Who's playing first fiddle?

What’s the biggest economy on earth?

When the Group of 20 met in Hangzhou for an economic summit last weekend, the United States media was fastidious about putting China in its proper place. The Washington Post daily repeated, as relentlessly as a drumbeat, that China was “the second largest economy.” According to The New York Times, the People’s Republic “is determined to show the world that it is an equal partner in one of the most exclusive clubs of wealthy nations….Not for the first time, officials want to demonstrate to people at home and abroad that China, the world’s second-largest economy after the United States, deserves a bigger role in global governance.”

There is only one problem with these bromides. China is the largest economy and has been since 2014. No wonder the Chinese forgot to provide a gangway for the presidential entourage to clamber down from Air Force One.

The error occurs because the press ranks economies in a way that economists rejected decades ago. That is to adjust the value of a nation’s annual production (gross domestic product) by using the current exchange rate. Suppose that GDP in Kazakhstan is 10 trillion tenge and that the exchange rate is 200 tenge per US dollar. Then the dollar value of GDP is 1 trillion tenge divided by 200 tenge per dollar, or $50 billion.

The flaw in this method is that the exchange rate may vary for reasons that have little to do with the nation’s ability to produce. For example, in August 2015 the central bank of Kazakhstan decided to let the market determine the exchange rate of tenge per dollar; up to that point, the National Bank had held the exchange rate within a corridor. Overnight, the dollar value of the tenge plunged by more than a fourth. But Kazakhstan’s productive capacity certainly didn’t fall by this much.  

Numlock

Rather than use the current exchange rate, economists recommend an approach that mirrors productive capacity more closely. This is a metric that has the same value, in terms of output, in any country. For example, suppose that we are measuring national production in terms of newspapers. Also suppose that a newspaper costs $1 in the US and 100 tenge in Kazakhstan. Then our metric for comparing American and Kazakhstani production is 100 tenge per dollar, regardless of the actual exchange rate of the moment (340 tenge per dollar, as we speak). To calculate the dollar value of Kazakhstan’s economy, we will divide its tenge GDP by 100. For obvious reasons, the idea behind this metric is called purchasing power parity.

Here’s a simple example. Suppose that Rich Country has a GDP of $1,000; and Poor Country has a GDP of $100 at the current exchange rate. Also suppose that a newspaper costs $1 in Rich Country and $.50 in Poor Country. Then, adjusted for purchasing power parity, GDP is equivalent to 1,000 newspapers in Rich Country and 200 newspapers in Poor Country.

In reality, economists base PPP on a bundle of typical products -- not on just one good like a newspaper. But you get the idea.

The World Bank provides measures of parity for nations, online for free. Table 1 shows the lineup for 2015. Adjusted with PPP, gross domestic product in international dollars is higher for China than for the United States. (The international dollar is the price, in local currency, of a bundle of goods that would cost $1 in the US.) China’s GDP is 19.5 trillion international dollars; that of the US, 17.9 trillion.

Rank	Nation	ID
1	China	19.5
2	United States	17.9
3	India	8
4	Japan	4.7
5	Germany	3.8
6	Russia	3.6
7	Brazil	3.2
8	Indonesia	2.8
9	United Kingdom	2.7
10	France	2.65

Table 1: The 10 biggest economies in 2015, measured in trillions of international dollars of GDP.

Data source: World Bank, World Bank Indicators.

Well, surprises galore. Of the G7 nations, which journalists call the “rich man’s club,” only 5 are among the 10 biggest economies (the US, Japan, Germany, the United Kingdom and France). This is largely because the biggest economies are often big because of population rather than individual affluence. Moreover, of the 10 largest economies, 4 are in Asia (or 5, depending on whether you classify the Russian Federation as in Europe, Asia or Hades). There’s your pivot. Finally, 4 are among what used to be called "developing countries." So much for the American Century.

Why do journalists still refer to the US as the biggest economy? Because of the occupational hazard of journalism – intellectual inertia. Why bother to check the facts when you have the mantra down pat, especially when all the other journalists are chanting it, too? 

There may be a murkier reason. The White House surely knows of parity, and the puzzle is why it doesn’t correct reporters who still refer to China as second banana. Hmm…I seem to remember that this is an election year. China became the largest economy on President Barack Obama’s watch, although he didn’t have much to do with it. Pointing out the event might give the Republican Party candidate, Donald J. Trump, a card to play against the Democratic Party candidate, Hillary Clinton.  God knows he’s holding a weak hand. –Leon Taylor, tayloralmaty@gmail.com

Notes

Technically, the theory of purchasing power parity holds that changes in the exchange rate will ensure that a given bundle of goods will eventually have the same price in any country in a given currency.  Suppose, for example, that the bundle costs $1 in the United States and 100 tenge in Kazakhstan. Then the exchange rate will go to 100 tenge per dollar. At that rate, the bundle will sell for $1 in either country – or, if you prefer, for 100 tenge in either country.

This proposition is logical. Suppose, for example, that the current exchange rate is 200 tenge per dollar. Then the bundle’s price is $1 in the US but $.50 in Kazakhstan. Since the bundle is cheaper in Kazakhstan, people will demand tenge (and sell dollars) in order to buy it here. The tenge will gain value in terms of dollars until the exchange rate becomes 100 tenge per dollar. The bundle will now sell for $1 (or 100 tenge) in either the US or in Kazakhstan. That’s parity.

In the real world, the theory of purchasing power parity rarely holds, especially in the short run; for a good discussion, see the textbook by Kaufman, Obstfeld and Melitz. But because parity is logical, it provides a useful way to compare the output value of two countries.  For its GDP estimates, the World Bank calculates exchange rates as if parity held.

References   

Paul Krugman, Maurice Obstfeld, and Marc Melitz. International economics: Theory and policy. Ninth edition. Addison-Wesley. 2012.

Jane Perlez and Yufan Huang. China, eager to host elite club, primps for G-20 meeting.  New York Times. August 30, 2016.

World Bank. World Development Indicators. worldbank.org