Uncertainty and Investment

Matt Yglesias argues that regulatory uncertainty can deter investment.

Writing about a DC bar that had to close its doors because it couldn’t get a liquor license, he writes that this isn’t just bad because of the loss of economic activity from that one bar but also because it’s

a sign to would-be entrepreneurs everywhere that their potential investments are much riskier than a superficial read of market conditions would suggest.

Well, exactly.

I’ve been an entrepreneur, startup advisor and technology journalist, and I’ve always been surprised at how risk-averse venture capitalists seem. Isn’t the whole point of their job to take risks?

And yet most venture capitalists have very narrow sets of criteria under which they invest.

The answer is that risk isn’t unidimensional. Whenever you undertake something there are many factors that can go wrong. And it’s precisely by mitigating risks in most of these factors that you feel comfortable taking bigger risks along other factors.

So a VC will try to back a team that’s located in Silicon Valley, has the right pedigree, etc. and minimize all these other risks precisely because she’s taking a big risk on an untested product in an untested market.

To take another example, let’s say you’re a company that’s thinking about building and operating a bridge.

This type of investment typically entails spending a ton of money upfront, and then using money from toll fees and the like to recoup your investment over time. For these big types of projects, the time frame is generally measured in the decades. Usually these investments are leveraged: you borrow most of the money to build the bridge and then pay back interest out of the cashflow from the tolls.

That means you need to take into account not just how much it’ll cost to build the bridge and how many people will use it and how much you think they’ll pay (30 years from now!) but also things over which you have even less control like, say, interest rates and inflation.

Now let’s say you’re looking at two bridge projects, one in Germany and one in Argentina. Let’s say for the sake of argument that they are identical in terms of how much they’ll cost, how much you can expect to recoup (nominally), etc. What’s inflation going to be like in Argentina in 30 years? What about Germany?

Well, no one can say for sure. But one can guess. One can note that inflation has been pretty moderate in Germany for over 30 years. One can note that Germany’s political culture is hellbent on keeping inflation under control, even if this entails considerable other costs. One can note that Germany is in a region, Europe, that has had generally sound monetary policy and credible central banks.

Meanwhile, one can note that Argentina defaulted on its loans and dramatically devalued its currency a decade ago and that it hasn’t yet come to an agreement to the satisfaction of all its bondholders. One can note that not only is inflation rampant in Argentina right now but that the government is actively involved in denying the extent of the phenomenon, going so far as harassing analysts putting out inflation numbers that contradict the government’s figures.

Again, let’s say that on the “pure” business metrics, the two bridges are the same. Something tells me the bridge in Germany is going to get built, and the one in Argentina isn’t.

Of course, it’s possible that this is wrong. Maybe one day Germany decides to debase the euro to keep its exports competitive and hits onto an inflationary cycle that gets out of control. Maybe Argentina elects a former hard-left trade unionist who realizes that credibility with international investors will help regular people in Argentina and manages to keep Argentinian economic policy “orthodox.”

But right now, there’s just a lot more uncertainty associated with building a bridge in Argentina than in Germany, and this means that, ceteris paribus, Argentina will get less investment than Germany.

All of which is to say that, yes, regulatory uncertainty can and does indeed deter investment. And the key to grokking that is to understand that it’s precisely by making some criteria more certain that entrepreneurs and investors are freed to take more risks.

Certainly it doesn’t mean that there aren’t a lot of politicos BS-ing about this. It’s not an argument against all regulation (indeed in some cases good regulation is better than no regulation). And after taking the US federal government to the brink of default, the Republican Party is arguably the least well placed in talking about “certainty.”

But, “uncertainty” matters.