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Subject: The Mother of All Chasms Date: 8/8/2002 4:30 PM
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This is the "Mother of All Chasms" article I published in the RTW monthly. I thought it would help to post it here so people could understand any discussion that arises.

Note to TMF: I am the copyright holder on this material.

The Mother of All Chasms
by Paul Philp, http://www.rtwreport.com/article.asp?newsID=153


Common wisdom, fueled by popular media assumes the economic boom and the Internet bubble were terrible mistakes caused by misguided monetary and fiscal policies. This argument misses the core functioning of the American economy: it is not simply cyclical, it is dynamic - always moving forward into the future. Far from a policy mistake, the technology bubble was a necessary, normal and healthy event in the progress of the economy.

In order to analyze bubbles we must identify the type of the bubble. There are three types of bubbles:

1. Asset bubbles
2. Technology bubbles
3. Structural instability bubbles

Asset bubbles are when the price of a particular class of asset uncouples from its economic value and rises to very high levels, driven by an investment mania. The infamous Dutch Tulip Bulb bubble is an example. The Japanese land bubble in the '80's is another. The key is that these bubbles leave nothing of sustained economic value behind. This is the type of bubble the Austrian school of economic analysis describes.

Technology bubbles happen when a radical technology emerges that has the potential to transform the economy, society and politics. The bubble itself is driven by exactly the same manias. The difference is, at the end of the bubble there is much left behind (technology, knowledge, social practices, infrastructure) that has economic value. Technology bubbles increase the wealth creating capacity of the economy.

Structural instability bubbles happen when non-economic events impact an industry that cannot absorb the shock. An example of this is the oil services industry. There is instability because of the operations of OPEC and the political instability of the region. This can cause oil prices to rise/fall with no underlying increase/decrease in demand. The DRAM industry has/had structural instability bubbles as well. I suspect that the US S&L bubble was like this as well.

Not all bubbles are alike. However, all are driven by investment manias, thus making the last half of the bubble and the whole crash all look very similar. It is what happens after the bubble where the type of bubble matters. Technology bubbles are good for the economy. The fact that 12 of the 14 technology bubbles since the Industrial Revolution have happened in America is not a coincidence and should be celebrated.

It is often claimed that turns in the stock market are early predictors of booms and recessions. In much the same way, technology bubbles are early indicators of radical transformations in the economy, society and politics. Each of the 14 technology bubbles I reviewed led to significant changes in the way societies operate. Each bubble ultimately led to an increase in the standard of living for that society.

There are three dynamics underneath the formation of technology bubbles:

1. The new technology is radical, it operates at the foundations of the economy and society;
2. No one knows how to apply the new technology profitably; and,
3. A shared infrastructure is required.

Two other things must be true - the economy is healthy and interest rates and inflation are low.

If you put these five ingredients together in any country in the world, except the USA, you will get a very slow process that attempts to understand the risk and dangers of the new technology, people will study various deployment strategies to see how the technology might be made profitable, and a few hundred feasibility studies would be undertaken to sort out how to build the shared infrastructure.

Mix those ingredients in the USA and all hell breaks lose. Entrepreneurs grab some of the cheap money and start to build. Instead of a careful evaluation of the new technology, a brutal version of Darwinian capitalism is unleashed.

I think of the beginning of this period as the start of a marathon with each runner representing one idea about how to move the new technology forward and build the shared infrastructure. The runners are told the course is 26.2 miles long and that water tables have been set up every half mile over the course. Of course, this is too much and some of the runners over-indulge and quit the race. Then the tables are set up a mile apart. This is just fine and all the remaining runners are well hydrated and fed. Then, at mile 13, a cruel joke is played on the runners. No more water tables for the rest of the course. Sorry. The runners start to drop out the race rapidly. At the end of the race, the only runners left are the ones that were strong enough to stay the course.

It is a giant experiment. At the end of the experiment there are several outcomes. The best technologies are left standing. The holes in the technology have been fixed. A few companies have figured out how to use the technology to make money AND, this is the most important, the shared infrastructure is built. This is important and it happens to some degree in every technology bubble. The fact is, there is never a sufficient economic justification for building the shared infrastructure. The capital required to build and maintain the canals, railroads, telegraph, road system, hydro grids, rocket pads, satellite tracking, TV and radio infrastructure - never pay back their invested capital even though the infrastructure is crucial for the success of the technology.

It seems that American capitalism has found an accelerated and efficient method to quickly mature new radical technologies and build the shared infrastructure needed to make the technology productive. This process is far from rare. It has happened at least 12 times since 1840, about once every 15 years. Bubbles are not all the same magnitude; the railways and Internet were the two largest, by far.

Bubbles build the shared infrastructure needed to make radical technologies profitable when there is no economic incentive for any group of investors to build that infrastructure. The economic pay back begins at the bottom of the crash, when entrepreneurial businesses start applying the technology and infrastructure to make their businesses orders of magnitude more productive.

Who knew when the railway was being built that Mr. Sears would start selling household goods through the stationmasters at the new railway stops. Business picked up to the point that he needed to print a catalogue to help them keep track of the merchandise.

Who new when TV was first invented it would be the final piece in the mass production value chain. The ability to communicate directly to a mass market and convey the message of your product was essential for starting the mass production boom of the '50's and '60's.

The economic capability - the wealth creating capability - left behind after technology bubbles is awesome. All that is needed is for the entrepreneur and innovator to apply them and transform their industries. Bubbles aren't pretty but they work.

People talk about the Internet Revolution or the Information Revolution. Both are very limited interpretations. As Peter Ducker continues to remind us, we are at the crux of the Knowledge Revolution just as the railways were the crux of the Industrial Revolution.

Collectively, the business mistakes of the past seven years were not mistakes at all. We have not been left with an over-capacity of fiber optic networks that we need to burn off. We were left with a shared infrastructure that we are just now learning how to use. As always, Schumpeter's Gales of Creative Destruction are blowing through the economy, moving capital from unproductive assets and processes to more productive ones.

How do bubbles happen?

Radical Technology

Every new technology does not start a revolution or cause a financial bubble. There are three classes of new technology:

· Sustaining / Continuous
· Disruptive / Discontinuous
· Radical

In this classification, I refer to both Geoffrey Moore's Continuous / Discontinuous model and Clayton Christensen's Sustaining / Disruptive model. While the two models do not overlap each other exactly, for the purposes of understanding how new technologies are financed they are very similar. I use both for completeness.

A sustaining / continuous technology is a new technology that improves the value proposition of an existing technology for existing customers. Sustaining / continuous technologies may grow the size of a market but they do not change the structure of the market. Examples of sustaining / continuous technologies include: automatic transmissions, color TV, CD music, DVD video, multimedia PCs and digital cellular. Each of these new technologies increased the size of the market without significantly altering the competitive position of the companies in that market. Sustaining / continuous technologies favor market leaders.

A disruptive / discontinuous technology is a new technology offering a different value proposition from current dominant technology. Disruptive / discontinuous technologies alter economics of existing industries causing a significant shift in market structure and industry power. The personal computer is a classic example of a disruptive technology. People buying computers at the time the PC arrived had no interest in a smaller, less powerful computer. The PC industry, with the exception of IBM, was a fringe industry for a few years. Eventually the PC gained momentum and restructured the entire computer industry. Disruptive / discontinuous technologies favor new market entrants.

A radical technology is new technology that transforms societies, politics and economies. The root of the word radical means: to operate at the foundation. Radical technologies operate at the foundation, reshaping the entire society. Examples of radical technologies are: steam powered machines, railways, electricity, mass production, the interstate highway system and the Internet. From the time a radical technology is introduced until it is mature, entire industries are created while others disappear. Every person, company and institution is altered by the application of the new technology.

This foundation that radical technologies alter is the way we think about the world. Peter Drucker calls this 'altering our mental geography'. Steam power changed the way people thought about where to live and how to put food on the table. Railways changed the way people thought about distance and trade. The Internet is changing the way we think about how people, companies and institutions connect and interact. In many ways, the Internet is changing how we think about space and time.

Technology Clusters

We oversimplify reality when we speak of technology eras as the 'Stream Era', 'Railway Era', 'Automotive Era' or the 'Internet Era'. Technology tends to develop in clusters, and the cluster of technologies combine to create value. In the computer industry, Moore's Law does all the heavy lifting in public. Less visible are equally dramatic improvements in other technologies. Disk drives capacity has kept pace with Moore's Law even though there is little in the way of shared science and engineering between the microprocessor and disk drive industries. Advances in display technology, although less dramatic, are as important to the success of the personal computer as the processor and the disk.

Technology clusters are self-reinforcing and co-creating. The opportunity for any one of the technologies is determined through integration with other technologies in the cluster. There is no market for 2.5' disk drives separate from the market for microprocessors. As this integration increases there is a self-reinforcing competition for the slice of the overall profits that will end up in each industry. While the industries are competing for profit share at the same time they must work together to ensure the technologies integrate to create a product customers will buy.

Eventually, as the technology matures, a standard architecture for integrating the pieces together emerges. Once established, control of the architecture determines the profit distribution. It can be very difficult to predict in the early stages of the market the final architecture. This uncertainty makes rational investment impossible, leading to an over investment in some industries compared with the ultimate opportunity. In the PC era, there was an over investment in manufacturing and assembly since the profits of the industry ended up with the processor and operating system.

The Spark

Every technology bubble needs a catalyst setting the chain of events in motion. At the macroeconomic level it is all well and good to speak about the economic possibilities of a technology or ways in which society can be transformed. However, this does not explain why individual people make their decisions, which trigger the bubble. Bankers, investors, and entrepreneurs are not individually motivated by the macroeconomic possibilities.

Each of them is seeking to invest their capital (financial or knowledge) in a way the produces superior returns. It is the promise of excess profit that draws people and capital to the new technology. When investors and entrepreneurs see others making superior returns they have the incentive to enter that market.

In the case of the Internet bubble, what got the ball rolling was the Netscape IPO in August 1995. Netscape had $14 million in revenues and a $4 million loss when they went public, and yet raised $2.6B from their share price , which doubled on the first day of trading. The Netscape IPO produced such an extreme valuation because at the time Netscape was one of only a very few technology companies focused on Internet technology. Investors were scrambling to get Netscape shares. This created a supply and demand imbalance, the capital markets were becoming aware of the opportunity the Internet offered and the only way they could invest in a public at the time was to buy Netscape shares. There is no doubt Netscape's backers worked hard to create a big buzz, but they tapped into a market ready to take risk and build the future.

The Netscape IPO was the spark lighting the first match of the Internet mania. The supply and demand imbalance would soon be rectified as technology entrepreneurs and investors immediately set their focus on the Internet with great urgency.

The Tipping Point

The last piece of the bubble puzzle stems from the nature of technology clusters discussed above. The technology cluster surrounding the Internet was quite incomplete at the time of the Netscape IPO. There were not many web sites offering interesting content or services. The tools for building web sites were very limited and it was almost impossible to connect a web site to a database. The telecommunications infrastructure was not designed to support large amounts of data traffic and the primary way to connect to the Web was through a slow modem.

The Internet would not be a viable technology until all the pieces of the technology cluster were in place. The clustering paradox is a feature of technology bubbles. The railways needed complex scheduling systems, interconnects with canals and ports and entirely new forms of management. The automobile needed roads, gas stations, service and maintenance.

The entrepreneurs and investors understood the opportunity, but also knew that without the other pieces of the cluster there is no end product and no way to make a profit because the overall technology will not deliver. The situation is like a high school dance with the boys on one side, the girls on the other side and nobody willing to be the first.

The paradox remains unresolved until there is a catalyst and it becomes very clear that a good return is possible. Suddenly, they all look to each other knowing success depended on all their technologies being available. Now, instead of saying 'you go first' they say, 'I'll go if you go'. This is the tipping point, a large number of companies and a big supply of capital rush into the market at the same time.

A feature of the early stages of creating the technology cluster is that it is impossible to predict the ultimate profit structure of the new industry. Each technology in the cluster is funded as if it could be one of the few that get the highest profit share. There is simply no way to properly assess the risk at this stage. People in Silicon Valley remember the endless debate, 'Content is King', 'Infrastructure is King', 'Connection is King', Application is King and 'Community is King'.

With fuel flowing after the Netscape IPO, hundreds of new ventures form. New magazines and journals were created to cover the action. Venture Capitalist, John Doerr became a rock star figure for the Net. Up until this point, all the economic actors have been making rational investments for worthwhile technologies that had real applications with customers.

Investment bubbles have three phases: investment, speculation, and mania. The first, the investment phase was discussed above. The second phase, speculation, begins when the process moves from being about making valid investment technologies and the investing of good capital into dubious companies with unknown prospects. These were the days of using the Internet so people could ship heavy bags of cat food across the country for free. There were some truly bad ideas that got financing. Also during speculation, the infrastructure of the capital markets expands. New analysts covered new industries, which did not exist the previous year. The numbers of venture firms almost tripled. There is now a lot of money in the hands of people with all the ideas but not a lot of experience.

This leads to the last period of bubbles, the mania. You know it is a mania when your taxi driver tells you that Juniper is going to wipe the street with Cisco. Now, everyone is an expert. The stock market keeps rising. The NASDAQ went up 1,000 points in a few months. CNBC is covering the events live as if it were some Roman spectacle. Investment capital from around the world was parked in technology stocks. Executives quit their jobs to become day traders.

The Internet frenzy in American was no better or no worse than earlier technology bubbles. By the time of the mania, the new railways were issuing scrip to the general public. Scrip represented as little a 5% the value of the bond and the investor made weekly payments to finish buying the bonds.

Dozens of new trade journals were created to serve new demands for information. The press was madly running stories about the coming new Economic era. Confidence is high all around and the finest clarets were flowing. In both England at the time of the railways and the US at the time of the Internet, this high confidence wouldn't last long.

Why do bubbles burst?

There are several things that happen to stop the mania and lead to a crash. Some are common to all bubbles and some are unique to technology bubbles. In all bubbles a point is reached when the supply of money for the economy is lowered. In some cases, this happens when government simply goes bankrupt. In less extreme cases, the treasury or central bank simply increases interest rates. This has the effect of reducing the amount of money flowing in the economy.

Another feature common to all bubbles is the total amount of money needed to keep growing the bubble increases with the price of the asset. For example, when the NASDAQ increased from 4,000 to 5,000 points it required 25% more to be invested in the shares of NASDAQ companies. It is like trying to roll a snowball up a snow-covered hill while it gets heavier the further up you get.

It is overly simplified, but it is easy to see a decrease in the supply of money while the stock market needs more dollars to keep moving up is unstable. Eventually the economy simply runs out of dollars to keep pushing the bubble forward and the market collapses under it's own weight. This dynamic is common to the collapse of all bubbles but technology bubbles have a unique trigger for the collapse.

While the bubble is still growing, companies make increasingly unrealistic financial predictions. The roots of this phenomenon lie with the uncertainty while technology clusters are forming. It quickly becomes apparent the companies claiming the fastest growth and highest profits attract the most investment capital. It is difficult for a venture to compete when rivals raise more capital at a lower price. Each company starts to make aggressive projections in order to not be at a disadvantage. During the Internet bubble, there were cases of companies removing a CEO for not being sufficiently aggressive. The message is clear to everyone - grow aggressively or perish. This starts a vicious cycle of ever increasing growth projections and higher valuations.

The vicious cycle can continue through the initial period when the financial results don't match the predictions. When capital is cheap and abundant there are many ways for companies to make it seem as though they are growing. The initial losses are ignored because revenue growth is so high. Suddenly it all falls apart, revenue growth reverses and losses accelerate. It becomes apparent to investors these companies will never be able to deliver the predicted financial results. Of course, this leads to a stampede for the exits and the bubble crashes.

Why do the financial results reverse so suddenly during the height of the mania? It happens because the new technology fails to deliver on its promise to transform both society and the economy. There is nothing the technology companies can do about it either. It is not a technology problem it is a social problem. The entrepreneurs and investors (and by now the whole world) watch in horror as expected profits turn into losses and big dreams seem to die a quick death. What happens?

The Mother of All Chasms

The concept of the chasm was developed by Geoffrey Moore, technology-marketing consultant extraordinaire. Moore observed there is a phase during the development of new technology markets when revenue growth and profitability become unpredictable quite suddenly. It is normal for many startup companies to fail and larger companies can decide to abandon the market. The period between the early growth spurt and more stable growth Moore called the chasm. Although the dynamics of a new radical technology are not identical to Moore's model, the period of turmoil following an initial growth spurt is very similar.

Since the dynamics of radical technologies impact the entire industry, and occasionally the entire economy, I call this period 'The Mother of All Chasms' to give it pride of place. This larger chasm starts with bursting the bubble and it lasts until a stable, predictable market emerges for the new technology. The Mother of All chasms is a feature of a technology bubble and it is also known as the worst hangover of all time. The party is over but the mess remains behind.

Moore uses the idea of the 'whole product' to explain how the chasm happens. The whole product is the minimal set of technology, services, manufacturing, training and documentation needed to solve the customer's problem. When a technology is new the whole product is very limited. Before the whole product can develop, the technology needs to perform as expected and it must be packaged and delivered to solve a particular customer problem. This process of maturation takes time. There are some customers who are willing to buy the new technology before it is mature. Moore calls these customers visionaries and they are motivated to risk the new technology in order to get a competitive edge in their market.

The initial growth in technology markets comes from these visionary customers. However, there are a limited number of visionary customers willing to work with an incomplete solution. The next groups of customers are called pragmatists. They are willing to buy technology, however, insisting on having a complete working solution before buying. Visionary customers make many demands on their technology suppliers, leaving them with few resources to complete the working 'whole product' the pragmatist demand. This is the source of the chasm. Eventually all the visionary customers have been sold and the pragmatists aren't willing to buy the incomplete whole product. The technology vendors run out of customers. Only the best-run companies survive the chasm and even they find it challenging.

The concept of the whole product must be extended to understand what causes 'the mother of all chasms' as a radical technology develops. I call this extended whole product the 'whole industry system economics' [WISE] - admittedly a broad term but a fitting one nonetheless. The WISE is the set of all the social, political and economic practices and policies that make up the industry. Social includes all management, work and personal practices, political includes all the laws and regulations governing and industry and economic includes all business and financing strategies.

When a radical technology emerges WISE of the time is designed around the previous radical technology. When the steam engine emerged the economic system was organized around farming. When the railroad emerged the economic system organized around factories and mines. When the Internet emerged the WISE, by and large, was organized around mass production. The heritage left from earlier radical technologies resists the adoption and application of new radical technologies. The people, businesses and institutions cannot make effective and profitable use of the new technology.

The entertainment industry is a current example of a WISE resisting a radical technology. The current entertainment industry is organized for mass production and distribution of music and movies. The Internet and compression technologies, such as MP3, are a radical technology changing the way customers think about entertainment products. The experience with file sharing services, like the infamous Napster, demonstrates customers are interested in selection and flexibility, not simply CDs and DVDs. However, the entertainment economic system is organized around producing, copying and distributing these products. The revenue and cost structure is all based on the industry controlling copying and distribution. The laws are based on the assumption the industry and not the customers can do the copying. The radio and TV business is built around this assumption. The entire economic system of the entertainment industry resists the new technology because it cannot make effective use of the new technology. The situation is very similar in the telecommunications industry. To a lesser degree, every industry is in the same situation today.

When the telephone, a radical technology of its day, developed, the primary means of communications were post and telegraph. When the telephone first arrived, businesses and people were quite content communicating this way. It took time and experience to learn how to apply the new technology. The laws and regulations regarding communication supported the postal and telegraph industry. The battle between established telegraph industry and the new telephone industry was every bit as hard fought as the current battle between entertainment and computer industries over intellectual property rights.

Although the promise of the new technology is very real, the ability to deliver on the promise is constrained because the current industries cannot profitably apply the technology. With every new technology there are always a few new and small industries that emerge. Early in the development of the railway, there was a new industry built for transferring coal from railway cars to canal barges and freight ships. It is when these new industries become saturated and stop investing in technology that the 'mother of all chasms' happens and the bubble bursts. However, the promise of radical technology is no less during the chasm period but the focus shifts from the technological invention to business innovation.

The retail commerce industry is always one of the first to take advantage of radical technology. In the transition to the new form of retail, it is always a new company leading the way. Sears began by selling watches through stationmasters along the railroad. As the railway expanded and towns began to grow around the railway stations Sears already had access to that market and they simply increased the number of goods they sold, and published the entire line in a catalog. Kmart took advantage of the growth of suburbia the highway boom allowed. Wal-Mart applied information systems to inventory control in order to offer customers 'every day low prices'. Today, eBay has turned the world into a giant lawn sale, eliminating the need for inventory altogether.

These new retail industries succeed because they satisfied a customer base whose needs could not be satisfied by the existing retailers and where there is no existing economic system to overcome. Free from constraints of old practices and regulations, they are free to experiment, innovate, and ultimately thrive.

These successful early examples of innovation demonstrate the application and integration of the new technology into business practices, blazing the trail that every industry eventually follows. Part II of this article, 'The Long Harvest', discusses how this process of innovation and the resulting period of prosperity ultimately unfold.
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