Is China's Economy 'Ahead' Of America's?

So if you're in a third country like South Korea, and you're asking,“Which is a more important market for my goods, China or America?”, the answer has definitely shifted toward“America” over the last three years. And lo and behold, America recently overtook China as South Korea's largest export market . Market exchange rate GDP might also translate into clout within international economic organizations.

But on the other hand, market exchange rate GDP comparisons have some serious downsides. First of all, exchange rates can be determined by policy instead of by market fundamentals. China used to peg the yuan to the dollar. Now it uses a“managed float”, in which the exchange rate is allowed to fluctuate within a range determined by the Chinese government. In practice,
this can look sort of like a peg .

What this means is that if China's government decided to change the range in which it allows the yuan to trade against the dollar, it might be able to suddenly make China's economy look bigger than America's in charts like the ones at the top of this post.

And if China decides to make its currency cheaper in order to sell more exports to the world, it can do that too. That will make its economy look smaller in nominal terms, but in fact it will improve China's export competitiveness, so in some ways it means China's economy is actually stronger.

More fundamentally, exchange rates don't affect real living standards. Despite all the headlines about trade deficits and such, most of what Chinese people buy is produced within China, and most of what Americans buy is produced within America.

This includes rent, medical care, transportation, and so on. That means that the material living standards of Chinese people and Americans will be determined much more by local prices than by international ones.

PPP is an attempt to adjust for differences in local prices. International organizations like the World Bank send out research teams to various countries to look at local prices of things that aren't sold on international markets - things like rent and medical care. They then assemble these into a price index. Comparing these price indices across countries gives you a PPP conversion factor that they use to compare economies.

In theory, this gives a better comparison of how much actual stuff different countries produce. But there are many practical problems with this approach.

First of all, the teams that the World Bank and other organizations send out to take stock of local prices won't necessarily get a great sample of those prices. They might look too much at overpriced cities like Shanghai and not enough at small towns. Or they might look at fancy high-quality apples in a boutique grocery store, not realizing that regular apples cost much less.

On top of that, PPP is often out of date. Prices can change pretty rapidly, while the teams that go out to measure PPP can't do a thorough survey every year. This can lead to
big sudden revisions
that change our understanding of the past as well as the present.

As if that weren't enough, PPP also has a hard time comparing quality between different countries' goods and services. A haircut in Japan might just be better than a haircut in America, but the people who do surveys for the World Bank may not realize this.1

That quality difference should make Japan's GDP (PPP) a little higher relative to America's, but in practice, the statistics will often miss it. This is especially important when it comes to the quality of big-ticket items like medical care and the housing stock.

Finally, it's difficult to compare overall prices between countries because people buy different things in different countries. One country's people might spend more on health care and less on housing than another country's. Do they do that because health care is more expensive there, or because they just want more medical care in the first place? It's hard to say.

All of these measurement issues lead to
big discrepancies
between countries' own internal growth numbers and changes in the international PPP comparisons. And they lead to general uncertainty about how much we should trust PPP numbers. When I cite PPP comparisons, someone often pops up in the comment section or the X replies to say“PPP is garbage!”.

That's wrong - PPP is
not
garbage, it's just hard to measure. But when you're comparing individual living standards - that is, per capita GDP - there's really just no alternative. How much actual stuff a person in China or America or France can afford depends much more on local prices than on exchange rates, so if you want to know how rich people in these countries really are, you have no choice but to use something like PPP.

When it comes to comparing national power and importance, though, it's not clear PPP is the right measure either. The cheapness of haircuts isn't necessarily an important factor in the rise and fall of great powers.

But lots of things that are purchased domestically rather than traded on world markets are very important for national power - for example, the salaries of soldiers, locally sourced armaments, local logistics costs, and so on. So if you want to look at military strength, you can't really use market exchange rates either.

For this reason, some people try to construct a“military PPP” that takes explicitly military expenditures into account. These numbers show, for example, that China's military spending is
much closer to America's
in size than official dollar numbers reflect.

But national power is probably determined by things other than armies alone - for example, lots of civilian consumer manufacturing could be converted to military uses in the event of a major war,
as it was in America
and many other countries in World War 2. So if you want to know about military capacity, you can't just look at defense spending - you have to include all the dual-use stuff as well.

Earlier this year, Han Feizi
used this sort of comparison
to argue that China's economy is already much bigger than America's:

A recent post
by the blogger“Austrian China” makes a number of other such comparisons - all of which are in China's favor.

The argument here - that expensive services don't represent true economic output, and that comparisons should look mainly at physical goods - is pretty bad when it comes to measuring living standards.

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Housing, medical care, child care, and other services are incredibly important determinants of how pleasant a life citizens of various countries lead, and to just leave these out of international comparisons and focus only on electricity and cars and ships makes little sense.

But if you're comparing national power, this sort of argument might make a lot of sense. Nice housing, quality medical care, or high-quality insurance services won't help you much when a foreign empire's bombs are raining down on your cities and foreign missiles are sending your country's fleet to the bottom of the sea.

Fundamentally, this is why I think Americans should take little comfort in the fact that their total GDP at market exchange rates is outpacing China's. With the world looking more dangerous and warlike by the day, manufacturing is a competition that the US and its allies can ill afford to lose .

Yes, China boosters like Han Feizi and“Austrians” who care only about physical goods are overconfident about the supremacy of the world's sole manufacturing superpower. But in my judgment, taking comfort in America's higher nominal GDP numbers is even more dangerously complacent.

Note:

1 I can assure you with reasonable confidence that the researchers at the World Bank are not known for their stylish haircuts.

This article was first published on Noah Smith's Noahpinion Substack and is republished with kind permission. Become a Noahopinion subscriber here.

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