With much faster growth rates between 2011 and 2014, China is now being forecast to eclipse the United States as the world’s largest economy sometime this year. The U.S. has been the world’s largest economy since the 1870s when it overtook Great Britain.
Before the current revisions were released this week, it was widely expected China would not overtake the United States until the end of this decade. The new data also catapulted India to the third largest economy, surpassing Japan.
In the meantime, economic freedom in the U.S.—what should be the real driver of our economy—is languishing. Similar can be said of America’s allies in Japan.
After extensive research on the price of good and services across 199 countries, the World Bank sponsored International Comparison Program (ICP) concluded that prices levels in developing countries were significantly lower than previously thought. This matters because there are basically two ways to measure the size of an economy. One is through current exchange rates, which do not take into account the differences in the cost of living between countries. At current exchange rates, the developed world, despite protracted slow growth, still accounts for two-thirds of global GDP.
The second method, Purchasing Power Parity (PPP), attempts to take into account the differences in the cost of living between countries and adjust Gross Domestic Product (GDP)—or the market value of output—accordingly. For example, if two villas of comparable quality were built—one outside of Shanghai and one outside of New York City—the market value, and in turn, contribution to GDP would be much lower in China unless an attempt was made to adjust for the price differences.
During the last revision of the survey in 2005, the ICP thought that China’s economy only accounted for about 43 percent of America’s total. But a combination of the recent revisions and much faster growth in China placed China’s GDP at 87 percent of the U.S. in 2011. With much faster growth rates occurring in China between 2011 and 2014, China is forecast to eclipse the United States sometime this year.
The New Equal?
GDP size – Trillions of dollars
Source: World Bank
The revisions bring two important questions to mind. First, are the new figures to be trusted? Second, if they hold some validity, what does it mean?
The PPP method of quantifying an economy’s size is certainly not perfect and has shortcomings, the largest of those being that goods and services are not comparable across countries. This was probably true in the past but the level of quality of goods and services has increased dramatically in many emerging economies in recent years. Moreover, the ICP attempts to take into account the differences in quality. Having recently lived in China for over three years, I know the quality of my haircuts, maid service, taxi rides and dinners out were of comparable quality as in the United States. But I paid a fraction of the price for these services in the Middle Kingdom. At least the PPP methodology attempts to take into account the differences in the cost of living. Moreover, volatile exchange rates are hardly a reliable reflection of the true cost of goods and services. Bottom line? The PPP methodology is a rough approximation of an economy’s “size”, but in most cases it is a better approximation than at current exchange rates.
On the second question, does this really mean anything? On the one hand, the new methodology has not changed the actual size of any of the economies. It is just a formula. But on the other hand, the new figures show how much the world economic order has changed in just a few years. India moves to third place from tenth and Brazil, Russia Mexico and Indonesia now make the top 12. Asia’s global share of GDP only rose by 2 percent under the new accounting, but it now accounts for 40 percent of world output.
Two Worlds Diverge
(Accumulated real GDP growth since 2007, 2007 =100)
Source: World Bank
The real lesson here is that the emerging world is catching up not because they are doing everything right (most have not engaged in structural economic reforms for over a decade), but because the developed world has been doing everything wrong in steering their economies. It would be more constructive to focus on why economic growth has all but disappeared in the developed world.