5: When Business Is Scared Stagnant

Fear is on the march. And this could make Americans retreat so much from taking chances that economic growth stalls

After living through the past year, Americans have some legitimate reasons to be scared. We have learned that there are terrorists who want to destroy this country. People can be killed by opening envelopes containing anthrax. In the business world, some respected executives have turned out to be brazen cheaters. And the stock market has become far less reliable than most people were counting on. The bear market is both a symptom of the fears and a cause of them.

But there is a chance that the pendulum is swinging too far, right past prudence into the realm of unreasoning fear. There is a danger that America could scare itself into stagnation--retreating so much that economic growth stalls.

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Increased caution is already hurting the economy by crimping the potential for growth and innovation. Investors have been shunning initial public offerings, depriving young companies of the money they need to grow. Venture capitalists are shutting down other promising startups before the businesses have a chance to get going. And companies in general are extremely tentative about resuming their investment in structures, equipment, and software--prerequisites for new business and growth.

At the extreme, excessive risk aversion by investors and corporations could lead to a repeat performance of the stagnant 1970s. Josh Lerner, a professor at Harvard Business School, says the venture-capital business slumped so much during that decade that in one year, 1975, not a single venture fund was raised. Some academics speculate that the venture-capital drought of the '70s delayed the introduction of personal computers and office data networking. Says Lerner: "With venture funds sitting on billions in uninvested capital, it's hard to feel that we're quite [back to the '70s] yet. But that's the ultimate thing to worry about."

This time around, a retreat of investors from risk-taking could have broader impact. Start with infrastructure. Cut off from access to capital, phone and cable companies are being forced to scale back the deployment of broadband communications networks, which potentially could have enormous payoffs but require perhaps an additional $200 billion to build out nationwide.

Many new products will never get their shot at success, as companies struggle to find the capital necessary to roll them out on a large scale. For example, Pluris Inc., a Cupertino (Calif.) network-equipment company, was forced to fold in May in the middle of designing a $1 million Internet router for high-speed networks--all because its potential customers were in financial trouble, even though the test results for the new product were good. An aversion to risk-taking could also force companies to skimp on research and development--delaying the introduction of as-yet-unimagined products in a variety of fields ranging from software to biotechnology to fuel cells.

It's not just about money, either. Innovative companies are having a harder time getting and retaining workers, too. "Three years ago, we had people standing in line wanting to go to early-stage companies because they thought there would be a windfall," says Steve Maxwell, an executive recruiter in Boston for Russell Reynolds Associates. Now, seasoned managers would rather sit tight. "There is more risk aversion than at any time during the past several years," says James W. Breyer, managing partner of venture capitalist Accel Partners in Palo Alto, Calif.

One of the less recognized advances of the boom years was financial innovation--and now that's under assault. Investment banks had engineered new ways for companies to hedge or speculate. Today, understandably, many CEOs don't want the words "creative" and "finance" to appear within five miles of each other. But clamping down on the legitimate use of financial tools could make companies less efficient and more unstable.

For instance, off-balance-sheet special-purpose entities, while abused by Enron Corp. and others, are legitimately used by pharmaceutical companies for ventures with biotech outfits, and by manufacturers to finance customer purchases. Likewise, it would be a big mistake to crack down too hard on over-the-counter derivatives. These instruments shield companies against destabilizing interest-rate or currency shocks. As Federal Reserve Chairman Alan Greenspan testified to Congress earlier this year, derivatives "are a major contributor to the flexibility and resiliency of our financial system."

It would be especially troubling if risk becomes a dirty word. The trick is to have a clear-eyed view of the trade-offs between risks and rewards. "Risk is a choice, rather than a fate," writes investment adviser Peter L. Bernstein in his book Against the Gods: The Remarkable Story of Risk. A sensible level of confidence--neither the euphoria of the '90s nor the fear of the '00s--would benefit just about everyone.

By Peter Coy

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