Media Review: Money of the Mind
I recently finished reading Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milkin. It is essentially a history of interest rates in the United States from the 1860s through the 1980s. Over some 440 pages, James Grant presents a survey of major events that have affected and been affected by borrowing. He looks at everything from the maturation of New York City as the financial center of the country to the gradual demise of the international gold-exchange standard, and from railroad bonds to the popularization of consumer lending.
I decided to tackle this tome for two key reasons.
I’m taking quantitative courses on both investing and economics through the lens of history this quarter. Never having studied either subject, I wanted a qualitative introduction to both topics. The book certainly delivered on that!
I need to better understand the history of investing in the US. It’s important to me to understand how VC fits into the financial puzzle that is the American economy. I can’t responsibly engage in venture capital investing without working to understand the financial sector more broadly. In this sense, the book is an excellent starting point.
Regulation is Reactive
An important theme throughout the text is the development of regulation in the banking industry. American bankers have historically taken some interest in regulating themselves. However, this hasn’t always been sufficient. Over the past century in particular, the federal government has become a very visible force in rule-making for the industry.
Almost every regulation the book discussed was reactionary. Certainly every government regulation was reactive, and a response to an economic problem or crisis. Based solely on gaps in the book between the timing of government interventions, it looks like economic cycles that inspire new rules for investing and lending are longer than they were 175 years ago.
The meaning of this as far as I can tell is that the financial sector, and its government regulators, have not yet figured out how to stop economic downturns altogether. However, they have gotten much better at stopping downturns from happening for the same reason twice. The exceptions that define the rule do not actually look like economic phenomena at their core; they seem to me to be economic responses to changes in the diplomatic and public health domains.
America’s Economy is Cyclical
From my perspective, the most essential thing this book did was emphasize the extent to which both debt and equity investing follow a cycle. Nowhere is this more clearly illustrated in the book than banks themselves. There are periods of growth followed by periods of decline. The Great Depression is perhaps most well-known period of decline in the book; it certainly had the most significant impact from a consumer’s perspective because it led to the creation of the Federal Deposit Insurance Corporation, but the attention paid to it isn’t special. There’s plenty of detail on all of the cycles, as well as their causes and effects in the banking world.
Many of these cycles were tied to individuals and institutions making lots of investments in specific industries. The book covers railroads in the late 1800s, oil in the 1970s, and others. More recently, subprime mortgage lending caused the Great Recession, and before that the tech industry itself was tied to a recession when the dot-com bubble burst.
The book presents investments, and lending in particular, as a common thread between these downturns. Within this framing of American economic history, the thing that’s different as time and technology progress is the industry responsible for changes in the economic cycle. This leads to an important question:
What types of cycles matter most today?
Having just finished this book, I would be missing the point if I didn’t point out that the most important economic cycle to watch today may be interest rates, which is very much not a new idea. Here’s what the Federal Reserve Bank of St Louis says the Federal Funds Effective Rate, a benchmark for interest rates that measures domestic unsecured loans between certain banks, has looked like since the past 1950s:
The rate at which banks lend to each other affects the rates at which they’re willing to lend to consumers like us, as well as other institutions that lend or invest outside the financial sector.
From where I’m sitting, the situation today is not so much that rates are all that high today (though they are up in the short term) — in their historical context, they really aren’t. Rather, the interest rate cycle was essentially stopped artificially by the Fed. It didn’t just slash interest rates, which is normal. It practically sat on them, holding them to almost nothing for multiple years, which is not normal.
This happened in two consecutive environments where interest rates were rising: once as a response to the Great Recession starting in 2008, and once as a response to COVID-19 starting in 2020. We’re now seeing rates return, not to normalcy, but to something more like what the world knew before 2008.
That makes today a interesting time to be making venture capital investments, because it’s the first time we’re seeing high interest rates since Marc Andreessen proclaimed software’s return from the dot-com bust when he wrote, originally in the Wall Street Journal, that “Software is eating the world.” Investors who haven’t been doing this for a solid 15 years have never seen this before, which concerns both the venture capitalists, as well as the people who invest in them.
This matters to venture capitalists because startups are already a risky business. The macroeconomic environment has changed, and there’s more to it than that. In an era when lending is expensive, the gap in returns between less risky forms of investment and venture capital shrinks. This makes the risk/reward profile of startups less attractive to some limited partners in venture capital firms, which drives some venture capitalists out of business entirely, and affects the investing behavior of many (though not all) others.
Because VC investors are thinking about this, founders should at least be cognizant of it. Entrepreneurs and investors have a symbiotic relationship. The better an operator on either side can anticipate and assuage the other side’s needs and sensitivities, the greater their own potential for success.
Through international monetary policy, the interest rate cycle is also connected to changes in the diplomatic environment. Developments in the South China Sea and Ukraine indicate the end of a unipolar post-Cold War international relations landscape, in a way that I think of as really cyclical. The re-emergence of what policy analysts call “great power competition” is underpinning changes in America’s international relations and defense strategies. I expect this transition in the diplomatic cycle to impact the US startup ecosystem in more visible ways over the next decade.