What Investors Want

Private investment is one of the largest constraints on politics

"Startup Weekend LA" by plewicki is licensed under CC BY-NC-SA 2.0

Imagine you have a cool idea for an innovative startup and good access to seed capital. You think your project stands a good chance of proving other people wrong about something fundamental. Let’s also imagine that you have some experience in the startup world. You have also lived in two or three countries over the course of your career and speak a couple of languages. You have drawn up a shortlist of two tech-friendly cities in different countries. Where should you set up the headquarters?

Obviously, you should begin your decision-making processes by studying the details of life in the two cities. Where would you and your family feel more comfortable? Where is it cheaper and easier to hire developers? What are office rents like? Is there a supportive ecosystem for startups? What is the red tape like in each place? Let’s say the advantages and disadvantages of both cities end up balancing each other out. You have a tie.

The next layer is to add in some macro-economic and political analysis. If your project is successful and you end up selling it, how much capital gains tax would you have to pay? Imagine one country has something like the UK’s Business Asset Disposal Relief, which would tax your gains at 10%. The other country would whack you with a 30% tax.

Raising funds throughout the project would dilute your stake, so you assume you might make 5 million or so on an eventual sale. Setting the headquarters in one city will leave you with 4.5 million. Doing it in the other will leave you with 3.5 million. Which one do you choose? All else being equal, most people will obviously choose the city with the more favourable tax regime most of the time.

Imagine your startup is successful. Every time the company sells its products or services, the government gets tax income. You end up employing 50 people in the city in question. All of them pay social security and income tax every month and then pay taxes pretty much every time they leave the house.

Economist Enrico Moretti has found that every tech job has a multiplier effect and creates more jobs for waiters, taxi drivers and builders, among others. This means that the advantages for the city with the best tax regime compound as more and more startups take similar decisions, creating jobs both directly and indirectly. Cities that become successful startup hubs become increasingly attractive to other startups, as well as to young people.

When a city becomes a startup hub, housing becomes the big constraint on growth. The city administration will need to build or incentivize new flats and houses for the influx of tech workers and young people. If it doesn’t, rents and prices will soar, as the residents of San Francisco have found out the hard way.

Startups are a good entry point to thinking about the benefits of private investment because most of us can see ourselves as the founder of a startup, even if it is only a day dream. In fact, investors take decisions like this every single day, whether it involves a new clothes shop, a factory making engine components or the regional headquarters of a multinational.

A friend of mine who advises investors once told me that it is very easy to understand what his clients want. They need to plot out the expected returns of an investment on an Excel spreadsheet. The most basic question on the macro side is what the tax rate will be in a few years. This leads to further questions: Is the government centre-left, centre-right or populist? Does it have a majority? When is the next election due? Is there a large amount of deficit spending?

My friend says investors tend to prefer centre-right governments with a big majority and a long way to go to the next election, as well as low deficits or budget surpluses. They can work with other scenarios, but what they particularly dislike is uncertainty. A centre-left government with three years to go and a big majority is better than a centre-right government with a small majority on the brink of a hotly contested election. To cut a long story short, uncertainty about future tax rates messes up investors’ spreadsheets.

We can see the downside of uncertainty by looking at what happened in Catalonia in 2017. The regional government announced a new transitional legal regime as part of a unilateral and unconstitutional push for independence without a real majority behind it. It wasn’t clear whether companies would have to continue paying taxes under the old system or to what was supposed to be a new state.

As a direct result of this uncertainty, some 3,000 companies, including both Catalan banks and other Barcelona-based major multinationals, switched their headquarters out of Catalonia in a matter of weeks. More followed later. The lost tax revenue meant the regional government had to ramp up taxes on residents at the same time that job creation slowed significantly.

Luckily, observers of politics have a very handy bellwether to spot the risk of capital flight before it happens: The bond market. In this case, Catalonia’s bonds had non-investment grade status (in other words, junk bonds) during the push for independence, with one rating agency citing “unprecedented levels of uncertainty” as a core reason.

Bonds can get a little technical, but the basic principle is very simple. Bonds have two elements, the price and the yield, which are inversely related. So, if the price of a bond goes up, the yield goes down; and if the price goes down, the yield goes up.

Governments use bonds to finance their activities. There is a secondary market where investors can trade bonds that have previously been issued; and a primary market where governments issue new bonds on a regular basis. Prices in the secondary market act as a reference for prices in the primary market. Ratings agencies play a key role in both markets by ranking bonds in terms of their perceived riskiness.

Imagine that a government announces plans involving a large amount of deficit spending. Running a deficit is roughly equivalent to having an overdraft on your bank account. Bond traders will assume that a growing deficit means the government will have to raise taxes and/or issue more bonds at some point in the future. Rating agencies might agree. The prospect of more bonds in the future hurts the supply side of the supply-and-demand curve. This means that the price of existing bonds in the secondary market should track lower, particularly if they receive a lower rating. The yield will rise. This makes it more expensive for the government in question to issue new bonds in the primary market in the future.

Ordinary voters are rarely aware of these subtleties, but the bond market acts as a very powerful brake on politics. James Carville, a political adviser to Bill Clinton, famously said in the 90s: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

The lesson for mainstream politicians should be clear: Keep an eye on bond yields, try to create good conditions for investors, encourage economic growth and avoid uncertainty and capital flight. If you do this, your electorate will find it easier to get a job, you will have more tax revenue to play with and it will be easier to service your debt, although the housing market might move against you. Unfortunately, this is a surprisingly difficult message to turn into an election-winning slogan! Populists, who have never thought about the bond market in any depth, might connect better with voters’ emotions by using simplistic narratives, but it will be hard for them to actually deliver their promises.

I remember once explaining how the bond market and private investment works to a very left-wing friend. He asked if I was defending “trickle-down economics.” The answer is no. The kind of business-friendly approach discussed here is just at home on the centre-left as it is on the centre-right. It can easily be combined with non-punitive but progressive income taxes, a welfare state and sensible spending on infrastructure in a growing economy, even though capital-gains taxes for genuine entrepreneurs who build something new should be as moderate as possible.

“Trickle-down economics” (more correctly called supply-side economics) is a subset of business-friendly politics that argues that slashing taxes on the ultra-wealthy should be a very high priority for politicians. In particularly toxic versions of this theory, tax cuts for the rich are paid for by slashing the welfare state and infrastructure spending. Doing this will allegedly help the poor in some mysterious way, but in practice never has. Of course, ultra-wealthy donors to right-wing politicians still try to keep the idea alive.

One of the strangest messages for left-wing people who haven’t thought much about private investment is the identity of the investors who constrain government spending. If you have a private pension or have put some of your savings in an investment fund, you are an investor! You probably chose a fund based on the potential returns and forgot about it. Professional fund managers then look after your money by working out where it does most good. They think long and hard about the macro-economic and political issues we have briefly mentioned and then act on your behalf to secure you decent returns. See you next week!

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[Updated on 10 March 2022] Opinions expressed on Substack and Twitter are those of Rupert Cocke as an individual and do not reflect the opinions or views of the organization where he works or its subsidiaries.