Network States and the Nature of the Firm

what Coase might have had to say about starting a bunch of new countries

I.

Economists love simple models.

And of course, they get criticised for it. Smart people love nothing more than telling other smart people they’re wrong. And there are plenty of people on the other side of the walls of the world’s economics departments ready to hurl accusations of simple-mindedness. You’ll find a fair number of them going about their business on  everyone’s favourite bird app. 

But simple models are nonetheless useful tools for thinking. Even if it’s something like using hotdog buns to talk about the consequences of technology-enabled growth in supply.

“You can’t do serious economics unless you are willing to be playful. Economic theory is not a collection of dictums laid down by pompous authority figures. Mainly, it is a menagerie of thought experiments—parables, if you like—that are intended to capture the logic of economic processes in a simplified way. In the end, of course, ideas must be tested against the facts. But even to know what facts are relevant, you must play with those ideas in hypothetical settings. And I use the word “play” advisedly: Innovative thinkers, in economics and other disciplines, often have a pronounced whimsical streak.”   - Krugman

Sure, you could try to account for every little edge case and stubborn exception. You could try. You could just throw up your hands in despair and yell about how everything’s unknowable so we should just stop trying. There’s a whole school of economic thought that argues for exactly this. But either way, you’d end up the same way: empty-handed. 

Or you can join the dark side. Assume perfect knowledge, grab a few fixed rates of growth, pick your rational agent, and it’s off to the naive modelling races. The prize is a fake Nobel and the rules are based on how well can you sell a narrative. There are worse ways to live, y’know?

And it isn’t all that bad. There are still brilliant ideas that come out of the field. Utility functions, Schelling points, price signals, auction strategies, RCTs, growth theories, etc. etc. They might not be made up of sacred and universal truths; and their lists of assumptions is a long one. But you need these simplifications if you want a model that you’re able to work with. And they’re each insightful enough to be worth a few dozen papers, and maybe your attention too.  

When trying to express my scepticism around network states, I tried imagining the world in a decade from now, tried to see all the likely developments and possible branches. I visited all the relevant blogs and opened a few Metaculus page. I tried to factor in the impact of unknowns unknowns. And then I gave up. 

Balaji is a really smart guy, and I’m just some kid with a blog. When it comes to predicting the future, I think that puts as at pretty much equal. The future is just that hard. Even if you see all the strands that make up the current tapestry, the new patterns will have whole new colours, the material is changing all the time, and you haven’t even met the new weavers.

So instead I retreat to simple models, and analogy. A cheap trick, no doubt, but one that no writer should be ashamed of wielding (Balaji is a pretty liberal user himself). This piece will contain almost no facts, figures, irrefutable graphs, or other such weapons that usually make up the blogger’s MO. They’re not worth much anyway. All facts are cherry-picked; experienced readers can spot the omissions, inexperienced ones are fooled. And nobody’s the happier. 

So instead, I’m going assume a few spherical cows, and see where that goes.

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II.

First, a quick intro to Balaji, who’s one of the few people who seems to spend more time on Twitter than me. 

He’s a vocal techno-optimist, trans-humanist, libertarian, ex-startup founder, crypto-billionaire. That’s a long list, but we don’t have to worry about all those things right now (pick up the Silicon Valley engineer starter pack at a tech party near you, and it will get you 90% of the way there). We really only care about one particular niche: his ideas for a future of decentralised nation-states.

This talk fromY-Combinator in 2013 does a pretty good job of explaining where he’s coming from. In it, he talks about Hirschman’s book Voice, Loyalty and Exit, the progression of software from local first to the cloud, the decentralising effects of crypto, and how America is going to shit. It’s a good talk, as far as talks usually go. The briefest possible TLDW is this:

1) Some places suck

2) Reform often fails 

3) Let’s leave, go to other places and do things better there instead.

Lots of people love these ideas. Everyone in tech hates bureaucracy. Everyone in tech hates paying $5k in rent every month. Everyone in tech hates that they’re not allowed to brew nootropic concoctions from eight different non-FDA-approved drugs in the comfort of their fusion-reactor powered flying car. 

And the idea of the network state, on a high-level at least, is pretty simple. You have a bunch of people across the world who share a strong-enough purpose to pool their resources together. Once they have enough money, they can buy real land, leave their old lives behind, and live in a brand-new country. Free of those silly zoning laws and FDA regulations. Or, in Balaji’s own words:

A network state is a highly aligned online community with a capacity for collective action that crowdfunds territory around the world and eventually gains diplomatic recognition from pre-existing states.

It’s an appealing idea. In the same way that planning to build and populate a village with your friends is appealing in college. Or the idea of squad wealth is appealing to a certain set of internet enjoyers. The glory of getting to be the founding fathers, the creators of your own little sovereign city. The us vs. the world dynamic is a powerful bit of psychological tooling. 

There are definitely some obvious benefits in being free of the overhand of state processes and regulation, one of which is the rate of experimentation and innovation that it could unlock. You can iterate faster when you don’t have to go through 5 layers of approvals and the bi-annual creation of yet another hoop to jump through.  You’d finally be free of the debt of legacy law and the consequences explored by public choice theory: the annoying fact that the default tendency is towards creating new rules and increased oversight and that it’s much harder to get rid of a useless law once it’s in place. 

Replace “state” with “startup”, and “America” with “FAANG”, and what you have is the classic call to leave the mothership and go build something new. Indeed, back in the day, much of what makes up the idea of network states fell under the more direct term “startup city”. But the idea goes beyond just building technological innovation and high-productivity zones, network states are an experiments at the level of social structure itself. 

You get to use your own selection effects. Defining your immigration policy, visa rules and ultimately the kind of people that make up your new country’s population. If done right, this could be an upgrade to the already powerful agglomeration effects of large cities. Getting a bunch of people with similar goals together in one place has huge positive effects on growth, and this collection is usually left to free market forces like earnings and demand from local employers. Running your own country would mean that, instead of selection pressures based on income and education, you could intentionally set the KPIs for your future citizens based on the state’s shared values. 

This seems like the kind of thing that could result in a lot of cool weirdness. A possible antidote to the end of history that’s creeping up on us. Which is all well and good, just as the economy always needs new, nimble market entrants to raise the bar for innovation, society can do with some weirder outliers. 

But Coase had something to say about this.

Okay, that’s not true, but he did have something to say about companies, In perhaps his most famous piece of writing, he asked a simple question:

"Outside the firm, price movements direct production, which is co-ordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-co-ordinator, who directs production. It is clear that these are alternative methods of coordinating production. Yet, having regard to the fact that if production is regulated by price movements, production could be carried on without any organisation at all, well might we ask, why is there any organisation?"

Why does the economy need people to come together in groups, usually under the supervision of one or more managers, to produce things as an entity instead of as individuals? Why doesn’t the price mechanism, the invisible hand of all that is good and true in free market economies, coordinate things perfectly on its own?

Okay, yeah, you already know the answer to this one if you’ve tried to hire a freelancer before. Or if you’ve had to switch barbers, buy a new coffee table, or find a new job. You already know about the price that you pay, whether in time, effort and comfort. Economists lump those, and other similar costs, under the term “switching costs”. But there’s also the cost of going looking for a new hairdresser, table or employer, and judging their suitability. Those go by the equally creative name of “search costs”, and they’re usually included under switching costs. 

And then they put all of those (plus some other things like “enforcement costs”, which is exactly what it sounds like) under the giant label “transaction costs”, and set those to work explaining why the free market often fails in the ways it does. According to them, these costs are just the price of things break ing down in the absence of the handy duo of perfect knowledge and perfect competition. 

But the firm can do things differently, Instead of going out looking for specialised labour, and drawing up individual contracts each time it needs to get something done, it hires them as permanent employees. Instead of checking the market to find the best prices each time it needs to buy raw materials, it sets up contracts to purchase them in bulk. Instead of sending the goods through multiple craftsmen to get to the finished product, it builds its own production processes. 

In the absence of these, firms would just be…people. The invisible hand could do its thing, and markets would work perfectly fine. Everyone would find what they need, at just the right quality and price, and the libertarian future would have arrived. Instead, firms have an imperfect substitute in the form of  the “entrepreneur“, who directs production and allocates resources without having to pay the transaction costs that the open market would experience. 

Simply put, the harder it is to get things done efficiently in the free market, the more of an advantage it is to run production within a firm-like organisation. Putting groups of people together in these alternative structures has a huge effect on coordination outcomes and the resulting output, just by freeing them from certain transaction costs and market demands. 

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III.

If you screw on your economist hat tightly enough, countries are just really big firms.

And they have all the benefits and weaknesses that come with agglomeration and scale. For example, you can build larger portions of the supply chain and human capital in-house instead of being dependent on imports (or slave labor). You can work the internal propaganda machine (patriotism) to inspire effort the way a company ethos is supposed to. You can get people in charge of important sectors to live closer to each other in the hopes of fostering more cooperation. 

You also have to be more careful about harming people, the effects of getting something wrong has a larger fallout.  Bureaucracy becomes a necessity. As headcount grows, you’ve got to manage your own version of the free-rider problem. 

But if Coase is right, the main benefit of having a large firm instead a bunch of tiny ones is the ability to sidestep the variety of transaction costs. And I think this is also the case when we’re talking about countries instead, the costs just look a little different. The parallels between large countries and huge firms might look a bit blurry, but some things are similar enough to be worth thinking about. There’s stuff that all countries need to do that happens to be rather inefficient, and that could just be enough of a cost to prevent people starting new ones. 

Laws:

The inconvenience of drawing up of individual labour contracts has a handy analogy when it comes to nation-states: the legislative system. 

If the whole point of a new country is being able to change the rules, it kind sucks that this happens to be a really hard problem in practice. There’s a reason most countries let the central government define the rules instead of re-drafting them at the level of each small town: these contracts are expensive things. 

It's fairly easy to say "okay, we'll all let people drive after 16". But how do you do that with something like military spending, drug regulation or privacy laws? Each of these things takes a committee to draft, an army of paralegals to interpret, and a national legislature to enforce. The current judicial system doesn’t have many fans. But it got to this point after a long evolutionary process and whole libraries worth of debate. Would you want to go through that each time you draft draft your own laws?

Those fond of repeating “code is law”, would do well to remember that this means nothing when the compilers are human. Heck we haven’t even figured out automation yet. Even if you set up things really well, software and simple rules only gets you most of the way there. The last few detail take exponentially more work, and start to negate the advantages that code provides. 

I was going to write a few hundred words more on the under-appreciated difference Law the Platonic Idea and law in practice. But Nihal did it for me, so you can just read his excellent post instead. The upshot of it all is that hard part is not  framing the laws (and  that’s pretty hard already!), it’s dealing with the messy bits in the aftermath.

Even if you have simple laws, and the greatest implementation processes ever devised, you’d still have to interface with others who don't. And since you’re a tiny state that’s highly dependent on your trade partners, you’d have to do this for lots of things. Now imagine that, multiplied across every new state. That’s a lot of messy law!

Even search costs have an analogue in the legal system. Much of navigating said system is knowing how things works, whom to bribe, when to sue, what you can get away with and what you definitely won’t be allowed to do. The discovery process for these implicit structures map directly to the act off going through a market looking for the best deal. If network states create new systems each time, it makes it the much harder for practitioners to get up and running. 

Governance:

How many people want to be involved in governance? How many should be? How many even want to be? Balaji likes to talk about the fakeness of democracy, how a 49-51 vote silences half the population. This sounds really unfair, in theory, until you look and find that no population has ever been split right down the middle like that. And if the injustice is truly big enough, 49% is usually more than enough people to attempt more direct methods, like a revolution or something. If you ask another notorious Twitter intellectual, it’s often the intolerant minority that wins. 

And if your country is made up of high-functioning entrepreneurs trying to run their own world-changing companies, it’s not very efficient to ask them to do the oft-boring work of running a country at the same time. So maybe direct involvement isn’t very practical. But if you bring in other people to handle things, how do you know that the same old story of bureaucratic growth and scope creep won’t play out all over again? Governance is hard, and its institutions have historically chosen to extend the reach of their powers. 

Firms, especially small ones, have the advantage of dedicating their resources to the head entrepreneur. Per Coase, this is the advantage that a firm has over the free market. The entrepreneur’s decisions are what get rid of the transaction costs between its members and their different functions. So should network states pick dictators, in the name of efficiency? Singapore did that for a while and they turned out great, half a dozen African countries tried it too and they did…not so great.  The free market equivalent of governance probably looks like libertarianism, but that has its own costs, just like markets do. 

Longevity:

The brutal efficiency of markets limits what their members are allowed to do. For larger entities, the ability to stand firm (sorry, had to) against the whims of supply and demand lets them do things like survive longer at times when it seems like they shouldn’t. 

This feels weird. Perhaps because anti-fragility is usually associated with small, nimble organisms that adapt quickly to the kinds of changes that kill the slower, more ossified ones. But on the meta-level, the most anti-fragile thing you can do is to diversify, staying alive really is the primary goal here. A highly-specialised network state would be the exact opposite of this ethos. It’s a bunch of like-minded, and probably similarly-skilled, people who happen to be clustered together geographically. 

“In the 1920s, it was commonly believed that American banks were too big, and so regulations were passed limiting their size, most of all by restricting interstate banking… When the Great Depression started, however, a large number of these small banks failed, as they were insufficiently diversified and had a hard time raising capital or otherwise protecting against sudden losses. In Canada there also was a severe depression, but the banking sector was much more concentrated, and so Canada did not see any bank failures at all.” - The Virtues of Big Business in America

Central banks get a lot of hate. But I would also not want to live in a country without them. It’s all well and good to live in a financial system that’s close to reality to keep you humble through natural correction mechanisms. But very often, the price of those corrections are too high! Not having built the things necessary to tackle a pandemic looks stupid in hindsight, and we should have been completely helpless in the face of it. Instead, we could just choose pour billions into vaccine production and stimulus checks to avoid that.  Governments are able break the rules when they feel like they need to, and this can be a good thing. 

One underrated effect of being the large, incumbent country (other than the fact that you’ll still be around in the case of like, a hurricane or something) is the trust that it creates, for both your citizens and everyone else. Things like welfare programmes, lender insurance and an army might seem like fairly unproductive investments, but the payoff during an emergency is huge. Size justifies wasteful measures that occasionally ensure survival. 

This trust makes it easier for investors to get involved, but more importantly, most people can only really dedicate their lives to a living in a particular country if they know it plans to stay around. Which leads into yet another feature of large organisations…

Mega-projects:

The benefit of being able to choose exit is that you can leave and go somewhere better. The downside of easy exit is that now there’s one less reason for people to stick around. Why were we able to build cathedrals over 1000 year timespans? One answer is that we had completely different societies and coordination technology then, and getting people to work on things together was way easier. The other answer is that they just had really low opportunity costs. If you, your grand-parents and grand-children were going to live in the same town for your entire lives, it makes it a bit of a no-brainer to continue building the thing they started out with. 

There’s a version of the prisoner’s dilemma that creeps into all collaborative projects with long-term payoffs. There’s always the temptation a larger short-term reward available somewhere else, and if enough people choose that, the probability of the long-term one succeeding falls too. So it’s only worth getting started if you trust other people not to defect. And it would be naive to think that making it easier to leave wouldn’t affect their choice. States themselves are the largest of all mega-projects, ones that span multiple generations. How do network states intend to last the whole mile?

Huge projects are also expensive. So much so that they’re often downright wasteful. Markets hate waste, but firms can be more forgiving. This ability to explore outside of the constraints of efficiency gives them access to completely different strategies. 

Large countries can do things like put together space programmes and huge research projects, funded by taxpayer dollars that don’t have to answer to the forces of short-term profit-maximisation. Google can fund research that your local SaaS company can’t because they just have that much more cash and brainpower to burn. Amazon could afford to pull off a loss-making product like Prime for the same reason. Facebook too, can dare to sink billions into a project like the metaverse. Reliance created the greatest telecom network in the world through fixed cost investments that look a lot like public sector budgets. 

Maybe tech increases productivity to the point that tiny teams can pull off miracles of engineering. Maybe software eats enough of the world that we don’t need a spin up a web of complex physical relationships to get things done. Everything becomes an API call, everything is cheap. Superabundance kills the firm. 

But those are big “maybe”s, and to me, it seems that both these concerns limit the size and ambition of the projects that smaller organisations can consider working on. 

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IV.

Regardless, network states could still work out.

Like I said, I have no idea how the future will pan out in a few decades from now. This entire piece was just a (perhaps) silly thought-experiment in drawing parallels between network states and free markets, large countries and firms. The question being “if you start a new country of your own, you’ve got to deal with things your old country took care of by default, is this worth it?”

But it might just happen that network states become hotbeds of innovation because of these constraints. The difficulties with laws, coordination and incentives might birth new ways of attacking those problems. Having dragons around helps drive progress.

Even if all they accomplish is making countries take immigration seriously, that’s a huge net good right there. The current system just isn’t it man, “sub-optimal” would be an understatement. They don’t even have to actually succeed in bringing in the best, experiments in policies and selection mechanisms will have their own value. 

In this case, they’re playing the role that their startup-counterparts often do. Creating a new approach to a problem, and inspiring subsequent adoption among the incumbents. Either because of the fear of getting left behind, or through outright acquisition. (What will it look like for a country to buy a network state?)

Or it might work the other way around. As countries slip into a managed decline, with demographic crisis looming and their infrastructure fading fast, the new nations could be the places to push forward the kind of risky innovation that extends healthspans and holds up global TFP levels. If regulation arbitrage is a big enough advantage, legacy nations could fall far enough behind that network states become invaluable partners in their development plans. 

If you run the founding experiment enough times, maybe it converges to an optimal constitution. Maybe the point of network states isn’t to build massive multiple-generation-spanning nations, but just to let some fairly weird people live together with their own rules. Maybe we’ll have specialised nation-as-a-service firms up and running to handle legislation and other thorny problems their clients don’t want to solve for themselves. Maybe de-regulation experiments act as inspiration for other countries to follow upon without having to play with the risks themselves. Maybe. I don’t know how this will go. Nobody does.

But it might just be really fun. 

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