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The Bear's Lair: Small is not just beautiful, but essential

May 5, 2014

It is becoming increasingly clear that size, in government and business, was a fetish of the early and middle 20th century, caused by the peculiar technological capabilities of that period. Humanity had gained access to enormous power sources, so production could be aggregated into enormous units, but we did not yet have the informational capabilities to manage those units in a sophisticated manner.

The economies of scale from mass production overwhelmed the advantages of flexibility, because that flexibility could not be attained on any but the tiniest scale. Needless to say, today's technological landscape is very different, and the new world favors the small.

This tendency isn't just apparent in the corporate sector. Among governments too, agglomerations of power such as the U.K. that have held together for hundreds of years seem likely to be broken apart by referendum later this year. If Scotland goes, can Catalonia be far behind? Even in the U.S., surely the most successful large country the world has ever seen, cemented together by a bloody civil war, not only has Texas rumbled about secession but Wisconsin also. The latter, a state with political position close to the national epicenter and without any obvious way of communicating with the outside world as a separate entity, is to discuss secession at a state party convention this month.

Before 1945, size was a considerable advantage for a country: It gave you some protection against being invaded. In 1945-1990, it offered an economic advantage; with size you could develop the world-scale industries that allowed your people to become prosperous. However, as scale has become less important industrially (as we shall see below) its political advantages have also declined. Today, a small country gets equal representation at the United Nations, and if it wishes to gain a greater a voice in global foreign policy, it can join a loose agglomeration like ASEAN, the Pacific Alliance or the European Union.

The original 1950s dream for the EU, of course, was to become a gigantic United Europe, a fitting ambition for the era that gave us U.S. Steel, General Motors and the 1960s version of IBM. However, political resistance to the United Europe concept has steadily grown, and in this month's European elections it's likely the biggest gains will be made by a motley collection of national parties, inexperienced in government and disliked by the mainstream, whose only common principle is rejection of the centralized EU apparatus and all it stands for.

Today, the only advantage of size is protection against being invaded by Vladimir Putin. However as Ukraine is discovering a population of 46 million and a land area nearly twice the size of Germany isn't sufficient to avoid this, while at current rate of progress the Baltic States may discover that even membership of a super-state of 500 million population doesn't avoid it either. Still, Scotland does not fear invasion from its larger southern neighbor and presumably Texas considers itself sufficiently well-armed, and Wisconsin sufficiently provided with burly linebackers, for them to resist invasion from north or south. Thus the military advantage of size, while absolute, is important only if you're unlucky enough to live in a rough neighborhood.
For businesses, I wrote some months ago on the late economist Ronald Coase's work, which suggested that business size was dependent on the economies available from aggregating labor in large agglomerations. Single workmen and small groups would incur unnecessarily high costs in negotiating prices and conditions for the work they did within the manufacturing process, whereas a large entity could internalize these costs, pay workmen standard wages and thereby optimize the production process. I also showed that modern technology had reduced the cost of these internal negotiations. Indeed under certain circumstances cellphones could negotiate prices and conditions on the workman's behalf. Thus, smaller aggregations had now become more effective relative to large ones.

The ubiquity of Big Data and the Cloud only intensifies these tendencies. In Don Draper's world large companies had an enormous advantage, especially in industrial marketing, in the great mass of information they had on clients and potential clients from past business dealings. Banks knew all the details of potential borrowers' credit weaknesses, machinery companies knew all the details of the customers' technical requirements, and so on.

This was a real advantage. Back only a few years post-Draper I worked for a medium-sized commercial bank which was expanding into international business. It proved well able to generate lending business from large corporations and commodities houses, by quoting rates slightly finer than those at which its big competitors did business. Unfortunately, when the downturn hit, the fallibility of this strategy became apparent. Weaknesses appeared in the credit of many of the banks' clients, while some of the commodities houses proved prone to fraud. Lacking the data and experience to which its larger competitors had access, my ex-employer generated credit problems at a rate far above the average.

Even more recently, we saw the same problem in the 2007-08 subprime mortgage crisis, in which medium-sized German landesbanks, although in the regulatory sense "sophisticated," ended up with portfolios of unexpectedly unsound subprime mortgage CDOs they had been sold by Wall Street houses with more intimate knowledge of the market.

With Big Data available on the Cloud, this problem goes away. A smaller banking competitor simply has to purchase access to all the data now available about the minute details of each company's business—or each portfolio of subprime mortgages—and put it through analytical software which is also readily available. The result will be a loan portfolio which matches market averages— or, in the case of a machinery company, an ability to design to clients' particular needs that is fully the equal of its larger competitor.

In finance, you can see the process of downsizing beginning. The Big Six, "too big to fail," U.S. banks are reporting notably lackluster earnings, as are the British clearers, while they struggle with the deadweight of their grossly overpaid investment bankers. Big bank revenues are now in a long bear market from three effects. First, the extraordinary monetary stimulus worldwide is winding down; this has propped up investment-banking trading operations since the middle 1990s, but will soon stop doing so. At that point, the traders will be faced with a problem they can only dimly remember, from 1994 or earlier: making a loss.
Second, the advisory business has migrated to boutiques and is increasingly doing so, with the Cloud's analytical and Big Data capabilities helping smaller investment banks just as they are their commercial banking and industrial cousins. Third, as the mechanics of fast trading and the risks of exotic derivatives become better understood by the regulators, they will be sharply restricted and will no longer be available to provide extraordinary boosts to the likes of J.P. Morgan's "Whale" and Goldman Sachs.

With extraordinary profits no longer possible, the banking behemoths will suffer severe competitive disadvantages from their administrative and top management bloat, and will rapidly lose out to smaller houses with less overpaid and more productive personnel.

Outside banking, the economically unsophisticated will object that we are currently seeing an unprecedented spate of merger and acquisition activity, especially in the pharmaceutical sector. The latest fad, driven by tax considerations, is for U.S. companies to merge with foreign companies and re-domicile themselves overseas, thus saving much high-rated (but loophole-ridden) U.S. tax.

However these mergers do not in the long run increase the size of corporations, in terms of capital employed or headcount; they are a symptom of de-capitalization, not of growth. When stock buybacks are running at record levels, and genuine capital investment is low, as at present, the merger of two behemoths produces not a larger behemoth, but a behemoth in which costs are cut relentlessly, duplicating activities are shut down and "non-strategic" assets are sold off to pay down debt. Meanwhile the shareholders of the acquired company take their proceeds and redeploy them in other businesses; this capital has been liberated by the merger.

Even in the tech sector, where mergers are undertaken to grow the underlying businesses, they merely allow those businesses to keep up with the reckless pace of technological change. The $19 billion Facebook acquisition of What'sApp will never produce a business with $19 billion in genuine assets; it will merely allow Facebook to use its overpriced stock to stave off for a few years or even months longer the inevitable erosion of the social media business with which it started.

As we are seeing in the tech sector, value is created in this economy by brilliant technological innovation, generated by a few specialists within organizations of at most a few hundred people. Meanwhile other businesses such as the automobile companies will continue to make money, but will discover their best success to come from running both labor and management as lean as possible, innovating in only a few core aspects themselves, and outsourcing most innovation to specialists in other businesses, who can push the automobile business forward technologically without themselves being part of it.

If the GPS had been available for the Model T, Henry Ford would have incorporated a GPS Division within the River Rouge, would have ordered Harry Bennett's goons to crack the heads of its engineers until they came up with a product that worked and then would have built a side arm on the assembly line, including a micro-electronic fabrication unit, to produce GPS's for insertion into his cars. He'd probably have bought a beach to get the silicon, as well.

We don't do things that way now, and we will never do things that way again. Economically and politically, we will over the next generation find that small units work much better than behemoths, and will move to them throughout our civilization.


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