Wednesday, May 7, 2014

China Surpassing America's GDP in PPP Terms Doesn't Matter Much

Last week, the World Bank came out with its International Comparison Program (ICP) report, which provides comparative price data, measures the Gross Domestic Product (GDP), as well as purchasing power parities (PPP). The most controversial of these implied findings is that when GDPs are adjusted for PPP, which is a variant of the nominal GDP measurement, China's economy is predicted to surpass the United States by the end of this year. The nominal GDP is but one measurement of economic success, but it is still used as a primary yardstick of such success. Some individuals think it's cause for concern. Interestingly enough, the Chinese government has reservations about such claims. Is China's rise in the GDP [in PPP terms] a reason to worry or are people making a mountain out of a molehill?

First, we need to determine why adjusting the GDP in PPP terms is important. Comparing prices across borders can be tricky because the nominal GDP does not factor the value of the dollar in a cross-country fashion; it merely uses the current exchange rate to convert the GDP from one currency to another. The purchasing power parity is comparative measurement of what a certain amount of dollars [or other currency] in one country can buy in another country. A dollar can buy a lot more in China that it can in the United States, i.e., a greater bang for your buck. To adjust for comparison of living standards can help provide a clearer picture, which is why more and more economists are using GDP in PPP terms.

Much like with the nominal GDP, I also have my criticisms about using the GDP in PPP terms. When adjusted for PPP, the basket of goods examined is based on the price of the final good. The premise behind PPP is the Law of One Price, which states that identical goods should carry identical prices if the markets are efficient. The problem is that this economic theory does not play out well in practice. Let's first go with the assumption that goods or services are identical across borders. The Big Mac Index is an informal way of measuring the PPP. The Big Mac was used because it has cross-border similar inputs. Even under the Big Mac Index, we don't have identical goods. In Israel, the Big Mac is different because under Jewish dietary law, one cannot mix meat and dairy, which means that the Big Macs in Israel have to use both kosher meat (which is more expensive) and faux cheese. In India, cows are not considered sacred because they are considered sacred in Hinduism, which is why the Big Mac either contains chicken or mutton. Even going outside of the Big Mac Index example, it's not a stretch to believe that goods in one country are qualitatively different in another, which is why relative PPP might be a better metric.

Other factors go into defying the Law of One Price, such as transportation costs. The further a good has to travel to reach its final destination, the more it will typically cost. The transport costs are added into the price of the final good. Economic barriers, such as tariffs or taxes, alter the price from accurately following the Law of One Price. Demand for goods also do not hold constant across countries. Even if a good had the same supply per capita across countries, a lower demand in one country will mean that country has a lower price than another country. To assume that two families in differing countries have identical consumption baskets is untenable. These differentials make it more difficult to accurately calculate various countries' PPP, which is why it should be no surprise that the last time the World Bank published the ICP report for 2005, China's PPP-adjusted GDP was cut 40 percent in the last round of revisions per the World Bank methodology. It should also be no surprise that the World Bank factored in a margin of error up to 15 percent with their calculations (ICP, 2014, p. 23). Finally, this assumes that the numbers from China's National Bureau of Statistics are accurate, which is a tenuous assumption, to say the least.

Let's argue that in spite of the PPP's flaws, it still a good enough of a proxy to determine economic largesse. Should America worry? I don't think so. For one, in absolute GDP without PPP adjustments, the American economy still outpaces the Chinese economy by an approximate factor of two. Not to be too tautological, but the PPP measures purchasing power. Adjusting for PPP does not suddenly aggrandize the economy. One cannot purchase goods or services with PPP-adjusted dollars. One has to pay at the prevailing exchange rates, which is true in our global economy, and which is also why measuring the GDP as such is a better proxy for relative geopolitical power. There is also the issue that the GDP measures annual transactions and resets each year. Economies, however, do not reset. When looking at the wealth differentials between China and the United States, China lags behind the United States by at least $30T. Even if you want to argue that factoring in PPP brings us a more accurate picture, it doesn't matter nearly as much because none of these adjustments take in the population into account. When the GDP in PPP terms is adjusted per capita, you see a whole different picture (see below).

When adjusted for a per capita basis, the United States is 12th and China is 99th. Not only that, in per capita terms, China's economy is about a century behind America's economy. The GDP is an accounting device to measure domestic output, so none of this measures economic wellbeing in America in comparison to China, the composition of the economies, nor does it take innovation into account (see here and here). China also has a shrinking labor force and deteriorating economic health (also see here), not to mention China has larger issues regarding resource sustainability.

I imagine there will be a point when China's nominal GDP surpasses America's. There is a distinct possibility that China might pass the United States in per capita terms if it makes enough economic reforms. However, unless China creates structural reforms that allow for more liberalized markets or even focus on ways to improve upon the standard of living, I see this "milestone" as mere smoke and mirrors.

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