RIP the era of low interest rates

For more than a decade, ultralow interest rates generated a tide of cheap money lifting many boats, both rickety and sound. Companies that had little or no current profits, but a faint promise of possible big payoffs in the future, easily got financing.

Now that era of cheap money is ending, as central banks worldwide raise interest rates to fight inflation. And a reckoning has begun.

In Silicon Valley, the ax is swinging. Among crypto, social media companies and more traditional software services firms market values have plummeted, followed by a wave of layoffs. In some cases, you can blame mismanagement and unforced errors (see: Elon Musk’s tragicomic Twitter takeover). Elsewhere funny business has also been alleged. (See: the recent collapse of cryptocurrency exchange FTX, which reportedly used billions of dollars of its customers’ assets to fund risky bets being made by its affiliate.)

But the bigger issue is that even with competent, honest managers at the helm, a lot of these business models were simply not built for a world where borrowing might someday be costly. Some companies need reliably cheap money for their math to add up. And many assumed that interest rates would stay ultralow, well, forever.

Warren Buffett has said that only when the tide goes out do you see who’s been swimming naked; well, the tide has retreated, and it’s a veritable nudist colony out there.

What kind of business model is so dependent on low interest rates? One typical example might be a firm counting on future network effects. X company decides to invest tons in growing its customer base with big discounts or other incentives, potentially enduring losses in the near term in hopes of eventually becoming mega-profitable a decade later.

Think: An on-demand delivery startup. A ride-hailing business. Maybe even an established company making an expensive bet on the Next Big Thing, such as Facebook parent-company Meta’s gambling tens of billions of dollars to one day rule the metaverse.

These kinds of business strategies may have made decent sense when interest rates were close to zero. But at 5 or 6 percent, or even higher? Getting the math to work is trickier.

Even ventures that still appear solid for the long run, such as electric vehicles, are struggling in this new environment. For example, Tesla makes cars that people want, and the coming clean-energy transition will bring them even more customers. But over the past year or so, the company’s market value has still fallen roughly in half.

Why? It’s easy to blame the fact that Tesla’s CEO, Musk, has been wreaking havoc over at Twitter; this probably hasn’t given Tesla shareholders great confidence in his judgment.

But even absent that sideshow, Tesla’s valuation would likely still be battered by tightening financial conditions. A year ago, Tesla’s market value had surpassed that of its next five biggest rivals combined, although it doesn’t sell anywhere close to the most cars or have the highest profits. It was the eighth-most-profitable auto company worldwide last year. Investors have been betting that Tesla’s profits will one day take off and eclipse those of its competitors, and low interest rates made the prospect of those future expected profits more attractive.

In a world with higher interest rates, those future profits get discounted more.

In a way, the past decadeplus of low interest rates was a blessing we largely squandered. When borrowing was basically free, businesses and governments had the opportunity to make big upfront investments in things that would pay off into the future: increasing the housing supply, investing in new equipment and technology, better infrastructure, universal prekindergarten, clean energy.

It’s easier to justify big investments in, say, converting a utility to solar power when financing is around zero percent, rather than north of 5 percent; the annual debt costs are lower, and the investment pays off reaches its break-even point sooner.

But instead of wise, forwardlooking investments, we got a lot of get-rich-quick speculative bubbles in the private sector, and some wasteful deficitfinanced tax cuts.

One puzzle is why businesses and governments didn’t do more of these forward-looking investments when they had the chance. Part of the answer is that executives and politicians face some bad incentives: Their company (or country) might be better off if it made big productivity-enhancing investments today, but if those leaders don’t think they’ll be around to take credit for the benefits, why bother? Better to goose profits a bit more next quarter, or send out another round of tax cuts or stimulus checks when they’ll get to reap the glory (and maybe a payday).

This past 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 those decisions will be implemented right as financing costs spike - when we’ll get much less bang for our buck, and every penny will count.