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The Genius and Struggle of PayPal

Mises Daily: Tuesday, January 04, 2005 by

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The PayPal Wars: Battles with eBay, the Media, and the Rest of Planet Earth. Eric M. Jackson, World Ahead Publishing, Los Angeles, California, 344 pages, $27.95.

Almost five years have passed since the heady days of the dot.com boom, an era that began as the "New Economy" and ended in yet another recession and the collapse of stock prices that in 1999 seemed to have no upward limits. In hindsight, we can see that the "New Economy" was nothing more than the shotgun wedding of the obvious commercial possibilities of the Internet and the irresponsible, expansionary monetary policies of Alan Greenspan's Federal Reserve System, not a marvelous invention created by Bill Clinton through the magic of raising income tax rates.

That the dot.com boom turned into a bust does not take away from many of the real success stories of that time, one of them being the emergence of PayPal, which helped revolutionize the way payments could be made using the Internet. The original vision that the creators of PayPal (Peter Thiel, a hedge fund manager, and Max Levchin, an engineer who originally was from the Ukraine) had in mind was a system that would permit people around the world not only to be able to pay each other via the Internet, but also to be able to protect themselves when their governments were inflating their currencies.

"World Domination" was the theme of this venture, beginning in 1999, in Silicon Valley. Like so many other "high-tech" companies that bloomed in the San Francisco Bay Area during the 1990s, it had the famed "no collar" business culture that made these firms the darlings of an adoring media that later would turn against them en masse when the "New Economy" collapsed like the house of inflationary cards that it was. PayPal, unlike many of the others, like Pets.com, Webvan.com, and etoys.com, hung on, grew, and finally prospered, thanks in no small part to a refugee from the "Old Economy," Eric M. Jackson, who has authored this book. While Jackson's book is far from an exercise in megalomania (in fact, Jackson is one of the more humble authors I have read recently), he was the one who steered PayPal to its most famous moorings: the mechanism of payment choice for hundreds of thousands of people who use the on-line auction services of eBay.

Before going on, let me say that The PayPal Wars is valuable not only because it gives the reader an inside view of the entrepreneurial madness that was Silicon Valley, but also because Jackson understands the larger picture of which PayPal was a part. He understands the nature of boom and bust (this despite the fact that he received an economics degree from the decidedly mainstream program of Stanford University), pointing out the role of the Federal Reserve System in this latest sorry economic episode. That alone is enough to make the book worth reading.

Furthermore, Jackson understands the predatory nature of the regulatory system that nearly brought down the company after it successfully completed its initial public offering (IPO) in 2002, a feat notable in itself, given the hostile climate that developed after many of the dot.coms went bust. State and federal regulators, as clearly demonstrated in this book, contributed nothing to the quality and "safety" of the product, that being a relatively safe and secure mechanism for using the Internet to make payments.

Before the regulators came the fierce competition from other companies wanting to duplicate—or at least closely resemble—the PayPal system, as it should be. Such competition made PayPal more innovative and nimble, a trait that was enhanced by the innovative and nimble corporate culture that the company developed, something those interested in Austrian Economics would appreciate, given the primacy of the entrepreneur in the Austrian system.

Yet, despite the challenges from competitors, the invasion of Russian organized crime rings that almost brought down the firm through fraudulent accounts, and the pack mentality of the news media, as Jackson points out, government ultimately slowed and nearly stopped the whole enterprise. The state-enforced roadblocks came through predatory regulators and politicians like Elliot Spitzer, the state attorney general of New York, who graciously took time from his shakedown of Wall Street firms to squeeze some "free" cash from PayPal. The second state-enforced barrier came from the trial lawyers acting through class action suits, a mechanism set up by government courts that enriches lawyers and ultimately impoverishes businesses and consumers.

The story begins with Thiel recruiting Jackson, in November 1999, to his new firm using that "New Economy" incentive, the stock option. Jackson at that time was a young analyst locked in the bowels of the firm formerly known as Arthur Andersen. At the time, it must have seemed a foolish move, what with PayPal being an unknown startup and Andersen being one of the best-established firms in the world. (Who would have imagined that in five years hence, PayPal would be a world-wide name and Andersen eviscerated by John Ashcroft's Department of Justice on bogus criminal charges for the crime of being the unlucky firm to be handling the Enron account?)

Jackson's arrival at PayPal proved to be something out of Silicon Valley stereotypes. He writes:

I introduced myself to the receptionist, who had no idea that I was expected. . . . My concern grew. Three people in the company who should have known about my job offer seemed completely stumped. Could Peter (Thiel) have changed his mind? . . . I had no idea what was going on. (pp. 17–18)

Nor did the initial conditions he faced at Confinity (the official name of the company that gave us PayPal), where the environment was thoroughly unstructured, ease his anxiety:

What have I gotten myself into? I pondered as I tested the password to my new Confinity e-mail account on a borrowed computer. I had no job description, my colleagues didn't know who I was, and there wasn't even a desk for me in the building!  At least Andersen gave its new hires a place to sit. (p. 20)

The company brass finally found a place for Jackson to sit—in the "ping-pong room"—and the young Stanford economics graduate soon found out he would be involved in marketing PayPal. The idea behind Confinity's signature product was disarmingly simple. While there were many ways for individuals to transfer money to each other, all had limitations. Wire transfers could be costly and required knowledge of both bank accounts, which is information that could easily find its way into the wrong hands. Credit cards are convenient, but few individuals have setups where they can handle the plastic, that being the purvey of businesses who deal in volume.

But Thiel's inspiration was far more encompassing than just developing a convenient payment system for small merchants and traders. Jackson recalls a conversation during which Thiel explained his vision:

The need PayPal answers is monumental. Everyone in the world needs money—to get paid, to trade, to live. Paper money is an ancient technology and an inconvenient means of payment. You can run out of it. It wears out. It can get lost or stolen. In the twenty-first century, people need a form of money that's more convenient and secure, something that can be accessed from anywhere with a PDA (palm pilot) or an Internet connection.

Of course, what we're calling "convenient" for American users will be revolutionary in the developing world. Many of these countries' governments play fast and loose with their currencies. . . . They use inflation and sometimes wholesale currency devaluations, like we saw in Russia and several Southeast Asian countries last year, to take wealth away from their citizens. Most of the ordinary people there never have an opportunity to open an offshore account or to get their hands on more than a few bills of a stable currency like U.S. dollars.

The $64 question is this: How did this grand vision of an alternative way of holding and trading money ultimately become the mechanism of choice for traders using eBay?  The credit there goes to Jackson, who while surfing the Internet came upon eBay and realized that most of the small traders and sellers using that site were limited to using the mail to transfer payments in the form of checks, since the average household is not set up to handle credit cards.

It was not long before Jackson convinced his superiors to use eBay, and soon it accounted for about 70 percent of PayPal's transactions. However, there were two problems that soon followed. The first was finding a way to make the system profitable. PayPal did not charge for small users (the company did introduce transactions fees for "business" users), instead making its money through the "float" in which it was able to temporarily hold the money before the final transactions were completed. Dependence upon the "float," however, proved to be a loser and the company struggled with a mechanism that would enable it to collect fees yet not drive away its loyal customers.

The second problem dealt with duplicate services. For example, eBay developed Billpoint, its own online payment mechanism, and other similar services soon popped up, most of them being backed up by large banks. Furthermore, eBay used a number of tactics in an attempt to steer its customers toward Billpoint and away from PayPal, only to find that the decentralized and nimble crew at Confinity always found a way around the private barriers.

To deal with one competitor's threat—coming from X.com—Confinity ultimately merged with the firm, creating a marriage that was made elsewhere than Heaven. While Confinity was loosely structured with an entrepreneurial spirit, X.com was more "top down" in structure, decision making dominated by Elon Musk, a capable but sometimes bull-headed CEO who imposed policies that seemed to come more from the comic strip "Dilbert" than the honest give-and-take of business analysis. For example, Musk was stuck on the "X" name to be given to PayPal (X-PayPal) despite its negative connotations. Writes Jackson:

While compiling research to support the continued use of the PayPal name, I tracked down a videotape of several focus groups held by an X.com researcher hired the prior summer. The participants in the groups unsurprisingly disparaged the X brand. Women complained that it seemed pornographic, and middle-aged men remarked that it sounded too much like Generation X, comments similar to what we'd heard during the several focus groups held by Confinity. The tapes provided no rationale whatsoever for the use of the X brand. . . .

The official write-up from the research answered the question. In almost Orwellian fashion, the summary claimed that the participants liked the X.com name and identified it with "brand X," which supposedly stood for the underdog or the sympathetic little guy. (p. 131)

I include this passage not to disparage Musk but rather to point out that even in the profit-making world of business, reports sometimes are written to please the top brass, not deal with real consumer preferences. However, unlike government, where such reports are commonplace and the authors and originators of failed policies rarely must pay for telling half-truths or outright lies, Musk ultimately paid for his bad vision. He was removed from his CEO position by the company's board of directors almost immediately after he announced that X.com was going to discontinue PayPal. The commercial marketplace—that entity regularly denounced by the political classes—rewards truth and punishes lying (or "spin," as politicians like to call it).

The next challenge came from Russian mafiosos, who were tapping the PayPal accounts on a regular basis, creating large fraud losses. Again, the nimble corporate culture came to the rescue, as the PayPal teams found ways to circumvent the criminals without largely inconveniencing their customers.

(Contrast this with the way the Transportation Security Administration largely inconveniences airline passengers to conduct what clearly are ineffectual methods to prevent terrorist hijackings. A gaggle of lawyers soon appeared to sue PayPal because some customers had trouble accessing their accounts; no one sues the TSA just like no one sued the FAA or other U.S. Government agencies after the 9/11 attacks. Only the airlines found themselves in court.)

After suffering losses its first few years, PayPal finally began to show a small profit, and it was able to attract the investors who ultimately were willing to purchase its stock following the company's IPO in early 2002. Not surprisingly, the prospect of a new firm coming into the public arena drew not only media coverage, but "entrepreneurial" lawyers and government regulators. Lawyers found ways to bring class action suits while government officials like Elliot Spitzer found ways to demand payments from the company for nonexistent regulatory violations in order to gain permission to operate within their states.

In the end, however, PayPal "won." That is, the idea survived and the company survived as well. However, soon after the IPO was completed, the principals decided to sell it to eBay, which quickly jettisoned its ineffective Billpoint and used PayPal as one of its payment mechanisms. Jackson and others who had thrived in the open culture of Confinity (and later X.com) found the "old economy" top-down, MBA-oriented culture of eBay too much to handle and left for other ventures.

I have gone through the story, but have not commented on my opinion of this book. Is it worth reading?  Absolutely. Does it have a useful and important story to tell? Yes, indeed it does. (I must admit that I liked it so much that I plan to make it required reading for my MBA students beginning in the fall of 2005.)

The genius of The PayPal Wars is more than it's being an interesting business story. In the end, it is a wonderful exposition of Austrian Economics, even if that is not what the author intends. We see entrepreneurship, government regulation, and the boom-and-bust business cycles in action, presented in a manner in which the author not only sees the immediate "small" picture, but the larger picture at the same time. It definitely is worth taking the time to read, and those who do will better understand those madcap days in which people mistakenly believed that the laws of economics had been overthrown forever.

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William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him MAIL. See his Mises.org Articles Archive. Comment on the blog.