Box.net CEO and co-founder Aaron Levie argues that cloud computing is unleashing a massive value shift across the enterprise IT ecosystem.

By Aaron Levie, contributor

FORTUNE — Fans of Clayton Christensen’s “Innovator’s Dilemma” will be unsurprised that the formula is still alive and well, even in 2011. Yes, apparently innovation still matters. To see the original effect in action, look no further than your desktop. How much desktop software do you generally use on a daily basis? Now, compare that to how many services you — and your company — are using in the cloud, delivered over the web. If you’re like most business people, for the past two decades you’ve been dealing with slow, painful and cumbersome applications to help run your projects, manage your customers and share files. Installations of software tend to take months, maintenance costs more than the original product price, and unexpected delays and down time result in a massive drop in productivity. But all this changes with the cloud.

Cloud-delivered enterprise solutions fit consistently and nicely into Christensen’s framework for “disruptive innovation.” They offer cheaper, simpler and often more broadly applicable alternatives to legacy models of enterprise computing. They tend to start out as low-end disruptors, bringing cost and performance advantages to over-served customers, but as these technologies mature in their reliability and sophistication, they’re spreading throughout organizations and solving some of the most demanding problems. Christensen must be gloating.

All this spells very big trouble for the traditional enterprise software leaders who plainly know they need to make the leap, but don’t have the business models, DNA, or dire necessity to support the change today. Over $270 billion dollars are spent on enterprise software every year, but so far, only a fraction of those dollars is going in the pockets of cloud vendors. There just isn’t much explicit incentive for the enterprise stalwarts to move that aggressively to the web. Sudden and forceful movements may confuse customers, disrupt channels, transition economics inequitably, or lead to poor product execution. Hence the predicament.

Why is cloud a disruptive innovation?
Not all innovations are disruptive, of course. If a technology advance merely reinforces the position of incumbent vendors in a given category, it qualifies as a sustaining — rather than disruptive — innovation. If there are minimal changes with respect to business models and go-to-market strategies, or the technology advance is non-linear technology, existing market players are generally safe. In the memory business, for instance, improvements in performance (within a given range) are often sustainable by the leading storage providers. Whereas the introduction of an entirely new technology, such as flash storage, gives the advantage to new players who can capitalize on the opportunity and commercialize it more quickly. This, predictably, shows up time and time again.

When the world wide web came along and Dell (DELL) launched the Dell.com website in response, it simply became another channel with which they sold the same products. The differences between a catalog and a website are insignificant if you take advantage of the Internet effectively. Yet every market is different: The Yellow Pages dropped a ball that Yelp picked up in the world’s move to hypertext, not because the web alone was a disruptive innovation for accessing local information, but because user-generated reviews were a brand new way to experience local guides. And a product like Yellow Pages that already lacked a community had none to transfer over to the new world.

Nothing in this world nothing can be said to be certain, except death, taxes, and enterprise software disruption. In the ’90s, the industry went through an upheaval as the client-server model displaced the mainframe. Describing PeopleSoft, and by extension the new wave of client-server computing, the New York Times in 1995 said, “tasks are split more or less evenly between desktop ‘client’ computers and larger machines.” This new (and now old) standard represented a cataclysmic shift in value, because applications could now be much more powerful and modern using PC standards, data could be mostly centralized, and everything would run at a fraction of the cost compared to mainframes.

Fast forward a decade and a half, and the same large-scale change has occurred yet again with our most core business applications by bringing them to the web. Why is this such a fundamental change, and not one that the old guard can quickly latch onto?

Well, because nearly ever dimension of the sales, marketing, distribution, and the utility of cloud-powered software is different than before. Sales and marketing are now tied to end-user adoption of services, not mandated top-down deployments of enterprise software. Distributing technology over the web offers current market leaders no intrinsic advantage that a startup can’t access – that is, the web is served up completely democratically, whereas software in the past was usually delivered via partners or vendors with the most extensive salesforces. Finally, the products themselves are nearly entirely different. Cloud solutions generally embrace a world defined by collaboration, mobility, and openness.

And in a few software and hardware categories, traditional vendors are more or less forced out of ever supporting their customers through the cloud. Put yourself in the shoes of an incumbent storage vendor that has traditionally sold its hardware to IT buyers and service providers alike. When Amazon (AMZN) builds out its own storage that it can offer to developers and customers (which it has) because of the scale they’ve achieved, do you decide to compete with them by launching a cloud storage service? Most in the storage space haven’t, because they would find themselves competing directly with their other service customers. This leaves many vendors in the unenviable spot of having to finesse their business model like a game of Risk.

Altogether, this gives startups a unique set of value drivers that allow them to compete with traditional powerhouses from a safe distance.

Just as MySQL classically went up against Oracle (ORCL) without ever competing for customers, many cloud solutions today are similarly disrupting the older guard by initially slipping into the “just good enough” category. From there, product roadmaps become more elaborate, customers are served in more meaningful ways, and before you know it just good enough becomes great, and then better. Those who’ve watched Salesforce.com (CRM) over a ten year period have witnessed a striking example of this trend. In 2002, the then-upstart CRM had 2% marketshare of the global CRM space, and analysts often wrote it off, saying, “[Salesforce] doesn’t compare well at all with other large CRM packages like Siebel and PeopleSoft… they will almost always come up short on the functionality side of the equation.” In 2011, they’ll hit $2 billion in revenue and 100,000 customers, putting them on track to quickly be one of the largest software companies in the world.

The same is happening with the next batch of enterprise software players in the cloud, where lower cost and fundamentally simpler applications have emerged as aggressors to the traditional enterprise stack. Workday, no longer a mid-market-only play, has quickly shot up market, closing deals with Time Warner (TWX) and Thomson Reuters, which is sure to ruffle some feathers in Redwood Shores and Walldorf. GoodData raised $15 million on the heels of over 2,500 customers realizing they can get business intelligence software at a fraction of the cost of solutions from IBM (IBM) and Oracle. And at Box, customers can store content often for a fifth of the cost of traditional systems, and then get to that information from any device, something that is universally impractical with an on-premise application.

Similarly, many emerging companies are operating on dimensions that were never easy, possible, or necessary in a previous generation of software. Zendesk and Assistly have disrupted the support market by integrating more easily into the myriad of systems which now act as customer touch-points, something on-premise vendors have neither the technology nor wherewithal to do. Jive and Yammer take on traditional email and collaboration systems by incorporating an untouchable social and stream-like model that anti-social technologies from Microsoft unsurprisingly lack. Okta and Snaplogic help businesses connect their identities and application data together respectively. What do all of these services have in common? They’re all solving new problems that the incumbents not only can’t attack, they also can’t even begin to understand. But before they know it, startups will have pulled away significant market share as move more deeply into the enterprise.

These new approaches and disruptive go-to-market techniques can get new enterprise software companies to scale at a speed only previously seen by technology aimed at consumers. Just like the last great wave in computing that occurred over two decades ago — putting companies like SAP (SAP), Microsoft (MSFT), and Oracle in the leadership positions they hold today — we are on course to see a new set of leading vendors. And along with this, the entire information technology landscape will change.

A value shift across the enterprise IT ecosystem
Many of the questions around what a utility computing world will produce pertain to the future of the IT function and services industries. When applications and infrastructure are delivered over the cloud, where do the business models of system integrators, ecosystem partners, and IT professionals go? With a direct-to-customer model, is there room to be a middle-man?

I believe this is in the category of sustaining innovations for the current system integration firms, but with a lot of change to come. The business model remains very similar, but the execution and actual value provided moves higher up in the stack. Instead of hiring “experts” to do everything – from putting together servers, plugging cables into boxes, all the way to integrating and deploying applications – IT of the future will begin to support higher order problems. In the words of Accenture (ACN) senior executive Kevin Campbell, “[Cloud] provides the opportunity for the IT department to focus on delivering business value.” In the past, client budgets often ran out well before the successful integration of multiple systems, and long before a business could begin to truly build interesting value on top of the software and systems that they had in their business.

This leads information technology experts to spend less time implementing and maintaining the basics of an IT strategy, and ultimately adding more value to the ‘core’ business processes of a company. Instead of working on the necessary but lower utility tasks like managing data, running email servers, and installing CRM software, IT teams and service firms can spend times in high leverage areas of the business. We’re seeing this happen across industry and markets with our customers. At Pandora (P), its IT leads are freed up to integrate applications to produce better value, speed, and flexibility for their employees; at Dole, individuals can work from their iPads to pull down critical business information from anywhere; and at Procter & Gamble (PG), their innovation-centric IT group is delivering the cloud to teams across the world, enabling them to work more productively from anywhere, and connect with other groups, securely.

Because of all this change, customers are going to begin to experience a much more dynamic and democratic software environment. Solutions will be forced to update to the latest trends more regularly, and this will drive better business results for all enterprises. Work will be done faster, people will get more value from their technology, and the ecosystem will even grow as a result of the breadth, diversity, and reach of technologies availble.

In a market as continually churning and revolving as information technology, one can easily marvel at how Microsoft and Oracle have maintained leadership for so long. But then again, the world hadn’t fully flipped over in the past twenty five years as much as it has today. Change is undeniably here, platforms are rapidly maturing, and now the disruptors of a previous generation must now decide whether they will disrupt themselves in the name of future relevance, or cling to old paradigms as new players emerge.

–Aaron Levie is the CEO and co-founder of Box.net.

Filed under: Contributors

The Chinese search giant is growing at incredible rates and dominates its home market. That means it has to contend not only with a domineering government, but also with cunning state-run media and increasingly aggressive private competitors.

By Katherine Ryder, contributor

FORTUNE — Unlike Google, Baidu, China’s largest search engine, cooperates with the government’s policy of censorship. The western press commonly asks the company’s CEO, Robin Li, how he justifies such a decision. Naturally, Li’s responses are generally quite deferential to the government. An unfavorable onlooker might even consider some of his rhetoric to veer precariously close to pandering. Take, for instance, Li’s dictum on big tech in China: “…walking the path of socialism with Chinese characteristics is the well-spring of strength that will allow the Chinese Internet to continue its healthy and rapid development.”

So it came as quite a surprise when CCTV, one of the government’s many state-run media organizations, aired a damning 26-minute documentary on Li’s company last month. Millions of Chinese viewers watched footage of a Baidu employee helping a man posing as the owner of what he admitted to be a sham healthcare company buy a fraudulent advertisement for a phony weight-loss pill. For weeks, the media speculated on the rationale behind the attack, which struck many as particularly harsh. Was the government getting uncomfortable with Baidu’s monopoly on the search market? (It controls about 80% of the market.) Or was CCTV acting out of commercial opportunism, since the broadcaster is also developing a search engine of its own? Did someone at CCTV have a personal vendetta against a higher-up at Baidu?

The row seems to have passed without too many answers. Baidu TV and CCTV recently reinvigorated CCTV’s online television station, CNTV.cn, according to Duncan Clark, the chairman of BDA China, a consultancy, which is aired on Baidu. As if to close the loop, Baidu was paid a very public visit at a technology exhibition earlier this month by a high-ranking Politboro member, which usually signifies that a company is again in good graces with the government. Such is the way of doing business in China.

The recent spat is part of a well-rehearsed dance between the Chinese government and its domestic tech sector. Search companies like Baidu and online media companies like Sina Corp, which owns China’s version of Twitter, Weibo, are essentially information companies in a land where peddling information is not fully allowed. In 2008, internecine attacks broke out between CCTV and Baidu which led Baidu to sponsor CCTV’s 2009 spring gala and spend 41% more on advertising for the year, much of that money going directly to CCTV. In the last few months, microblogs in China have come under regulatory fire. Baidu shut down its microblogging service in August.

Another underlying factor may be that state-run media companies are losing advertising dollars to private firms like Baidu, Sina Corp, Alibaba and Tencent. Government supported enterprise may be striking back in its own particular way. China’s new internet generation is proving to be less interested in local, state-run television stations like Xinhua and CCTV and more interested in new media, particularly online video. Although state media report that CCTV doubled its television advertising revenues from 2005 to 2010, such increases pale beside those of internet companies. Baidu, for instance, saw its revenues increase 60% in the first quarter of 2010 alone. What’s more, a major growth business is Qiyi, Baidu’s online video venture, which attracted 150 million users in its first year of business. What CCTV’s attacks represent, says Clark, is a fight that “is more about control and economic interests than anything political.”

While it’s clearly not in the State’s interest to crimp the profits of China’s thriving private internet sector — after all, a good number of public officials have lucrative connections with such companies — Robin Li and the CEOs of Chinese Internet companies still face a very real risk. As state media companies lose lucrative advertising deals, more stringent regulation may well be in the works, cutting into the bottom line. “The real regulatory risk for Baidu may be around anti-monopoly policies,” says Bill Bishop, an independent analyst who writes for Digicha.com. “As they increasingly roll out other verticals like travel and video, they are going to be competing with other companies in China.”

There is another risk for Baidu, as well. A lot of the firm’s revenue comes from the billions of dollars being invested in e-commerce sites — web sites that buy a lot of keyword ads. If the Chinese e-commerce market doesn’t take off in the way that analysts predict and a lot of these start-ups don’t become profitable, Baidu’s growth could take a serious and unexpected hit. And for Robin Li, that would be significantly more troubling than the occasional CCTV swipe.

Filed under: Contributors

Yes, it has to evolve or die. But lost in the drama over its recent bold moves is a big change that cuts directly to the core of its brand.

By Kevin Kelleher, contributor

FORTUNE — Credit Netflix with this much: It knows how to stay ahead of the game. In the Internet industry today, you either thrive by making bold and original moves, or you languish as you struggle to ape the leaders. Netflix has an idea of where online video is going, and it’s lately been making bold move after bold move in hopes of getting there first.

As everyone knows, this is having dramatically mixed results so far. But as Marc Randolph points out, however big the Netflix (NFLX) controversy is today, the company’s “relentless focus” remains on what happens tomorrow. Netflix knows that future lies in streaming video in a global market — and not so much DVDs shipped through the mail in the U.S.

Netflix can export its streaming-video service abroad much more easily and cheaply than it can its original DVD-by-mail service. It has more leverage with studios if it can offer access to audiences in Asia, Latin America and Europe. And so however loud and intense the outrage over Qwikster — its plan to split streaming from DVDs — is in the U.S., it’s just not a big deal for most of Netflix’ future subscribers.

So as much as I loved the old, too-good-to-be-true Netflix subscription package and as little as I’m looking forward to having to manage a second rental queue through something called Qwikster, none of this really worries me in the long run. Netflix is doing what it has to do to remain successful. I get that. What worries me is something else.

To create a streaming-video service with a global audience, Netflix is showing signs of catering to the lowest-common denominator. Recent moves, lost in the brouhaha over the Qwikster caper, suggest it’s abandoning niche titles — classic films, independent movies — in favor of blockbuster, mainstream fare. Put in technical jargon, it’s cutting off its long tail. Put in admittedly dramatic terms, Netflix may be about to lose its soul.

When Netflix CEO Reed Hastings announced the Qwickster move, he buried in the comments a hint that the company would announce some high-profile licensing deals this fall. Sure enough, as the Times reported Sunday, Netflix inked a deal with Dreamworks that analysts estimate will bring the studio as much as $30 million per picture.

That’s significantly higher than the $20 million per picture Dreamworks previously paid to Time Warner’s (TWX) HBO for the exclusive rights to the so-called “pay-TV window” that opens up shortly after a movie becomes available on DVD. As the Times noted, Netflix has had similar deals for “smaller titles” — which I guess is a way of measuring independent movies in terms of their short-term box-office potential, rather than their long-term importance.

It’s not hard to imagine why Netflix was willing to pay a 50% premium over HBO: In 2013, when Dreamworks films start streaming on Netflix, the company is likely to have tens of millions of new subscribers overseas, subscribers HBO can’t reach. But to keep its margins down, Netflix will be pressured to let go of some other titles. That is, they are likely to let go the “smaller” titles that comprised the bulk of the movie library on which Netflix has built its streaming business so far.

This has been happening for a few months. The Criterion Collection is a distributor of classic movies with a modest but passionate customer base. Criterion maintains a handpicked library of 800 movies that may never be blockbusters but will have a long-tail appeal for decades to come. But earlier this year, Criterion began moving its library from Netflix to Hulu Plus, and classic titles from Akira Kurosawa, Roman Polanski and Max Ophuls have vanished from Netflix Instant queues.

Since then, there have been signs that Netflix is breaking its ties with distributors of independent movies. Dana Harris, indieWIRE’s editor-in-chief, wrote in a post after the Qwikster controversy,

“Meanwhile, I’ve already heard from some indie filmmakers complaining that not only is Netflix (sorry, Qwikster) not renewing their DVD deals, it’s also not looking to make their films available via streaming. Their movies are no longer necessary to the Netflix or Qwikster business models.

“My dad had a saying, as dads often do: ‘Don’t forget the facts that built the business.’ Sometimes he meant it literally, but it was handiest as a metaphor for any kind of successful partnership: Know why it works and never lose sight of it.”

Of course, many of Netflix’ customers won’t complain about the loss of so many independent and classic titles. And Randolph may be right that Netflix is doing the right thing in maintaining its long-term financial focus. But what he overlooks is that Netflix the long-tail success story is turning into the kind of blockbuster distributor it set out to undermine in the first place.

In the meantime, the non-blockbuster titles of classic and independent movies are migrating to niche sites following the trail that Netflix blazed. Hulu has Criterion, and sites like SnagFilms and Fandor are beefing up their offerings of independent fare.

But as Harris noted, by forsaking independents for blockbusters Netflix won’t just be cutting off its long tail, it will be cutting itself off from its own roots. And it’s pretty rare that a company continues to thrive after they move away from the very thing that made it a success in the first place.

Filed under: Big Tech, Contributors

Leonard Green & Partners is raising $5 billion for its sixth private equity fund, according to a regulatory filing.

The Los Angeles-based firm invests in a variety of industry sectors, but is best known a retail portfolio that currently includes Sports Authority, Niemen Marcus and Whole Foods (WFM). Soon it plans to add BJ’s Wholesale Club (BJ), via a $2.8 billion take-private acquisition in partnership with CVC Capital Partners.

The firm’s SEC filing does not indicate that it has closed on any money, but certain public pension systems have already approved commitments. This includes $300 million from the Washington State Investment Board and up to $50 million from the Ohio School Employees Retirement System. According to an Ohio SERS document:

GEI VI will primarily make control investments in established, middle market companies across a broad range of industries, with a preference foe companies in the retail, distribution, healthcare, aerospace, consumer, and business services sectors.

Through the end of March, Leonard Green had called just over 70% of its fifth private equity fund, a $5.3 billion vehicle that held a final close in 2007. At the time, CalPERS reports that Fund V had a 20.2% IRR (a figure likely to be lower in the Q3 marks, due to public market valuation declines). Its predecessor, a $1.85 billion fund from 2003, had a 9.9% IRR.

Leonard Green also raised a credit fund in 2007, to take advantage of debt opportunities. That vehicle is fully-called with a 7.8% IRR.

The regulatory filing does not reflect any changes in Leonard Green’s partnership structure.

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Filed under: Private Equity Deals, Term Sheet

Conservative media mogul Andrew Breitbart raises $10 million.

Breitbart News Network yesterday reported to the SEC that it has raised $10 million in private funding from a pair of unidentified investors.

My initial thought upon seeing the filing was that BNN is the parent company for right-wing activist Andrew Breitbart’s myriad of websites. You might remember them from such hits as the edited videotape of Shirley Sherrod or the photo leaks that led to Rep. Anthony Weiner’s resignation.

But then I noticed that the incorporation year was 2011, whereas many of Breitbart’s online endeavors started years earlier. So either this is simply a new legal entity formed this year to do formalize matters, or Breitbart is launching a different type of platform.

Supporting the latter theory is a checkmark next to “$1 – $1,000,000″ in revenue. Brietbart claims more than 20 million pageviews per month, which would mean he’s earning less than half a penny in ad revenue per pageview. In industry jargon, that’s horrible (particularly when matched up against his available ad positions and rate-card).

I left a message yesterday for Larry Solov, the only executive other than Breitbart listed on the regulatory filing,but heard nothing back. So, for now we know that Breitbart has raised $10 million… to do something.

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Filed under: Term Sheet, Venture Capital Deals

Do corporate salespeople need a new type of email? A new start-up says “Yes!”

Yesware came out of stealth mode today, offering a cloud-based email productivity solution for salespeople. It also formally announced a small round of seed funding from Google Ventures and Foundry Group. So I spent some time on the phone with company founder and CEO Matthew Bellows, to understand why salespeople need better apps. What follows is an edited transcript of our conversation.

Fortune: Why did you launch Yesware?

Bellows: The basic idea was inspired by my experience as a sales guy and running a sales team. I spent so much of my time asking my guys to update their CRMs, so that they could report it to me and I could report it to the board. It became frustrating not only for me, but for them too – which led to a ‘garbage in, garbage out’ situation.

Even when they got to it, I felt terrible. These were hardworking guys who should have been getting clients, not doing data entry. We were using Salesforce (CRM), but we started looking at other CRMs to see if they had a better solution. They didn’t.

Sales guys live in email. Their data is in email. Their contracts, and redlined contracts, are in email. But it’s isolated from the rest of the organization – because the enterprise doesn’t have access to the stuff in Gmail accounts of .PDF files. It was baffling to me that salespeople use generic email tools whereas other types of professionals have highly-toned tools.

So that’s the idea: Give salespeople tools optimized to do their jobs, and then extract out of that information for the enterprise.

Your initial product is focused on Gmail. Will you expand to Outlook Exchange?

There are about four million businesses on Gmail, which is a reasonable-sized market but we won’t be Gmail only forever. We will definitely do Outlook Exchange, since that’s the other 97% of the market and we need to be there. We chose Google Apps and Gmail as the launch platform because it’s a great testing environment. Once we get the feature set really right, then we’ll expand.

One of your new investors is Google Ventures, whose team happens to feature the original creator of Gmail. How important has that type of expertise been so far?

It was a fantastic thing to be able to get Google Ventures on our team. They really distinguish themselves among VCs by having a whole staff of people who are experts in their fields. People like Braden Kowitz in UI design or David Krane in PR. And, as you say, they have built the products and know intimately how they function. They treat us like a portfolio company – not doing anything weird or pulling any Google (GOOG) strings – but have been super-helpful. 

You had a regulatory filing in April showing a bit less than $1 million raised. Is that this round?

Yes. We never announced back then because we wanted to wait until the product was actually being used by salespeople. I had a small heart attack when I saw you announced it, but things worked out okay – and we topped off the round with a total of $1 million.

What is your near-term plan for additional funding?

We’ll be raising a Series A later this year that we plan to close by the holidays. Probably in the $4 million range.

Consumer apps just go into the app store, but don’t you need a real marketing team for an enterprise app? And maybe people to train users?

To date we haven’t done any marketing, it’s just been word of mouth. The product is free to use for individuals, and we’ve seen a lot of viral spread among sales colleagues. We will need to have some marketing, so that we can look at a sales team, identify the hot spots – the people using it – and then say to the VP of sales, “Hey, a few of your guys are using it, don’t you want your entire group using it? And we charge for that.

What if they all sign up individually for free?

We’re totally happy if they all sign up. At some point we might offer a pro version with extra features, but we aren’t there yet.

The main way we earn revenue is by giving an enterprise the ability to see reports about how salespeople conversations are going, whose emails are getting opened or links getting clicked. Plus they can create a team library of templates they can share so that all salespeople are speaking on the same page. Or if there’s a breaking event or product launch, the marketing department doesn’t have to put information on a wiki no one really sees. That’s our basic value proposition.

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Filed under: Term Sheet, Venture Capital Deals

The Republican Chairman of the House Budget Committee introduced a market-driven plan for healthcare reform which died earlier this year. Now, he’s adding a revolutionary proposal that could change everything.

FORTUNE — Congressman Paul Ryan, Chairman of the House Budget Committee, introduced a radical, market-driven plan for healthcare reform in the “Path to Prosperity” budget that passed the House, then died in the Senate in May. Today, Ryan (R-Wisconsin) is scheduled to present an updated and augmented version of that blueprint at Stanford’s Hoover Institution. Fortune reviewed a copy of the speech a few hours before Ryan is scheduled to deliver it at 10AM in Palo Alto, California. The talk, titled “The Optimist’s Guide to Repeal and Replace,” keeps the pillars of the original Ryan plan in place — such as giving seniors fixed monthly Medicare payments to purchase private insurance — but adds a revolutionary proposal that hasn’t been aired seriously since it helped sink John McCain’s presidential run in 2008.

Ryan wants to effectively dismantle the system that’s insured most Americans for seven decades, heavily subsidized, employer-provided coverage. It’s vintage Ryan: Whether you agree or disagree with his views, he stands in sharp contrast with the rest of the political class in his willingness to take unpopular positions backed by strong intellectual arguments.

His campaign to grant workers the advantages they now receive only through employers is his most daring proposal yet. Ryan is right on the economics, but it will take a gigantic leap of faith for Americans to embrace such a jarring change. Ryan’s view is that the cost of the current system so endangers our economic future that only a manifesto that allows everyone from seniors to employees to shop for their own policies with their own money will fix it.

In the Stanford speech, Ryan states: “Under current law, employer-sponsored insurance plans are entirely exempt from taxation, regardless of how much an individual contributes to their policy. With regard for health insurance for working Americans, patient-centered reform means replacing the inefficient treatment of employer-provided care.”

Ryan argues that the tax laws make it far cheaper for a corporation to purchase coverage for workers than for the worker to buy a similar policy on their own. He’s correct. For example, ABK Auto Parts (a hypothetical employer) can provide a worker with a $50,000 salary with a $15,000 family policy without including that $15,000 in the worker’s compensation, so the benefit is tax-free to the employee. Under the current tax regime, if the company simply increased the worker’s salary by $15,000 to $65,000, he or she would have to pay tax on that extra income — say at a 25% rate, including payroll levies. Hence, the worker would be to buy only an $11,250 policy with the extra pay. “This tilts the compensation scale toward benefits, which are tax-free, and away from wages, which are taxable,” the speech says.

He also argues that the system is especially helpful to the “rich:” “It also provides ways for high-income earners to artificially reduce their tax-able income by purchasing high-cost health coverage — which in turn can fuel the overuse of health services.”

So what’s Ryan’s solution? He proposes shifting the tax exemption that now goes only to company-provided plans to individuals instead. In our example, if ABK Auto Parts keeps providing coverage, employees will need to pay tax on the value of the policies. But the employee will be able to buy a policy on their own and get a tax credit for the entire cost of the plan.

If Ryan’s plan becomes law, it’s likely that most companies would drop their plans. Why provide coverage when employees now pay tax on the benefit but get a tax credit if they buy their own plans? The advantage is that employees would no longer lose their coverage if they lose their jobs. The policies would belong to them and be fully portable to the next job. It would also turn workers into consumers, giving them an incentive to shop for the lowest cost plans with their own money.

Here’s the rub: Can workers really be sure employers would pad their paychecks with the same dollars those corporations now pay for their coverage? The laws of economics say yes. In a competitive labor market, the total cost of workers should stay the same, and employers should care little whether they pay in benefits or direct wages.

But it’s not clear to America’s workers, now deeply distrustful of corporations, that they will see that money. And in these uncertain times, the concept of shopping on your own for benefits, with raises that may not be there, for coverage you now receive automatically, may look extremely scary to millions of Americans.

Indeed, it was those fears that made the McCain plan a major problem for his campaign. It would be extremely helpful if America’s employers would reassure workers that they will be “made whole” if Ryan’s plan become law. Indeed, companies would relish shedding their role of providing healthcare insurance. To make that happen, they have a strong incentive to tell workers they will receive the full value of their current benefits in raises. Ryan’s skill in enlisting companies to make those assurances could determine the success of his plan.

The Stanford speech also renews the call for reform in Medicare and Medicaid, both included in Ryan’s 2012 budget. The concept, as with the elimination of the employer exemption, is to move America from today’s “defined benefit” system to a type of “defined contribution” regime. It mirrors the shift in the private sector from guaranteed pension benefits to fixed 401K contributions. Ryan advocates “premium support” for Medicare beneficiaries, fixed monthly payments that would be as much as twice as big for low-income Americans as for high earners. Seniors would then use that money to shop for private plans, and the incentive to choose the lowest-cost, highest-quality coverage would be strong, since any cost over the fixed payment would be covered by the newly empowered customer.

Ryan draws a strong contrast between his own philosophy of controlling costs through market forces and the approach advocated by President Obama. Put simply, Obama is relying chiefly on price controls to control costs. But price controls do not lower costs. The 2010 Patient Protection and Affordable Care Act limits the growth of Medicare, starting in about ten years, to GDP plus one percentage point. In his most recent budget proposal, Obama lowered the number to GDP plus one-half a point. But Medicare costs are now rising at two to three times the rate of growth in national income. Hence, the price controls will simply drive providers out of business, encourage doctors to turn down Medicare patients and generally cause waits and rationing. As Ryan points out, Medicare’s chief actuary, Richard Foster, has frequently stated that blunt caps on spending won’t work.

The Ryan speech doesn’t address one of the most damaging, and least discussed, problems in our healthcare system. The market is rife with cartel-like, anti-competitive practices that wouldn’t be tolerated in any other business. Many exist at the state level; they need to be eliminated to create the flexible market that Ryan advocates. For example, in over half of America’s 314 urban areas, a single insurer holds over half the market, severely dampening price competition. About half the states have strict “certificate of need laws” that restrict the number of hospital bed, clinics and imaging centers, granting regional monopolies to high-cost, entrenched providers and making it extremely difficult for insurers, or Medicare, to negotiate discounts. It’s the same story for physicians: the doctor supply is essentially fixed even as demand for services explodes, guaranteeing that practitioners are always busy and, hence, reluctant to lower prices.

The Obama plan would, believe it or not, further limit the supply of physicians by reducing Medicare’s contributions to residency plans. Like many of these restrictions, the justification is that more providers leads to higher costs. Nowhere else in business does such an argument work, nor does it work in medicine.

Put simply, the plan Ryan outlines in his new speech is the best approach to avoiding what’s now looming: A future of price controls and rationing. He makes a strong point in his speech when he says, “The system that shields us from the cost of services has left us paying much more.” It’s not at all clear America is willing to make that leap — but to escape the current shambles, the leap is well worth taking.

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