You are best known for founding PayPal and for your hedge fund. But you recently set up a venture capital vehicle. What prompted that?

As a result of my Silicon Valley connections from having led PayPal, I’d been doing some small venture capital investing on the side for the last five or six years.

The basic challenge with venture capital, and with private equity, is that you have basically too much capital chasing too few good opportunities. We decided to do a small fund because there are a limited number of good deals. But even so, I don’t think you can deploy anything more than $5 million to $7 million a year in capital; anything beyond that, your returns really start to go down.

What do you look for in a venture capital investment?

The most important thing is the caliber of the people starting a company, because at an early stage in these tech companies, the plan often changes. You can change the business plan much more easily than you can change the people, so you want the right ones.

You look for people who are both quite visionary and also somewhat open-minded. You just try to make some judgment as to what it’s going to be like to work with them, because once you write the check, you’re always pretty much stuck as an investor.

One thing I ask is the salary of the CEO. The general rule I’ve found is: below $100,000, almost always great; above about $180,000, almost always bad. The basic question is: Are they going to be aligned with you—do they believe the equity is going to have any value?

Secondarily, but still very important, you ask just how big is the idea. Is it something that can inspire other people to work on it? If not, to attract good people, the business will have to offer high salaries, which is difficult for young companies.

What should an investor who wants to put money into a private equity fund look for?

At this point in time, people should not be putting any money into any private equity deal whatsoever. Returns are just not there. You have too much capital chasing too few good opportunities.

Now the same thing is true in venture capital as an industry, but I think within venture capital, returns are quite differentiated. The returns historically have been 35 percent annualized for the 90th percentile and something like 10 percent annualized for the 50th. So it’s an incredible delta between the top and the average people. You don’t have such a delta in the private equity world, which is why, if the average returns go down, it’s likely they won’t be good anywhere.

What would bring private equity returns back?

We are probably going to have 10, 15, 20 years of lots of capital chasing returns that are not great. I don’t think that this is an acute issue that’s going to get fixed quickly, like it was in the late 1980s, when you had a similar problem solved by a massive downturn, so that four or five years later you could resume investing. Nothing of the sort has happened today.

The venture capital industry is a great example. In 2000, I would have said there’s this massive overhang of venture capitalists; a lot of them are going to go out of business, and a few years down the line, venture capital will be a good thing to invest in again. But nothing of the sort happened; they just stayed around and raised lots of money. So I think we’re dealing with an overhang that’s going to be with us for many years.

Why did the overhang persist despite the dot-com crash?

The way to see the housing slowdown is as a deflationary shock. When the bubble ends, it’s like the ATM machine in everybody’s house gets turned off.

Part of what’s driving the overhang is the baby boomers’ need to save for retirement. The savings rate in the U.S. at this point is at 0 percent. But we already have an overhang because of high levels of savings in China and Japan and growing levels in Europe. Now, the savings rate in the U.S. is going to start going up, a lot, and I don’t think it is going to come down elsewhere.

Say you want to earn 70 percent of your pre-retirement income in retirement. How much do you need to save? The answer is very sensitive to the return you can expect to make. But even if you expect returns of something like 5 percent after inflation, which is quite high historically, the U.S. would have to save about 10 percent more of its GDP than it does now. Basically $1 trillion a year would have to shift from consumption toward savings. You could argue the shift actually has to be even bigger than that, because if you have $1 trillion going into savings out of consumption, investment returns will go down. The equilibrium savings point will be incredibly high.

When do you see this shift filtering through to asset prices?

This is the question I spend a lot of time thinking about on the hedge fund side. One big new idea that we’ve had over the last few months is that one of the main sources of global liquidity driving asset prices today is the rise in oil prices and the petrodollar recycling effect.

The rise in oil is like a $1 trillion per year regressive sales tax on the middle class, which would otherwise spend that money on consumption. The money goes primarily to very wealthy people in Russia, Saudi Arabia and various other places. And they invest it. Now, normally, if you had a $1 trillion sales tax, it would be bad for stocks. But what would happen if the government took the money and used it to invest in the equity markets? Our analysis shows that the net effect is the markets actually go up. So the financial petrodollar effect so far is dominating the real effect of the higher oil prices.

What would disrupt this capital flow?

I think there is a point where higher interest rates may break the cycle. You shouldn’t underestimate central bank monetary policy. But the question really is what happens with oil. If oil prices stay where they are, I think the petro­dollar effect could go on for quite a while. One really big question is what would happen if the price of oil fell sharply. All of a sudden there would be no petrodollars supporting the financial markets.

That could be bad. Remember it’s a cycle: The money goes from the middle class to Saudi Arabia and Russia and then it gets returned to the middle class in the form of credit or debt, home equity loans, things like that. If the oil price goes down, people may have all these debts, but no ability to service them. This is what happened in the early 1980s when petrodollars were invested in the emerging market countries. These countries actually did quite well in the 1970s because they could just borrow money like crazy. In theory, like the middle class today, they should have done badly because of the higher oil prices, but the real effects on their economies were more than offset because they were able to borrow a lot of money. But they hit the wall in ’81, ’82 when the oil price came down; all of a sudden there was no credit left. That’s one scenario to worry about today.

A second scenario is if the oil price goes a lot higher, there’s some point where the effect on the real economy starts to hurt too much. But I actually think that it may have to go up a lot for that to happen. If the price goes to $100, $120, the petrodollar effect gets even bigger and, so far, it has had this strange sterilizing effect.

What does this mean for your investment strategy?

The high-risk category that we like best remains various oil equities. There are actually two independent reasons for this. One reason is just the conventional reason—people are underestimating the long-term supply problem.    

So you believe the peak oil thesis?

Yes. And that makes oil a fairly good investment. But the petrodollar effect opens some opportunities. If you are in Riyadh or Moscow or wherever, and you have a pile of money you made in oil, you’re not going to invest in oil or energy companies. That’s why these companies are still systematically cheap. If you look at the forward price of oil for 2012 and beyond, it’s like $70 per barrel. But oil company equities are being priced as though oil is going to be $45 to $50. It’s the one risky asset in the world economy where there are no petrodollars going into it.

What sort of oil stocks do you like? The majors?

We think many of the oil services companies are quite attractive in a peak oil world because people are going to have to spend a lot more on servicing these fields. We also like the Canadian oil companies. The problem with the majors is that in a peak oil world, you have to worry about confiscatory taxes. Even in the U.S., at $100 a barrel, we’ll start hearing talk of windfall profits taxes and all sorts of stuff. Our judgment is that Canada is probably the single country in the world that’s the most immune to the tax risk of higher oil prices.

What other themes is Clarium pursuing?

Our other short-term view is that there’s a massive housing bubble in the U.S. In many ways, it’s similar to the 1990s equity bubble. By any of a number of measures, house prices are extreme. We think that housing is going to slow down quite a bit.

What will precipitate that? The Fed’s tightening?

I think the housing bubble is like a light switch. It’s on or off. When it’s on, the Fed’s not tight enough, no matter how high it sets rates. And once it gets turned off, it will turn out the Fed’s way too tight, no matter how much it eases. The Fed is in an unenviable position; it is very similar to 1999, 2000, when it was trying to raise interest rates and deflate the equity bubble, but once they poked it and got it to burst, it was not like they could all of a sudden cut rates and get it restarted.

Although that was Greenspan’s recurring strategy.

Yes. There are two thoughts on that. Certainly the view that there was a “Greenspan put” gave people an excessive degree of complacency about investing in equities in ’98 to 2000. But the Greenspan put had this byproduct of creating a housing bubble that was even bigger than the equity bubble. So if you’re a policymaker today and you’re trying to think what you are going to do the next time around, it would seem to me that the bias this time around is going to be to stay tight for somewhat longer. While they may be done raising rates, they may just not cut them that aggressively.

How does your fund trade off this view?

We haven’t targeted housing stocks specifically. What I think people don’t understand is the way the housing bubble is linked to the rest of the economy and the way in which it’s linked to consumption. The fact that we have a 0 percent savings rate is driven by the housing boom, because people don’t feel they need to save when their house prices go up every year. And so there are a whole set of repercussions from a macro view.

The way to see the housing slowdown is as a deflationary shock. When the bubble ends, it’s like the ATM machine in everybody’s house gets turned off. Money will be scarcer, prices will fall. From late 2000 to late 2002, the inflation rate fell off by about 3 percentage points, and we’d expect something like that to happen, maybe even more, with respect to the end of the housing bubble.

If you think about which financial investments will do very well in that world, the most straightforward are 30-year U.S. government bonds. Now, the 30-year bonds are probably the least favored investment in the world today. You have all these different ideological camps with different views on the fixed-income markets, but they all come out with the same answer: 30-year bonds are awful.

One really big question is what would happen if the price of oil fell sharply. All of a sudden there would be no petrodollars supporting the financial markets.

You have a flat yield curve today.  The “Goldilocks” people, who think that the economy is perfect, say it’s going to go back to a normally shaped yield curve and probably move up by maybe 100 basis points—so you don’t want to hold 30-year bonds; you should have your money in stocks. You also have people who say there’s inflation in the pipeline, the Fed’s way behind the curve and it’s going to have to tighten more, and the bonds are going to sell off. And a lot of the inflation people also think there is going to be a dollar collapse because the current account deficit will cause Japan and China to sell bonds, so you really don’t want to hold bonds. And then you have the deflation people, like Pimco’s Bill Gross, who believe the Fed will cut the short rate very quickly if housing crashes, and then the yield curve will steepen. Economically, you might get deflation, but politically, we will get inflation because Bernanke’s going to print money—the helicopter money scenario.

Now under what scenario do 30-year bonds actually do well? I think they do very well when the economy slows, housing slows, but oil prices stay high—and therefore the Fed can’t cut rates. You then get a massively inverted yield curve and a relentless rally at the long end. It’s the deflation scenario without the helicopter money.

So Bernanke will have to keep short rates high to defend
the dollar?

That’s exactly what happens. You don’t want to ease, because the risk is that if you ease, the dollar weakens and the oil price goes up tremendously. Therefore you’ll see a housing collapse and a recession with no monetary easing.

What about political pressure on the Fed to cut rates—
the man in the street probably doesn’t understand the link between short rates, the dollar and the price of oil.

Most people think politics will force the government to print money. But I think the politics are actually very unclear. The Fed’s fairly independent. Remember, Volcker raised rates in ’79 to ’82 to deal with the last big oil crisis; we ended up with 10.8 percent unemployment by early ’82 and the worst recession since the 1930s. And arguably the oil situation is more out of kilter this time around than it was then, because in the ’70s there was no real shortage.

Are there other macro themes you find compelling?

Because of the petrodollar theme, I don’t think we’re going to see a dollar collapse. So I think people should be very careful about shorting the U.S. dollar.

As a lot of people found out last year . . .

And even this year. You know it’s not really off that much. I think the weakest currency is probably the euro, and maybe the pound. These have been the core beneficiaries of the petrodollar recycling.

How scaleable are your macro plays?

They are pretty scaleable, but you never know. We are not going to scale it beyond the point where it doesn’t make sense. From a manager’s perspective, you want to scale it to infinity. From a return to investor’s perspective, there is some limit—maybe it’s $5 billion, maybe $10 billion; somewhere in that range is the limit for a global macro fund that’s not doing a diversified multi­strategy approach.

How do you use leverage?

We calibrate it by the riskiness of the assets. You don’t want to use very much leverage with equities. I think with fixed income or currencies, you can use somewhat more. We try to avoid incredibly leveraged and theoretically offsetting positions that are popular. I think that’s one of the lessons from Long Term Capital Management.

That theoretically offsetting positions start to correlate under pressure . . .

They start to correlate, yes, so we think of each of our positions on its own merits. We don’t look at them as much on a portfolio basis, so that somewhat constrains the amount of leverage you can use, if you’re not taking these theoretically offsetting positions.

When you’re considering a position, what’s the breakdown between quantitative, fundamental analysis and the “gut,” or more qualitative factors, you consider?

It’s a combination of both. We try to bring quantitative analysis to bear on the problems we are looking at. Those problems are, by their nature, however, not entirely quantifiably reducible. We’re not at a point yet where we have a computer program that can do classic global macro investing.

Petrodollar recycling is a shorthand adopted after the first oil shocks in the early 1970s to describe the process by which proceeds from the sale of oil are reinvested by oil producing countries in either hard or financial assets, usually in oil consuming countries.

Peak oil is the theory that global production of oil has (or soon will have) reached its peak.

The Greenspan put is the former Fed chairman’s policy of providing massive liquidity injections after market shocks—first employed in the wake of the 1987 market crash and most recently in the wake of the dot-com bubble.

Long Term Capital Management was a $5 billion highly leveraged arbitrage hedge fund that suffered massive losses during a flight to quality after the Russian default in the late 1990s. Many of its positions were designed to offset one another, but they began to move in the same direction during a severe market sell-off.

Photograph by Thomas Hart Shelby.