The Genius and Struggle of PayPal

[Mises Daily Article]

<http://www.mises.org/articles.aspx>
The Genius and Struggle of PayPal

by William L. Anderson

<http://www.mises.org/fullstory.aspx?Id=1710>[Posted January 4, 2005]

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 duplicateor at least closely resemblethe 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.
1718)

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 sitin 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 moneyto
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 threatcoming from X.comConfinity 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 marketplacethat entity regularly denounced by the political
classesrewards 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.

_______________________

William Anderson, an adjunct scholar of the Mises Institute, teaches
economics at Frostburg State University. Send
him <mailto:banderson at mail.frostburg.edu>MAIL. See his
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