The Essential Fact About Capitalism

You may have noticed Harvard Business School’s Clayton Christensen has been getting quite a bit of press over the past few days, on a topic that you should be well acquainted with by now: disruptive innovation.

Christensen coined the term in his 1997 book, The Innovator’s Dilemma, which is partially what led Addison Wiggin and myself to sit down with him at his office on the school’s campus (a snippet of that interview can be seen in today’s video).

It’s also what led New Yorker writer, Jill Lepore, to pen an article, “The Disruption Machine,” in an attempt to disprove Christensen’s theory – and take all this “innovation” mumbo jumbo down a peg or two.

“The idea of innovation,” writes Ms. Lepore, “is the idea of progress stripped of the aspirations of the Enlightenment, scrubbed clean of the horrors of the twentieth century, and relieved of its critics. Disruptive innovation goes further, holding out the hope of salvation against the very damnation it describes: disrupt, and you will be saved.”

Hmmm. Not exactly how Christensen describes his theory, which is rooted within economist Joseph Schumpter’s model of creative destruction.

Creative destruction, according to Schumpter, is “the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.”

This “fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods…the new markets…that capitalist enterprise creates…that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”

Christensen has spent his academic career studying the problems of innovation – specifically looking at what it is that makes success so difficult to sustain. What causes some companies to flourish within Schumpter’s “capital engine” and some to burn out?

And so, in answering these questions, a new buzzword was born: disruptive innovation. Christensen defines his contribution to Schumpter’s model as ‘the causal mechanism by which creative destruction occurs.’

“The mechanism that causes successful companies to fail,” Christensen told us, “is that they actually do everything right.”

“It’s the principles of good management that are taught at places like the Harvard Business School, that sow the seeds of every company’s ultimate failure.

“And that, I think, was quite a breakthrough insight,” continued Christensen, “that it was not that these people are stupid. It’s that, they really are managing their companies well – that’s what causes them to fail.”

Sounds crazy – until you stop and think about it.

As companies become successful, they begin to settle in…they get comfortable, they’ve found what makes them money, and what their customers want…and the stench of the ‘if it ain’t broke, don’t fix it’ mentality begins to permeate the air.

The company stops pushing the envelope. Why should they? They’re raking in money…until a smaller company comes out of nowhere, with a newer, cheaper way of tapping into their customer base…and that’s when things begin to fall apart.

You can see it all around you – the companies that didn’t pay attention to the little guy coming in at the bottom of the market that was dismissed as a flash in the pan.

“A great example of this process of disruption is in Detroit,” Christensen explains.

“Toyota basically killed the Detroit auto makers. But, they didn’t do it by introducing Lexuses to compete at the high end with Detroit’s most profitable products.

“Instead, they came in, in the 1960s, with this rusty little subcompact model called a Corona. And then, Toyota went from a Corona, to a Tercel, to a Corolla, to a Camry, to a Forerunner… to an Avalon, to a Forerunner, to a Sequoia, and then, to a Lexus – step by step, moving up market.

“Every once in awhile, GM and Ford would see Toyota coming at them from the bottom, and say, ‘You know, we ought to go compete against those guys.’

“But then, they would compare the profitability of the little subcompact with the profitability of a Cadillac Escalade, or an F350 pickup; and, it just didn’t make sense to invest to defend the least profitable part of the business.

“And, now that Toyota has come up to the high end of the market, it makes consummate sense that General Motors and Ford should have worried about this twenty years ago; but, the game is over.”

This scenario has been playing itself out in one way or another for years…but now this disruptive process is accelerating, and leaving a lot of causalities in its wake.

One such casualty was New York Times’ executive editor, Jill Abramson. After she was fired last month, the Times’ 2014 Innovation Report started circulating on the web – and turns out, the report drew inspiration from Christensen’s book, The Innovator’s Dilemma.

“Today,” warns the report, “, a pack of news startups are hoping to ‘disrupt’ our industry by attacking the strongest incumbent—The New York Times.”

Lepore’s response in the New Yorker comes as no surprise:

“A pack of attacking startups sounds something like a pack of ravenous hyenas, but, generally, the rhetoric of disruption—a language of panic, fear, asymmetry, and disorder—calls on the rhetoric of another kind of conflict, in which an upstart refuses to play by the established rules of engagement, and blows things up.

“Startups are ruthless and leaderless and unrestrained, and they seem so tiny and powerless, until you realize, but only after it’s too late, that they’re devastatingly dangerous.

“Think of it this way: the Times is a nation-state; BuzzFeed is stateless. Disruptive innovation is competitive strategy for an age seized by terror.”

Change is hard – especially when it’s coming this fast and upending your entire livelihood.

But the bigger picture here, the one that’s missing from the New Yorker article is how America, as a country, deals with these changes. We have a few options:

We can dig our heels in and dismiss these innovations, these entrepreneurs, these start-ups as cheap knock-offs that won’t amount to anything…that is, until we need a massive bailout or government intervention.

We can put up barrier after barrier to innovation…more taxes, more regulations, more changing rules…and end up forcing businesses to generate their wealth overseas.

Or we can embrace the change and realize most of the wealth that’s been created in the U.S. over the past 30 years has come from new businesses and new industries.

These waves of change can be brutal, says Juan Enriquez, “But they’ve also generated a Hell of a life, in terms of lifespan, in terms of health, in terms of wealth. In terms of opportunity, for about a third of the population of the planet, that’s been taken out of poverty in the last 20 years. And that’s the power of embracing this stuff.”

The Daily Reckoning