By: Alex Vronces, Executive Director, PayTechs of Canada
From the 16th through the 18th centuries, life on a merchant sail-ship was brutal. The work was dangerous, and so was the leisure. The ships were crammed, and the food as scarce as the privacy. Death from disease, such as scurvy, was common. Yet these weren’t the only dangers to seafarers: on the waters, you also had to worry about running into pirates and privateers.
Each voyage was a huge risk. Everything, even your life, could be lost to the pirates and privateers who dogged the Atlantic for ships to plunder. The threat probably kept some merchant ships from setting sail altogether, but it didn’t stop all of them.
Some merchants braved the waters anyway. The risk was high, of course, but so was the potential reward. Buyers were willing to pay a premium to people who, for a little more money, would run cargo between Britain and North America and the Caribbean. There were merchants who took the premium, although they paid mightily to protect themselves from pirates and privateers.
Dangerous transoceanic shipping was a transaction cost
When people want to trade, but the market conditions raise the costs of trading for buyers and sellers, the ghost of Douglass North cries, “Transaction costs!” The late Douglass North, who won the Nobel prize in economics in 1993, is best known for his work on transaction costs and their role in economic progress over time.
Transaction costs are to economics what friction is to physics. They’re a drag on people buying and selling, like friction is on things moving through space and time. High transaction costs are usually bad because they lock up economic value that would have otherwise been generated for buyers and sellers.
A good case in point, Douglass North studied transoceanic shipping from the 16th through the 18th centuries. Based on the historical record, productivity was going up over the 300-year period. Merchants voyaging across the ocean were getting more bang for their buck. Douglass North put the historical record under the economic looking-glass to figure out why.
The answer? Transaction costs were falling.
In his paper, which was published in the esteemed Journal of Political Economy, Douglass North reviewed how the costs of a voyage from port to port had changed over time. He found that the costs of operating a ship stayed relatively constant over the 300-year period. There were some changes, of course, but they weren’t the ones that made the biggest difference.
The difference-makers were pirates and privateers. To ward off the threat they posed, merchants had to pack their ships with large crews and armaments. Merchants also had to buy insurance, which protected them in the event their cargo was plundered or their ship was downed.
Piracy and privateering made it difficult to trade because they forced merchants to divert their resources away from simply trading, and toward protecting their ability to trade. In other words, pirates and privateers raised the transaction cost for merchants looking to do transoceanic business.
Douglass North found that piracy and privateering declined over the 300-year period he studied. When these transaction costs went away, it was a boon for the transoceanic shipping industry.
The payments market is one big transaction cost
The payments market doesn’t have pirates and privateers as far as I can tell, although I don’t doubt some are revelling in my extension of the metaphor. Even today, payments involve more parties than just buyers and sellers. The payments market is complex, with more intermediaries than you’d like to know, each taking a cut of the action.
I should clarify. When I say “payments market,” I mean the market for payments themselves. I mean sending and receiving payments and that’s it. I don’t mean the value-added services offered by payment technology companies.
In 2017, the Bank of Canada published a discussion paper in which they looked at the cost to the Canadian economy of making payments at the point-of-sale. Looking at the costs of cash, debit card payments, and credit card payments, the paper estimated that such payments cost the Canadian economy about 0.8 per cent of GDP, which was almost $16 billion at the time. If you add the costs of cheques and wire payments, that number is even higher.
The bad news is that the number is an aggregated transaction cost. Recall what transaction costs do: they divert the resources of consumers and businesses away from simply trading, and move them toward the execution of the trade itself.
Some people ask me if the payment market should grow, but I say transaction costs are not the stuff an economy should be built on. Just like the decline in piracy and privateering improved the transoceanic shipping industry, the reduction in modern transaction costs will build back a better Canadian economy.
Payment technology companies try to give Canadians and businesses better ways to participate in the digital economy. Many offer their customers innovative ways to pay, even bundling them with value-added services. In other words, they provide the type of competitive pressure needed to lower transaction costs in Canada and make the Canadian economy more productive over time.
But Canada’s public policy regime makes it nearly impossible for these companies to compete on a level playing-field with banks. To offer better ways to pay, payment technology companies need access to the national payment system. The problem is that federal legislation prohibits payment technology companies from accessing the payment system, forcing them to go through the banks they’re competing with.
Though the Canadian public policy regime has this wonky effect, promises made in the 2019 budget were supposed to be the corrective. Payment technology companies were going to be regulated and given access to the payment system, eliminating the need for them to go through banks.
It’s 2021 and we’re still waiting for those changes. Canada hasn’t seen a federal budget in two years, longer than it has ever gone without one, although people are expecting one this year.
According to Ottawa insiders, one of the themes this year is to build the Canadian economy back better. If so, I’d advise Ottawa to heed the lesson of Douglass North: you can’t build back better in a world with high transaction costs.