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Creative Destruction

January 18, 1999

"Creative destruction" is a term economists use to describe the way in which dynamic new industries overtake then replace old industries.

It is not intrinsically a benign process, and it can create wrenching social and economic dislocations, as I shall make clear. But it is nonetheless capitalism at its dispassionate best, redirecting investment and resources toward their most efficient use.

When this occurs, new wealth is a salient byproduct -- one which benefits all members of society, albeit not necessarily democratically, and which further incentivizes change.

This is progress of a purely economic sort, and history has shown time and again that, in strictly economic terms, it will always create more wealth than it destroys, raising the standard of living for all.

This will surely be the case with the Internet, which has the potential to revolutionize the global economy. But the gains may be longer in coming than most people suspect, and the economic pain of getting there will be like nothing civilization has ever experienced.

Up till now, the most compelling paradigm lay in the spectacular growth of the auto industry, whose eventual impact on this country could not have been foreseen even by the visionaries who pioneered the assembly line, much less by those die-hards whose financial well-being lay in horse-and-buggy sales.

Fifty years from now, as much may be true of the Internet. Although it has sparked a speculative fever on Wall Street and attracted America's best and brightest to centers of innovation such as the Silicon Valley, few could say with any certainty what great successes the industry will be able to claim twenty years down the road, or even ten.

This has not discouraged hoards of investors from bidding skyward the shares of such Internet-based firms such as Amazon, E-Bay, America Online and Yahoo! .

I do not consider myself a horse-and-buggy reactionary, nor do I think that the potential of the Internet can be overestimated. But I'd still bet that, two or three years from now, many of today's cybershare zealots will look like fools, and some of the smaller companies that have been attracting their speculative dollars won't even be around.

Looking out on a more distant horizon, however, neither I nor anyone else should deign to predict which of the companies will eventually live up to today's extravagant expectations, and which of those that remain will be relegated to the purgatory in which investors have placed such conceptual clunkers as paper products, steel pipe and oilfield services.

Ironically, in the heat of our relatively recent infatuation with Internet companies, few investors seem to realize that the very success of such firms implies "creative destruction" on a most spectacular scale.

For starters, we can write off the bricks and mortar of every downtown financial district in the world, because little of it will survive the competition with cyberworld. In fact, virtual commerce has already rendered obsolescent the skyscrapers, stock exchanges, bank lobbies, record stores, luncheonettes, newsstands, book stores, commuter trains and much else that we can see from our office windows.

There was fresh evidence of this last week with the announcement that Bank of America, a successful company in a hot industry, plans to lay off 18,000 employees. Another story around the same time said a planned merger between the Pacific Exchange (PCX) and the Chicago Board Options Exchange (CBOE) has been called off.

CBOE authorities cited regulatory overload for their reluctance to proceed. A more plausible reason is that they are mortally afraid of competition from electronic exchanges now in the planning stage, and are therefore reluctant to add prime real estate in downtown San Francisco to their stock of capital.

Meanwhile, the PCX canceled grandiose plans of its own to build a new $150 million securities exchange south of Market Street. They still plan to expand, but evidently decided it will be cheaper and wiser to rent rather than build.

The CBOE, PCX and other securities exchanges may be able to survive, but their odds will worsen to the extent they are burdened with the costs of operating and maintaining trading floors and support offices that sprawl over millions of square feet in downtown financial districts. Meanwhile, many of the floor traders I know have opted to hang up their smocks and trade electronically from their homes or suburban offices.

Commercial real estate won't be the only casualty as virtual commerce burgeons. Since the World Wide Web gives companies the ability to sell directly to their customers, America's sales force is going to be decimated.

This is inevitable, although neither the companies nor their employees in the field are eager to acknowledge it quite yet, for both have too big a stake in the status quo. Despite this, nearly every retailer and manufacturer in America has opened up Web site in the last two years, tactfully encouraging customers to drop in from time to time.

The firms are being coy, reluctant to compete aggressively with their own sales channels, but it is only a matter of time before they embrace the savings that Web-based sales allow and jettison payrolls and commissions.

The record industry may not be so fortunate as to have a choice, since the artists whose work they have long produced and marketed can now sell directly to the public on the Internet by way of a digital technology called MP3.

Record companies are getting nervous about this and using copyright laws to fight the trend, which so far is being pushed mostly by self-publishing rock 'n' roll bands. But in the end the corporate biggies will lose, since, technologically speaking, most of the hugely expensive infrastructure they have created to move a recording from studio to home is by now wholly unnecessary.

Meanwhile, as economists argue about whether the global deflationary trend that lately has constrained sellers of goods from raising prices will pass quickly, the much bigger picture suggests it will be with us for decades to come and that its force will greatly intensify before it is spent.

For if nearly all manufacturers can sell directly to the public, and retailers can operate from exurban warehouses, they eventually will, with the result that their existing physical infrastructure will be allowed to wither away.

Moreover, it is by no means inconceivable that some manufacturers themselves will be put out of business by as-yet-unforeseen technologies.

Can anyone be certain the day will not come when an MIT graduate student working in his basement can design, produce and market one of the manufacturing world's most capital-intensive products, a semiconductor chip?

It may sound farfetched -- but so, ten years ago, did the idea of putting a two-hour movie on a plastic disc no bigger than 6" in diameter.

Someday, building on the technologies of such movie studios as Pixar and Industrial Light & Magic, your kids may be able to make and distribute their own feature films -- using a space no bigger than a darkroom.

And then where will Hollywood be, along with its $20-million-a-picture stars?

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