Startups & small businesses are facing a dire situation akin to a mass extinction event, as a decade of zero interest rates, has led to a surge in bankruptcies. Recent data indicates that the problem persists, with the Wall Street Journal reporting a grim outlook for startup companies, including a sharp rise in closures, fire sales, and desperate pivots to salvage businesses by depleting funds. The intentional hike in interest rates by the Federal Reserve last year has effectively dried up bank loans and venture capital, pushing tens of thousands of small businesses to the brink of collapse. The business models that thrived in an era of cheap money have become unsustainable, as highlighted by the Wall Street Journal.
This phenomenon aligns with the key mechanism of the business cycle model in Austrian economics, where the boom-bust cycle, fueled by cheap money, leads to a proliferation of unsustainable businesses called malinvestments. Eventually, the cheap money-induced inflation prompts the central bank to combat it by raising interest rates. These rate hikes, intended to rein in inflation, effectively dismantle the foundation of these malinvestments, causing a wave of failures. Unlike the occasional individual business failures in a healthy economy, these failures cluster around interest rate hikes, which became necessary due to the previous period of zero interest rates.
Currently, we find ourselves in the midst of an extensive cycle of interest rate hikes, following a decade of near-zero rates. The Wall Street Journal’s description of a “mass extinction” aligns closely with the Austrian business cycle theory, and it is encouraging to see such concepts being discussed in the mainstream, although it would be beneficial for the theory itself to be better understood.
Recent figures reveal a significant decline in venture capital (VC) activity, with a decrease of two-thirds over just one year, amounting to a total of $37 billion. The Journal mentions one VC firm that has already seen more than half of its original portfolio companies go out of business. The internal rate of return for venture capital firms as an industry has plummeted to a negative 7%, resulting in a loss of 7 cents on every dollar invested. One VC representative compared the situation to an industry that indulged in excessive drinking and is now facing the consequences. This illustrates the profound impact of cheap money.
One notable example of a prominent failure is robotic pizza maker Zoom, which saw its valuation plummet from $2.25 billion to being sold for scrap. Previously, when teaching about malinvestment, an absurd example like a restaurant built inside a whale’s mouth was used to demonstrate an unsustainable business. However, with recent events, it may be necessary to revise that example to a $2.25 billion robot pizza venture.
The situation is far from over, as numerous zombie startups are still operating with leftover capital, with a staggering $350 billion raised in 2021 alone. As time passes, more and more startups will exhaust their resources, leading to liquidations, employee layoffs, and lease terminations, amplifying the mass extinction effect.
To address this crisis, a simple solution would be to raise interest rates to a reasonable level, around two or three percent. This would prevent the clustering of liquidations and allow for a more gradual resolution. Additionally, if the federal government curtailed inflationary practices through deficit spending, it could further mitigate the boom-bust cycles and the need for drastic measures.
Put simply, ending the Federal Reserve and returning the setting of interest rates to the hands of the people and the free market, as it had been for centuries, would effectively stop these recurring cycles of inflation, recession, and bailouts. However, such a change is unlikely to occur in the near future. We will continue to monitor the situation and provide updates in the future.