Bringing Back American Investment
The run on Silicon Valley Bank in March 2023 was a shock to both policymakers and business leaders, revealing previously unknown fragilities within the banking system. But the significance of this episode goes beyond questions surrounding the insurance and regulation of midsize banks; in many ways, it illustrates the larger imbalances facing the U.S. economy as a whole.
As is now well understood, the problems at Silicon Valley Bank arose from its reliance on a customer base heavily concentrated in one industry: the software start-ups that have come to define Silicon Valley. During the COVID years, with interest rates near zero, tech-sector enthusiasm swelling, and the latest SPAC bubble underway, software companies were flush with cash, and the bank’s deposits rose rapidly. Typically, a bank with a growing deposit base will happily make more loans, increasing its profits. But what makes Silicon Valley software companies attractive is precisely their low capital intensity. They are asset-light companies mostly based on intellectual property rents rather than physical production, and they usually seek to maximize revenue growth and valuation rather than operating cash flows. As such, they are poor candidates for conventional bank lending. Thus, facing limited appetite from its customer base for conventional loans, Silicon Valley Bank essentially turned to speculating on interest rates. As Bloomberg’s Matt Levine summarized:
Crudely stereotyping, in traditional banking, you take deposits and make loans. In the Bank of Startups, in 2021, you take deposits and mostly buy bonds. … Or, to put it in different crude terms, in traditional banking, you make your money in part by taking credit risk. … In the Bank of Startups, in 2021, you couldn’t really make money by taking credit risk: Your customers just didn’t need enough credit to give you the credit risk that you needed to make money on all those deposits. So you had to make your money by taking interest-rate risk: Instead of making loans to risky corporate borrowers, you bought long-term bonds backed by the U.S. government.
Inevitably, when interest rates rose, the value of Silicon Valley Bank’s bonds declined. At the same time, the end of easy money meant leaner times for software start-ups—that is, more withdrawals and fewer deposits—forcing the bank to sell its securities at a loss. The consequent deterioration of the balance sheet provoked further customer concerns, leading to more withdrawals and more losses, culminating in a classic bank run.
Less appreciated, however, is that the story of Silicon Valley Bank is in key respects the story of the American economy. During the last few decades, the U.S. economy, like Silicon Valley Bank, has become heavily reliant on software and internet companies—now so dominant they are often considered synonymous with “technology.” As of March 2023, the top five U.S. companies by market capitalization were Apple, Microsoft, Amazon, NVIDIA, and Alphabet (Google), which account for around 18% of the total S&P 500 index value, a level of concentration unprecedented until recent years. Moreover, Apple, Microsoft, and Google alone account for almost 16% of S&P 500 profits. (NVIDIA is a “fabless” chip company that doesn’t manufacturer its chips, specializing in design and then outsourcing production to Taiwan.) Even within venture capital, there has been a strong shift away from “hard tech” and toward software. In 2006, 45% of venture capital investment went to hardware, but that figure was down to 8% in 2017, according to the U.S. Department of Defense’s Office of Strategic Capital.
In the “Fordist” economy of the 1960s, the largest profits were generated by companies—mostly integrated manufacturers like GM or GE—with the largest labor forces and highest capital spending. Today, by contrast, the most profitable companies—asset-light software and some financial firms—employ relatively few people and have few capital spending needs. In other words, the U.S. economy’s shift toward asset-light companies means that profits are increasingly separated from production, capital spending, and labor, limiting opportunities for productive investment. As with Silicon Valley Bank, this “excess cash” is increasingly deployed in financial speculation—stock bubbles, crypto bubbles, subprime real estate securities, and so on. This diversion of resources away from productive business investment and toward unproductive—and often destabilizing—financial activity is one definition, and the most pernicious effect, of the phenomenon called financialization.
In the wake of the Silicon Valley Bank failure, federal agencies rushed to shore up the regional banking system, providing additional deposit guarantees and other measures to prevent capital flight from smaller banks. Whether one characterizes such actions as a “bailout” or not, these interventions—enthusiastically supported by erstwhile “tech libertarians”—follow a typical pattern: Under the sway of “neoliberal” dogmas parroted by various “experts” and political lobbies, the United States at first refuses to consider proactive policy measures to advance a national economic strategy, only to be forced into rushed, reactive interventions later, urgently demanded by the same industry lobbies. Amid the panic surrounding a crisis, these interventions often prove more extensive, intrusive, and arbitrary than might have been necessary earlier. Ultimately, we end up drifting further and further from any laissez-faire ideal, yet without a coherent strategy guiding economic policy. A more prudent approach would be to proactively develop such a strategy and incentivize capital allocation around national goals, in order to minimize the risk of crises and the inevitable bailouts that effectively subsidize bad behavior.
Unlike Silicon Valley Bank, of course, the fundamental imbalances plaguing the broader U.S. economy will not be resolved through more deposit insurance or better interest rate hedges. Nor are the effects limited to the financial system; they threaten our defense industrial base, critical supply chains, and capacity to innovate in “hard tech” and “deep tech” sectors, while also contributing to workforce precarity. At bottom, investment in these and other capital-intensive sectors is discouraged by factors including financial market incentives, corporate profit strategies and compensation schemes, rival foreign subsidies and industrial policies, cumbersome environmental and permitting regulations, the loss of skills following decades of deindustrialization, and beyond. Even the rare U.S. manufacturing bright spot of recent years, Tesla, has had to rely on significant subsidization. In the United States, this took the form of a Department of Energy loan for its first factory and consumer subsidies for the purchase of electric vehicles. Tesla has also received significant support from China, which is now home to the company’s most profitable factory and key elements of its supply chain.
The good news is that, understood in these terms, the concept of financialization helps to explain much of what ails the American economy and, thanks to its many causes, offers a wide range of levers for policymakers to pull. It is not possible in this memorandum to discuss all of these complex, interlocking issues, or to provide a comprehensive list of detailed policy recommendations. Nevertheless, one proposal stands out both on its own merits and as an illustration of general principles: what former Bridgewater CEO, Treasury official, and Senate candidate David McCormick has called an American Innovation Fund. This model—providing matching equity and other forms of government capital to institutional investors in strategic sectors—has been successfully employed in Israel and other countries and offers a number of advantages over conventional subsidy schemes.
First, in an era of “shareholder primacy,” industrial strategies must incentivize capital allocation at the investor level, not merely at the corporate level. Subsidizing corporate profits is unlikely to motivate firms if shifting into a capital-intensive activity results in a lower equity valuation (as I discussed in “Steering Finance,” published by Boston Review). Directly channeling investor capital and supporting investor returns in strategic sectors is often more efficient and less expensive.
Moreover, an American Innovation Fund would enable the government to mobilize “mainstream” private capital behind strategic goals. Rather than attempting to build a new government financial sector—outside of the existing investment universe—to provide loans and subsidies directly to firms, an effective industrial strategy should take advantage of the vast resources of American finance. Innovation funds should be administered by successful private investment firms, pooling private and government capital to target a range of asset classes (private equity, private credit, venture debt, and venture capital) and strategic sectors (defense-industrial base, key supply chains, critical minerals, capital-starved hard tech, manufacturing, and the like).
Financialization has been a structural macroeconomic problem for the United States in recent decades. But the massive size of U.S. capital markets and the expertise of American finance could become important economic advantages, if they can be channeled to support strategic national objectives. The disruptions caused by COVID-19 and the conflict in Ukraine have highlighted critical vulnerabilities in America’s supply chains and domestic industrial base. The collapse of Silicon Valley Bank should likewise inspire new thinking about how the financial sector currently allocates capital, and the need to create better policy incentives to support productive investment.