Don't Spook The Venture Capitalists

Risk plays an important role in capitalism. But economists and policymakers often fail to understand that a New Economy based on fast technological change requires the constant care and feeding of risk takers. In periods of low inflation, venture capitalists have little need to fear high interest rates and are willing to take chances on new business models that exploit new technologies. But when inflation rises, raising the cost of money and lowering stock prices, VCs tend to retreat from betting on the long shots. This is true even though these startups might later prove to have the "killer apps" that generate huge profits. This seems to be happening today, as a growing number of dot-coms and genome-based biotech companies experience a capital shortage.

A technology-driven economy that generates growth through innovation does best in a low-inflation environment. In light of new evidence of inflation creep, policymakers must act and quickly. If the inflation genie is let out of the bottle, the risk factor for venture capitalists will rise sharply. The break in the flow of VC money could turn into a long-term drought and severely hamper economic growth.

The role of venture capital in generating growth is poorly understood and rarely taken into account by policymakers. Periods of technological upheaval are relatively rare in economic history, coming every half century or so. When new technologies, such as computers, the Internet, or genomics do appear on the economic scene, no one knows at first how to commercialize them. No one knows what will work and who will profit. Who would have guessed, for example, that auctioning, a century's old marketing tool, would become a killer application on the Net for eBay?

Venture capitalists typically fund a series of business prototypes that succeed or fail in rapid succession in the marketplace. The more VC money available, the more prototypes are tested. If inflation and risks remain low, VCs will take more business gambles, increasing the odds of big payoffs for the economy. If rates and risks rise, VCs will limit their bets to a smaller number of quicker, surer things.

Today, biotechnology seems particularly vulnerable to a drying up of venture capital. The tools to extract, organize, and use genetic data to create innovative drugs improve every day. But the time horizon on development and commercialization remains unknown. Under any condition, the risks are rather high. With the stock market soured by rising rates, that risk premium widens for venture capitalists. Ultimately, this may delay the time when genomics can deliver on its great promise--and help drive economic growth in the process.

To hear the Wall Street spinmeisters tell it, the shakeout in dot-com land is merely the wringing out of crazy kids with nutty ideas and no serious business plans. But who's to say that the idea denied would not have been the one to succeed. Steve Jobs was young once, too, you know.

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