American Disruption

I have a few informal guidelines that govern my writing on Stratechery, including “Don’t post more than one front-page Article a week”, “Don’t talk about my writing process”, and “Don’t start Articles with ‘I'”; it’s an extraordinary week, though, so I’m breaking a few rules.

There are three old Stratechery Articles that, after reflection, missed the mark in different ways.

• The most proximate cause for my rule-breaking was Monday’s Trade, Tariffs, and Tech; I stand by everything I wrote, but it was incomplete, lacking an overall framework and satisfying conclusion. That’s not surprising given the current uncertainty, but that means I should have waited to publish a front-page Article until I had more clarity (I do much more musing in my Updates, which that Article is now categorized as). Now I have to break my rule and write another Article.
• The second Article to revisit is November’s A Chance to Build. This Article was in fact deeply pessimistic about President Trump’s promised trade regime, particularly in terms of what it meant for tech; the title and conclusion, however, tried to find some positives. Clearly that was a mistake; that Article was predictive of what was happening, but I obscured the prediction.
• The third Article to revisit is January 2021’s Internet 3.0 and the Beginning of (Tech) History. This Article was right about tech exiting an economically-defined era — the Aggregation era — and entering a new politically-defined era. It was, however, four years too early, and misdiagnosed the reason for the transition. The driver is not foreign countries closing their doors to America; it’s America closing its door to the world.

The proximate cause of all of this reflection is of course Trump’s disastrous “liberation day” tariffs. The secondary cause is what I wrote about Monday: the U.S. has a genuine problem on its hands thanks to its inability to make things pertinent to modern warfare and high tech. The root cause, however, is very much in Stratechery’s wheelhouse, and worthy of another Article: it’s disruption.

The Disruption of American Manufacturing

The late Professor Clayton Christensen — one of my personal heroes and inspirations — coined the term disruption in a seminal paper called Disruptive Technologies: Catching the Wave, which he expanded to book-length in The Innovator’s Dilemma. However, Christensen’s most concise summary comes from this 20-year retrospective in Harvard Business Review:

“Disruption” describes a process whereby a smaller company with fewer resources is able to successfully challenge established incumbent businesses. Specifically, as incumbents focus on improving their products and services for their most demanding (and usually most profitable) customers, they exceed the needs of some segments and ignore the needs of others. 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.

This is almost a perfect summary of what has happened in manufacturing, and, as I noted in that November article, it started with chips:

That history starts in 1956, when William Shockley founded the Shockley Semiconductor Laboratory to commercialize the transistor that he had helped invent at Bell Labs; he chose Mountain View to be close to his ailing mother. A year later the so-called “Traitorous Eight”, led by Robert Noyce, left and founded Fairchild Semiconductor down the road. Six years after that Fairchild Semiconductor opened a facility in Hong Kong to assemble and test semiconductors. Assembly required manually attaching wires to a semiconductor chip, a labor-intensive and monotonous task that was difficult to do economically with American wages, which ran about $2.50/hour; Hong Kong wages were a tenth of that. Four years later Texas Instruments opened a facility in Taiwan, where wages were $0.19/hour; two years after that Fairchild Semiconductor opened another facility in Singapore, where wages were $0.11/hour.

In other words, you can make the case that the classic story of Silicon Valley isn’t completely honest. Chips did have marginal costs, but that marginal cost was, within single digit years of the founding of Silicon Valley, exported to Asia.

Notice what did still happen in the United States, at least back then: actual chip fabrication. That was where innovation happened, and where margins were captured, so of course U.S. chip companies kept that for themselves. It was the tedious and labor-intensive assembly and testing that was available to poor Asian economies led by authoritarian governments eager to provide some sort of alternative to communism.

One important point about new market disruption — which Asian manufacturing was — is that it is downstream of a technological change that fundamentally changes cost structures. In the case of the Asian manufacturing market, there were actually three; from 2016’s The Brexit Possibility:

In the years leading up to the 1970s, three technological advances completely transformed the meaning of globalization:

• In 1963 Boeing produced the 707-320B, the first jet airliner capable of non-stop service from the continental United States to Asia; in 1970 the 747 made this routine.
• In 1964 the first transpacific telephone cable between the United States and Japan was completed; over the next several years it would be extended throughout Asia.
• In 1968 ISO 668 standardized shipping containers, dramatically increasing the efficiency with which goods could be shipped over the ocean in particular.

These three factors in combination, for the first time, enabled a new kind of trade. Instead of manufacturing products in the United States (or Europe or Japan or anywhere else) and trading them to other countries, multinational corporations could invert themselves: design products in their home markets, then communicate those designs to factories in other countries, and ship finished products back to their domestic market. And, thanks to the dramatically lower wages in Asia (supercharged by China’s opening in 1978), it was immensely profitable to do just that.

Christensen, somewhat confusingly, actually has two theories of disruption; the other one is called “low-end disruption”, but it is also pertinent to this story. From The Innovator’s Solution:

The pressure of competing along this new trajectory of improvement [(speed, convenience, and customization)] forces a gradual evolution in product architecture, as depicted in Figure 5-1 — away from the interdependent, proprietary architectures that had the advantage in the not-good-enough era toward modular designs in the era of performance surplus. Modular architectures help companies to compete on the dimensions that matter in the lower-right portions of the disruption diagram. Companies can introduce new products faster because they can upgrade individual subsystems without having to redesign everything. Although standard interfaces invariably force compromise in system performance, firms have the slack to trade away some performance with these customers because functionality is more than good enough.

Modularity has a profound impact on industry structure because it enables independent, nonintegrated organizations to sell, buy, and assemble components and subsystems. Whereas in the interdependent world you had to make all of the key elements of the system in order to make any of them, in a modular world you can prosper by outsourcing or by supplying just one element. Ultimately, the specifications for modular interfaces will coalesce as industry standards. When that happens, companies can mix and match components from best-of-breed suppliers in order to respond conveniently to the specific needs of individual customers. As depicted in Figure 5-1, these nonintegrated competitors disrupt the integrated leader.

This is exactly what happened to categories like PCs: everything became modular, commoditized, and low margin — and thus followed chip test and assembly to Asia. One aspect that was under-discussed in Christensen’s theory, however, was scale, which mattered more than the customization point. It was less important that a customer be able to use any chip they wanted than it was that a lot of customers wanted to use the same chip. Moreover, this scale point applied up-and-down the stack, to both components and assemblers.

Note also the importance of scale to the new market disruption above: while outsourcing got easier thanks to technology, it’s difficult to be easier than working locally; the best way to overcome those coordination costs is to operate at scale. This helps explain why manufacturing in Asia is fundamentally different than the manufacturing we remember in the United States decades ago: instead of firms with product-specific factories, China has flexible factories that accommodate all kinds of orders, delivering on that vector of speed, convenience, and customization that Christensen talked about.

This scale has, as I noted last November, been particularly valuable for tech companies; software scales to the world, and Asian factories, particularly Chinese ones, scale with it, providing the hardware complements to American software. That is why every single tech company — even software ones — are damaged by these tariffs; more expensive complements means lower usage overall.

The other scale point that is particularly pertinent to technology is chips. Every decrease in node size comes at increasingly astronomical costs; the best way to afford those costs is to have one entity making chips for everyone, and that has turned out to be TSMC. Indeed, one way to understand Intel’s struggles is that it was actually one of the last massive integrated manufacturers: Intel made chips almost entirely for itself. However, once the company missed mobile, it had no choice but to switch to a foundry model; the company is trying now, but really should have started fifteen years ago. Now the company is stuck, and I think they will need government help.

iPhone Jobs

There is one other very important takeaway from disruption: companies that go up-market find it impossible to go back down, and I think this too applies to countries. Start with the theory: Christensen had a chapter in The Innovator’s Dilemma entitled “What Goes Up, Can’t Go Down”:

Three factors — the promise of upmarket margins, the simultaneous upmarket movement of many of a company’s customers, and the difficulty of cutting costs to move downmarket profitably — together create powerful barriers to downward mobility. In the internal debates about resource allocation for new product development, therefore, proposals to pursue disruptive technologies generally lose out to proposals to move upmarket. In fact, cultivating a systematic approach to weeding out new product development initiatives that would likely lower profits is one of the most important achievements of any well-managed company.

Now consider this in the context of the United States: every single job in this country, even at the obsolete federal minimum wage of $7.25/hour, makes much more money than an iPhone factory line worker. And, critically, we have basically full employment; that is what makes this statement from White House Press Secretary Karoline Leavitt ridiculous; from 9to5Mac:

In response to a question from Maggie Haberman of The New York Times about the types of jobs Trump hopes to create in the U.S. with these tariffs, Leavitt said:

“The president wants to increase manufacturing jobs here in the United States of America, but he’s also looking at advanced technologies. He’s also looking at AI and emerging fields that are growing around the world that the United States needs to be a leader in as well. There’s an array of diverse jobs. More traditional manufacturing jobs, and also jobs in advanced technologies. The president is looking at all of those. He wants them to come back home.”

Haberman followed up with a question about iPhone manufacturing specifically, asking whether Trump thinks this is “the kind of technology” that could move to the United States. Leavitt responded:

“[Trump] believes we have the labor, we have the workforce, we have the resources to do it. As you know, Apple has invested $500 billion here in the United States. So, if Apple didn’t think the United States could do it, they probably wouldn’t have put up that big chunk of change.”

So could Apple pay more to get U.S. workers? I suppose — leaving aside the questions of skills and whatnot — but there is also the question of desirability; the iPhone assembly work that is not automated is highly drudgerous, sitting in a factory for hours a day delicately assembling the same components over and over again. It’s a good job if the alternative is working in the fields or in a much more dangerous and uncomfortable factory, but it’s much worse than basically any sort of job that is available in the U.S. market.

At the same time, it is important to note that this drudgerous final assembly work is a center of gravity for the components that actually need to be assembled, and these parts are all of significantly higher value, and far more likely to be produced through automation. As I noted yesterday, Apple has probably done more than any other company to move China up the curve in terms of the ability to manufacture components, often to the detriment of suppliers in the U.S., Taiwan, South Korea, Japan, etc.; from Apple’s perspective spending time and money to bring Chinese component suppliers online provides competition for its most important suppliers, giving them greater negotiating leverage. From the U.S.’s perspective this means that a host of technologies and capabilities downstream from the smartphone — which is to say nearly all electronics, including those with significant military applicability like drones — are being developed in China.

Beyond Disruption

Fortunately, while true disruption is often the ultimate death knell for an individual company with a specific value proposition, I don’t think it is a law of nature. Disruption is about supply, but success on the Internet, to take one example familiar to Stratechery readers, is about demand — and controlling demand is more important than controlling supply. I expanded on this in a 2015 Article called Beyond Disruption:

The Internet has completely transformed business by making both distribution and transaction costs effectively free. In turn, this has completely changed the calculus when it comes to adding new customers: specifically, it is now possible to build businesses where every incremental customer has both zero marginal costs and zero opportunity costs. This has profound implications: instead of some companies serving the high end of a market with a superior experience while others serve the low-end with a “good-enough” offering, one company can serve everyone. And, given the choice between a superior experience and one that is “good-enough,” of course the superior experience will win.

To be sure, it takes time to scale such a company, but given the end game of owning the entire market, the rational approach is not to start on the low-end, but rather the exact opposite. After all, while marginal costs may be zero, providing a superior experience in the age of the Internet entails significant upfront (fixed) costs, and while those fixed costs are minimized on a per-customer basis at scale, they can have a significant impact with a small customer base. Therefore, it makes sense to start at the high-end with customers who have a greater willingness-to-pay, and from there scale downwards, decreasing your price along with the decrease in your per-customer cost base (because of scale) as you go (and again, without accruing material marginal costs).

This is exactly what Uber has done: the company spent its early years building its core technology and delivering a high-end experience with significantly higher prices than incumbent taxi companies. Eventually, though, the exact same technology was deployed to deliver a lower-priced experience to a significantly broader customer base; said customer base was brought on board at zero marginal cost.

I want to be careful to draw too many lessons from Aggregation Theory in an Article about manufacturing, given there are by definition marginal costs involved in physical goods. However, I would note two things:

• First, marginal manufacturing costs are, for many goods, going down over time, thanks to automation; indeed, this is why the U.S. still has a significant amount of manufacturing output even if an ever-decreasing number of people are employed in the manufacturing sector.
• Second, the idea that demand matters most does still hold. The takeaway from that Article isn’t that Uber is a model for the rebirth of American manufacturing; rather it’s that you can leverage demand to fundamentally reshape supply.

It’s not as if the Trump administration doesn’t know this: the entire premise of these tariffs is that everyone wants access to the U.S. market, and rightly so given the outsized buying power driven both by our wealth and by the capacity for borrowing afforded us by the dollar being the reserve currency. It’s also true that China has an excess of supply; given that supply is usually built with debt that means the country needs cash flow, and even if factories are paid off, the country needs the employment opportunties. China’s hand is not as strong as many of Trump’s strongest critics believe.

The problem with these tariffs is that their scale and indiscriminate nature will have the effect of destroying demand and destroying the capability to develop alternative supply. I suppose if the only goal is to hurt China than shooting yourself in the foot, such that you no longer need to buy shoes for stumps, is a strategy you could choose, but that does nothing to help with what should be the primary motivation: shoring up the U.S. national security base.

Those national security concerns are real. The final stage of disruption is when the entity that started on the bottom is uniquely equipped to deliver what is necessary for a new paradigm, and that is exactly what happened with electronics generally and drones specifically. Moreover, this capability is only going to grow more important with the rise of AI, which will be substantiated in the physical world through robotics. And, of course, robots will be the key to building other robots; if the U.S. wants to be competitive in the future, and not be dependent on China, it really does need to make changes — just not these ones.

A Better Plan

The key distinguishing feature of a better plan is that it doesn’t seek to own supply, but rather control it in a way the U.S. does not today.

First, blanket tariffs are a mistake. I understand the motivation: a big reason why Chinese imports to the U.S. have actually shrunk over the last few years is because a lot of final assembly moved to countries like Vietnam, Thailand, Mexico, etc. Blanket tariffs stop this from happening, at least in theory.

The problem, however, is that those final assembly jobs are the least desirable jobs in the value chain, at least for the American worker; assuming the Trump administration doesn’t want to import millions of workers — that seems rather counter to the foundation of his candidacy! — the United States needs to find alternative trustworthy countries for final assembly. This can be accomplished through selective tariffs (which is exactly what happened in the first Trump administration).

Secondly, using trade flows to measure the health of the economic relationship with these countries — any country, really, but particularly final assembly countries — is legitimately stupid. Go back to the iPhone: the value-add of final assembly is in the single digit dollar range; the value-add of Apple’s software, marketing, distribution, etc. is in the hundreds of dollars. Simply looking at trade flows — where an imported iPhone is calculated as a trade deficit of several hundred dollars — completely obscures this reality. Moreover, the criteria for a final assembly country is that they have low wages, which by definition can’t pay for an equivalent amount of U.S. goods to said iPhone.

At the same time, the overall value of final assembly does exceed its economic value, for the reasons noted above: final assembly is gravity for higher value components, and it’s those components that are the biggest national security problem. This is where component tariffs might be a useful tool: the U.S. could use a scalpel instead of a sledgehammer to incentivize buying components from trusted allies, or from the U.S. itself, or to build new capacity in trusted locations. This does, admittedly, start to sound a lot like central planning, but that is why the gravity argument is an important one: simply moving final assembly somewhere other than China is a win — but not if there are blanket tariffs, at which point you might as well leave the supply chain where it is.

Third, the most important components for executing a fundamental shift in trade are those that go into building actual factories, or equipment for those factories. In the vast sea of stupidity that are these tariffs this is perhaps the stupidest detail of all: the U.S. is tariffing raw materials and components for factory equipment, like CNC machines. Consider this announcement from Haas:

You can certainly make the case that things like castings and other machine components are of sufficient importance to the U.S. that they ought to be manufactured here, but you have to ramp up to that. What is much more problematic is that raw materials and components are now much cheaper for Haas’ foreign competitors; even if those competitors face tariffs in the United States, their cost of goods sold will be meaningfully lower than Haas, completely defeating the goal of encouraging the purchase of U.S. machine tools.

I get the allure of blanket tariffs; politics is often the art of the possible, and the perfect is the enemy of the good. The problem is this approach simply isn’t good: it’s actively detrimental to what should be the U.S.’s goals. It’s also ignoring the power of demand: China would supply factories in the U.S., even if the point of those factories was to displace China, because supply needs to sell. This is how you move past disruption: you not only exert control on alternatives to China, you exert control on China itself.

Fourth, there remains the problem of chips. Trump just declared economic war on China, which definitionally increases the possibility of kinetic war. A kinetic war, however, will mean the destruction of TSMC, leaving the U.S. bereft of chips at the very moment that A.I. is poised to create tremendous opportunities for growth and automation. And, even if A.I. didn’t exist, it’s enough to note that modern life would grind to a halt without chips. That’s why this is the area that most needs direct intervention from the federal government, particularly in terms of incentivizing demand for both leading and trailing edge U.S. chips.

I do, as I noted on Monday, have more sympathy than many of Trump’s critics for the need to make fundamental changes to trade; that, however, doesn’t mean any change is ipso facto good: things could get a lot worse, and these “liberation day” tariffs will do exactly that.

The Melancholy of Internet 3.0

I started this essay being solipsistic, so let me conclude with some more navel-gazing: my prevailing emotion over the past week — one I didn’t fully come to grips with until interrogating why Monday’s Article failed to live up to my standards — is sadness over the end of an era in technology, and frustration-bordering-on-disillusionment over the demise of what I thought was a uniquely American spirit.

The first emotion goes back to that January 2021 Article about Internet 3.0 and the Beginning of (Tech) History:

• Internet 1.0 was about technology. This was the early web, where technology was made for technology’s sake. This was where we got standards like TCP/IP, DNC, HTTP, etc. This was obviously the best era, but one that was impossible to maintain once there was big money to be made on the Internet.
• Internet 2.0 was about economics. This was the era of Aggregators — the era of Stratechery, in other words — where the Internet developed, for better or worse, in ways that made maximum economic sense. This was a massive boon for the U.S., which sits astride the world of technology; unfortunately none of the value that comes from that position is counted in the trade statistics, so the administration doesn’t seem to care.
• Internet 3.0 is about politics. This is the era where countries make economically sub-optimal choices for reasons that can’t be measured in dollars and cents. In that Article I thought that Big Tech exercising its power against the President might be a spur for other countries to seek to wean themselves away from American companies; instead it is the U.S. that may be leaving other countries little choice but to retaliate against U.S. tech.

One can certainly make the case that the Internet 2.0 era wasn’t ideal, or even actively detrimental; it’s similar to the case that while free trade might have made everyone — especially the U.S. — richer, it wasn’t worth national security sacrifices that we are only now waking up to. For me, though, it was the era that has defined my professional life, and I’m sad to see it slipping away. Stratechery has always been non-political; it bums me out if we are moving to an era where politics are inescapable — they certainly are this week.

The second emotion — the frustration-bordering-on-disillusionment — is about the defeatist and backwards-looking way that the U.S. continues to approach China. These tariffs, particularly to the extent they are predicated on hurting China, are a great example: whether through malice or incompetence this particular tariff plan seems designed to inflict maximal pain, even though that means hurting the U.S. along the way. What is worse is that this is a bipartisan problem: Biden’s chip controls are similarly backwards looking, seeking to stay ahead by pulling up the ladder of U.S. technology, instead of trying to stay ahead through innovation.

There is, admittedly, a hint of that old school American can-do attitude embedded in these tariffs: the Trump administration seems to believe the U.S. can overcome all of the naysayers and skeptics through sheer force of will. That force of will, however, would be much better spent pursuing a vision of a new world order in 2050, not trying to return to 1950. That is possible to do, by the way, but only if you accept 1950’s living standards, which weren’t nearly as attractive as nostalgia-colored glasses paint them as, and if we’re not careful, 1950’s technology as well. I think we can do better that that; I know we can do better than this.