In April and again last month, the World Bank and International Monetary Fund made headlines by projecting the Chinese economy to surpass the American economy this year. The international institutions see China as attaining a larger gross domestic product calculated under the assumption of purchasing power parity (GDP PPP). However, this method and this view are fundamentally flawed. In fact, the U.S. economy will remain larger than China’s for decades.
It is of course true that the average American is far better off than the average Chinese. But size does matter in economics – for people, companies, and countries – so the comparison between a long-predominant U.S. and an expanding China merits attention. The problem is the Bank and Fund use a measure of economic size that badly distorts the China-U.S. comparison.
Start with PPP. Its application stems from observing that $100 generally buys less in Austria than Zambia. Just comparing incomes in the two countries is misleading, so an adjustment is needed. From there, though, problems with PPP mount:
1) Just compiling price levels for China and the U.S. is a huge task, given their size and internal variations. Comparing them is that much harder. And price comparisons can change rapidly, undermining the “latest” PPP adjustment. The most dramatic expression of this occurred in 2007, when the World Bank abruptly cut China’s 2005 GDP PPP by 40 percent.
2) PPP relies on something called “the law of one price,” that is, prices should be the same in all competitive markets, since buyers will find the cheaper good and push its price up. But China controls prices in energy, grain, and capital, including the exchange rate. It distorts market competition in construction materials and labor. Applying full price parity to China is dubious.
3) PPP was meant to apply only to consumer buying power. But GDP includes activities other than consumption – in China most GDP is not consumption. The law of one price in competitive markets plainly cannot hold for purchases made by the Chinese government. Yet the World Bank and IMF apply PPP to those purchases.
For these reasons and others, global rankings of countries on the basis of GDP PPP border on nonsense. The tougher question is the use of GDP itself. GDP measures certain kinds of transactions annually – is this the right way to measure an economy?
GDP is an accounting device for national income. It is not actual money, it cannot be spent. As a result, the distribution of GDP is meaningless. In China in particular, GDP per person of about $6800 far outstrips disposable income of about $3000.
Moreover, because GDP is just an accounting tool, it cannot cause anything. Statements along the lines of “weak employment is due to slower GDP” are like saying your scale is making you fat.
GDP is dubious even as a scale. Building a house, tearing it down, and rebuilding it each add to GDP, as does selling the same house multiple times – but there’s still just one house. Meanwhile, imports benefit their purchasers, yet are treated as harmful in GDP accounting.
On January 1st of each year, GDP shifts from huge to minimal, while the economy certainly does not. In contrast, national wealth – the monetary value of everything we have — does not reset each year, it accumulates over time.
Wealth can actually be spent, so changes in personal wealth do cause other economic changes. The distribution of wealth and wealth per person are vitally important policy variables. Wealth is a better representation of the economy than GDP.
US vs. China Revisited
What does this mean for China and the U.S.? The Federal Reserve measures net American household wealth on a quarterly basis. At the end of June, the number was approximately $79 trillion (non-profits push the total to $81.5 trillion). Credit Suisse has a similar figure for the U.S. and also publishes one for China. Credit Suisse puts private wealth in the U.S. at $83.7 trillion, private wealth in China at $21.4 trillion.
This stunning gap is not the whole story, of course. There’s also net public wealth. The calculations for the U.S. are multi-faceted, including state debt, local debt, federal debt held by the public, and intra-government debt. The value of federal land and property is large and positive but difficult to pin down because it is off-market. In net terms, American public wealth is clearly large and negative, on the order of $10 trillion.
Chinese public wealth is more difficult to grasp, as the value of state assets is often considered a matter of national security. The bulk is held by the State-Owned Assets Supervision and Administration Commission. The gross value was about $14 trillion as of mid-2014 (based on previous figures and approximate growth rates). Other state assets could add $4 trillion to that.
Chinese local government and state corporate debt is also sizable, perhaps $11 trillion, and rising quickly. Net Chinese public wealth is therefore positive and exceeds $5 trillion, though it may no longer exceed $10 trillion. Credit Suisse’s private wealth gap thus exaggerates the true distance between the U.S. and China. Rather than $62 trillion, it’s closer to $40-$45 trillion.
No reasonable person, certainly including Chinese experts, believes that ranking first on the doubly artificial GDP PPP scale is worth $40+ trillion in additional wealth. The U.S. is not only ahead of China, it is far ahead.
Unlike the Bank and the Fund, the Chinese government is well aware of this. The Communist Party’s third plenary meetings last fall touted the absolute necessity of sweeping reform. And broad, market-oriented reform would indeed trigger another full generation of wealth increases in China.
The key, then, is turning reform talk into powerful action. This has not yet happened, perhaps because the anti-corruption campaign must be completed first. But unless it does, and for an extended period, China will not repeat the rapid, sustainable growth of 15 years ago. And the U.S. will remain clearly dominant economically.