In Silicon Valley, the ax is turning. Among crypto, social media and more traditional software services companies market values have fallenfollowed by a wave of layoffs. In some cases, you can blame mismanagement and direct errors (see: The tragicomic takeover of Twitter by Elon Musk). Elsewhere, amusing affairs have also been alleged. (See: The Recent Cryptocurrency Exchange Collapse FTXwhich allegedly used billions of dollars of its clients’ assets to fund risky bets made by its subsidiary.)
But the biggest problem is that even with competent and honest managers at the helm, many of these business models were simply not designed for a world where borrowing could one day be expensive. Some companies need reliable, cheap money to make their calculations add up. And many assumed that interest rates would stay ultra low, well, forever.
Warren Buffett said it’s only when the tide goes out that you see who’s swimming naked; well, the tide has gone out, and it’s a veritable colony of nudists there.
What kind of business model is so dependent on low interest rates? A typical example might be a company relying on future network effects. Company X decides to invest tons in growing its customer base with deep discounts or other incentives, which can lead to short-term losses hoping to finish become mega-profitable a decade later.
Think: an on-demand delivery startup. A carpooling company. Maybe even an established company making an expensive bet on the Next Big Thing, like Facebook’s parent company, Meta’s play tens of billions of dollars to one day rule the metaverse.
These types of trading strategies may have made decent sense when interest rates were close to zero. But at 5 or 6%, or even more? Making the math work is trickier.
Even companies that still look strong in the long term, such as electric vehicles, are struggling in this new environment. For example, Tesla makes cars that people want, and the coming the clean energy transition will bring them even more customers. But over the past year, the company’s market value has fallen further roughly in half.
Why? It’s easy to blame the fact that Tesla CEO Musk wreaked havoc on Twitter; that probably didn’t give Tesla shareholders much confidence in his judgment.
But even without this sideshow, Tesla’s valuation would likely still be affected by tightening financial conditions. A year ago, Tesla’s market value had outmoded that of its next five biggest rivals combined, although he does not sell the most cars or make the highest profits. It was the eighth-the most profitable automobile company in the world last year. Investors bet that Tesla’s profits one day take off and eclipse those of its competitors, and low interest rates have made the prospect of these expected future earnings more attractive.
In a world of higher interest rates, these future benefits are more discounted.
In a way, the last decade of low interest rates has been a blessing that we have largely squandered. When borrowing was basically free, businesses and governments had the opportunity to make large up-front investments in things that would pay off in the future: increasing the supply of housing, investing in new equipment and technology, improving infrastructure, universal preschool, clean energy.
It is easier to justify large investments in, say, converting a utility to solar power when the funding is around 0%, rather than north of 5%; annual debt costs are lower and the investment pays for itself — it breaks even — sooner.
But instead of smart, forward-looking investments, we’ve had a lot of private sector get-rich-quick bubbles and wasteful deficit-funded tax cuts.
A riddle is Why companies and governments have not made more of these forward-looking investments when given the opportunity. Part of the answer is that leaders and politicians face the wrong incentives: their company (or country) might be better off if it made big productivity-enhancing investments today, but if those leaders don’t think that they will be there to take credit for the benefits, why bother? Better to boost profits a little more next quarter, or send another round of tax cuts or stimulus checks when they can reap the glory (and maybe a payday).
Last year, Congress finally agreed to big investments in infrastructure and climate. Which, to be clear, we should be grateful for. It’s just a shame that these decisions are being implemented just as funding costs are rising, when we’ll get a lot less for our money and every penny will count.