The last decade of economic policy was a really weird one. For the first time in history the economy spent a long period of time operating under Zero Interest Rate Policy (ZIRP). Essentially, the Federal Reserve wanted interest rates to be as low as possible to stimulate growth, which is why, even now with the Fed hiking rates at historically aggressive levels, the Fed Funds Rate is still below where it was prior to the 2008 crash.
The easiest way for people to think about this interest rate is that when the line in that graph goes up, the interest rate on a new mortgage also goes up. A really high credit score will only ever get you a mortgage rate a few percentage points higher than the Fed Funds Rate. The reason for this is what economists call opportunity cost.
Essentially an opportunity cost is what you give up when you make a choice. If a bank chooses to lend you $500,000 for a mortgage, they give up the chance to invest that money in something else. If they just invested it in Federal Treasuries, they could get the rate in the graph above, and have a 100% chance of getting all their money back, plus the interest rate. This is because US government debt is considered risk free. The US, it is assumed, will never default on its debt. This is becoming less of a guarantee since some Republicans think that letting the US default on its debt is a useful political tool—essentially the political equivalent of threatening to burn your own house down because you don’t want to pay your own credit card bill. But whatever. I’ll get into that another time.
Even with this self-harm tendency from The Party Fiscally Responsible™, the Fed Funds rate is still like 99.99999% safe. You, on the other hand, are not 99.99999% safe. The risk that you will default on your mortgage is much higher than the risk that the MAGA bros will force a default on US debt just because they don’t like Social Security, or something. Because of this risk, the bank charges you a higher interest rate to make the opportunity cost worth it for them. So, right now with the Fed rate at 4ish%, you might get a mortgage at 7ish%.
This principle applies to all investing. The easiest way to think about all investments (except stocks) is to think about the interest rate someone gets as a stand in for risk and opportunity cost. As the Fed Funds rate goes up, all interest rates for all investments have to go up to make the risk for that investment worth it—otherwise people would just buy federal debt. Stocks are a bit different because they are basically a marker of what people are willing to pay to own part of a particular company right now. There are risks and there are opportunity costs, but people can do this for reasons other than financial ones. Elon Musk wanted to pay $44 Billion to own all of Twitter’s stock, even though Twitter was definitely not worth $44 Billion. But, most people who own stocks do it for financial reasons. For this, part of the risk and opportunity cost is on the benefit side. If a ton of people want to invest in a stock, you miss out by not investing. Think gamestop, even though meme stocks are a rare and extreme example.
In the stock market there isn’t a simple, set interest rate you earn, and the risks are also less predictable. The better an investor is at guessing when other people will want to buy and sell, the more interest they will earn.
Opportunity costs still come into play in the stock market quite a bit, and the end of ZIRP has shown how much people were willing to put into the stock market when there weren’t many other options for a decent return on investment without massive risk. And this, in general is true of many other investments. ZIRP explains quite a lot about the last decade of economic growth. Every time I think about ZIRP, this is what my mind jumps to:
And if you got that reference, bravo indeed.
The reason ZIRP is such a crazy drug is that it creates some really drastic expected value calculations. I know I’ve thrown a lot of economics at you so far in this post, but this one is critical, and also pretty simple. Expected value is basically just the reward times the risk. Flipping a coin is a 50% chance of success, and a 50% chance of loss. If you make a $10 bet that a coin will land on tails, your expected value is $5, because $10 times 50% is $5.
In the high stakes world that Wall Street has become in my lifetime, people expect a constant rate of return. If a person is going to get, say 7% return from a safe stock market index fund, I have to be able to beat 7% to convince you to give me your money. With ZIRP beating the stock market gets a bit harder because interest rates for basically all investment classes are down. So, ZIRP gives me the incentive to do some pretty crazy stuff that I wouldn’t do if interest rates were normal—kinda like taking a drug. This is why there was so much money in the stock market with ZIRP, and why the stock market started to fall when interest rates rose. People could get other investments with higher returns. I wrote about all this back in the summer.
But, if I had to beat 7% to get your money, one of the things I might do is throw Big Billions at risky start ups. The start ups might fail 95% of the time, but the one that doesn’t fail might make me 250%. So, 5% success times 250% return equals an expected value of 12.5% return. I’m making this way more simple than it really is, but hopefully you get the idea.
There is really no good way, as far as I can tell, to guess which startups are gonna make a killing. Would I have guessed that Amazon—a website that just sold books—would become Amazon? Probably not. Would I have guessed that Uber—a company that helps random people earn extra money one their own time, and makes most everything about a taxi better—would never be able to make a profit? Probably not, but it’s true! Uber has never made a profit! Yet, somehow, Uber has been worth as much as $50 Billion!
Uber is not the only big tech company that can’t seem to make any money. Some really big names in tech are not profitable. Lyft, AirBnB, Pinterest, Pelation, DropBox, Snapchat, and Zillow are all not profitable. How do these unprofitable companies stay afloat? ZIRP.
Nobody wants to miss out on the next Amazon, or Apple, or Facebook. When interest rates are at zero opportunity cost is really low because there just isn’t really anywhere else that an investment manager can go to earn a lot of money. With opportunity cost low, FOMO gets high, and the expected value of an investment in a risky startup starts to look a whole lot better.
So, how do I know what startup to throw money at?
Charisma.
If a confident and charismatic person gives me a great pitch, I’m likely to think their idea is better than it actually is. So, a confident and charismatic person is gonna get a lot more money from venture capital or private equity than a meek and timid person with the same idea. If charisma sounds like a weird business model, it’s because it is.
Remember, these investors on Wall Street have to promise people more money than they can get from the stock market. ZIRP makes this harder to actually achieve, so investment managers have a tendency to be more optimistic about long shot start ups.
Basically, ZIRP makes the “Bro! Trust me, it’s gonna be LIT!” investment pitch viable, and a charismatic, confident person can “it’s gonna be LIT” themselves into billions of dollars in investments.
Sometimes this works.
Facebook, for example, was probably ZIRP’s first big success. The company was middling along until ZIRP hit. Then in 2009 Zuck landed some big fat investments from Russia and had another huge round of investments in 2012. This wasn’t entirely a “trust me, bro” investment, since Facebook had a proof of concept and millions of products people to market to. But, with ZIRP Facebook grew from a company making $53 million in 2012 to almost $16 billion 5 years later.
This is why investors kept flinging money at unprofitable companies during ZIRP. Uber might one day turn it around like Facebook because they have so many users, like Facebook.
But charisma comes with a risk. There is a reason the “con” in con man is short for “confidence”. ZIRP has given us some of the biggest frauds and failures in the history of the business world because some business concepts seemed to consist of nothing but charisma. WeWork, Theranos, and now FTX have all built multi billion dollar companies on the back of “it’s gonna be LIT”, and all of them have come crashing down on to of the investors that funded them. Think about it: all three of these are Enron type collapses and failures, and all three of them have happened in just the last 10 years. The common thread here is ZIRP.
Big investors get suckered by charisma, and the charismatic leaders build a mirage of a company, and then it all comes crashing down.
Sometimes there is a middle ground here. Elon Musk is the definition of an “it’s gonna be LIT” businessman, but so far it has seemed to work out. I say so far and seemed because I’ve made no secret about my analysis of Elon Musk as a businessman. I think his record shows that he isn’t the person he is perceived to be. Tesla is another one of those big tech companies that isn’t really profitable on its own. If it weren’t for government money, Musk would have failed years and years ago. Now, that’s not a knock on Musk for using government money. I think government investment is massively underutilized; it has given us some of the most important technological and medical advancements in the last 100 years, so that isn’t a jab at Musk.
But Musk used his charisma to become a cultural icon and then manipulated investment markets to make himself rich by leveraging his charisma. Building average quality cars with government money and manipulating investment strategies isn’t really a resume for hall of fame corporate management. And I think the Twitter trainwreck is further proof of this.
I don’t mean for this to be all about Musk, so I won’t go into too much detail, but the short of it is that Musk basically agreed to buy Twitter as a joke, then realized laws actually do apply to him (the Securities and Exchange Commission had consistently allowed him to not be bound by laws). When text messages came out that made it look like he really wasn’t a corporate genius of any kind at all, he relented and agreed to pay way too much for a company that wasn’t making money. Musk used a bunch of debt to buy Twitter, which meant higher debt service payments for a company that wasn’t making enough revenue. His desperation to meet these payments seems to have led to him making one terrible business decision after another. Twitter has been hemorrhaging both users and advertisers since Musk took over, and now Musk has started a fight with Apple, which owns an App Store that Twitter relies on.
The question now is whether or not Musk, who has had trouble with his companies producing enough revenue on their own in the private market, can charisma his way into more investments to keep things alive without the benefits ZIRP provided in opportunity cost and expected value for investors.
But Musk isn’t the only one on the line. Every other “middle ground” company like Uber and AirBnB is gonna have to prove themselves without ZIRP too. With interest rates higher there are other places investors can go to get a decent return. Charisma isn’t going to be as attractive as it was for the last decade. The end of ZIRP is going to really put the brakes on the tech boom. Even companies like Facebook that have been successful might need to rethink ideas—like not throwing hundreds of billions into a metaverse even their own employees don’t want to use.
Or, maybe none of this will matter at all. The financial world is already pricing in expected decreases in the federal funds rate after inflation goes away. The New York Times and the Wall Street Journal have managed to convince enough people that the stock market is the economy, so every political leader will feel pressure to keep the Dow Jones Industrial Average above 35,000 and growing. Doing that might mean pressure on the Fed to lower interest rates back close to zero.
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