02/05/90 THE FUTURE OF SILICON VALLEY

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THE FUTURE OF SILICON VALLEY
Does the U.S. Need a High-Tech Industrial Policy To Battle Japan Inc.?
The violin that arrived at the White House for Budget Director Richard G. Darman was no token of appreciation for the policy tune that Washington is playing. Inside was a note from Andrew S. Grove, president of Intel Corp., suggesting that Darman might like to pass some time fiddling while American high technology burns. The way high tech is getting kicked around in Washington, Grove says, ''I feel we are fighting two governments at the same time -- Japan's and our own.'' Grove is not alone. From California's Silicon Valley to Route 128 in Massachusetts, a chorus of U. S. executives is calling for a new strategic partnership between the electronics industry and government. Computer makers, software houses, telecommunications companies, and chip producers are urging Washington to help bolster America's competitiveness. Their agenda includes relaxing antitrust regulations, recasting fiscal and tax policies, and adopting a more pragmatic stance on trade.
The mid-January demise of U. S. Memories Inc. is not likely to strengthen high tech's case in Washington. This was the ambitious plan hatched by IBM and six other big high-tech players, including Intel, to recapture some of the computer memory-chip business lost to Japan in the 1980s. The idea had been to collaborate on making dynamic random-access memories (DRAMs) and increase domestic supplies to U. S. users (BW -- Jan. 29). But if the electronics industry isn't willing to back such self-help schemes, many lawmakers may be apt to wonder whether the high-tech crowd really wants a bailout instead of a helping hand. So far, the Administration has turned a deaf ear to the appeals.
TV-JEEBIES. What the high-tech gurus want is for the U. S. to forge a cohesive and comprehensive industrial policy -- and there the battle line gets drawn. The very concept of industrial policy is anathema to Darman, White House Chief of Staff John H. Sununu, and Chief Economic Adviser Michael J. Boskin (page 60). A good many economists and legislators share their feelings -- as do some high-tech executives. For them, former President Reagan's ''magic of the market'' is the bedrock of American capitalism. It has delivered a cornucopia of riches matched by no other system, including a venture-capital environment that is the envy of the world.
During the Bush Administration's honeymoon phase last spring, Washington seemed a staunch ally of high tech. Commerce Secretary Robert A. Mosbacher promised that the Bush team would hammer out a strategy to nurture high-definition television. HDTV will be far more than just a consumer product. The new technologies needed to bring HDTV to market will catalyze major advances across the entire spectrum of electronics, from chips to supercomputers. That's why the industry terms HDTV the next ''technology driver.''
But the HDTV initiative never left the starting gate. Such targeted federal spending didn't sit well with the White House. So Mosbacher was summoned to a chat. ''We told him it is not our policy to talk up a single slice of industry,'' recalls Sununu, because that would impede ''our true competitiveness policy.''
By late last year, the Capitol's rumor mills were smoking with reports of other pullbacks: The Office of Management & Budget had told the Defense Dept. to rein in the modest HDTV effort at the Defense Advanced Research Projects Agency (DARPA). The White House hit list also included DARPA's research on X-ray lithography, a leading candidate for ''printing'' invisibly thin circuit lines on future computer chips. Even the Pentagon's $100 million annual contribution to Sematech was rumored to be in doubt. This industry-government consortium is working on new chipmaking techniques that could let Silicon Valley leapfrog Japan in the mid-1990s.
Long before winter's chill glazed the Potomac, Silicon Valley's cozy feeling for the Administration had plunged to arctic extremes. So now electronics industry associations are banding together -- call it ''Silicon Valley Inc.'' -- determined to force the Administration to rethink its priorities. Something must be done, and quickly, to counter the government-industry colossus known as Japan Inc., warns Mitchell E. Kertzman, chairman of the American Electronics Assn. (AEA) and president of Computer Solutions Inc. ''We're closer to the point of no return than most people think.''
This flip-flop is pretty astounding, coming from many of the freewheeling entrepreneurs who once were rabid free-traders. Now, they sound more like the steel industry, beseeching Washington for protection from foreign competitors. Actually, petitioning Washington galls even the activists. ''I remain a free-trader and, fundamentally, so do most electronics executives,'' stresses M. Kenneth Oshman, co-founder of Rolm Corp. and now president of startup Echelon. ''But the government has been so lousy at providing the mechanism for free trade, we have to do something.''
SYNFUELS REDUX? Economists contend that interfering with market mechanisms would be costly. It would lead to protectionism, denying low-cost imports to consumers and blunting incentives to improve productivity. And the thought of the government's meddling with the process of innovation -- and thereby politicizing it -- worries Paul R. Krugman, a Nobel-laureate economist at Massachusetts Institute of Technology. Subsidizing a push in HDTV, he says, could wind up as a repeat of the synfuels project undertaken during the energy crisis of the 1970s -- a multibillion-dollar sinkhole.
Indeed, the prospect of Japan's dominating HDTV doesn't bother Jagdish N. Bhagwati, an economist at Columbia University. He asserts that the U. S. ought to be able to exploit foreign knowhow just as easily as foreign companies profit from American inventions. ''It's not established that the people who develop HDTV will be getting all the returns,'' he notes. Devout free-traders are willing to blow a good-bye kiss to chips or any other high-tech area, if that is the outcome of market forces.
This logic appalls Grove and the other wizards of Silicon Valley. Semiconductors, they argue, will continue to be the ''enabling technology'' underpinning advances in every field of science and technology for decades to come. If semiconductors go, telecommunications and the rest of the electronics field won't be far behind -- including supercomputers, which are rapidly becoming indispensable tools in engineering and science. To risk entering the 21st century with a second-rate semiconductor industry is sheer folly, they say.
If present trends remain unchecked, that is exactly what's likely to happen -- and not because Silicon Valley can't compete in a free market. As many U. S. executives see it, Japan has devised a strategy that twists free trade to serve its own ends. Japan is prepared to absorb losses on export goods indefinitely, until entire industries are brought to their knees. It makes up the deficits by ''taxing'' domestic consumers. That's why Japan shelters the markets it targets for domination. With foreign competition blocked, Japanese manufacturers can charge much higher prices at home -- as they do for consumer electronics, for example.
What the high-tech community asks is that Washington level the playing field to ensure fair trade. As for Washington's ''picking winners and losers'' by subsidizing individual industries, which many lawmakers believe is implicit to industrial policy, that is emphatically not part of industry's formula. ''To hell with that,'' growls Grove of Intel. ''Let the companies fend for themselves.''
Even in academic circles, there is growing agreement that it's time to examine how federal policies affect all industries' ability to compete. ''What we need now,'' says Robert B. Reich, a political economist at Harvard University, ''is for government to take a broader, wider, and more strategic view of what's good for the nation -- some sense of how trade policies, fiscal policies, and monetary policy all fit together.'' In this country, he says, ''that has never happened.'' Adds Michael G. Borrus, co-director of the Berkeley Roundtable on the International Economy: ''It's impossible to have this discussion anywhere in Europe. They just shake their heads incredulously and ask, 'What on earth can the U. S. government be debating?' ''
TERMITE STRATEGY. U. S. policy, for example, played right into Japan's hands when that nation swept to dominance in consumer electronics a decade ago. When Japan dumped TV sets in the U. S., Uncle Sam merely winked. Why? ''Classical trade theory holds that if other nations are stupid enough to subsidize their export industries, American consumers ought to welcome the gift,'' states economist Robert Kuttner, a BUSINESS WEEK columnist, in a paper written for the Economic Policy Institute (EPI).
But TVs were just the final stage of a ''termite strategy.'' Years before, Japan had begun supplying the guts of a growing array of consumer products for less than the cost of local U. S. production. That they usually lost money didn't faze the Japanese. Gradually, more and more of the manufacturing pie shifted offshore, leaving U. S. consumer electronics companies increasingly dependent on their Japanese sources.
Now, the pattern is repeating in computers. Japanese producers -- plus Korean and other Asian manufacturers imitating Japan's tactics -- have already knocked off the lion's share of most computer components. Later this year, NEC Corp. will mount the stiffest challenge yet to U. S. supremacy in supercomputers. The Tokyo company will introduce its SX-3 system, which it claims will substantially outstrip the performance of the biggest machine from Cray Research Inc. By 1993, Japan will pass the U. S. in worldwide computer sales, predicts a Commerce Dept. white paper.
The challenge to U. S. leadership in computers stems directly from Japan's domination of consumer electronics. Japan has pushed that technology to the point where it now drives the cutting edge of electronics, says Ian M. Ross, president of AT&T Bell Laboratories. The chips in a common camcorder, for instance, put out more processing power than those in strategic military systems. Before, advances originated in military systems, then ''trickled down'' to commercial and consumer markets, recalls Harold Brown, former Defense Secretary and now chairman of the Foreign Policy Institute at Johns Hopkins University. Today, he adds, the trickle-down flow has reversed.
For U. S. industry, which has widely retreated to high-end niche markets,the trickle-up trend paints a grimfuture. That's why jumping back into the consumer arena via HDTV technology is crucial. Two studies sounded the clarion call just before Thanksgiving. An EPI analysis predicts that maintaining current hands-off policies could lock the U. S. into a technological decline that would add $225 billion to the annual trade deficit by the year 2010 and put 2 million Americans out of work. And a blue-ribbon National Advisory Committee on Semiconductors (NACS) called for immediate action on industrial policy. ''We see the greatest urgency,'' says Bell Labs' Ross, who also heads the NACS. ''There is a great deal at stake.''
An effective strategy, according to the NACS, should begin with concerted efforts to reduce the cost of capital by stimulating more savings, trimming the federal deficit, and discouraging consumer and business debt. Next is blocking imports that use predatory pricing. Then come such steps as indexing the capital-gains tax to encourage longer-term investments, and eliminating double taxation on dividends. White House policymakers note that the Administration favors some of these measures, since they would apply across all industries. Indeed, President Bush has just endorsed relaxing antitrust barriers to joint manufacturing ventures.
Where the two sides clash is over applying the microeconomic Band-Aids that industry believes are vital until the more sweeping changes can be implemented. ''If something isn't done fast, we'll look back in only four or five years and wonder how it all slipped away so quickly,'' warns James H. Clark, chairman of Silicon Graphics Inc., a leading producer of so-called graphics workstations.
QUICK RELIEF. To provide quick relief, the NACS whipped up a menu of stopgap measures pegged to a major thrust in HDTV. At the White House, however, HDTV technology is regarded as too narrow for federal consideration. Critics of the Administration retort that Bush's economists have a distorted view of history. In fact, says Don E. Kash, a political science professor at the University of Oklahoma, there isn't one major industry, other than autos, ''where the federal government didn't absorb some of the risks.'' More significantly, he adds, the biggest successes have been scored in areas ''where the universities, government, and industry are in bed with each other -- and have been for decades.''
The most crucial need, according to many top executives, is to create a pool of low-cost, patient capital. Developing new technology has gotten so expensive, explains Kertzman of the AEA, that the outcome of competition is now decided largely by spending power. And thanks to Japan's lucrative base in consumer electronics and DRAMs -- plus U. S. tax and fiscal policies that force American business to focus on short-term returns -- Japan has taken a huge lead in investment. In 1988, notes Kertzman, Japan for the first time eclipsed the U. S. in capital spending. ''With an economy only 60% as big, they out-invested us by $46 billion. And that gap is projected to climb to $100 billion in 1990.''
The capital crunch threatens chips in particular. IBM President Jack D. Kuehler says that Big Blue -- the world's largest chip producer, all for its own consumption -- has already spent $400 million to develop X-ray methods of printing chips. By the time this esoteric technique is ready to go into production, sometime after 1995, Kuehler figures that IBM will have shelled out more than $1 billion over 15 years.
No other U. S. chipmaker has seen fit to sustain that kind of protracted investment, although Motorola Inc. recently signed up to collaborate with IBM in X-ray lithography. Without manufacturing consortiums, only a handful of American chipmakers can dream of owning a semiconductor factory at the turn of the century. ''They will cost as much as a Stealth bomber,'' notes G. Wesley Patterson, executive vice-president of startup Xilinx Inc.
The fact that few chipmakers are investing in X-ray technology is, to the White House, prima facie evidence for denying federal funds: If it's too risky for the private sector, then government shouldn't go near it. ''The irony is, that's just the opposite of Japan's attitude,'' says Clyde V. Prestowitz Jr., a former Commerce Dept. official specializing in Japanese trade. ''The Japanese say the government must subsidize these things because they're too risky for private business.'' In Japan, more than a dozen research programs in X-ray chipmaking are under way.
WEAKEST LINK. Loosening the antitrust yoke so companies can share the huge capital burden of commercializing new technology, collaborating on manufacturing as well as research, might put a damper on some startups, admits Arthur Rock of Arthur Rock & Associates, who helped seed such companies as Intel and Apple Computer Inc. But that's beside the point. ''It's not a matter of protecting my investments,'' he says. ''It's a matter of saving this nation's future.''
The weakest link in the technology food chain is the semiconductor equipment industry. In the U. S., the companies that generate new tools and techniques for making chips are overwhelmingly small and undercapitalized. Because they can't bet as boldly as the major Japanese players, America's share of the world market -- 80% a decade ago -- has been chopped almost in half. And the chipmaking equipment operation of Perkin-Elmer Corp., long the world's No. 1 supplier, has been on the block for 10 months, starved for capital to develop its next-generation system. But a buyer may finally have been found: Silicon Valley Group Inc., backed in part by IBM.
U. S. semiconductor companies don't relish becoming reliant on Japan's equipment vendors, because their Japanese rivals routinely get preproduction models of new machines up to a year before the systems go on the open market. That gives them a big head start. And in the semiconductor business, being late to market by just six months can spell the difference between decent profits and crossing your fingers for better results the next time around.
In addition, if U. S. chipmakers are tardy in delivering the latest semiconductors to U. S. computer companies, then another American technology will be in trouble. There's already concern that Japanese computer designers have a leg up: They are privy to the details of upcoming chip designs, so the computer divisions of Japan's major chip producers -- Toshiba, NEC, Hitachi, and Fujitsu -- can begin engineering new machines earlier than American companies.
So why is Washington so slow in getting the message? Industry believes economists either don't understand the dynamics of high tech or don't appreciate its strategic importance. But such attitudes make Silicon Valley its own worst enemy, says Kenneth S. Flamm, a Brookings Institution economist. Because the technology types ''see the economists as the enemy,'' most economists naturally react with cynicism. Worse, the industry doesn't couch its arguments in economic terms, and the studies it lays on the table don't reflect sound economic theory -- including the NACS report. Yet, Flamm adds, there is a strong economic case that can be made for government-industry collaboration.
To a few economists, high tech's dilemma suggests that some basic assumptions may need revision. David J. Teece, a University of California at Berkeley economist, asks whether a free market can be truly efficient at allocating resources in the electronics age. Steadily rising capital intensiveness, ever-shorter product life cycles, and the ease with which new technology can be copied make companies prone to underinvest in the future. Economists at Columbia, Harvard, MIT, and Stanford have joined Teece to form the Consortium of Competitiveness & Cooperation.
When Congress tackles industrial policy in coming months, lawmakers will undoubtedly find that Silicon Valley Inc. by no means speaks for everyone. Heading the parade of dissenters will be T. J. Rodgers, the feisty founder of seven-year-old Cypress Semiconductor Corp. Although he agrees that capital costs, tax policies, and unfair trading practices demand attention, Rodgers finds little merit in many of the stopgap proposals.
Government-industry consortiums, for example, are a waste of money, asserts Rodgers. ''I object to Sematech's swallowing $100 million of the taxpayers' money,'' mainly to benefit the 14 chipmakers that can afford to join, while 275 smaller companies sit on the sidelines. Such schemes, he charges, are dreamed up by people who ''have lost the spirit of Silicon Valley.''
Louis R. Tomasetta, president of five-year-old Vitesse Semiconductor Corp., worries most about what might follow if Congress heeds the advice of the Heritage Foundation and removes the threat of triple damages from antitrust lawsuits against consortiums. ''Once you open this Pandora's box,'' he notes, ''it becomes a lot less painful for a group of companies to band together and go after the startups.''
TRADE ANARCHY. Silicon Valley's industrial-policy converts have ready rejoinders. ''The T. J. Rodgers genre of free-trade fanaticism'' lasts only until a company meets the Japanese head-on, says Regis McKenna, a venture capitalist and marketing consultant. ''As T. J. gets into higher-volume commodity chips, he'll find out.''
And the priests of high tech assert that it's naive to suppose that Japan can be cajoled into abandoning a strategy that has been so spectacularly successful. With U. S. markets already wide open, they have little incentive to join the free-market club. That's why Silicon Valley grudgingly advocates carrying a bigger trade stick, at least temporarily.
The crux of the dispute is not protectionism vs. free trade, insists Michael C. Maibach, director of government affairs for Intel. ''It's about having rules. We don't have a system with rules. We have trade anarchy.'' Long-term, Silicon Valley yearns for nothing more than to return to the good old freewheeling days when companies didn't have to consider working together. But only if free trade stands a fair chance.

Richard Brandt, Jonathan B. Levine, and Robert D. Hof in San Francisco, John Carey in Washington, and Otis Port in New York, with bureau reports