The Internet Economy: the World's Next Growth Engine

The U.S. boom is only the start of a global surge

By Michael J. Mandel. With Irene M. Kunii in Tokyo.
Business Week

October 4, 1999

Starting with the Middle Ages, the story of the human race has been marked by accelerating economic growth. In the 1400s, global per capita income rose at only 0.1% per year, estimates economist J. Bradford DeLong of the University of California at Berkeley. Over the next five centuries, that rate moved steadily upward, finally hitting nearly 3% in the second half of the 20th century. Now, it looks as though the global growth rate may be on the verge of ratcheting up again.

Why? We have entered the Age of the Internet, a globe-spanning technology that has taken hold amazingly quickly. Just as data flows across the Net in easily digestible packets, knowledge, in the broadest sense, can now be easily tapped and exchanged by people in every corner of the earth. The result: an explosion of economic and productivity growth--first in the U.S., with the rest of the world soon to follow.

The dynamics of global growth are changing at least as profoundly as they did with the advent of railroads or electricity. The evolution of the Internet as a pervasive phenomenon means that the traditional factors of production--capital and skilled labor--are no longer the main determinants of the power of an economy. Now, economic potential is increasingly linked to the ability to control and manipulate information.

The initial manifestation of the new era is the stunning performance of the U.S. economy in the 1990s. For most of the postwar era, Western Europe and Japan slowly gained ground on the U.S. by adopting U.S. technology and adding their own innovations. In 1970, U.S. per capita income was 31% higher than that of other major industrialized countries. By 1991, the difference had narrowed to only 10%.

But with the dawn of the Internet Age, the gap has started to widen again, to more than 22% this year. "This is historically unique," says Luc Soete, an economist at Maastricht University in the Netherlands and Europe's leading expert on the New Economy. "For the first time in the postwar period, you have growth divergence--the pulling away of the leading technology country."

The acceleration of U.S. growth is only the opening act of a much larger drama of global economic change--and growth. For starters, the Internet should make many more industries open to globalization. Historically, international trade flows have consisted mainly of goods. Whether it was spices or airplanes, it was far easier to ship goods overseas than services. But with the Internet, it becomes much easier to provide services of all types--banking, education, consulting, retailing, gambling--through a Web site that is globally accessible. "The Internet is the backbone of greater service trade," says Joseph Quinlan, senior international economist at Morgan Stanley Dean Witter.

Beyond that, as more and more countries become tied into the global Net, there may well be an acceleration of the rate of innovation. New growth theory predicts that as the size of the global market gets bigger, the rewards for uncovering lucrative new ideas get bigger and bigger. Moreover, as new ideas flow back and forth across national boundaries faster and more easily, everybody will benefit. "There are lots of reasons to think the Internet will lead to much more rapid diffusion of knowledge," says Jonathan Eaton, an economist at Boston University. A study by Eaton and his co-author, Samuel Kortum, has estimated that in the extreme case, if national borders became irrelevant, global growth could go up by one full percentage point.

To be sure, the global economy has not yet reached that point. The U.S. still dominates the Internet, accounting for more than half of individuals online and three-quarters of Internet commerce. With only a few exceptions, most other countries have less than one-quarter of their people online, which appears to be the level at which the U.S. took off. Moreover, most industrialized countries are not yet seeing rapid accelerations in information-technology spending.

Even as the size of the global pie increases, there is the question of who will get the biggest share of the benefits. Periods of great technological ferment often see new countries or regions become pacesetters for the global economy. The second Industrial Revolution of the late 1800s and early 1900s saw the U.S. supplant Britain as the major industrial power, in part because the U.S. adopted new innovations faster.

The Internet makes innovation even more important. With new ideas diffusing quickly, there is little chance of protecting a monopoly. Nor are small differences in production cost as important when the technology is quickly evolving. Instead, whichever country is able to generate and make use of innovations the fastest will come out ahead.

It is possible to overemphasize the differences between the Information Revolution and earlier technological breakthroughs. In the second half of the 1800s, the combination of railroads and the telegraph greatly reduced the cost of overland freight transportation and sped up the rate at which new ideas could diffuse across the industrializing world. The widespread use of telephones and air travel in the 20th century increased the rate of technology diffusion even more. And as the size of markets increased, so did the potential rewards for new ideas.

Yet there were still enormous impediments to the free flow of information, especially across national borders. An economic study done in the 1980s found that it still took upwards of 10 years for an important innovation made in one country to be adopted elsewhere. That's about how long it took American auto makers to adopt Japanese manufacturing methods after Japanese cars took a large share of the U.S. market in the early 1980s.

Business-to-Business Boost. Now, the global economy has speeded up to Internet time. A computer manufacturer running low on chips can have a new batch delivered from half a world away without lifting a finger because a supplier's computers detected the shortage automatically. A new bit of audio software can propagate by the millions in a week. Knowledge of every sort becomes available and useful much sooner. By itself, that increases the pace of global growth and boosts efficiency. A recent study from Giga Information Group Inc. argues that the cost savings globally through business use of e-commerce will rise from from $17 billion in 1998 to $1.25 trillion in 2002, with U.S. companies reaping half the long-term benefits.

In addition to spreading innovations and cutting costs, the Internet may also boost world trade. One reason is better information. Despite the global nature of the economy, most consumers and businesses still are much better informed on the products available in their own country. As a result, many potentially useful trades go unmade.

The Internet changes all that. Suddenly, it is possible for better or cheaper products to compete in a global market, especially if the products have relatively low shipping costs. "The amount that you have to be better than the other guy will shrink," says Gene Grossman, an economist at Princeton University., the French-based gourmet cheese site, gets about 55% of its business from the U.S. On the eBay Inc. consumer auction site, someone putting an item up for a bid can just as easily find a buyer in Europe or Latin America as in the U.S. Indeed, eBay offers detailed directions on how to ship auction goods internationally.

For businesses, the Internet also makes it much easier to reach beyond the home country to find the best suppliers. True, companies have always relied on foreign sources for cheap parts and assembly. But now, it has become possible to integrate foreign companies more closely into the supply chain, boosting savings and speeding up innovation.

Beyond that, the Internet could turn large portions of the service sector into export industries. Higher education is one clear opportunity. American universities and colleges are acknowledged to be the best in the world, but until recently, the only way for them to "export" their wares was to have foreign students come to the U.S. Indeed, such students added almost $9 billion to U.S. exports in 1998.

The Internet brings education to the students. Europe is way behind in higher education, and the gap is widening as European universities have trouble adjusting to the rapid pace of change. "You have complete rigidity here," notes Soete. "The courses are not being updated."

Financial services is another prime candidate for export. In Japan, the deregulation of stock transaction fees in October will trigger a tidal wave of online brokerages. That includes U.S. operators such as E*Trade and Charles Schwab & Co., which are setting up Internet-based operations in hopes of tapping into a potentially huge market.

How Jarring The Shift? Although increased trade and faster diffusion of information lets companies and countries play on a larger field, the laws of comparative advantage between countries have not been repealed. The U.S. starts with two big advantages: It was first, and it has the biggest home market. How those two advantages play out will determine how jarring the impact of the Internet is.

The advantage of being first will ebb away over time. The U.S. lead in Internet penetration is already being eaten away, especially in Europe. Jupiter Communications Inc. predicts that the number of online households in Europe will triple over the next five years. In the Asian Pacific, the number of people who regularly use the Internet is anticipated to at least double over the next two years, fueled by growth in China and Japan.

The number of non-U.S. companies using the Internet to do business is rising fast as well. In Japan, "there will be two waves--business to consumer and business to business," says George Makhoul, a partner at Price Waterhouse Consultants Co. in Tokyo. "In business to business, it's definitely starting." According to a recent joint study by Japan's Ministry of International Trade & Industry (MITI) and Andersen Consulting, business to business accounted for nearly all of the $79 billion in e-commerce in Japan in 1998.

Catching Up Quickly. What's more, the rapid diffusion of ideas in the Internet Age is helping European and, to some degree, Asian companies learn from what American companies have done. "European businesses were slower to move to the Net," says Suzan Nolan, president of Paris-based Blue Sky Inc., a Web marketing and research company. "But that lets them accelerate along the learning curve." The Europeans have caught up remarkably quickly in online banking. Last November, there were 878 bank sites in Europe. By June, that number had more than doubled, with two-thirds of them allowing online transactions.

The gains are especially apparent in a few Internet-savvy countries, especially Scandinavia and Britain. Already, Iceland, Finland, and Sweden have more Internet usage per capita than the U.S. And over the past three years, information-technology spending as a share of gross domestic product has risen by one-third in Britain. "We've got a boom going," says Roger Baker of Roger Baker & Partners, a British recruiting firm focusing on information-technology consulting jobs. "If you go back 12 months, you could see it coming."

Despite the fact that the Internet makes national boundaries more porous, the U.S.'s edge in the size of its home market is not so easily overcome. One example: Gartner Group Inc. estimates that the average cost of developing and launching an e-commerce site is $1 million, mostly for labor. That's true whether the site is for the U.S. or France--a market less than one-fifth the size of America. As a result, it is far more attractive for U.S. companies--especially small ones--to go on the Web. "The size of the American market is one of the most important advantages U.S. companies have," says Johan Stael von Holstein, a board member and business coordinator at Stockholm-based Icon Medialab International, a Web consulting company with 600 employees in 12 countries.

It isn't just a matter of being able to amortize costs over a larger base. In a rapidly changing market, it helps to be able to try a lot of new things rapidly. "The advantage of America is that it is a large laboratory," says Nolan, "They can cycle through experiments quickly, make mistakes quickly, and recover."

A common market in Europe helps, but because of the multitude of languages and cultural differences, the Continent cannot compare with the relatively homogeneous American market. Moreover, it is possible that the introduction of the euro actually diverted attention from the ongoing Internet Revolution. "The Internet is making the world global," says Soete. "But we made Europe more European."

It doesn't help that local phone calls are still charged by the minute in most European countries, discouraging extensive use of the Internet. And while venture-capital funding for entrepreneurs is finally picking up in Europe, its availability is still far less than in the U.S., depriving Europe of one of the key growth engines for the Internet Age.

So there are some impediments to the Net achieving its full global potential. A technological headstart and a big home market will still help U.S. companies. David Roddy, an economist at Deloitte & Touche Consulting, argues that the high valuations of many U.S. stocks--particularly in the technology sector--make sense only if investors are assuming that a huge export surge is coming. "The true gains are going to come from being able to be a net exporter," says Roddy. Meanwhile, for a variety of cultural, legal, and linguistic reasons, even powerful American companies will have a tough time establishing dominant positions in Europe and Asia. "It's not going to be that easy for one to roll in and beat the other," says von Holstein.

Site Snags. For one thing, consumers in each country will have definite preferences about the look and feel of Web sites. Nolan notes that, to many Europeans, American sites come off as having too many bells and whistles. European sites are more consumer-oriented. Or it can be something as simple as cultural differences: In America, red is the color of love, argues von Holstein, but in Spain, it is associated with socialism.

More to the point, even in the era of branding, the best marketing is still done locally, in the language of the customer. And once a Web site has to be redone in a different language, much of the scale advantages disappear. Indeed, European companies that learn how to cope with the Continent's language and cultural barriers may find that gives them a competitive edge.

Asia lags behind Europe, but with its enormous markets, it may have a better chance of thriving in the Internet Age. The key nations are China and Japan. China has more than 4 million Internet users, but that number is expected to jump to 27 million by 2001.

Japan, despite its advanced technology and global business skills, has some catching up to do. Only about 17 million Japanese, or 13% of the population, used the Internet as of March, 1999. It's still tough for startups to find scarce capital, the most promising engineers continue to stick to safe jobs, and Internet infrastructure remains weak. Hitoshi Shin, a senior high-tech analyst at Merrill Lynch & Co. in Tokyo, explains: "If all of a sudden we began using the Internet like it is in the U.S., the system would explode because it wouldn't be able to handle all the data."

There are signs of gains. Domestic shipments of home-use PCs grew by more than 80% in the April-June quarter as consumers jumped on the Web. And business investment is expected to boost Japan's information-technology services market by 26% over the next five years. "From there, it will start feeding on itself, as it did in the U.S.," says Makhoul.

Softbank Corp. founder Masayoshi Son is showing the way. He is creating a financial keiretsu on the Japanese Internet by setting up E*Trade Japan, Morningstar Japan for stock quotations, and other financial consumer services. He wants to create a Japanese arm of the U.S. Nasdaq stock market for businesses unable to meet the stringent requirements for initial public offerings on existing markets.

Indeed, the real key to the next stage of the Internet Age will be whether financial innovation diffuses as fast as technological innovation (page 120). Despite the apparent globalization of financial markets, the differences between countries has so far turned out to be important. The U.S. financial sector was ready to invest in new knowledge-based companies via venture capitalists and IPOs. But in Japan and Europe, banks and other financial institutions remained heavily tied into the old industrial companies.

If these differences persist, the locus of innovation will remain in the U.S., no matter how many Web sites are set up in Europe and Asia. So even if the rest of the world catches up in e-commerce, the U.S. may have already gone on to break new ground in something else. But if the financial-innovation machine of the U.S. spreads overseas, ideas will come fast and furious from everywhere. Then, the Internet Age will truly be an era of global growth.

Copyright 1999, by The McGraw-Hill Companies Inc. All rights reserved.