At economic development conferences over the last 20 years, the conversation frequently turned to the same question: How can we create our own Silicon Valley? And many countries and cities claimed that they had. One thinks of Silicon Glen (Scotland), Silicon Saxony (Germans tend to be literal), Silicon Taiga (Russia), Silicon Wadi (Israel), and Silicon Mountain (Cameroon), among others. Some of the copycats were more successful than others, but none achieved the magic of the original. It’s special and rare when the most creative and talented people come from around the world to a location to build new things. Such innovation hotbeds, from the Renaissance in Florence to the Enlightenment in Britain, have played an enormous role in economic history. And as many well-intentioned policymakers discovered, these places are both hard to replicate and fragile to maintain.
Now, reeling from an absurdly high cost of housing, sky-high taxes, and worsening crime and disorder—all of which make living and running a business there far less compelling—Silicon Valley may be seeing its magic wane. What ultimately kills the magic, though, may be rising interest rates. For an innovative ecosystem to work, you need stars to align, yes; but also critical is cheap, easy access to capital. Investment firms willing and able to supply that capital were a big part of what created Silicon Valley.
The first shoe to drop could be the collapse of Silicon Valley Bank. The failure of the bank and its poor risk management is getting all the headlines, but it started with a deeper issue that will pose more problems for the Valley in the years ahead. The bank realized that it was in trouble when depositors, tech firms, and start-ups started pulling out their deposits because they needed the money to fund operations when their financing dried up. The money stopped flowing because of rising interest rates. Even though tech firms’ deposits are insured, a bailout can’t solve the deeper problem that we are in a higher interest-rate environment—and that means the days of easy money in the Valley are over.
Silicon Valley’s ascent coincided with a fall in global interest rates, which started in the mid-1980s, for various reasons. Federal Reserve policy was more accommodative. More globalization fed the demand for U.S. assets, especially from foreign governments looking to manage their currencies and stash excess savings. Low and stable inflation also resulted in lower rates because investors needed less yield to see a positive real return, and less inflation meant less risk in bond investing.
And low rates were good for risky investments in startups, the bread-and-butter of venture capital firms. A critical part of the Silicon Valley environment was the venture capital industry that grew alongside it. By the early 1970s, Silicon Valley was boasting lots of technology firms, but entrepreneurship had yet to explode: those early tech firms depended on government contracts. Most of the private action—and money—was on the East Coast, especially in the Boston area, where the early venture funds got their start.
But in the late 1960s and early 1970s, venture firms went west: Kleiner Perkins (then Kleiner, Perkins, Caufield & Byers) was founded in 1972, the same year as Sequoia. At first, the two Menlo Park–based firms were relatively small. But as opportunities for investment expanded, so did the funds. By 1992, the West Coast was receiving 48 percent of venture investment money.
Many things went right for Silicon Valley during this time and explain why it overtook Boston as the center of tech innovation. University of California–Berkeley sociologist AnnaLee Saxenian argued that it was not just the timing; a unique, more open, social structure helped. The nature of technology out west also made it easier for tech workers to change jobs or start new firms, taking some of the knowledge from their previous positions with them and building on it. Venture firms, meantime, were intimately involved in the firms in which they invested, sitting on boards and providing intellectual support, in addition to capital, so that a permeable relationship existed between investors and founders. This interdependent system made Silicon Valley possible.
Still, it was arguably falling interest rates that propelled the growth. Venture capital had been around for decades but was considered a risky investment—and it was. An investor’s money was locked up for years, sometimes decades, with bets made on often unproven technologies and sometimes inexperienced managers. But as rates fell, investors needed to find yield somewhere. This was especially true for pension funds that had long investment horizons and underfunded plans, so long-term risky investments—with their potentially big payoffs—looked especially attractive.
In 1979, the Employment Retirement Income Security Act’s “prudent man” rule allowed private pensions to invest in venture capital, further fueling growth. Pension-fund commitments to venture capital rose dramatically. Today, pension funds (public and private) account for 45 percent of the largest 100 investors in the more than $2 trillion venture capital industry. California has won the lion’s share of those investments: in 2021, the Golden State received $153 billion in venture capital investment, more than three times New York’s haul.
As interest rates continued to drop around the world, investment in Silicon Valley expanded beyond local venture firms. In the 2000s, especially after the financial crisis brought even lower rates, large global investors became attracted to Valley tech firms, all seeking yield.
Low rates not only meant more money for private equity investment; they also had a hand in propping up tech in public markets. Those venture investments needed a profitable exit, after all, and that meant taking startups public. Low rates also pushed stock prices higher. The value of a stock equals its expected future profits divided by current interest rates. The lower the rates, the higher the stock valuation—particularly for corporations with greater profits expected far into the future—and thus a bigger exit, which made Silicon Valley startups even more attractive to investors. And the cheap money also bolstered the valuations of more established public firms.
When capital is so easy to come by, and not too expensive, investors can get sloppy. It wasn’t just the new Google or Apple receiving investor money; there were many bad companies and outright frauds getting funded, including WeWork, Theranos, and various crypto products. Someday, it will seem crazy that so many high-profile tech firms plainly stated in their investment prospectuses before going public that they had never made a profit, and perhaps never would, and yet still had successful IPOs. This could happen only because interest rates were extremely low.
When inflation spiked—the consequence of too much government spending and the Covid-19 and Ukraine war supply-side shocks—interest rates rose, and the realization dawned that Silicon Valley’s easy-money days were over. Venture capital investment is starting to shrink, after years of growth. Valuation of tech firms has plummeted. In a time of cheap money, the Ubers, WeWorks, and DoorDashes could charge very low prices to gain customers, with little concern about whether they made a profit. When interest rates are up, investors are less generous; prices on all these services are subsequently rising. The Atlantic’s Derek Thompson calls it the end of the millennial lifestyle subsidy.
Even with high rates and falling valuations, venture companies are still claiming substantial investment returns. But because this is a private and illiquid market, the firms have lots of leeway when they calculate returns. Eventually, their investors will need money, and the true cost of betting on forever-low rates will then be apparent. This may mean that pension funds and endowments will have less money than they expected, at least if rates don’t return to their low levels—and there’s good reason to believe that they won’t.
Inflation was the first shoe to drop: the ten-year bond yield is twice the rate of a year ago, largely because higher inflation means higher interest rates. It’s unlikely that inflation will go back down to pre-2021 rates—and that means higher interest rates will last, too. Rates may also remain higher because foreign governments have less excess savings to park in U.S. Treasuries, our debt levels are astronomical, and the Fed, trying to keep inflation in check, is less able and inclined to buy U.S. bonds.
With money tighter and investors more selective, what made Silicon Valley so innovative may be reaching its terminus, especially given the area’s other glaring problems. Early-stage firms in the Bay Area are already getting a declining share of venture funds; money is moving instead to places like Salt Lake City, which is attracting tech workers and offers a lower cost of living, lower taxes, and a nice quality of life, among other advantages. There may be some upside to this new reality: if Silicon Valley venture firms are smart, they will return in spirit to the old days of the 1980s, when rates were also high and they found genuinely transformative ideas and acted as useful partners, as well as investors. This would mean less wasted capital and fewer market distortions.
Less optimistically, it could also mean less synergy, as talent and money disperse around the globe. That would be a loss for the California economy—and perhaps for the rest of the world, too.
Photo: A key to the success of Silicon Valley was the venture capital industry, much of it concentrated on Sand Hill Road. (SMITH COLLECTION/GADO/GETTY IMAGES)
