China, Now With World's Largest Economy

According to the IMF the People’s Republic of China has just surpassed the United States as the world’s largest economy. This represents the first time the United States has been unseated as the world’s supreme economic power since it attained the position by surpassing the United Kingdom in the late 19^th century. China’s economy has been growing at such an extraordinary rate over the last two decades that its supremacy as an economic world power was not only expected but was long ago foretold.

The significance of this crossover surpasses just China but speaks to Asia’s economic ascendancy as well.  Of the 6 largest economies in 1980 five were developed western states including four European nations (West Germany, France, the United Kingdom and Italy) and the United States. At number 2 Japan was the lone Asian entry on the list.

Fast forward 30 years and a major disparity between the past and present emerges.  Instead of the former European dominance the list now includes newcomers China, India and Russia in addition to holdovers Japan, Germany and the United States. Asian states now comprise half the list. As a Eurasian state Russia is usually considered to be European, however the majority of its landmass is located in Asia along with the vast oil and natural gas reserves which has propelled its economy since the fall of the Soviet Union. This leaves Germany as the lone European state, whose majority landmass is located on the continent, left.

But don’t start celebrating (or proclaiming Armageddon) just yet.

A nation’s economy is measured based on the country’s Gross Domestic Product (GDP), which attempts to ascertain the entire value of productivity produced by that state per annum. GDP can be measured in one of two ways, nominally or by a formula called Purchasing Power Parity (PPP).

The calculations used by the IMF to determine China’s new found economic supremacy was based on Purchasing Power Parity. By comparison, under nominal standards the World Bank lists China’s economy at a size of $9.2 trillion dollars, still far behind the United States' at $16.8 trillion. Considering the signs of a slowing economy, and strong indications that the country is on the precipice of a construction crisis, it will be awhile before the People’s Republic surpasses the United States in economic size if at all.

Considering the large disparity between these two metrics an important question emerges as to which calculation is more definitive and generates the most accurate picture. In order to make such a determination it is important to define the two standards.

Nominal GDP calculations are pretty straightforward. They add the value of everything produced within the state with the aggregate being the final calculation. In essence it’s just addition. Unlike estimating the nominal value of a state’s GDP, PPP accounts for price variations among economies and adjusts the aggregate calculation accordingly.

PPP is better explained through the Big Mac example. In country A, an individual might be able to buy a Big Mac for $5, however in country B that same Big Mac will cost the equivalent of $7 (the prices listed here are not actual McDonalds prices but are arbitrary numbers picked to illustrate a point). Citizens in B therefore have a greater purchasing power than in A since their $5 can buy an entire Big Mac while the people of A can only purchase 5/7 of a Big Mac when they pay the same value in their country.

PPP takes the price disparity into account and develops a formula where the value of all the Big Macs produced in country B is equal to that in Country A. So if A produces 10 Big Macs and B produces 9 Big Macs the nominal domestic product of A would be $50 and B would be $63. However under a PPP formula the value of all the Big Macs in both countries A and B would be altered to reflect parity, for the sake of this argument we’ll say $6. Therefore the GDP by PPP standards for all Big Macs produced in country A would be $60 and $54 in country B.

While the previous example may be over simplified it illustrates the important distinctions between nominal GDP and GDP by PPP. The application of PPP to GDP has a disparate effect in that it usually raises the value of productivity in developing nations and decreases it in developed states. A sizable number of economists and political scientists prefer PPP over nominal GDP as a more balanced approach to determining the full value of each state’s economy.

By applying PPP over nominal calculations economists negate the factors that contribute to the price disparity found in different states. While many factors contribute, the high cost of labor in the developed world is the primary force.

Relatively high costs of living, standard minimum wages, and a unionized workforce prevalent throughout the country, all add to the cost of American labor. That cost is then added on to the production value and subsequently the price of the product. The International Labour Organization (ILO) estimates that the average monthly wage for an American in 2009 was $3,263. 

Comparatively, developing nations rely on a large cheap labor force to cut manufacturing costs making them attractive destinations for industry. According to the ILO Chinese workers average a monthly income of $656.

This is not to say that the labor and products produced in developed nations are necessarily better than the labor and the same products produced in developing countries. In some cases the opposite may hold true. However, the professionalization of the labor force add to the cost and raising the production value of the same product in the developed world.

Even agricultural items are subject to similar valuations. A cow in the United States may produce the same milk as a cow in China, the extraction of the milk from the cow, the packaging of the milk for market consumption, and the administration of regulations over the process  requires a human element which generates higher labor costs and increases the value of the foodstuff.

Commercial prices offered to the public to buy the product are made on the basis of the product's production value. The production value is ascertained by calculating the total cost of production including labor. The price then fluctuates based on supply, demand, and profitability of the producer. 

Thus the production value of a product and the product’s market price are intertwined. By creating price equilibrium PPP negates the effects of the production value. In essence PPP undermines the very purpose behind calculating GDP, which is to calculate the true value of a state’s economy. On the other hand nominal GDP produces a more accurate picture of the true value of a state’s economy.

China’s economy might have surpassed the United States’ on some convoluted metric which skews results in favor of developing states, but the real coronation is still a ways away. For now the United States retains its crown.