Arnold Kling  

Venture Capital and Loan Guarantees

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As the World Ages... When to Wash Your Hands...

It is important to understand the difference. Megan McArdle writes,


A lot of Solyndra's defenders have been arguing that if the government is going to play venture capitalist, this is simply what's going to happen: venture capitalists accept that a lot of firms in their portfolios are going to go bad.

But that is why venture capital has an upside. That is, the venture capitalist wins big on the investments that pay off.

A loan guarantee has no upside. If the venture works, the equity-holders get the upside. If it fails, the taxpayers get the downside.

To put this another way, suppose Dr. Steven Chu hands out all $40 billion he is authorized to provide in loan guarantees using our money, and suppose that every single one other than Solyndra turns out to be a winner. As taxpayers, we still come out behind, because the Solyndra loss is not offset by gains elsewhere.

In fact, the proportion of losers is likely to be even higher than it is in venture capital. If these were solid VC plays, after all, they would have attracted solid VC money. So this is like doing VC after adverse selection. With, I repeat, no upside.

Does Dr. Chu understand this? Or care? I doubt it. He is brilliant--he does come from MIT, after all. And he cares about green energy. That means he knows more than we do about how we should be deploying our money. End of story.


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CATEGORIES: Business Economics



COMMENTS (13 to date)
Chris Koresko writes:

I think everybody understands that loan guarantees are a form of subsidy, not an investment in the conventional sense. The payoff is supposed to come in the form of some benefit which would not otherwise be created because the benefit is spread too widely to be captured effectively by normal investors. Kick-starting a profitable, self-sustaining solar energy industry could plausibly fall into that category. So I disagree that Dr Chu is making a self-evident mistake.

A better question (it seems to me) is whether the potential payoff (private and public) from Solyndra was worth the (private and public) risk.

joshua writes:

"If the venture works, the equity-holders get the upside. If it fails, the taxpayers get the downside."

Just another example of "Capitalism on the way up, socialism on the way down."

Chris - Good point. Part of the problem is that your political bias will largely influence your opinion on the potential public payoff.

Michael writes:

While I mainly agree with your points, in your hypothetical where the other 99% paid their loans and performed, could there be a spillover effect and a social benefit that would result? Yes, the private sector could better identify the potential winners, but the extra loans that are given out would provide some benefit.

Chris Tessone writes:

The other situation where loan guarantees can be useful, and comparatively low risk, is where equity investments are difficult/impossible and commercial lenders over-estimate the risk in a given market. For example, charter school facility loans. Credit enhancements have done a decent job of attracting debt capital that might never have come if governments hadn't smoothed the way. As banks start to catch on and lend in this market, the subsidies can go away.

Of course, loans secured by school facilities in urban areas with active real estate markets are one thing and speculative investments in solar are another.

Bob Murphy writes:

Great post Prof. Kling.

Mike Rulle writes:

What is good about seeing these in advance is we can make predictions. My prediction is these two companies will lose money. I also predict that when they lose money, they will either go bankrupt, seek more loans or guarantees from the government directly, or have the government somewhere (State and/or Federal) be its largest or dominant customer, thus masking losses though subsidized buying. I am betting most on choice number 3.

Dan Hill writes:

It's called venture CAPITAL not venture debt for a reason. It's a worry when people who don't understand the difference between being a stockholder and a being creditor think they are running the economy!

PrometheeFeu writes:

I think this is the point where someone needs to channel Russ Roberts channeling Hayek:

"The curious task of economics is to demonstrate to man how little they know about what they imagine they can design."

Let's be honest, Steven Chu is in that job to lend fake legitimacy to the administration's energy policy. Sure, he's smart and knowledgeable about some of the physics of energy production but what is at issue is not technology or science. The issue here is how we will allocate our final resources in order to meet some of our unlimited wants and desires. In that area, Steven Chu is not more competent than the average citizen.

jeff writes:

I remember when Chu was appointed, the self-anointed brainy left was gushing about what a great appointment it was - this man was a scientist, he cares deeply about global warming, he would make decisions based on science, not politics, Republicans would never appoint such a smart, rational man, etc.

Turns out, once he gets into government, he does what everyone else does when they get there - routes resources from higher-value to lower-value uses.

Lars P writes:

You're under-representing Chu's credentials.

He's not just from MIT, he is a Nobel Prize winner. Physics, 1997.

Jeff Sadighi writes:

I don't think money extracted from Citizens in taxes should ever go to private firms, or to be pledged as loan guarantees.

If such funds are pledged, those Citizens should have a proportional EQUITY position in those firms and participate in any profits, and I cannot understand why that isn't always the case. Over 99% of businesses FAIL so the government shouldn't be distorting market forces in favor those who have 'donated' funds to the politically active among us...

Robert writes:

The projects I've been involved with you've certainly had to pay (a hefty amount) for a loan guarantee. Perhaps the government doesn't price these properly and maybe its crowding out other big org's from providing guarantees but the principle seems sound enough to me.
Isn't a CDS a guarantee on a loan?

Alex writes:

Lars P writes:
You're under-representing Chu's credentials.

He's not just from MIT, he is a Nobel Prize winner. Physics, 1997.

Irrelevant. If his Nobel were in economics, that would be somewhat relevant (although still not necessarily sufficient to adequately qualify him to analyze government funds allocation; just look at Paul Krugman). You might as well claim that a Nobel Prize winner in literature can be assumed to be a great physicist. Expertise cannot be assumed to cross between unrelated fields, no matter its magnitude.

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