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The PI Blogs

If the Stimulus is the New Black, I’m betting on Red

David Reed

April 1st, 2009

The collapse of the finance sector must surely be of great concern to those who depend on the growth of the Internet. Creating planet-scale networks appears to require planet-scale investment, and therefore access to capital ought to bring the entire communications value chain to a crashing halt. “Sell the Internet short!” That should be the rallying cry for anyone who meets the capital requirements to trade the relevant securities. In fact those who depend on continued growth of communications activity should be at the tail end of a so-called “bullwhip effect” that makes the Googles and Amazons and Facebooks have enormous betas with respect to the overall capital markets—as their platform starves, they will be the most significant victims… so short Google!

I’m not above short-selling myself, so that started me thinking about how the Internet was actually built and financed. I think the story above is wrong. My conclusion is that we need to think about investment in communications in an extremely different way, and perhaps that way of thinking could be a far more effective stimulus to the communications value chain than would be an infusion of government cash alone.

I think back to the creation of the Internet itself, and how it was built, and how its growth was financed. We have to ask what the Internet really is. Is it Level 3 and ATT and Global Crossing? Actually, no.

The Internet is a set of agreements among members (who happen to control small, medium, and large networks). The agreement required members to carry each others’ packets, delivering them via best efforts to the hosts at the edge of the network—your laptop, Google’s server… What we (a motley crew of academics and DARPA contractors) did in the 1970’s and 1980’s was to create a mutual enterprise, one that enabled growth by contributing one’s network elements such as LANs, switches, routers, etc. to a common pool where every member pledged to help every other member deliver packets.

The first members to join, one will remember, were the academic departments who needed to share expensive timesharing systems, but who had very little money, scraping by on modest grants compared to the budgets of corporate labs like Bell Labs and IBM Research.

Due to the enormous benefit captured in the essence of Metcalfe’s Law, each member of the Internet who contributed to the mutual enterprise gained connectivity disproportionate to the member’s contribution. Since connectivity, or reach, has a value perhaps even more important than bit-carrying capacity, the incentives for members to join far outweighed the worry about losing control of one’s resources to “free riders.” Everyone was, in fact, a free rider on the excess value created.

How did the Internet grow? Well, adoption was driven by the needs of its users, who were largely institutions and companies who did not have huge budgets to roll out planet-wide private networks. The companies who had huge planet-wide networks were the last to adopt. Only after about 1996 did some of the largest communications providers start to “get it,” and the resulting growth in demand finally attracted the Milkens of the world who invented junk bonds and other ways to finance what was by then a really successful world-wide enterprise.

If we look carefully at the timing here, the biggest shift in the communications industry was not driven by the finance sector’s need to invest capital—in fact the real launch of the Internet came at a time of relative capital starvation, in the most capital-starved segment of the communications user community—academic labs in their role as customers. They invented it for their own needs.

Eric Von Hippel of MIT’s Sloan School of Management, who, back in the 1970’s, did the original research that proved that fundamental innovations are largely the work of Lead Users, would observe that this is a natural form of innovation. Perhaps it is the most natural form of innovation and industrial growth. However, what he did not say then is that the same Lead Users often provide the financial structure and investment “capital” in the form of resources, labor, etc., as well as the ideas.

The communications value chain is blessed with what economists call positive externalities—Metcalfe’s Law being one such externality. Such externalities enable Users to take the Lead in financing growth, just as they did in the early Internet.

Cisco, for example, became the powerhouse it is today by servicing Users, not by supplying operators, who were happy with Western Electric, ITT, Bell Labs, Northern Electric, etc. Those users, who were initially academic departments and DoD contractors, knew that they needed devices that could overlay routing on a motley collection of private networks. It was only very late that Cisco became a supplier to operators who were not Users themselves.

Today, the growth is in mobile and social communications and in what I call the Second and Third Clouds. Who will finance the growth there? Will it be the “stimulus economy”? I suspect not. I suspect it will be a collection of Lead Users who will build these things because they need them. And capitalization will come from those Lead Users, not from the financiers’ need to find targets for their dollars. I hope the government invests alongside these Lead Users, but in any case, I suspect the smart companies will help their Lead Users invent the future of these new computing and communications utilities.

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