Higher interest rates may mean less froth and bad ideas
The FTX fiasco and other infamous tech scams from the past encapsulate some of the worst outcomes when debt is cheap.
This week, we have two guest columns to share with you while Josh is on vacation.wrote Tuesday’s newsletter about regulating crypto, and today’s newsletter is by. Allison is an economist and senior fellow at the Manhattan Institute, a Bloomberg Opinion columnist, and she has a Substack called Known Unknowns. Allison is a brilliant read on risk (I highly recommend the book she wrote a few years ago called An Economist Walks Into A Brothel) and other topics, and like a lot of us right now, she’s captivated by the FTX and SBF fiasco. Josh and Allison talked a few months ago on the Very Serious podcast about how the environment of higher interest rates will have some positive effects on the economy, and today’s piece fits in with that theme. I hope you enjoy it.
Please keep sending me your holiday advice questions for Josh while he’s away (firstname.lastname@example.org). It’ll be a fun holiday-flavored Mayonnaise Clinic, where Josh will give specific gift-giving advice and recommendations for holiday gatherings, and elaborate on this:
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Nearly a month in, I still can’t get enough of the FTX story. At first I thought I loved the story because it played into my skepticism of cryptocurrencies. I never understood what problem they solved and found believers incredibly annoying and condescending whenever I asked them to explain it to me. They never could. And while I feel for some investors who lost money, I’ve taken an unhealthy amount of pleasure watching crypto prices fall.
Or maybe it’s because it exposes so many things wrong with politics and the media.
But as I think about it, I enjoy this story so much because it encapsulates everything I find annoying about the tech industry. There was always something grating about someone younger than I am, who won’t even put on real pants, getting super rich and lecturing me about how they were doing the Lord’s work by changing the world for the better. The Effective Altruism movement, which Sam Bankman-Fried championed and caught on big in Silicon Valley, was next-level annoying. They weren’t simply creating new products — they claimed to foresee humanity’s biggest problems many years into the future and could prioritize them over the problems we face today. The arrogance of it all! So annoying!!!
Despite this, I consider myself a tech-optimist. Innovation makes the world a better place; it is the only thing that can improve or even preserve our living standards. It’s incredible how much our lives have changed in the last 20 years thanks to the innovations that some of these annoying people came up with. Some of them are doing amazing things, many of which might increase future living standards in ways we can’t even comprehend today. Imagine explaining your life or job to someone in 1922. Who knows? Maybe there is even a use case for crypto we don’t yet understand, but I would not invest in it until someone can articulate it.
Long term, what’s happening in the tech industry is important and will serve humanity. But, along the way, expect many scams and bad investments that waste money. No one really knows what will turn out to be a real game changer, and this is natural given the inherent uncertainty of innovation. Sometimes, however, the bad ideas are pretty obvious. Remember Juicero? They got $120 million from investors to make a $400 machine that pressed juice out of plastic bags — which you could also do by hand! How did that happen? How do some clearly dubious ideas manage to get so much money?
The answer has a lot to do with interest rates. The tech industry got so frothy and crazy (and the entire crypto market became so valuable) because interest rates were low for a long time. When interest rates are low, debt is cheap and bad ideas receive funding, resulting in things like endless bad Netflix content. Low rates also prop up equity in both public and private markets. The value of a stock today is its expected future profit divided by today’s interest rates. Or, lower interest rates means higher stock valuations, especially tech stocks which are presumed to have big payouts far in the future.
Low rates also encourage investors to take on more risk — they have to if they want to earn more than the paltry returns bonds offered the last few decades. For example, public sector pensions (a big investor in private equity) needs to return 7-8% on its investments each year. If it can’t meet these targets after a while it has to admit it won’t have enough money to pay benefits, and that would mean tax increases, which no one wants. A high-risk, illiquid investment is very attractive to these kinds of investors, so they piled into venture capital.
And the money flowed to Silicon Valley, through both public and private markets, often not for the better. Historically, investments from private equity (an asset class that includes venture capital) increased the efficiency of firms they invested in or bought. But a new paper finds that, more recently, when public pensions invested, private equity caused more inefficiency. And this is important because when pension plans fall short, taxpayers are on the hook — meaning your money is on the line here too. In other words, we paid for the Juicero.
When cheap money comes so easy, the promise of big, future profits is more compelling. This may be why investors did not care if tech firms made big profits, so long as investors got a big market share which they hoped would somehow be valuable in the future. Near-zero rates can mess with people’s risk calculations. I still can’t believe Sam Bankman-Fried told George Stephanopoulos last week (!) that if he could do it over again, he’d spend an hour a day on risk management. One hour! Risk management is the entire point on investing. How did anyone give this man money?
Most people blame the low rates on the Fed. They did pursue a low-rate policy for the better part of the last 20 years, but low interest rates are mostly not the Fed’s fault. There are many reasons to believe that they were responding to a market where rates were lower due to market and natural forces. First, the Fed does not have much influence on longer-term rates (except maybe when they do quantitative easing and buy long-term bonds—and even that is debatable) because they target shorter-term rates.
Second, factors unrelated to Fed policy have caused lower interest rates, starting with increased globalization, which resulted in many countries buying up U.S. debt. Third, people also argue an aging population lowers interest rates, because in theory, older people are presumed to buy more bonds. Fourth, financial regulation required big financial firms to buy more debt and created another captive buyer. Lastly, partly because of globalization and lower inflation, the world was just less risky, and rates have generally been trending down as the world and financial markets became less uncertain (big countries rarely default on their bonds) and there were more instruments to reduce risk.
But the return of inflation last year changed everything. Interest rates are still low compared to historical averages, but they are much higher than they were last year or five years ago. Interest rates are based on several factors: risk in the economy, the desire of a society to save instead of spend money, and (especially for longer-term interest rates) market expectations of future inflation. There are reasons to hope that inflation will fall soon, as supply-side issues are resolved and Fed policy reduces demand. But while inflation will fall from 8%, it may also not go back to 2%. It could settle on something higher, like 3 or 4%, and remain unpredictable for a long while. If that’s the case, interest rates will also be higher for the foreseeable future, meaning the era of near-zero rates may be over, along with the easy money propping up crazy tech companies.
That won’t mean the end of scams or dubious investments. Some annoying people will still get rich in a higher-rate environment. Some will even deserve it because they created value. Scams won’t go away either and patently dumb investment ideas will still get money — maybe even your tax dollars. And the tech industry will also probably have more booms and busts, even with higher rates, because such is the nature of an innovative industry.
But higher rates will mean a different economy, where there is much less speculation and hopefully less reason to believe that someone under 30 can not only change how we transact (while being blissfully ignorant of hundreds of years of banking history), but also anticipate and solve the world’s biggest problems.
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This seems like an essay on your personal resentment at tech
You reference founders' age multiple times, "someone younger than me, who won't put on real pants." Later, "someone under 30."
You make a spurious claim that the general public (via pensions) is paying for Juicero. Venture Capital has performed very well as an asset class, and taking risks like Juicero is what makes this possible. If its effect on pension funds is truly your basis for evaluating tech companies, then you should be very happy with tech
Instead of a serious critique of Effective Altruism, you resort to name-calling. They're "annoying." But caiming to "foresee humanity's greatest problems" and "prioritize them over the problems we face today" is exactly what the adults in the room are doing. Just one group does it with climate change, while the other priorities AI risk and pandemic preparedness. You could have used the column to make a reasoned argument that AI risk + pandemics aren't worth the investment. But you didn't make that argument.
In short, this is just a post about which groups of people you don't like. You're entitled to dislike whichever group you choose, but I can get that content anywhere. It's not why I subscribe to Josh. I'm here for serious analysis.
I agree with a lot here, but this part irked me:
"They weren’t simply creating new products — they claimed to foresee humanity’s biggest problems many years into the future and could prioritize them over the problems we face today. The arrogance of it all! So annoying!!!"
The entire point here is societal risk-management. I plan my life around the idea that I will be alive another few decades and I have to safeguard against a variety of low-risk catastrophic outcomes. Any responsible business does the same thing. Some of these EA people (and lots of other people) pointed out that given the occasional occurrence of flu pandemics we might want to be prepared for the next Spanish Flu, and then it happens and we don't even have a stockpile of N95 masks or a CDC that can make a PCR test. One of SBF's big issues was future pandemic preparedness, and whatever else was wrong with that guy, it is really strange to me that we've lost interest in this issue so quickly.
The AI-risk stuff is harder to assess, but I think non-crazy to worry about. Certainly if we can worry about what global warming will do between 2050 and 2100, we can worry about pandemics and AI risk could do in that time..