Capitalism is about encouraging private initiative that on average brings rewards, but also about taking responsibility when such initiative fails. In general, it is a bad idea for the government to bail out individual firms and investors after such failure, as this DISTORTS everyone’s incentives to take risks in the future. Milton Friedman and many others wrote about this a long time ago. We can show that capitalism allocates resources and provides incentives well ONLY when the basic assumptions underlying our core economic models are satisfied, and this includes the existence of markets and institutions that allow economic agents to transact efficiently. The main difference between developed and developing countries is the existence of such markets and institutions, many of which are established, maintained, and supervised by the government. These include well-functioning judicial, financial, insurance, and many other markets and institutions. During normal times, these are sufficient to create an efficient market-based economic system.
All of the above changes during a crisis, whether man-made and especially when caused by outside forces, as we witness now. In the latter case, neither excessive risk taking, nor reckless business behavior brought many companies worldwide to the brink of bankruptcy. Nor was it their choice to cease operations for an unknown amount of time. Such shock could not have been anticipated or insured, as markets for such insurance, even when they exist are small and very expensive. Three months ago, nobody prepared their business for a COVID-19 pandemic, or for any other exogenous catastrophic event. Most importantly, it is highly unlikely that people’s behavior in the future will depend on whether governments intervene in the markets at this time.
Such shock requires a coordinated response, because most of the “usual” heuristics and concepts are not applicable economically, socially, or morally in many cases. (For example, under regular conditions, the public accepts that a rising demand or a decreasing supply raise market price. During crisis, however, such practice, termed “price gouging”, is viewed by most as immoral, and is strongly condemned even by strong advocates of capitalism). People are making rushed and suboptimal decisions, not because they have perverse incentives, but because they are scared and overwhelmed. Bringing calm into the system is of paramount importance, and only the government can do that. Government action in helping companies in such a crisis is not only compatible with capitalism; in fact, it is essential to restoring the markets and institutions that allow capitalist systems to function. The goal of this intervention should not be to penalize anyone, but to restore the market activity.
Modest government support of the tech sector will generate huge gains for Israeli citizens
There is a debate in Israel and other countries related to whether the government should help the Israeli technological sector, which is seen as much wealthier than the rest of the population. There are claims that the government should focus on other sectors, helping other businesses and workers, because a) tech professionals are more likely to be able to work from home; b) they have more resources; and c) if laid off, they are likely to find jobs more easily than many others. I argue that the main goal of the government’s intervention in the tech sector is not about bailing out high-tech workers and firms (even though I don’t see them as less important than others). It is all about investing small amounts of public money, and generating HUGE gains (or preventing tremendous losses) for the citizens of Israel right away, as well as over the foreseeable future. This conclusion hinges on the following arguments:
- There is a broad consensus that in 2020-2021 there will be a shortage of available investments not only for new firms, but also for high-potential firms in existing portfolios. While the magnitude of estimates vary, the direction is agreed, because: a) most foreign investors are gone and will stay away for a while; and b) the length of the lockdown is uncertain, thus most angel investors and funds (apart from the newly raised ones) are rationing their remaining resources. They do it by drastically slowing down new investments, culling the companies in their portfolios that they previously wanted to keep, cutting wages and costs in the remaining companies, and driving their valuations down.
- As a result, many quality firms that warranted investment and would have received it only a few weeks ago, will shut down, and many of their employees will be laid off, destroying accumulated knowledge. Surviving firms, which are forced by their investors to cut costs, will lay off people, destroying knowledge and becoming much less prepared to compete in the day after.
- It is also widely agreed that Israeli technologies in the fields of Cyber Security, Artificial Intelligence, Enterprise Software, Industry 4.0, and Digital Health will become much more valuable post-coronavirus. This is because the current crisis has hastened the transition to a much more technology-dependent society. This creates an interesting combination of many firms with lower current valuations and a higher expected future value, i.e. greater investment opportunities. In normal times, these opportunities would have been picked up by investors, but during the liquidity crunch and in times of much greater uncertainty, many of them will not materialize.
- Israeli firms and the entire ecosystem compete with many others from other countries that are rolling out large support packages for tech. Compare the package a forward-looking German government announced: an immediate, €2 billion fund designated for startups, followed by plans to establish another €10 billion fund – all for an ecosystem of startups that represents a miniscule portion of the German economy. France announced an aid package of €4 billion. Israeli companies, if not helped, will be at a great disadvantage and may lose important markets once things calm down. Israel, out of all countries, is the least equipped to lose its current leadership position, as this implies much slower economic growth in the next decade.
- As I mentioned, private investors have a shortage of resources, thus the rate of return (ROR) they require for every shekel invested has gone up dramatically since March. At the same time, it is very easy to show that from the point of view of the Israeli people (represented by their government) the ROR for every public shekel “co-invested” with a private investor – which saves a company from being closed or severely delaying its time to market – is higher in the order of magnitude than the ROR for the private investor. The reason is that private investors are not taking into account the externalities they impose on the government in their decisions, which the government must account for.
- Here’s a simple example to illustrate my argument: a private investor may not want to continue investing $1 million in a portfolio company that yields 25% ROR after one year, because the investor’s (now much more limited) resources are better spent on other companies. This will cause the company to close and lay off all of its 10 employees. Let us suppose that the government invests in this company 30%-50% of the total required investment, and the private investor would be willing to invest the rest, as he now needs a smaller amount. The gross investment in this company is $300,000-$500,000, but what does the government really invest? Since most (at least 80%) of the new money invested in a company is used to pay wages, the government will collect the same year 35% in taxes on income, or $280,000. In addition, the government will save on paying these workers unemployment insurance, which amounts to at least $80,000. Finally, it will collect VAT on the purchases of these worker’s families, adding an additional $60,000, adding up to $420,000. Thus, if the gross budgetary outlay is $300,000, the NET investment by the government, is -$120,000, i.e. the government saves $120,000 by helping the company, and in addition is entitled to a 25% return on its gross investment. If the required co-investment, is $500,000, then the NET outlay is $80,000, which entitles the government to ROR of 680% (1.25*$500K/$80K). Even if the government saves only one-quarter of companies from closing, in this example the government’s ROR is between 60%-80%. Even if in the end, private investors end up losing a significant portion of their investment, the government will still make a positive ROR. It is pretty obvious that the government can create a great value by investing little, thus it does not make sense not to.
One may ask why this logic doesn’t apply to other sectors or to the tech sector as it was six months ago. It turns out that tech now is rather unique. Only in tech, new investments are continuously made by private investors who are familiar with these firms, and never invest unless they expect a significant positive return on their additional investment. Thus, only in tech, the government pays less than half, but benefits from taxes on the whole amount. Unlike now, two months ago the tech sector was facing a severe shortage of talent, thus displaced workers would have found another job right away and the government would have not lost much by the closing of a company. Thus, the claim above is relevant for now, and mostly for tech.
- Statements (3)-(6) imply that leaving the “market” (or whatever is left of it now) to deal with the current liquidity crisis creates massive losses for the Israeli economy, and for the Israeli government. Therefore, it is in the interest of Israeli citizens to prevent these losses and they must demand that the Israeli government acts to prevent these losses. Note that such an intervention is not intended to put tech workers ahead of others, and it definitely does not provide the wrong incentives for investors and firms. It would be completely unreasonable for the Israeli government not to intervene after such a colossal exogenous (not man-made) shock.
- The intervention must be done in the most effective way. This year’s budget will be dramatically increased, so there should be some resources to support the main growth driver of the Israeli economy. It is imperative to tailor effective support instruments to different types of companies. At the same time, the use of budget funds that compete with other rescue efforts should be minimized, and they should be leveraged to the greatest possible extent.
- Israeli institutional investors have been mostly absent from the Israeli tech ecosystem since they got burned investing in the dot.com bubble. Only recently, some institutions started acquiring expertise and making investments in tech, which is a very welcome development. This crisis provides a great opportunity for them to invest much more heavily in Israeli tech, as they can have access to the best deals, working with other experienced investors.
Despite recent losses, Israeli institutions still have enormous resources, and only a very small part should be invested in the fastest-growing, most productive sector of the Israeli economy. In my opinion, broadly investing in Israeli tech at this time is a great opportunity for long-term savers, but also, as I have shown, presents an even greater opportunity for taxpayers and the government. This means that the latter should share some of the excess value created by this investment with the former. Notice that there is a very large overlap between the two groups.
Even though it is a great investment opportunity, it is unreasonable to expect from institutional investor boards and investment committees to significantly increase their exposure to the tech sector when all their risky investments are going down. This is not a normative statement, but an observation, based on simple psychology, and on the fact that the media is likely to criticize them if they do. They feel much safer waiting. Therefore, the government, whose ROR on such investments is incredibly high, should encourage them to take this opportunity for the savers’ sake by sharing some of its value (none of the value goes to venture funds).
There are many reasons to help the tech sector weather the storm and come out on the other end stronger and more competitive for all our sake. Having said that, I must state that the tech industry must do some soul searching. While it is still the main driver of future growth, the tech sector has become less connected to and less impactful on the Israeli economy over the past two decades. More and more firms are leaving only R&D functions in Israel, moving most of their other activities overseas. Many firms are less interested in engaging talented individuals from underrepresented populations in Israel, preferring to hire people in other countries. Many firms are not at all interested in applying their technology in Israel, which is oftentimes more difficult than many other places, but is much more impactful on the country. Many never make an effort to raise more capital in Israel, instead of relying almost exclusively on foreign capital. What is easy, familiar and seems to make a better short-term business sense, may be detrimental in the long run for both firms and the entire sector. I hope that the current crisis will be remembered as a turning point, creating a much closer connection between the tech sector and the rest of the Israeli economy for mutual long-term benefits. The effect of VC behavior in recessions is not benign, and so, if the government can help alleviate this liquidity crunch, it will benefit the ecosystem and Israel’s citizens.