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Is China's economy really bigger than the USA's?

Kevin Frayer/Getty

The People's Republic of China has officially replaced the USA as the world's largest economy. That's thanks to a combination of China's large population, China's rapid economic growth over the past twenty years, and most importantly of all thanks to the World Bank's updated International Comparison Project (ICP) numbers from this spring. ICP aims at calculating what are called Purchasing Power Parities (PPP) for different countries, and the most recent update substantially increased the measured size of the Chinese economy.

These ICPs are conducted once every six years with a data lag, so in the spring of 2014 we're got the ICP for 2011 which superseded the 2005 ICP. The bottom line is that according to the new method, China is quite a bit richer than it was under the old method. So rich that its 2014 Gross Domestic Product overtook America's 2014 GDP. Overtook it, that is, if you adjust for PPP — a very simple idea that's very complicated in practice.

What's Purchasing Power Parity?

You know how Honolulu is more expensive than Omaha? That kind of observation is the motivating factor behind PPP. Land is more expensive in Hawaii than in Nebraska. Fuel is too, because it needs to be inconveniently shipped in. Taxes are higher. And because almost every business ends up bearing some of the costs of expensive land and expensive fuel, stuff in general winds up being more expensive. Consequently, comparing the income of the average family in Honolulu to the income of the average family in Omaha could give you a misleading portrait of Honolulu living standards.

The idea of PPP is that you should adjust for these things. You want to know how much stuff the average Hawaiian can buy compared to the average Omahan. You want to know, in other words, how much purchasing power he has.

Don't exchange rates cover this?

No. In a very simplistic and easy to work with model, international PPP would be easy because different countries use different currencies. If the price of something were systematically higher in Canada than in the United States, the relative price of Canadian dollars to American dollars would shift.

In practice, it doesn't work like that. For certain homogenous globally traded commodities, you might find that the dollar-denominated price in Boston is the same as the euro-denominated price in Berlin. But oftentimes something like gasoline will have wildly divergent prices in different places because of taxes. More importantly, a very large share of what people spend money on isn't traded in practice. You can't buy a Chinese sandwich or visit a French doctor or commute from your house in Peru or get your car fixed in Thailand on the exchange rate. International currency exchange rates are driven by a mix of currency speculation and trade in commodities and manufactured goods. That means they shift up and down without regard to non-traded services.

As these non-traded services are often labor-intensive, the living standard of a person with $15,000 in a poor country is generally higher than that of a person in a rich country.

Consequently, while in 2011 China had a per capita GDP of $5,456 when you adjust for PPP it came out to $10,057.

What changes with the new ICP?

The latest methodological shift in PPP calculations, including an effort to weigh the importance of different kinds of goods and to use a richer set of countries to compare prices interregionally give a bigger PPP boost to many middle income countries. Under both the 2005 ICP and the 2011 ICP, China and India look more prosperous than they do using market exchange rates. But using the 2011 ICP, the total size of India's economy looks larger than the total size of the Japanese economy (though, to be clear, Japanese people are still much richer on average) and the total size of China's economy looks bigger than the economy of the United States.

Obviously this is a statistical adjustment rather than a change in anyone's actual living standards, but China now gets to claim bragging rights as "the world's largest economy" sooner rather than later.

What are the limits of PPP?

These international price comparisons suffer from the serious practical limitation that they are difficult to undertake. Collecting and analyzing all the prices is hard. That's why it's only done every six years and only published with a lag. But the lags and the gaps undermine the precision of the numbers. And despite everyone's best effort, the estimates may not always be right.

And PPP is also a concept that's not without its conceptual flaws. Returning to the Honolulu/Omaha example, it's difficult to say what the price of a house within short driving distance from the beach would be in Nebraska. It's not just that houses aren't traded across long distances, you can't compare them directly. It is challenging to directly compare the "quality" of a dentist's visit in Chicago to one in Chengdu. You can compare the price of food in Mumbai to the price of food in Memphis, but the food for sale is totally different just as attending a football game in Birmingham, AL is not the same thing as attending one in Birmingham, UK.

Last but by no means least, if you have money in your pocket you can travel to a foreign country and buy things at the market exchange rate. Swiss living standards may not be as high as they first appear once you account for the high cost of living, but Swiss people can very much take those Swiss francs with them on vacation to Miami or Mexico City. So saying the Swiss aren't really as rich as they look can be misleading. Market exchange rates reflect a real kind of economic privilege, even if that privilege isn't captured in the local prices.

What's the bottom line?

Many developing countries — including the two biggest ones, China and India — have higher living standards than was previously realized. Better methods that compare more prices and cover more regions show that life is cheaper in these countries than previously thought.

That means that when you adjust for the local cost of living, the total volume of Chinese and Indian output looks bigger. With the new PPPs, India's economy overtakes Japan's as the third-largest in the world and China overtakes the United States as number one.

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