Project Syndicate
Has China really overtaken the US economically, or are we measuring power with the wrong yardstick?
The Wrong Way to Compare Economic Size
Author: Jeffrey Frankel
CAMBRIDGE—Last month, the Nobel laureate economist Paul Krugman gave a talk at the European Central Bank’s annual research conference, which focused on geoeconomics. The term refers to countries’ ability to exploit economic interactions for geopolitical ends. Think of China’s threats to cut off trading partners from its exports of rare-earth minerals.
Krugman’s talk, titled “Economic Size and Economic Power,” rightly noted that size matters for geoeconomics. Canada, for example, has more to lose from a rupture of trade with the United States, which can be expected to use its size to coerce its economically smaller neighbor. But I don’t agree with how Krugman compares economic power across countries.
The US, the European Union, and China measure GDP in their respective currencies. Comparing the size of their economies therefore requires converting these numbers into a common currency, with contemporaneous exchange rates being the most obvious metric. But there is an alternative approach: a measure of the real exchange rate adjusted for purchasing power parity (PPP) to account for the lower prices in China compared to the EU and the US.
Measuring GDP in PPP terms is the right way to compare standards of living. But assessing economic power is a different matter. Consider such examples of weaponized interdependence as trade and financial sanctions, leverage in global trade negotiations, influence in international bodies, and the ability to put a naval base on a small Pacific island country. In such situations, doesn’t it seem that what dollars and renminbi can buy on the world stage is more relevant than their purchasing power at home in their respective domestic economies?
This may seem like a technical detail, but it changes the answer. Did China surpass the US in economic size in 2017, in line with a PPP reading of the data? Or did the US remain over a whopping 50% larger, as the exchange rate implies? I favor the latter conclusion, but Krugman thinks the former, implying that China is now the largest economy.
Despite repeated declarations that China has eclipsed the US in economic size, it now seems possible that China will not do so for many decades when evaluated at its exchange rate. It may never do so, given its demographic decline and slowing productivity growth. The case for this is stronger if one believes that Chinese growth statistics are overstated.
While the comparison between the US and the EU doesn’t carry quite the same geopolitical weight, Krugman considers it important when determining whether American productivity growth has exceeded European productivity growth, as many believe. By standard measures, productivity has risen much more in the US than in the EU since 2000. Many interpret this as evidence that Europe’s more robust social-safety nets and regulations, coupled with its failure to compete at the technological frontier, have impaired its economic growth.
The answer changes when they are compared on a PPP basis rather than at nominal exchange rates. Adjusting for PPP, Krugman finds productivity performance in the EU to be much stronger than it first appears, challenging the conclusion that the US offers a superior economic model. In maintaining the superiority of the PPP comparison, Krugman relies on the volatility of nominal exchange rates: “Now you might say why not just use dollar values? And the answer mostly is just instability … So you would basically use something like purchasing power parity to smooth it out.” While there is some truth to this, a similar criticism applies to ranking countries on a PPP basis.
The World Bank’s International Comparison Program (ICP) collects price data on baskets of goods for the PPP numbers, at multi-year intervals, typically with a three-year lag. Earlier surveys produced benchmark data for 1993, 2005, 2011, and 2017. Between publications, the World Bank produces annual estimates, extrapolating from governments’ GDP statistics. The most recent available benchmark survey pertains to 2021, and the ICP has extrapolated the annual estimate up to 2023.
China experienced rapid growth early in this century. But the PPP-based estimate for 2005 GDP, as officially extrapolated over the next six years by means of national GDP statistics, encountered a rude shock when it was revised downward by 40% in the subsequent survey in 2011. Next, the extrapolations of the 2011-benchmarked data were revised upward by 21% between the first release and the time of the subsequent survey in 2017. Then, the 2017-based data were revised downward by 16%. Finally, the 2021-based data were revised upward again by 5%. These revisions are substantially larger than the annual fluctuations in the nominal exchange rate or in the GDP comparisons that use it.
Worse, the benchmark figures themselves are also sometimes revised. China’s 2005 PPP rate was originally published as 3.45 renminbi per dollar. When the 2011 ICP was released, it was revised to 2.86, raising China’s 2005 GDP in PPP terms by 20.5%. According to today’s data, it stands 21.8% above the original.
The ICP estimates for other emerging-market economies have been similarly volatile: Thailand’s GDP in PPP terms using ICP data was revised down 20% in 2011, up 43% in 2017, and down 3% in 2021. Revisions to ICP estimates for advanced economies have been more reasonable. (In the case of EU members, Eurostat and the OECD now conduct new surveys every three years, so revisions are smaller.)
Thus, when comparing national GDPs, volatility is hardly a justification for dispensing with exchange-rate data in favor of the ICP’s PPP data, which is subject to even greater swings. This undermines the argument that productivity growth is higher in the EU than in the US and implies that the US is still considerably more economically powerful than China. Even the Trump administration’s profound political malpractice has not yet erased the natural advantages that the US has long enjoyed.
Credits: TCA, LLC.