The Bear’s Lair: Gross Imaginary Product

In the era of crypto-currencies, I propose a new economic statistic: Gross Imaginary Product. This can be defined as the total output at market prices of all products and services which do not actually exist. Contrary to popular superstition, not all the $350 billion value of crypto-currencies is imaginary; there are some real values there. Conversely, in the physical economy, in California, London, Japan and everywhere that “funny money” has distorted it, there are apparently “real” values that are in truth purely imaginary. Needless to say, GIP has soared in an era of fraud and fantasy like the present, and appears to be at an all-time high.

The first recorded instances of Gross Imaginary Product, were the twin financings, equity for “a company for carrying out an undertaking of great advantage, but nobody to know what it is” in 1720 and the bond issue for the non-existent Republic of Poyais in 1822 (the latter was given credibility by the description of the capital’s imaginary cathedral.) These were both quite small deals, however, and merely scratched the surface of what subsequent bull markets showed to be possible.

In 1920, an especially famous though modest example of GIP was devised by Charles Ponzi, who absorbed some $20 million of people’s savings in a scheme to make an arbitrage profit out of international postal coupons. Again however, despite this scheme’s fame, $20 million was only 0.022% of 1920’s GDP of $88 billion; GIP was not yet a significant factor in the economy.

In 1963, the Great Salad Oil swindle involved loans being issued against $150 million of salad oil when only $8 million worth was in the tanks – inspectors would be fooled by tanks filled with water, with just a little salad oil on top. The GIP from this scheme alone was again about 0.022% of GDP of $650 billion – the GIP/GDP ratio had not increased significantly over the intervening 43 years.

The 2008 financial crash saw an upsurge in GIP. In housing finance, there was a huge volume of “subprime” mortgages, loans to people who had neither the income nor the prospects to have any chance of repaying them. Then there was the Bernie Madoff scam, when around $36 billion was invested in imaginary assets, with $18 billion repaid to early investors, some of whom got out with profits. The GIP in 2008 appears to have been some $100 billion, counting Madoff, fictitious subprime loans and fictitious derivatives and CDO squared contracts. This represented about 0.7% of U.S. GDP, already 30 times the relative size in 1920 and 1963.

By 2008, the “funny money” monetary policies since 1995 had already inflated GIP as a percentage of total output. It should be noted however that GIP no longer simply consisted of Ponzi schemes, embezzlement and legal fraud; while Madoff’s activities constituted a Ponzi scheme, much of the remainder of GIP consisted in loans originated and made by reputable financial institutions, and derivatives contracts created by Wall Street whizz-kids. While the imaginary quality of the GIP remained unchanged, its sources were diversifying and extending themselves into the mainstream economy.

Today, after more than 9 further years of “funny money” GIP has exploded. For a start, there are the crypto-currencies, by definition imaginary, in the sense that like all fiat currencies, they exist only at whim, with the difference that the whim is that of a bunch of basement-dwelling nerds, rather than that of a bunch of pompous overstuffed Keynesian central bankers. The nerds have a better grasp of economics than the central bankers, and have mostly avoided creating excess amounts of their imaginary money.

What is more, the nerds have found sources of genuine value for their money to back. These include true anonymity, allowing crypto-currencies to replace Swiss banks as government-proof havens – any instrument that facilitates this is a true boon and value to the global economy. Then there are new software projects, such as a fully decentralized Internet, and the payment mechanisms, which can be used to facilitate real-world transactions and hence have real value.

However, of the $358 billion total value of crypto-currencies as I write this, only about $6 billion are truly anonymous, and another $5 billion have worthwhile software projects attached. In addition, crypto-currencies have the short-term potential to be used as payments mechanisms in countries such as Kenya where many transactions are carried out over mobile networks. This might soon cover perhaps $200 billion of GDP’s transactions, for a value of $40 billion (US M1 being one fifth of GDP). Add to this the value of such additions as a crypto-currency social network, and you get maybe $60 billion in total genuine value in the crypto-currency nexus. That leaves $298 billion in GIP at today’s prices.

In today’s market, crypto-currencies are by no means the only source of GIP. In Silicon Valley, for example, there are now many zombie companies, which have received vast amounts of private equity funding at celestial valuations, but have no realistic hope of ever justifying those valuations, or even in many cases of making a profit. Uber, for example, received funding at the top of the cycle at a $68 billion valuation; now Uber employees are reported to be selling out to Japan’s Softbank at a $10 billion valuation. That’s $58 billion in GIP, right there. So many Silicon Valley companies have existed for a decade or more, without ever making a profit, while receiving endless private equity rounds from besotted over-funded capitalists. If they have no near-term prospect of making a profit, yet are propped up by funny-money-created pools of money, they are GIP. We can take a conservative estimate of the GIP in Silicon Valley today; it is at least $500 billion.

Globally, funny money in all rich countries has caused a tsunami of GIP wherever it has appeared. In Japan and China, for example, there are zombie companies that should have been bankrupt years ago, which are kept alive by endlessly prolonged loans from the banking system. Not all the value of those companies is GIP, but the excess of their assets over the value of their earning capacity certainly is; it is GDP that would not exist if the market were allowed to operate in a properly Schumpeteran manner.

In Europe, funny money has primarily produced government-sponsored GIP. At the peak of its over-inflation, for example, about two thirds of the Greek economy was GIP; its inhabitants were paying themselves $32,000 in GDP per capita compared with under $10,000 in comparably productive Bulgaria, Romania and Macedonia. That GIP has lessened now, and the equivalent GIP in Ireland and Portugal has at least for the moment disappeared. On the other hand, German electricity now costs about twice what it did, and three times what power costs in the United States; the excess cost of the output of all those windmills and solar panels is as imaginary as you can get, pure GIP.

In Britain, for the last decade, houses in London have changed hands at a large multiple of what their inhabitants could afford, if they were buying them de novo. The inflation is due to three factors: interest rates below zero in real terms, an artificial influx of rich foreign buyers who pay very little tax, and a “council tax” system that grossly under-taxes very expensive properties. The air in London’s property market must be let out, doubtless uncomfortably, in a process that the FT and the Economist will undoubtedly blame on Brexit. Meanwhile, it represents Gross Product that is entirely Imaginary.

Back in the United States, real estate is also a source of GIP, both in the ultra-expensive enclaves of Manhattan and San Francisco where real estate prices have made it impossible to employ people locally, but also in all the shopping centers and department stores that have lost their economic raison d’etre, as Internet shopping increasingly hollows out the “bricks and mortar” retail sector. Surplus shopping centers have very little economic value, so once they stop making a profit they become GIP; overpriced real estate is GIP only to the extent the locally employed cannot afford to live in it. In addition, Wall Street has not stopped creating GIP; indeed much of the derivatives sector is pure GIP, hedging risks that do not need to be hedged, thereby hopelessly obscuring the true economics of the business. The value of GIP in these sectors can conservatively be estimated at another $500 billion, but we should recognize it may be higher than this.

Gross Imaginary Product has exploded everywhere real interest rates have been kept below zero, because such rates subsidize assets and activities that have no value. The highest percentage of GIP may well be in Japan, which has had “funny money” policies for the longest period. However, in the United States, from the very rough calculations above we can tentatively say that GIP is now some $1.3 trillion, or 7% of GDP. That is some ten times its relative level in 2008, and 300 times its relative size in the halcyon days of 1920 or 1963. Assuming the rate of increase is approximately logarithmic, we can expect the entire U.S. economy to be imaginary by around 2033 – not coincidentally, the year Social Security goes bust.

Jerome Powell has as I write sailed through the Senate Banking Committee as the next Chairman of the Fed. It is to be hoped that he takes note of this problem, and takes steps as soon as he is in office to raise the Federal Funds rate to around 4%, and then to keep it there however loud the squealing from the newly insolvent. Happy as 2017 has been for investors in crypto-currencies, reality in the U.S. economy needs to make a swift comeback.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)