The Net Effect

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Ask an Internet executive how the Internet has affected the U.S. economy, and you'll get a quick and easy answer, something like: "It's huge. Stupendous. Remarkable. Bigger than anyone ever expected!"

Ask an economist how the Internet has affected the U.S. economy, and the answer isn't nearly so predictable.

No one disagrees that the Internet has profoundly changed American business and culture. Much ink has been devoted to Internet marketing, Internet stock trading, Internet shopping, Internet IPOs, Internet venture capital financing, Internet procurement, Internet music downloads, Internet, Internet, Internet.

There are now hundreds of thousands of people working for thousands of Internet companies with a combined market capitalization of trillions of dollars. These companies buy more technology products and services than other firms, and they create more wealth for their employees, through stock options and triple-digit stock market gains. These employees, in turn, spend more money more willingly than other consumers do. For proof, look at the Silicon Valley housing market, where the average selling price of a single-family home is nearly half a million dollars.

As Internet business has grown, so has the U.S. economy. We are now enjoying the longest expansion in U.S. history -- 108 months, as of March. Much of that expansion has come in the past five years, the years in which Internet business has undergone incredible growth.

The average annual growth rate of the GDP has risen from 2.7% in 1991-95 to 4.3% in 1996-99, according to Bloomberg Financial Markets. The productivity growth rate has risen from 1.8% in 1991-95 to 2.6% in 1996-99, according to economic forecaster Standard & Poor's/DRI. At the end of March, the Dow Jones Industrial Average was up more than 150% over 1995; the Nasdaq Composite Index, where most dot-com companies are listed, had risen more than 500%.

In 1997, there were nearly 150,000 U.S. households with an adjusted gross income of $1 million or more, triple the number in 1991, according to the Internal Revenue Service.

The impact of the Internet on the U.S. economy has been profound enough for President Clinton to take notice. Earlier this month, he hosted a daylong summit on the new economy, attended by economists, technology leaders and stock market analysts.

All around us there are signs that the Internet is affecting the economy in profound ways.

But while the effects appear obvious, these areas are nearly impossible to measure in strict economic terms.

"The links between what's going on on the Internet and in the economy are numerous -- and impossible to completely gauge," says Mark Zandi, chief economist with economic forecaster RFA Dismal Sciences.

His guess -- he admits it comes "from the gut" -- is that Internet business "is probably adding somewhere between a quarter to a half of a percent to the economy's growth per annum" -- about $50 billion annually. How does he arrive at that figure? By factoring out all the technology-related output that is unrelated to the Internet and seeing what's left.

But it's an inexact science. Adding up a company's investment in, say, personal computers, is easy. Figuring out what portion of that is specifically for Internet use is much harder, Mr. Zandi says.

Similarly, it's clear that business over the Internet is increasing the economy's rate of productivity growth by allowing companies to increase sales without greatly increasing sales costs and by giving them the means to become more efficient in their production and distribution. But figuring out what portion of the overall rate of productivity growth is attributable to the Net is nearly impossible.

It's not going to get easier, either. Unlike the automotive or chemical industries, which have relatively finite borders, the Internet crosses all industries. Many Internet executives and economists believe there won't even be an Internet economy in the future.

"Five years ago, only geeks could use [the Internet]. In five years, it will be almost invisible," says Ram Shriram, an Internet veteran who runs a Silicon Valley venture capital firm called Sherpalo. "There will be no such thing as Internet companies in five years."

Hal Varian, an economist and dean of the University of California-Berkeley's School of Information Management & Systems, shares this view. "There won't be an Internet economy in five years, in the sense that it will be the economy," Mr. Varian says.

However, there are clear economic shifts that began in the past five years and that we can attribute, in some degree, to the Internet. They include the efficiencies created by business-to-business commerce, the changing pricing structures created by Internet businesses, the dependence on venture capital investments and the shifting role of the stock market in the economy. How these concepts play out in the next few years will have everything to do with the state of the U.S. economy in the next five years.

B-to-B leads the way

Perhaps the most profound economic impact of the Internet will be in how businesses interact with each other. The Internet is changing the way companies operate, from man-ufacturing to resource planning to customer management.

Analysts have long said that business-to-business is the mother lode of the Internet economy. But those predictions are just becoming viable. Investment bank Goldman, Sachs & Co. forecasts that the b-to-b e-commerce market in the U.S. will rise from $39 billion in 1998 to $1.5 trillion in 2004, an 84% annual growth rate.

Also compelling is a second Goldman prediction: 10% of intercompany transactions will take place on the Internet in 2004, up from 0.5% today. In other words, even if 90% of transactions are still conducted some other way, the economic impact will be dramatic.

The rapid rise of Internet-based supply exchanges gives us the clearest sign of where this b-to-b economy is headed. In February, Ford Motor Co., General Motors Corp. and DaimlerChrysler agreed to form a new company that will electronically connect the automakers with their suppliers. The three companies combined purchase about $240 billion a year from more than 30,000 suppliers.

There are now Internet-based supply chain exchanges in development in virtually every industry, from steel to chemicals to travel to retailing.

And industries that haven't yet felt the full impact of the Internet soon will.

Healthcare is about to undergo a dramatic transformation. Internet-based companies such as Healtheon/WebMD want to link all participants in healthcare -- consumers, doctors, hospitals, insurance companies -- in one online business community. According to Healtheon/WebMD's mission statement, its goal is to "improve the overall quality of health" by making it easier and more efficient for practitioners and patients to communicate.

"There are literally trillions of dollars of efficiencies that will be wrung out of this economy," says Philip Anderson, associate professor of business administration at the Amos Tuck School of Business Administration at Dartmouth College.

The implication is clear: As companies become more efficient, costs go down and pressure increases to lower prices. "Within five years, no corner of the economy will be untouched by downward cost and price pressure," writes Harvard Business School Professor William Sahlman in a recent Harvard Business Review article on the new economy. "Companies will be forced to increase productivity, re-engineer business processes and basically delight customers in ever better ways."

There is considerable debate, however, over how much the Internet will lower prices in the long term, for consumers or for businesses. The common belief is that the more information about prices that is available, the easier it will be to find the best price. Comparison shopping was never so easy before the Internet.

On the consumer side, "it's going to make it much easier to find the companies with the best products at the best price," says Erik Brynjolfsson, asso-ciate professor at the Massachusetts Institute of Technology's Sloan School of Management and co-director of [email protected] "It's going to really help companies that are in that category and hurt companies that are able to muddle through based on geography or consumer ignorance."

Research that Professor Brynjolfsson and a colleague conducted in 1998 and 1999 found that prices for books and CDs were 9% to 16% lower on the Internet, even after factoring in shipping costs and taxes. But prices on the Internet won't be uniformly low, he argues. It also opens the doors to new pricing schemes that could result in higher prices.

Online auctions, for example, are designed to create higher prices as bidding goes on. New Internet technology, meanwhile, gives Web sites the opportunity to dynamically set prices based on an individual's willingness to pay. If you paid full price at an online drugstore in the past, on your next visit you may not be offered the deals someone else sees.

Another wrinkle in pricing involves creating customized goods, just in time and just for you. Dell Computer has built its entire business around custom production; Procter & Gamble Co.'s site, where consumers can have makeup and other products mixed specially for them, is a new example of this trend.

Typically, customized products equal higher prices, and on the Internet that may prove to be the case, despite the efficiencies the Nnet brings to other facets of running a business.

All these new pricing models wouldn't be possible without the Internet entrepreneurs and the venture capital firms that back them. The venture investors put $25 billion into Internet start-ups in 1999, up 310% from 1998, according to researcher Venture One. More than 68% of all venture money invested in the U.S. last year went to Internet companies.

In the past few years, start-ups that formerly had to bootstrap or seek bank loans have been showered with money by willing investors. Money right now is "cheap, very cheap. Just about every idea is getting funded," says Mr. Shriram, the venture capitalist.

Businesses no longer need to be profitable to be considered successful; the flow of cash from outsiders creates an environment where it's OK to go out on a limb with an idea.

Investors grow picky

"The technology revolution has been fomented by entrepreneurs and innovators," says Edward Yardeni, chief economist and global investment strategist with Deutsche Bank Securities. "What they recognize is that in a highly competitive market driven by technology, you can't sell the same thing over and over again. You have to come up with a new thing."

Will venture capitalists continue to fund Internet start-ups at the same pace five years from now? There are increasing signs that this incredible wave of investing can't last. As venture funds get bigger, they have more money that they have to invest quickly. However, investors are starting to become picky about the types of companies they fund.

"In some ways, venture capital success creates the seeds of its own destruction," says Professor Anderson of Dartmouth. The pressure to fund a winning company means many venture firms are passing up bright ideas that won't generate big enough returns.

Another factor affecting investing is the "pile-on" effect. If one idea in a category -- say, online pet stores -- gets funding, then every other idea in that category will also get funding. But only a few will succeed.

"Venture capitalists have a relatively simple objective, which is to invest in companies that create more value than the cost of investing. They'll continue to do that at a high rate as long as the returns are there," says Harvard Professor Sahlman.

"On the other hand, if we reach a period of oversaturation, where too many companies are being funded in the same segment . . .then you'll see the venture capital community cut back on commitments significantly," he says.

What may be far more worrisome to the Internet economy than a pullback in venture investment is a falloff in the other prime funding source for Internet economy companies: the public markets. In 1999, 250 Internet companies went public, raising $19.8 billion, according to Pegasus Research. In 1998, only 29 Internet companies went public, raising just $1.5 billion.

Investors' appetites for initial public offerings seem to know no bounds; the IPO pace shows no signs of abating so far this year. The Nasdaq continued to break records for the first two months of the year before dropping back in recent weeks; still, as of March 31, it was up 9.5% from the start of the year.

The stock market's role in the economy historically has been reactive. Good news for the economy translated into good news for the markets. A downturn in key economic indicators usually meant a downturn in stocks. In today's Internet economy, however, those roles increasingly are being reversed. What happens in the market can have an impact on the overall economy.

Because so much consumer wealth is tied up in stocks, any market correction would have an immediate impact on consumer spending. According to a recent Federal Reserve Board survey, 31.7% of American consumers' wealth was tied up in the stock market in 1999, up from 28.3% in 1998. A significant market correction would have a major effect on the economy. A downturn in stocks also would limit the ability of Internet companies to make acquisitions because the vast majority of acquisitions are paid for in stock.

Until recently, the tech portion of the stock market had been impervious to attempts to slow the economy. Although Federal Reserve Board Chairman Alan Greenspan has raised interest rates several times in the past year, tech stocks have only now started to react.

One reason Net stocks have resisted Mr. Greenspan's interest rate increases is that Internet start-ups are financed from venture investments rather than loans. Interest rate increases affect companies that borrow money. Mr. Green-span, however, is adamant that he will do what it takes to rein in even the high-flying Internet stocks.

At the Clinton economic summit this month, several attendees expressed concern over the stock market's recent gyrations and the possible negative effect on the economy.

Some economists say it's not a given that a tech stock crash would trigger a recession. "Since most of the economy is not yet integrally tied with Internet stock market valuations, it could be something like 1987, where you have the biggest stock market crash of all time," but it didn't lead to recession, says Austan Goolsbee, associate professor of economics at the University of Chicago Graduate School of Business.

Could this Internet-fueled economic boom continue for the next five years? Economists doubt it; but many of their assumptions are based on historic performance.

Slowdown inevitable

"I am absolutely certain that within the next few years we'll have a slowdown in economic activity," says Harvard Professor Sahlman. While he is a firm believer in the strength of the current economy, he likens slowdowns to brush fires: Neither is a good thing, but both are inevitable, despite the successes of Internet business.

Similarly, economists believe growth in the Internet portion of the economy -- that portion that can be measured, anyway -- will slow. "At some point within the next five years, I believe we will have largely built the infrastructure and the network, and rates of growth will begin to slow," says Mr. Zandi of RFA Dismal Sciences.

However, neither he nor another forecaster, Cynthia Latta, principal U.S. economist for Standard & Poor's/DRI, is willing to utter the r-word: recession. DRI has no recession in its baseline forecast for the next five years, Ms. Latta says.

Keeping this expansion alive "has a lot to do with productivity growth, which means new products, new [ways] of developing products and new markets to deliver products," says Ken Goldstein, an economist with the Conference Board, a nonprofit organization that issues economic indicator figures. "A lot of that has to do with the Internet."

Economists caution that Internet-related economic euphoria could end abruptly.

"The Internet represents all that's right with the economy, all that's good with the economy, but also represents all the things that could go wrong," says Mr. Zandi. "It's this euphoria that the Internet is going to contribute to our economic well-being that is, in an ironic way, posing perhaps the greatest risk to the economy."

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