ZIRP explains the world
A Margins' theory of everything
Ranjan here, writing about how low-interest rates have distorted everything about our economy.
I know there is not just one simple, overarching explanation for all the weirdness in the world, but, for me, when I see a bunch of scooters strewn about a sidewalk, the first thing that goes through my head is ZIRP.
For the uninitiated, ZIRP stands for zero-interest-rate policy. I will assume most Margins' readers are peripherally familiar with the term, but to clarify, it’s when a nation's central bank pushes nominal interest rates to 0% using monetary policy. There are a million complexities to how it's executed, and nowadays rates can even go negative (NIRP), but for this piece, I'll just refer to all exceptionally low-interest-rate policies as ZIRP.
My co-host Can recently introduced me to the physics concept of a 'theory of everything':
a hypothetical single, all-encompassing, coherent theoretical framework of physics that fully explains and links together all physical aspects of the universe.
That's how I feel about ZIRP and all things business today. To understand why let's first talk about money.
Maybe it's because I was an economics major or a currency trader, but I think of money as a living thing. Not as a sentient, conscious being, but more like one of those prehistoric, single-celled organisms. Or maybe sperm swimming towards an egg. Just millions and trillions of tiny little living things driven solely on biology towards some unforeseen source of nourishment; some instinctual goal.
Money is always swimming towards yield. Millions of investment professionals are taking tens of millions of actions, every day, to help drive capital to its sustenance. The entire global capitalist economy rests on this constant flow.
So what happens when you lower interest rates (especially to zero)? All those millions of little dollar-organisms have to change course. They need to find a new source of life.
THE RISK CURVE
All investment decisions are, in theory, an evaluation of risk versus reward. The US Treasury 3 Month Bill is often thought of as a "risk-free rate of return", or the yield you deserve for effectively assuming zero risk. It's called "zero risk" because we're assuming the U.S. Government will not default on their debt in the next 3 months. For reference, this currently gives you 0.71% (and was 1.25% when I started writing this on Monday 🥶).
That's your starting point. The more risk you take, the more yield you should get. If we're just looking at U.S. treasuries, the longer the maturity, the more yield you should get because there's more time that the U.S. government could default (note: at the moment, this is not the case because of an inverted yield curve, which is a whole other thing).
Then you start looking at U.S. investment-grade corporate debt, like a bond issued by Apple. It's a tiny bit riskier, so you should get a tiny bit more return. Then you move out to high-yield corporate debt which is a bit riskier. You keep moving out the curve, getting to hedge funds, private equity, venture capital, and real estate, and on and on. For each additional increment of risk you take, you get a bit more yield.
The image below from KKR, is the closest thing that represents what I’m talking about. The whole 80-page report is very good on this topic if you’re interested.
The thing is, money has expectations. At an individual level, most of us have become accustomed to bank savings accounts effectively returning zero. That wasn't enough for us though. Our money felt antsy, so it found index funds and other passive funds, to once again, find a bit of yield. They are certainly riskier than a bank savings account (where your only risk is the bank going under), but hey, no one has ever really lost in a Wealthfront account. Money swims towards yield.
That same, tiny behavioral shift takes place at every level of the risk curve, from your savings account to the trillions of dollars managed by large pension funds. That's exactly how it's supposed to work; rather than that money sitting in your 0.01% savings account, you put it to work somewhere else. For a pension fund, they might even have a prescribed expectation of yield (to match expected liabilities), meaning, to maintain a consistent return, they have to move up the risk curve.
So all these dollar-organisms all start swimming towards riskier waters. Treasury investors shift to corporate debt. Public equity hedge funds shift to late-stage private equity. Late-stage private equity shifts to mid-stage, mid-stage to early stage. Seed rounds become bigger. Angel investors become a thing. Unicorns, unicorns, and more unicorns. Ashton Kutcher.
And that's how we end up where we are. In the past, if somewhat risky corporate debt got you 10%. It now gets you 7% (I'm making up numbers here) so you start taking meetings with late-stage growth companies. The Saudi SWF wants to modernize their economy, but they are also looking to achieve returns once found in public equities, so they have to get creative. Blackrock gets jealous of KKR who gets jealous of a16z who gets jealous of YC. There is just so much money looking to do so many new, riskier things.
And again, that's exactly how it's supposed to work. Cutting interest rates spurs demand and risk-taking. The changed denominators of a million financial models make every investment idea look more enticing. If an interest rate is the cost of money, ZIRP means capital is now free.
This gets us back to those scooters on the sidewalk or a bike graveyard.
When that much money finds its way into places not used to that much money, weird things happen. It's how we got to Community-Adjusted EBITDA and sleep economies. You don't create a ridesharing service, but a service that oddly loses money on every ride with a promise to figure out some future business [Tough, but fair -Can]. The distortions live at the valuation level, but also the communications and expectations level. Things just get weird.
It's why, if you want to start a scooter rental business, you don't just buy some scooters and rent them out. You take hundreds of millions of dollars in venture and rapidly expand across cities. Money finds its way. Maybe it’s in the guise of an eccentric Japanese investor teaming up with a lavishly wealthy young monarch, but it finds the place that might give it that return, and where it ends completely changes things.
And boy, does it change things. We’ve certainly dabbled in the debate of “what is a tech company” but what we never addressed was why do companies do mental gymnastics to call themselves a tech company. It’s because venture as an asset class traditionally invested in technology because that is what presented the growth and return characteristics that matched their risk profile. So you try to call a desk rental or mattress seller a tech company.
Then, for the companies that attracted the money had to spend it. Salaries inflate. Cultures change. Consumers are subsidized. Sure, some technology is created, but overall, nothing operates as it would without that thirsty capital. It changes the economics for competitors that do not welcome in the dollars. The second and third-order effects are difficult to comprehend. Facebook’s advertising revenue has exploded thanks to heavily-funded companies acquiring customers, allowing the platform to resist any financial pressure which could force them to address fundamental platform issues. Uber made rides seem cheaper so we stopped taking public transportation. All this capital completely distorts things at the micro and macro level.
My co-host Can previously wrote how much of what we consider technological innovation is, in fact, business model innovation. I’d add that a lot of what is perceived as innovation is also some form of ZIRP-fueled arbitrage. Everything is ZIRP.
I’ve brought this theory up over the years and friends have provided reasonable rebuttals. This could just be the evolution of capital allocation. The traditional IPO has a ton of problems. Public market investors are too short-term oriented. Software is only eating more of the world, meaning there will be many other Facebooks. They are all good rebuttals.
But ravenous money searching for something to satiate its hunger is not a thoughtful rethink of flawed institutions. Things like the Long-Term Stock Exchange are working on solving these problems. AirBnB trying to time its IPO sitting on a $35 billion valuation with a money-losing, recession-prone business, assuming they could delay further with another huge private round, is not.
The thing that’s always been missing is this only works when there is a buyer. If you want to keep avoiding public market scrutiny, then you need Fidelity coming in for your Series R. If you want that $20mm cap convertible, you need a rich ex-Facebook employee looking for some angel investing social capital. If Softbank wants to raise Vision Fund 3, there’s only so many oil-rich nations looking to modernize themselves. That’s the thing about huge amounts of money swimming their way into uncharted waters. It all sounds good until it doesn’t.
Hi! Can here! This is a thing we are trying out, responses to each others’ pieces at the end.
Evolutionary algorithms were all the rage a couple of decades ago, but since then they have lost much of their luster. As Peter Norvig once said, the fascination with things like genetic algorithms was driven more by a Renaissance-esque attempt at bridging unrelated fields, rather than delivering results. Alas, I’ve always thought of ZIRP as a giant pool of money sloshing around and eventually pooling wherever has the lowest path of resistance.
But maybe, biology can help us come up with a better analogy. Certain types of slime mold can apparently traverse complicated mazes to get to the food, casually solving the path-finding problem in the process. ZIRP is similar, except it is money traversing a giant maze of pension funds to LPs to impressionable VCs to charismatic leaders. Molds get their food, and us, scooters on the sidewalks. If that’s not a grand unifying theory on how we end up scooters on the sidewalks, I don’t know what is.
Ranjan’s Closing Notes
There will be lots of talk in the coming months about central banks cutting rates as a response to the coronavirus impact. This entire piece is about how rate cuts spur demand, which has been shown to work exactly as it should over the past decade. The scarier part of our current environment is that the initial shock would be a supply-side one, i.e. Apple can’t make its iPhones and people can’t go to work. All the funding of Usain Bolt scooter startups in the world won’t solve that.
And in kind of funny, personal pandemic anecdotes (c’mon, we have to try to laugh):
I was studying abroad in Rome in 2000 when Mad Cow became a thing. The McDonald’s near our apartment in Piazza Della Rotunda stopped serving any beef products. They replaced the Big Mac, with a pork sandwich named…the McPink. Still my favorite named fast food product of all time.
I lived in Beijing for a few months in the summer of 2009, as Swine Flu was raging. The first thing that happened when I landed was two people boarded the plane with white guns and put them directly to your forehead. They didn’t speak any English and I had no idea what was happening. For a moment, I thought it was all over.
I was taking a Mandarin class while there, and one of the nights I went out pretty hard with some classmates. I called my tutor/teacher the next day and said I had a fever and was too sick to go to class (hungover). Someone knocked on my door a few hours later and it turned out he had called the local hospital.
KKR may be biased as they are a huge private equity company. It seems quite coincidental that private equity has the highest return on their chart... Their cost of equity must be really high since they are using a lot of debt. https://assetbrief.com/resources/wacc-calculator-9xr5y8r
"If we're just looking at U.S. treasuries, the longer the maturity, the more yield you should get because there's more time that the U.S. government could default"
Nobody thinks the US will default, but the longer-term bonds pay based on inflation expectations over the time period.