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The Future of Money in the Information Age

Chapter 5: The Technological Realities of Internet Commerce

Lawrence Gasman

There is a story from the 1840s, a period when the electric telegraph was creating almost as much excitement as the World Wide Web does at present. In the story, a farmer responds to all the fuss over the new technology with some skepticism and he places a wager. He bets that his horse can deliver a message faster than the telegraph.

The story is probably apocryphal, no more than a joke. But like all good jokes it makes a serious point. The story about the farmer and his horse makes fun of those who have no conception of how the new technology works. Horses seldom travel at the speed of light.

Of course, this story is barely funny any more, because, for most of us, some level of understanding of telegraphic technology is embedded in our general knowledge. However, many of us do not possess similar depth when it comes to the Internet, and there is a tendency to predict the impact of Internet based on notions that are not in tune with its technology.

Within the world of commerce and banking, there are those who see the Internet as no more than a vital new way to reach their customers in a cost-effective manner. Banks in particular have seized on the Internet as one way to solve the problem of the escalating costs of having human tellers spend long amounts of time dealing with smaller depositors. At the other end of the scale there are those who see in the Internet and its World Wide Web a mechanism for banking and commerce entirely free from the dead hand of regulation and central banks. For libertarians this is the dream. For central bankers and the managers of large financial institutions it is the nightmare.

My personal view of the future is closer to the libertarian dream than the bankers' nightmare. I think that the view of the Internet as just being another marketing tool is a gross underestimation of what the Internet will mean to us all within a few years. Viewing the Internet as just another marketing channel is essentially the late 21st century equivalent of the farmer's story with which this paper began.

But, as usually expressed, many current views of what the Internet will mean to us seem to exist in a rarefied environment that largely fails to take into account the technological reality of the Internet. As a result, some of the claims made for the potential of the Internet are overstated. The purpose of this paper is to redress that imbalance, if only by a little.

What Is Special About the Internet?

Today's Internet is a triumph for both human ingenuity and spontaneous order. In some parts it embodies leading-edge technology, such as SONET--a high-speed transmission standard--or Asynchronous Transfer Mode (ATM)--a powerful switching and multiplexing technology. But most users dial up their Internet service provider using 1870s technology--a regular analog telephone line. Many Internet service providers connect up their network nodes using 1970s technology--T1 (1.5 Mbps) and T3 (45 Mbps) digital lines. Even the World Wide Web is an ingenious mix of established Windows technology and hypertext linking. Hypertext has been pushed as a human-machine interface since at least the 1970s.

It is not new technology then that created the excitement about the Internet and the World Wide Web in the commercial and banking worlds. Rather it is a innovative combination of older technologies that appears to create a radical new trading environment. Specifically it is claimed that (1) the Internet ends distance limitations, and (2) the Internet empowers individuals in important new ways to create new commercial and financial entities.

In this paper, I examine these claims against the realities of current and emerging technologies, and I analyze the implications of those technologies for banking and commerce from a market-liberal perspective.

The End of Distance

Classical telephone communications has been distance limited in two senses. First, the further the call, the more it cost. Second, until quite recently, the further the call, the poorer the quality of connection. The quality of long-distance service has improved, so that a call from Toronto to Tokyo can be as clear as a call from New York to Newark, although calls to Third-World countries may still be problematic.

But telephone calls are still charged by distance. Even if you lease a private line, you are charged by how far that private line extends. The Internet is quite different: users pay only for access to the Internet; after that the ride is free. It is just as easy to call up an American Web site from Chicago as it is from London. Indeed the physical location of the server on which the Web Site is located may be unknown to someone visiting the site. It may even be unknown to the person who owns the site.

Those who look on the Internet as no more than a marketing opportunity see distance independence as an opportunity to carry out direct marketing to a self-selected international audience at very little cost. Taking this a little further, bankers see here an opportunity to win an international clientele for their products and services, relatively free from the burdens of regulation. But they would certainly stop short of endorsing the libertarian dream of free banking on the Web.

The libertarian dream is not completely tied to the notion of low-cost access and distance independence. Obviously, we can carry out transactions with foreign banks to our hearts' content over regular telephone lines if we are willing to pay the high transaction costs. But the libertarian vision of the ordinary citizen carrying out his banking transactions on a regular basis with some private banking entity in the Cayman Islands is obviously dependent on transactions costs remaining low.

The assumption is made almost universally that the transactions made on the Internet will never be distance dependent, but this may not be the case. It is true that the costs associated with the packet-switching technology that underpins the Internet are less distanced based than older telephone networks, but a long-distance packet call still travels over a lot more expensive transmission systems and switching equipment than a short-haul call. Thus, the costs of Internet services are less determined by geography than the old telephone system, but they are not entirely geographically invariant.

It is at least plausible to imagine forces that could come into play that could transform the current situation. Economics may be the most powerful such force. Because users currently only pay for Internet access, it has been claimed that there is a strong incentive to develop and deploy access facilities but considerably less incentive to improve on the long-distance backbone infrastructure that supports the Internet.

Of course, market forces may set access pricing for the Internet and distribute funds in a way that supports both access and backbone facilities. Nevertheless, it seems quite likely that current Internet pricing mechanisms (and certainly the pricing expectations of the cyberspace culture, which tends to see any non-zero pricing as a conspiracy of big business) reflect the Internet's origin as a network supported by the taxpayer and that Internet pricing will have to change significantly in the next few years to reflect new commercial realities.

Will such changes include distance-based pricing? Probably not--at least not immediately. The logic of Internet technology points to continued distance independence. For a start, that is what virtually all Internet users expect. It will be hard to change this business model for the Internet now. Second, the packet-switching technology that underpins the Internet was specifically designed to provide very cost-effective long-distance transport for computer data. Third, in most cases Internet service providers do not have billing systems that could bill by distance.

Nevertheless, the mechanisms for distance-based pricing are beginning to emerge. Already, MCI offers a distance-based pricing option for its frame relay data service. This is intended to provide corporate frame relay users, who need the service for regional rather than national networking, with a price break. But frame relay is a technology that is now widely used by smaller Internet service providers to provide themselves with backbone facilities. So charging by distance is not inconceivable, and that possibility is heightened by the fact that billing systems are a major area of research and development in the telephone industry at the present time. Thus, effective ways for Internet service providers to charge by distance seem certain to emerge.

There may even be some regulatory pressures to bring about distance-based charging on the Internet. Some of the small long-distance carriers are protesting to the FCC about voice traffic being carried on the Internet. They claim that they are being discriminated against, because long-distance telephone companies have to pay special fees mandated by regulators to the local telephone companies that provide their links to the customer, while Internet service providers do not have to pay such fees. Their point--and it is not an unjust one--is that this gives an unfair advantage to the Internet service providers and may ultimately destroy the telephone industry if it loses the voice traffic that accounts for the overwhelming majority of its business.

At this point it seems that the protests against voice on the Internet will be unsuccessful, if only because the chorus is not being joined by the big three long-distance carriers--AT&T, MCI, and Sprint--who see a profitable future in being Internet service providers themselves. But this situation could change and perhaps some day regulators will demand that the Internet service providers behave more like long-distance carriers and charge by distance.

Such a regulatory move could be prompted by lobbying not just from the potential losers in the telephone industry, but also from those in the financial services industry who see in the Internet the threat of consumers moving to offshore banks and, in the long term, the end of central banking. This is not an implausible scenario, for while the Internet may be unregulatable in a global sense, the regulation of domestically based Internet service providers is certainly a possibility.

The Limits to Individual Empowerment

The other claim that is made for the Internet, or more specifically the World Wide Web, is that it offers a powerful new tool for entrepreneurs. The point here is that anyone with the small amount of capital needed to open a CompuServe or America Online account has at his or her command most of the resources to build a Web site, which can be used as the platform for a business entity, perhaps even a cyberspace banking corporation. And while the server space available from the main on-line services is limited, space on other servers is available for modest rates with a rapidly growing community of Web Masters able and willing to serve the needs of entrepreneurs anxious to establish their own Web sites.

However, it is not just the availability of resources that is important here. It is the power of those resources. Business people and hobbyists have been setting up their own computer bulletin board systems for more than a decade, but these have been almost entirely text-based, with poor graphics. Web sites using the standard HTML programming language can easily incorporate sophisticated graphic images. Moreover, HTML's extension, VRML, promises to add virtual reality capabilities to the Web, while Sun's Java language offers multimedia capabilities including the power to incorporate moving images and sound.

There is little doubt that these capabilities will add powerful new marketing capabilities to the Web. But it is not just the presentation qualities of the Web that have attracted so much attention. It is also the fact that visitors to Web sites are self-selected. Web sites are much more like retail stores in that people choose to visit them. Contrast this with advertising or direct marketing where most recipients have no interest in the product being marketed. Adding even more excitement is the fact that even relatively small amounts of investment can produce Web sites visited by thousands of potential customers every week--perhaps every day.

All this has excited the marketing imagination to view the World Wide Web as an important new platform for commercial activity. This, I believe, is a correct assessment. The libertarian imagination has, however, taken the process one step further.

Libertarians frequently claim that the development of the Web is leading us to a brave new world in which small entrepreneurs will rise from nowhere, selling ``third wave'' products and services on the Internet, receiving electronic money in payment, and acting out of reach of government regulation.

There is some validity to this scenario, but as with the ``end of distance'' scenario described earlier, it is an exaggeration--perhaps a gross exaggeration--of the facts.

The Web does indeed offer new opportunities for entrepreneurs, and it lowers the barriers to entry in many sectors, but in the end the Web will probably come to be dominated by a relatively small number of marketing and financial services entities, just as other markets do when they mature. These entities may be the giants of today--K-mart and Citicorp, for example--or they may be companies that have yet to be born, the next generation of Microsoft and Netscape.

This type of scenario irritates those in the cyberspace community who are more than a little paranoid about big business. But such worries are somewhat irrational. First, in mature markets dominated by a few firms, it is still quite usual for there to be many successful smaller firms profitably serving the needs of market niches. Second, attacks on big business too often ignore the fact that big business gets that way by providing consumers with what they want and the fact that bigness itself can sometimes be a virtue.

This latter point is particularly important in the context of financial services provided over the Web. The Web may indeed create some opportunities for free banking with Web sites serving as proxies for offshore banks and physical money being replaced by some kind of electronic surrogate. However, it seems unlikely that the migration to cyberspace will alleviate financial entities from the need to back their activities with large amounts of assets.

This factor is enhanced in a world free from banking regulations, such as the one that some libertarians imagine for cyberspace. Who wants to bank with an institution that has neither backing from a large government or its own large resources?

The Price of Freedom

And will banks on the Web really be free from government interference? I have already pointed out that while the Web may be difficult to control, domestic Internet service providers are as easy to regulate as any other long-distance carrier. Similarly, Web sites, though the presence may be felt mainly in cyberspace, are no more than programs residing on computers located within national borders. Disk drives can be smashed just as easily as printing presses but there are more of them--and if you know the feds are coming, it is easier to shift your computer elsewhere.

Marketers and bankers who see new opportunities in electronic commerce as the result of the Web are correct in their analysis--the Web changes the economics of many businesses, although it does not change the laws of economics. They are also correct in thinking that the Web subverts national borders, there will be easy ways to route around most barriers to cross-border transactions.

But it is important for those of us who are of the libertarian persuasion not to think of the Web as a sort of commercial version of the platonic heaven, entirely free from the ravages of government action. Ultimately, it has a physical reality rooted in hardware, software, and human organizations, much like the human organizations we have always known and with the same weaknesses.

Even if some day the Web becomes the main avenue for commerce, its freedom will need to be protected by a system of laws made and continually supported by wise men and women. If this analysis is correct, then the price of free commerce and free banking on the Net will be much the same as for freedom itself--namely, eternal vigilance.

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