Why Sh*t is Hitting the Fan

How the Fed accidentally scuttled your Series B, simply explained

Last week I wrote about how tech is entering a downturn. Since then, things have only gotten worse.

Now, the main question on everybody’s mind is simple: why is this happening?

Lots of people will tell you there is an equally simple answer: “COVID stimulus and zero-interest rate policy caused the economy to overheat, global trade got screwed up and there was a semiconductor shortage, then to top it all off the war in Ukraine spiked the cost of oil and fertilizer, causing inflation to accelerate. So the Fed raised interest rates, which is triggering a correction, and possibly a recession. It’s hitting tech hardest because valuations were way beyond historical norms.” 

Telling this story is an easy way to sound semi-smart. But as Richard Feynman once said, there’s a big difference between knowing the name of a thing and actually knowing that thing. So I decided now is a good time to write a comprehensive guide to what is going on. If you’re like me, you probably have roughly 100x more motivation to learn this sort of thing right now as you would on a normal week. Perhaps May 2022 is for learning macroeconomics as Feb 2022 was for learning about international relations in eastern Europe. This kind of motivation fades quickly, but what you learn doesn’t. So it’s good to take advantage now!

This is a fairly in-depth paid post written for anyone who is curious to learn about how the federal reserve system actually functions, and how their decisions end up affecting small tech startups. It includes diagrams of cause-and-effect relationships, and lots of explanatory detail. I go much longer and in much more detail than usual because A) it’s what my curiosity demanded, and B) I have a hunch there are many others like me in the same boat. Some of it may seem basic at first, but pay attention, because it quickly gets interesting.

I should also clarify that my goal here is to give an intuitive and entertaining version of mainstream economics’ narrative of how things work. It’s of course possible that the narrative is wrong. But I am not smart enough to judge, and even if it is wrong in some important way, it’s still important and useful to understand how most people think. So for today’s purposes I’m sticking to the fundamentals.

Basically, this is the guide I wish I could have read.

New! Corrections policy: I spent a lot of time researching this and I’m fairly confident in my conclusions, but there’s always a chance something here will be wrong. If you find a substantive mistake or omission (i.e. not just a misspelled word or a broken link), let me know and I will send out a correction with my next email, credit you, and I’ll pay you $50 if you’re the first to find the error. To keep me honest here, I want all submissions to come in publicly through Twitter rather than privately, so everyone can see what corrections others have submitted, with no gatekeeping on my part, and judge for themselves if they want to. Just mention @Every and include the hashtag “#EveryWasWrong”.

Ok let’s dive in.

What is an interest rate?

Say for example you want to do something that requires more money than you have—like buying a house or a car, or starting a business—you can go to people with money and promise to pay them back later. Of course there’s always a chance you might not, so those people will only tend to agree to loan you the cash if you agree to pay them a little extra. This “extra” is called interest. How much extra you agree to pay is the interest rate.

When lenders offer low interest rates, people tend to get a lot of ideas and borrow and spend a lot of money. But when interest rates are expensive, people only borrow money if they really need to.

This relationship between the price of borrowing and how much borrowing people actually do turns out to be quite important. It’s the main mechanism by which the Fed—the central bank responsible for curbing inflation—does its job.

Why does the Fed want to control interest rates?

Lots of people borrowing lots of money might sound like a bad thing—we often hear about how it’s risky to go into debt—but it actually can have a lot of positive effects.

When people borrow money they usually have some specific purpose in mind: buy a home, start a business, go to college, buy a Peloton bike, etc. This means the money goes from the lender to the borrower to some other company selling something to the borrower. In other words, increased borrowing leads to increased spending. And increased spending leads to increased earnings and profits for businesses, which means they can re-invest in the business or pay profits out to owners. Both of these things cause the business to grow and become more valuable to shareholders. Also, in order to serve the increased demand the business may have to buy more raw materials, hire more workers, etc. This causes a chain reaction emanating from the original loan where more spending → more earnings → more spending.

This is the end of the free preview! To read the whole thing, and to get access to everything else in our library, become a paid subscriber.

Here’s what the rest of the post contains:

  • Why is inflation bad?
  • How does the Fed control inflation?
  • How do interest rate increases affect stock prices?
  • Why is tech hit harder than other industries?
  • How does this affect crypto?
  • How does this affect startups?

All-in, the piece is 3,804 words. Also if you have any questions or comments please leave a comment and I will be sure to respond. You can also hang out in our subscribers-only Discord. I want to treat this post almost like a mini async course, where we can all learn about the economy together.

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