venture firms, A16Z, was founded by two among the first entrepreneurs that have focused on the internet - a classical example of disruptive innovation.
I believe this shows how comfortable with weirdness and how allergic to consensus you need to be to do the job of the investor well. It also proves that, if countries want to catch the wave of disruptive technologies, they need to create an environment for these weirdos to thrive - imagine what the USA would be today if it wasn’t for the internet and the value it helped create.
Many more internets will come, and we should create the best playground possible for the disruptors to do their thing.
Love the parallel between "privacy" at the customer level and "sovereignty/resilience" at the national level. Efficient global markets for lower prices at the detriment of national resilience and sovereignty. I guess the weight of parameters is a function of time, too. In this sense, the 2020s and 2030s will price in more of that.