Progress Snapshot

Release 4.2 January 2008

Breaking Metcalfe’s Law

Progress SnapshotRelease 4.2 January 2008

by Bret Swanson

The power of a network grows approximately by the square of the number of connected 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. Thisrough rule is called Metcalfe’s 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.Metcalfe’s Law helps explain why the “information revolution” will rival or exceedthe Industrial Revolution in scope and scale. Metcalfe’s 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 powerfulwhen the town butcher and baker traded their specialized goods, the exchange of goods, services, and knowledge among ever larger groups yields more than linear growth. 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 of individuals 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 inoutput, the story of globalization is thus itself a dramatic manifestation of Metcalfe’spositive-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 1980s—3ComCorporation, 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 telecomequipment 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 China’s 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 Bain’s 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[People’s 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 law—HR 730—to block the deal.But political hearings and interventions on each cross-boarder investment in thisglobal economy are exactly what we don’t want. Although the deal seemed fairlyroutine, there was no advanced technology involved, and China’s 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 r eview, CFIUS is said to be moving on to an additional, andmore serious, 45-day review.

Although CFIUS could still approve the deal or ask Bainto make adjustments, such as divesting 3Com’s Tipping Point intrusion detectionproducts, some observers believe this extended review means the deal is “in trouble.”

Opponents of the deal betray a fundamental misunderstanding of 3Com’sproduct 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. 3Com’s 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

Tucker, 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

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

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 3Com’s Tipping Point intrusion detection products

had

failedto detect last year’s 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 CNOOC’sfailed 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 number of Hoosiers angrily objected to the $4 billion windfall.America has greeted other recent high profile deals in the financial sector, suchas Abu Dhabi’s $7.5 billion investment in Citigroup,more hospitably. But even somecapitalist stalwarts expressed skepticism at that deal.

And now yet another wave of foreign investment in American financialcompanies, from Merrill Lynch to additionalinfusions at Citi, is reportedly on the way.

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 don’t want the world’s capital. The more obstacleswe lay before highly skilled visa applicants and would-be immigrants, America’s 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 further depreciate 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. If America closes off investment from China, will China block us from investing in theworld’s 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

“Citi of Arabia.”

The Wall Street Journal

. November 29, 2007. p. A18.http://online.wsj.com/article/SB119630344845307407.html

Enrich, David, Randall Smith, and Damian Paletta. “Citigroup, Merrill Seek More Foreign Capital.”

The

Wall Street Journal

. January 10, 2008.