Do we understand the math behind the PPP calculations?

A new PPP study complied by the World Bank has generated some pretty excited and, to some, alarming headlines about the new world order. There has been limited reference to this in the Chinese press, for reasons I will discuss later, but here is the Financial Times on the subject:

The US is on the brink of losing its status as the world’s largest economy, and is likely to slip behind China this year, sooner than widely anticipated, according to the world’s leading statistical agencies. The US has been the global leader since overtaking the UK in 1872. Most economists previously thought China would pull ahead in 2019.

…In 2005, the ICP thought China’s economy was less than half the size of the US, accounting for only 43 per cent of America’s total. Because of the new methodology – and the fact that China’s economy has grown much more quickly – the research placed China’s GDP at 87 per cent of the US in 2011. For 2011, the report says: “The US remained the world’s largest economy, but it was closely followed by China when measured using PPPs”.

With the IMF expecting China’s economy to have grown 24 per cent between 2011 and 2014 while the US is expected to expand only 7.6 per cent, China is likely to overtake the US this year. The figures revolutionise the picture of the world’s economic landscape, boosting the importance of large middle-income countries. India becomes the third-largest economy having previously been in tenth place. The size of its economy almost doubled from 19 per cent of the US in 2005 to 37 per cent in 2011.

The article explains the reason for price adjustments in comparing economies, and says: “The estimates of the real cost of living, known as purchasing power parity or PPPs, are recognised as the best way to compare the size of economies rather than using volatile exchange rates, which rarely reflect the true cost of goods and services.”

There is a lot of very interesting information in the World Bank study but this statement is largely incorrect, or at least exaggerates the way PPP is recognized. Adjusting GDP for differences in purchasing power makes a great deal of sense in certain cases, but the way it is done is so filled with problems that it is extremely difficult to find any economist who takes these measures very seriously.

The concept behind PPP is quite simple. You cannot always compare two countries in a meaningful way by comparing their GDPs at current exchange rates. Prices are different in different countries in ways that current exchange rates do not offset. This means that relative living standards are a function of more than just relative incomes.

This doesn’t mean that comparing the GDP of two countries directly at current exchange rates is useless. For example – and this is a fairly obvious mistake made in the FT article, and indeed in nearly every other article I have seen on the topic – if we are interested in the relative weight of two countries in geopolitical terms you would almost certainly want to compare their GDPs on the basis of current exchange rates. Exchange rates may be volatile, as this article notes, but a direct comparison, unadjusted for price differences, better measures the relative importance of each economy for its trade partners.

And contrary to what the article says later, the World Bank findings should not “intensify arguments about control over global international organisations such as the World Bank and IMF, which,” the article correctly notes, “ are increasingly out of line with the balance of global economic power”. While there is no question that countries like China, India and Brazil should see an increase in their representation among international bodies, it is not because the PPP measure tells us much about the relative weight of these countries.

Its usefulness lies elsewhere. The PPP adjustment attempts to measure the relative living standards between the two countries adjusting for the fact that prices are not equal at current exchange rates. A family earning $40,000 in one country, for example, will have the same nominal income but a better standard of living than a family earning $40,000 in another country if both families spend a significant portion of their income on nannies for their children, and if nannies are far cheaper in the first country than in the second.

This is really what the PPP adjustment tells us, but even here there are lots of obvious problems when we try to compare the two countries. One such problem is the assumption that both families have the same consumption baskets, which the PPP adjustment implicitly assumes. It is very unlikely that this is true for all sorts of reasons, not the least being that consumption itself is affected by relative prices. All of us are likely to adjust our consumption baskets in favor of those goods and services that are cheapest in relative terms.

In Beijing, for example, the cost of getting someone to clean your apartment is far, far lower than it is in New York. On the other hand New York has one of the most vibrant theater scenes in the world. No one would be surprised to hear, consequently, that someone currently living in Beijing is likely to have a cleaning lady come to his apartment far more often than he did when he lived in New York, and is less likely to go to the theater in Beijing than he did when he lived in New York. In that case comparing his standard of living in Beijing and New York, even assuming he had the same income in both places, can be pretty difficult.

But these are all obvious problems with the PPP measure, the kinds that are discussed in almost any undergraduate economics class. As long as we keep them in mind we can find the PPP measures to be quite useful in some circumstances, even if in our excitement over the kinds of news stories that generate headlines we interpret PPP to have geopolitical implications that are almost the opposite of reality.

Not all accounting is the same

But there is another problem with the PPP measure that is much greater, so much so that in some cases it completely invalidates PPP as having any kind of informational content. Economists love to use mathematics – perhaps it gives them a sense of legitimacy – but it is not always clear that they understand it very well, especially when it comes to working out the assumptions that are implicitly embedded in the various models that they use. We have seen especially egregious instances of bad analysis backed by lots of very confidence-inspiring data when it comes to analyzing the Chinese economy. The China PPP adjustment is another example.

Remember that the PPP adjustment is an attempt to correct for a significant distortion in direct GDP comparisons. The PPP model has two important assumptions. The first assumption, an explicit one, is that different countries assign different prices to the goods and services consumed domestically in a way that is not fully captured in the exchange rate. The PPP adjustment is an attempt to correct for this by taking the US economy as the standard, comparing prices of a specified basket of goods and services in the US with the second country (China, in this case), and adjusting China’s numbers upwards or downwards to reflect these differences.

But the second assumption, implicit but just as important, is that the US GDP numbers very broadly capture economic activity in the US in the same way that China’s GDP numbers capture economic activity in China. If this weren’t true, adjusting the two for relative prices would be a useless exercise. This isn’t an assumption, by the way, that either country’s GDP is somehow “correct”. It is only an assumption that any mistakes or biases in the US GDP numbers are the same as those in the Chinese GDP numbers, so that except for prices the two are comparable.

Here, of course, is where the PPP calculation can fall apart, and it is why the assumption should be explicitly stated. If you are comparing the US with an economy that construct GDP in a fairly similar way, Canada for example, PPP adjustments can be very illuminating because it allows you to compare like with like. But if GDP is constructed very differently than it is in the US, the second assumption is violated, in which case the PPP adjustment becomes simply another random comparison, which might or might not be better than the non-adjusted GDP numbers.

In China, it turns out, and not surprisingly, the composition of GDP is very different than it is in the US, mainly because the two countries measure debt very differently. It is not because China sets out to record debt differently – on the contrary, most people will tell you China records it in the same way the US and other countries do, and China certainly intends to. The problem is that in China bad debt is rarely recognized, repayment isn’t enforced, and default is almost non-existent. Banks simply roll bad debt over indefinitely. This makes comparisons between the two countries pretty hard. Why? It helps us to understand this if we think about the difference in the way we account for expenditures related to consumption and to investment. Normally, when you spend money on consumption, you create an expense. When you spend money on investment, you create an asset.

Let us assume that two identical companies each spend $50 on the same thing (say scientific research), but in one company the expenditure is recorded as an expense and in the other it is recorded as an asset. What would the financial statements for each company look like? The answer is pretty obvious. In the current recording period the first company would show $50 lower net profits than the second and $50 less assets and equity – remember however that there is absolutely no difference between the two companies, only in the way they record expenditures.

We should understand that this difference in accounting isn’t permanent. Over time, the second company will amortize, explicitly or implicitly, the $50 in additional assets, so that in future periods its net income will be a little lower every year, until at some point, when the expenditure (asset) is fully amortized, the two balance sheets will again look identical.

The important thing here is to recognize that if two companies (and the same is true for two countries) recognize expenditures in different ways, one as an asset and one as an expense, in the short term their financial statements will look very different but over the longer term they will converge. One of the two will report better income and asset numbers in the period during which expenses are being reported as assets, worse income and better assets numbers during the amortization period, and identical numbers thereafter.

Adjusting for debt

It turns out that the difference between the way the US and China implicitly construct GDP shows up in the way bad debts are treated, and by bad debt I mean the excess of the cost of an investment over its value. What happens if you borrow $100 to create an asset that ends up being worth only $80? The best way to treat this would be to create an $80 asset and the equivalent of a $20 expense, with the latter loss showing up as a claim against profits (for a company) or GDP (for a country).

This is effectively what we do when we write down debt in a market-based financial system. If an investor borrows $100 and invests it in an asset that creates only $80 of value, he will either default, and the debt will be liquidated, with the difference between$100 and $80 showing up as an expense (as loan loss provisions in a bank, for example), or he will write down the difference by transferring money from operating earnings or the sale of assets, with the write-down showing up as an expense.

Let’s assume that in China defaults do not happen to the same extent that they do in the US. First of all, is this a reasonable assumption? It clearly is. Except for the occasional insignificantly small one (what the Financial Times calls a “Potemkin default”), defaults are extremely rare in China, partly because much of the lending into what we usually assume are the worst projects are implicitly or explicitly guaranteed by the state or by local governments and partly because it may be politically difficult to record certain loans as problem loans.

At any rate although I don’t have numbers with me I think it is pretty safe to say that the number and value of defaults in China are a small fraction of those in the US. For this there are only two possible explanations. One is that Chinese investors are and have been far, far less likely to make bad investments than US investors (90-95% less likely if there are 10-20 times as many defaults in the US as in China relative to the sizes of their economies).

A few years ago there may have been a few very brave people who still believed this, but not too many do any more. With a comparatively short history of making investments, much more rapid credit growth in recent years, extraordinarily low interest rates compared to nominal GDP growth rates, and seemingly near-infinite amounts of moral hazard, it is implausible that Chinese investors are so far less likely to make bad investments than US investors.

That leaves the only other possible explanation, which is that bad investments are simply not recognized within the banking system to the same extent that they are in the US, and are in fact rolled over. Because even government officials and senior bankers have admitted many times that this is what happens, I think we can assume that it does. The automatic consequence, if this is true, is that a lot of what should be recorded as “expenses”, e.g. loan losses, are actually treated in China’s GDP calculations as “assets”.

This matters when we compare China’s GDP with that of the US. The two countries treat the accumulation of bad debt in very different ways (not because China intends to, but simply because it is politically difficult in China to force repayment when most of the borrowers are politically powerful), and as in the case of the first company relative to the second, this difference means that as long as China is accumulating and rolling over bad debts, China’s GDP and its assets will be significantly overstated relative to those of the US.

A rough proxy for the amount of the overstatement might be the bad debt on Chinese balance sheets net of liquidation – if we were to define “bad debt” in economic, rather than legal, terms (for example by including debt whose repayment might be considered questionable were all explicit or implicit central or local government guarantees credibly withdrawn). One ironic implication of course is that if China were to engage in an orgy of bad investment, it would get poorer (as more and more money goes to what in reality are expenses) while artificially boosting its GDP growth (as more and more expenses are recorded as assets). This seems to have been what happened in 2009-10 and thereafter.

This is almost certainly why Premier Li has insisted again and again that in spite of what must be tremendous domestic pressure China will not attempt to regain growth by another “fiscal stimulus” after the disaster of 2009-10. This will just boost GDP by creating more losses and effectively converting them into “assets”. According to an article in Friday’s Financial Times:

Premier Li Keqiang has said the government will steer clear of short-term stimulus measures to boost the economy. Li (pictured) said in an article published yesterday that pushing through deeper economic reforms was a wiser and more courageous approach than relying on government spending and borrowing to produce growth.

If the premier refuses another major fiscal stimulus in spite of rapidly slowing growth it can only be because he does not believe that all the growth generated by previous fiscal stimulus package was real, and this can only be because they generated large losses that were not recognized as losses but showed up, instead, in the form of “assets”.

This means that on a comparable basis, if you believe that China does not recognize bad debt in the same way that the US does, China’s reported GDP is likely to be overstated by the failure to recognize the difference between the cost of investment and the value created by that investment. Unless you believe that the US fails to recognize losses on investments to anywhere near the same extent, if you really want to compare the two economies more usefully you would have to do at least two adjustments: you would have to adjust China’s GDP upwards for price differentials and also adjust it downwards for unrecorded losses.

By how much would it have to be adjusted downwards? My back of the envelope calculation is that GDP may be overstated relative to US GDP by 20-30%.

Implying false precision

Is this an implausible number? Probably not. It is admittedly very rough, but it is based on what I think are reasonable assumptions about the annual amount of debt-related overstatement that is likely to have occurred in the past one or two decades. There is already substantial evidence that the Chinese banks have a long-established track record of accumulating bad debt.

China’s last banking crisis, for example, was estimated to have cost China roughly 40% of GDP, with some estimates even higher, but remember that these did not show up immediately. They were created in the late 1990s and were effectively recorded over the 2000-10 period in the form of significant transfers from the household sector (I have explained before how financial repression was the form in which the transfer took place), whose growth lagged GDP growth substantially.

Of course household income still grew very rapidly (7-9% of GDP), driven by even higher growth in GDP, but this was because of a massive increase in investment during the amortization period. Unless the ability to invest productively has sharply improved, much of the previous losses will have been amortized effectively by creating a whole new set of losses in the banking system – a large portion, in other words, was simply rolled over.

Since the huge losses generated in the 1990s, total Chinese debt has become a much larger share of GDP, the accumulation of the debt system-wide has arguably occurred in a more opaque manner, credit has grown at a far more rapid pace, and interest rates have been extraordinarily low (for long periods of times 10-15 percentage points below nominal GDP growth rates). On the other hand Chinese banks have gained an extra decade of experience in making loans and there arguably may have been a small decline in moral hazard.

The former set of circumstances should increase the risk and amount of losses in the banking system and the latter should reduce it. Either way the claim that an amount equal to 20-30% of GDP that should have been written off as loan loss expenses were instead accumulated as assets is not nearly as extreme as it might seem.

I should stop here and make a point that I am almost certain is going to be very widely misunderstood by many people who read this blog entry. My argument is not that China’s “real” GDP is 20-30% lower than its stated GDP. The whole issue of measuring GDP is incredibly complex, and it isn’t meaningful at all to say that a country’s real GDP is some quantity more or less than its stated GDP.

My point is a lot smaller and a lot more precise. China and the US compile their GDP data implicitly in very different ways, among the most notable of which is the way Chinese lenders, banks as well as households, treat a substantial portion of the debt as if it were implicitly or explicitly guaranteed by central or local government agencies. This means investment losses don’t show up as losses (expenses) because it is politically difficult to do so, and are instead rolled over and so show up as assets.

Because their economies are implicitly structured in very different ways, which create very different balance sheets, the two economies cannot be directly compared. One difference, and this of course is addressed in the PPP calculations, is that because relative prices of goods and services are different enough if you want to compare living standards you must make adjustments to average income based on differences in purchasing power.

But another difference – and this may be just as important, or even more so, then relative price differentials – is that the two countries’ balance sheets are not comparable, because of debt, and have materially different ways implicitly to recognize the gap between the cost of an investment and the value of that investment. Adjusting for this fact, I would argue, is just as important in any comparison of the two economies as adjusting for price differences.

So what is the point of all of this? Mainly that sometimes simplifying or adjusting our analyses can be useful, but we should be very aware of the assumptions, explicit and implicit, that underlie our analyses. PPP adjustments are useful when we are comparing two economies that are structurally similar and that compile GDP in ways that make them comparable.

But if we are going to compare two very dissimilar economies, France and Sudan, for example, or Brazil and North Korea, or the US and China, we have to be cautious because there are many other equally important adjustments we must make before we can usefully compare their GDPs. The PPP adjustment is an obvious example, but in these cases just adjusting on a PPP basis is a pretty random way of choosing which adjustment we are going to make.

So what? It may be a random adjustment but it is still an adjustment, right? On average, adjusting for PPP probably leaves us no worse off than not adjusting for PPP, so why would we want to oppose doing so?

Only because the adjustment can imply far more certainty than is warranted (a common mathematical mistake among non-mathematicians). We should be wary because of the implication that PPP is not just a random adjustment, and that it actually significantly improves our ability to compare any two economies. In some cases it does, but too often it cannot, and actually makes the comparison worse. While the PPP adjustment should increase our confidence in our ability to say something meaningful about the relative sizes of the US and Canada, it should not increase our confidence in our ability to say something meaningful about the relative sizes of the US and China.

By the way I should add a quick math point here that is often forgotten. If we believe that in order to make it comparable to that of the US we should adjust GDP upward by 25% to reflect the price differentials (the PPP adjustment) and then adjust it downwards by 25% to reflect the different ways of recording debt-related losses, the net is not a wash. China’s GDP is 7% smaller after the two adjustments.

Beijing opposes the PPP calculations

By the way according to a Friday article in the Financial Times Beijing has been opposed to the new World Bank calculations:

China fought for a year to undermine new data showing it is poised to usurp the US as the world’s biggest economy in 2014 based on purchasing power, according to people who helped compile the report.

The report, released this week by the International Comparison Programme under the auspices of the World Bank, included a line stating that the “National Bureau of Statistics of China has expressed reservations about some aspects of the methodology”. Beijing has declined to publish the headline number for China and the report said that the NBS “does not endorse the results as official statistics”.

The FT article says that the reason Beijing was opposed to the study was fear that “ leaders do not want exposure to the international pressure that comes with being the world’s largest economy, according to people familiar with Chinese official views on the matter.” The article then quotes Vinod Thomas, director-general of independent evaluation at the Asian Development Bank as saying: “They certainly don’t want to overstate the size of their economy. They are sensitive about that.”

I think this is probably correct but I think the FT and others may have missed the point. If GDP is indeed “overstated” by the failure to recognize bad debt, remember that this overstatement is not permanent. The difference will necessarily be amortized over the future, and the result will be that today’s overstatement will be matched by tomorrow’s understatement, and for those who receive my newsletter, I explained in the latest issue that the overstatement is only equal to the understatement if there are no financial distress costs associated with the excessive debt burden. If there are, and there almost certainly will be, tomorrow’s understatement will exceed today’s overstatement.

This means that if you look only at PPP adjustments, China runs the risk of becoming the world’s largest economy earlier than expected, only to slip back to second place over the next few years. This, I suspect, would be a political embarrassment, and it is very understandable why the current administration would not want it to happen.


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  1. Great post, Professor Pettis.

    I was not aware of the differences in calculating GDP between the US and China. I did, however, doubt the new PPP numbers. I wonder which goods they are comparing. Having lived in China for several years, I found that survival was extremely cheap (necessary goods), but anything approaching a middle class life was even more expensive than a similar life would have been in the US. For example, cars are more expensive in China. Gas is more. Healthy food is more. Cheap clothes are cheaper in China…but decent ones are much more expensive! Most goods for child-care (decent strollers, milk powder, etc.) are more. Furthermore, many things like “education” which are cheaper at face value, become extremely expensive when you take into account all the hidden costs (extra classes after school, paying the extra fees to get your kid into the “right” school, etc.).

    I wonder if all those costs are taken into account….

    • The differences are not intentional, Paul, but mainly reflect the political difficulty of recognizing certain types of bad debt as well as the tremendous amount of moral hazard, under which lans are made in an undisciplined way on the assumption that they are guaranteed by local or state governments.

      And yes, there is a great deal of variety in pricing and some things are certainly cheaper in China than in the US while others are more expensive. This is true of any two countries, and I am sure the World Bank is aware of it and has attempted to correct for it. It isn’t easy, and of course there is no way to create a basket of goods and services that is equally representative of life in China and the US, but the claim that life is cheaper in China than in the US is, I think, pretty clearly true.

      • I agree that life in China is cheaper than the US for the lower classes, but for many middle class families and the upper classes, I’m not so sure that’s true. So I guess my question is, when comparing goods, which goods (or types of goods) are weighed more heavily? Essentials, or middle class goods?

  2. Also, for housing costs…I wonder if they only compared rent, in which case China is MUCH cheaper…but if they compare the price of buying a home, China is comparable, or even more expensive. (especially when you factor in that “buying” in China essentially means “renting for 70 years”)

    • My guess is that any of the complexities you can come up in the first few hours of sustained thing about it are likely to have been considered by the team at the World Bank.

      • I’m sure they’ve thought about this too. I’m not suggesting otherwise…however, when they don’t release how they determined the PPP adjustment, I wonder how they dealt with these issues.

      • Long time reader who loves your analysis, but I’m with Paul on this one Professor Pettis. I think if you compare “like” middle class goods (say, Tommy Hilfiger t-shirts) in the US vs. purchasing them in China, they are MUCH more expensive in China. That’s why my Chinese friends always ask me to bring back such goods for them when I return from the US and undertake shopping sprees themselves when they are in the US. At this point, I’d say “like” housing is as well (really not much by way of houses although villas are springing up). I think it’s actually fairly difficult to lead a middle class lifestyle on par with that in the US here.

        I’ll add that I have MUCH less faith in the World Bank than you.

        • Thanks, Alan, but the Chinese middle class that is comparable to the US middle class probably comprises less than 10% of the Chinese population. It isn’t clear to me why this would be the main comparison.

          • Indeed… as the PPP basket of goods, CPI basket of goods, and clearly what one considers GDP varies by country… so does the definition of what middle class is.

          • My point is just that the basket of goods (and the weight of goods in the basket) is the deciding factor. If the World Bank focused on goods consumed by the lower classes (necessities), then there is no doubt that China’s a much cheaper place to live than the US…but if the basket of goods was skewed toward middle class goods (brand named clothing, decent (imported) cars, gasoline, healthy (safe) food, housing ownership (rather than renting), air purifiers, etc., then the cost of living in China might be comparable to the US, or even higher in many cases…

            The choices in deciding what goods are in the basket and how those goods are weighed determines the outcome….and from the outcome, I think it’s a safe bet that the study was skewed toward lower income “necessity” goods.

    • Who knows what will happen in 70 years? There are old homes past 70 y/o and govt not come to collect them, if they do where people to live then? Plus we dont pay tax, how much taxes would have be paid for 70 years? I own homes in US and the lowest tax for a house i pay is $4K a year, let alone all kinds of insurances and HOA fees. i just bought a house in Tianjin suburb where i live now, 5000 sqft only $500K, 30 min away from downtown, Tianjin is a major big city also, much cheaper than US right?

  3. CHina’s property bubble began in 2005, the same year when china’s currency began to appreciate against the USD, and when china’s currency fell against USD, china’s property price also fell. Anyone can explain why this is so?

    Also china’s demographic problem will probably make it difficult for the Chinese economy to rebalance. Household consumption cannot increase when society is becoming older and old people do not spend a lot of money.

    • How many cases are you considering, Meofio, in which both the currency and property prices fell?

      • there have been only two instances since 2005 when CNY fell against USD for more than one month, in early 2012 and right now in 2014, both have coincided with falling real estate price.

  4. “For example, cars are more expensive in China. Gas is more.”

    But china has very good and extremely cheap public transportation

    • I think this statement needs to be taken with a grain of salt.

      Public transport in major cities is indeed quite good, and relatively cheap. But in smaller villages its not so great. Lots of riding around on the backs of motorcycles in my travels.

      Also, some public transit suffers from absurd price distortions. Beijing charges 2 yuan per ride on the subway, regardless of distance. Other cities in China charge 12 yuan or more for long distance trips. The Beijing subway might be “cheaper”, but the taxpayer just pays the 10 yuan difference in another form.

  5. Unpaid environmental degradation would subtract another 10% or so of nominal GDP

    • There is an academic, I think at Renmin University, who has calculated that if the economic cost of degrading the environment (for example the reduction in the value of farm land that borders highly polluted rivers) were correctly priced into Chinese GDP data, the total would amount to roughly 10-20% of GDP. I haven’t read anything more than a summary of his research, which came out, I think, about three or four years ago, so I cannot tell you much about its reliability, but a number of Chinese economists are trying to work out the economic impact of environmental degradation and it is clear that the number is quite large.

      That poses an interesting question. GDP is a precise-looking number and one that politicians love to target. If the economic cost of environmental degradation had been correctly priced into GDP calculations, would there have been a stronger incentive not to damage the environment?

      I wrote about this briefly once before, but it seems to me that if all countries were to price in environmental degradation correctly, countries that are just starting to destroy the environment would show lower GDP numbers, countries that have been destroying the environment consistently for many years would show no change in their GDP numbers, and countries that destroyed the environment many years ago but are now seeing improvements would show higher GDP numbers. This might create a positive incentive for policymakers.

    • This is such a complex and yet important issue to calculate. I don’t know if it’s possible to even come up with a remotely good estimate.

      Say a farm field is contaminated with heavy metals. The economic incentive might be to abandon the land entirely, since removing the contamination could take years, or be impossible. This not only reduces gov revenue from potential land taxation, but also total arable land area. It pushes up the price of property, makes the country more dependent on imported food, and so on.

      It would be interesting to see a case study on the cost-benefit analysis of cleaning up a single site in China. Might offer some data to base a prediction on.

      • There has been an argument put forward that much of the “wealth” of the western markets have actually been tacit transfers from environmental (cross-border pollution shifting) and social (loss of privacy) capital. If so, then GDP is doubly counted, once for the original activity, then again for the cleanup. Given that the first tends to be privatised and the second socialised (think bank bailouts) it means the economic costs are bourne by those least able to afford it.

        The challenge is whether the “deep” reforms can be carried through without social unrest … NZ managed to deregulate (Douglas reforms) but its economic trajectory has been below par (compared with Australia) so whether the PRC political leadership has the fortitude to survive an extended period of economic turbulence is an open question. Note that rebalancing has to happen on a global scale, so getting the West to up its savings rate is harder than China redirecting export expansion towards domestic growth … One hope is the alternative to state banks, new china financial intermediaries which are offering higher deposit interest rates provided they are rigorous in their lending policies.

        • You make an important point, Drllau, although one very hard to quantify. By “outsourcing” environmental degradation to China through Chinese manufacturing exports, there has been a hidden wealth transfer from China to its export clients, and this means that to the extent GDP is supposed to measure wealth creation and workers’ productivity, China’s GDP should be a little lower and that of its clients a little higher. This difference will reverse itself over the long term, of course, but it should not be ignored when comparisons are made.

          Where I disagree with you is in the claim that “getting the West to up its savings rate is harder than China redirecting export expansion towards domestic growth.” This may seem counterintuitive because with individuals it is always easier to get them to spend more than to save more, but for economies, historically it has usually been easier to raise the savings rate than to reduce it. Remember that high savings rates are usually not caused by household preferences but rather for structural reasons. China has the highest savings rate in the world not because Chinese are fanatic savers but because Chinese household income is such a low share of GDP, so household consumption is very low, and of course savings is just GDP minus consumption.

          China’s high savings rate, in other words, simply reflects the fact that Chinese domestic demand is structurally very low compared to its production of goods and services (which is why it must run a trade surplus). This means that even as it is bringing down investment, the other main component of demand, it must reduce savings or, which is the same thing, increase consumption (that is, increase household income). This is very hard to do.

          For low savings countries with high unemployment, all they have to do is intervene in trade for savings to rise. Why? Because doing so increases employment, which increase the production of goods and services faster than it increases consumption. In that case their savings will automatically rise relative to investment and their CA deficit will contract (CAD = Investment – Savings).

          But this also means that the savings of the surplus countries will automatically fall relative to investment. For China, savings can fall relative to investment in only one of three ways: it can increase investment (this is what China did in 2009, but Beijing would hate to have to do that again), or it can increase consumption by transferring wealth from the state to households (which is politically tough to do) or it can increase unemployment. No other plausible option is possible.

  6. I wonder about how comparable some of the measures are. For example, I spend a good portion of my income on living in a city, biking distance from work, in a quiet, non-polluted neighborhood. I wouldn’t consider an abode in China to be equivalent unless it matched all of these criteria.

    On the flip side, I’m sure that there are cities in China that have clearly superior public transportation, and the transit situation in my city would be laughable to residents of that city.

    Given that we’re talking about 20-30% of my income, this isn’t a small issue, and I can’t be the only one that has these preferences.

    Hard to say.

  7. You have a few interesting typos: hare instead of are and potions instead or portions; are these intentional?

  8. The FT reference to “volatile exchange rates, which rarely reflect the true cost of goods and services” is pretty flabbergasting when you consider that the FT is editorially in favour of global free trade and that a clear condition for global free trade to be mutually beneficial is precisely that exchange rates should reflect relative price differences.

    The introduction to the 1947 General Agreement on Tariffs and Trade (the predecessor of the World Trade Organisation) clearly states that “Being desirous of contributing to these objectives [raising standards of living, ensuring full employment and a large and steadily growing volume of real income and effective demand] by entering into reciprocal and mutually advantageous arrangements directed to the substantial reduction of tariffs and other barriers to trade …

    This is not a coincidence that the GATT in the field of trade and Breton Woods in the field of exchange rates were the two inseparably-related pillars of the prosperous post WWII period.

    However, since the early 1970’s, the Breton Woods exchange rate regime has been replaced by “freely” floating exchange rates, while the push for global trade liberalisation has intensified, with the poor consequences that we have seen globally on rising under-employment, rising income inequality (see your previous blog article), rising debt and weakening effective demand, ie. the exact opposite of the GATT initial intentions.

    It is not possible to separate international trade and exchange rates. They are one and the same thing.

    The FT should know better (and if it did, perhaps its audience will not be declining to the same extent).

    I think the point you make about the inherently different structures of production and demand in countries at different stages of development rather speak for allowing free trade between countries and regions of similar standards of living (subject to the same condition about exchange rate). These regions will still be large enough to ensure full competition in all markets, while largely avoiding the opportunities for labor arbitrage presently allowed in the current system of global free trade between countries and regions with salary costs ranging from 1 to 10 with no offsetting effect from exchange rates.

  9. Wonderful post. Thanks!

    I suppose I agree that the cost of living in China (I live in Beijing) is less than the cost of living in the average U.S. city, but the difference is considerably smaller than you’d perhaps expect given how much “poorer” the average Chinese person is compared to his American counterpart. Public transportation, taxi fares, and utilities (i.e., electric, water, cell phone, etc.) are much less expensive here, but so much else is as much or more expensive. Domestically manufactured cars cost just as much here, unless you purchase a cheap Chinese brand. Gasoline is more expensive here too. So are eggs. Milk may be cheaper, but parents routinely pay exorbitant amounts to purchase the most expensive domestic “guaranteed” products or imported brands. A latte at Starbucks is more expensive, as is a Big Mac – though a bowl of noodles in a shop near my home is very cheap (and delicious) at US$2. Homes in Beijing that cost RMB 6,000 per square meter fifteen years ago now frequently exceed RMB RMB 30,000 on the secondary market. Wages haven’t risen nearly so quickly during that time. I could go on and on. Sure, you can live cheaply in China, but no one I know wants to live like that. And as soon as a Chinese person begins living a recognizably middle class life, paying for all the things that the average middle class American takes for granted, costs go through the roof. Likewise, how do you account for the added expense of living in Beijing’s wretched environment? I went from never having a cold to having several every winter. What’s the cost to my health and productivity? The same question might be asked regarding rising rates of obesity, heart disease, lung cancer, diabetes, etc. Do PPP GDP measurements take into account the awful health care system here, the chance that your next bowl of rice may be contaminated by cadmium, or that arable land is shrinking and/or full of heavy metals? My rent here is a bit less than my rent in Cambridge, MA and Berkeley, CA, but my landlord is an unresponsive turd who makes my life miserable. How do I factor that in?

    I’ve lived in Beijing and HK for more than a decade, and I’ve long since stopped thinking of China as a cheap place to live.

    • What I utilize to determine PPP is the Big Mac index. According to this list, diners in china can gorge themselves at Mickey D’s for no less than half the cost of an american or british burger enthusiast.

  10. I’m a bit mystified by your argument that the way in which losses are recognised or not is affecting GDP comparisons. Since GDP is measured gross (and isn’t directly looking at the financing side), I’m puzzled as to why an “extend and pretend” approach to bad debt will produce different GDP results than a prompt recognition of the economic loss. If capital is being misallocated, the consumption of fixed capital numbers should be higher than would be seen in a more efficient economy, but that would affect net domestic product or net national income comparisons, but not ones of GDP.

    But I must be missing something important in the argument.

    • I suspect the easiest way to think about it Michael Reddell, is to use the $100 dollar investment in a project that creates $80 in value. In Country A of no investment misallocation, the project would have cost $80 and that is the number that would show up in GDP. In Country B, which is identical to Country A except for this one transaction, because the investment cost $100, GDP would be higher by that amount.

      Remember that both worlds are identical in every way before the transaction. In the period in which the investment takes place, they are still identical except that Country B has a higher GDP. In subsequent periods they are no longer identical. Country B has more debt which must be amortized and which may or may not create future financial distress costs.

  11. The whole argument relies on the assumption that China would be the only country that is not recognising bad debts in the GDP. IMHO, this is far from being the situation. Practically every OECD country refused to recognise the bulk of bad debts following the 2008-2009 financial crisis. In most of countries, the trick has been achieved through easy refinancing at the central bank or plain deficit spending by the sovereign states to guarantee the bad debts. The only way for these sovereign to not default is to pay extremely low real interest rate on this debt for a very long time and therefore repress savers. Very similar indeed to what is happening in China.

    • It doesn’t need that assumption at all, and I am surprised that it isn’t obvious that it doesn’t. All you need, as I pointed out, is to “believe that China does not recognize bad debt in the same way that the US does.” There is a unfortunately kind of binary thinking that pops up all too often in discussions about China in which the fact that something exists in two countries is enough to argue that it exists to exactly the same extent.

      • We probably have to agree to disagree on the “extent” of the misrepresentation of GDP in OECD countries. What the US and the EU did was to raise the sovereign debt to directly guarantee or pump up the economy enough that the bad investments are maintained afloat. The increase of the sovereign debt, depending on countries, was around 40% in the US and up to 90% in Ireland. This is similar magnitude than the 20/30% you mention in your article.

        • Maybe. I am trying to work through the consequences and haven’t done so completely, but hope to soon. By the way, we cannot simply compare government debt in the US and Europe with investment misallocation in China, especially when much of the increase in the formers’ debt occurred mainly as a consequence of the transfer of debt from bankrupt banks. The Chinese government hasn’t done this yet, but if and when it does (plus the net indebtedness of government agencies like the PBoC, the CDB, EX-IM, etc) total government debt is likely to be much, much higher.

          Remember that something similar happened in Japan. Most of Japan’s “fiscal expenditures” in the 1980s occurred through the banking system. In 1990, Japanese government debt was 20-25% of GDP, but over the subsequent twenty years as the debt was effectively transferred from the banks to the government, its government debt soared to well over 200% of GDP. Again, as we so often do in our analyses of China, when we compare its data to US data we assume we are comparing like with like , when in fact it is clear that we are not.

          • “The Chinese government hasn’t done this yet, but if and when it does (plus the net indebtedness of government agencies like the PBoC, the CDB, EX-IM, etc) total government debt is likely to be much, much higher.”

            I may have been also confused by the 20/30 % adjustment necessary : do you mean 20/30% bad debts unaccounted for EVERY YEAR or only on a CUMULATIVE basis since, say, 2008.
            Obviously the former means an Irish like adjustment rather than a US like adjustment. Saying that 20-30% of GDP, which for China means around 50% of investments is useless is quite an extreme and brave call.

      • Another example is to look at American macroeconomic textbooks used in Chinese universities; the assumption must be something like: 2+2=4 in the US or china, but as Michael and others have pointed out, fundamental variables like interest rates functiion in precisely the opposite direction.

  12. Dear Michael

    Another succinct and brilliant piece!

  13. Excellent post, Prof, as always! I note with pleasure that Gavyn Davies has linked this comment in his latest FT blog on Chinese exchange-rate policy. One most obvious point to add, more for the sake of completeness really, is the relevance of GDP per capita, which probably places China closer to Angola than anything else. My obvious implication is that if people want to be sensationalistic with rubbery figures and flimsy numerical comparisons, then we ought to remind them (the case of pollution has been raised) of the political implications of these economic data. My point is, to flatter myself, very much in line with what Professor Pettis does so valiantly and invaluably well, that is, to see economics and politics as a continuum rather than as discrete entities – which, I would humbly submit, is what lends his economic analyses their evident strength. Sooner or later, as Pettis insists, accounting ‘balance sheets’ must be reconciled; but it is the political ‘balance sheets’ that can make for far scarier reading! Cheers, warmest regards and thanks.

  14. Thanks for this post. Economists from Peterson Institute claim that these new PPP figures imply that the RMB is no longer undervalued ( ). What do you think about this claim?

    • I think of the RMB as only one of the factors, and not the most important (wages and interests rates are far more important), that determine whether or not the external account is in equilibrium, and so for me any argument that the RMB is over- or under-valued without reference to wages and interest rates, especially the recent “collapse” of the interest rate gap, is not very useful.

      But think about this. Suppose I were to posit a world of two countries in which one country had low unemployment and 7% growth, and the other was stagnating and had high unemployment. What would the current accounts look like? Pretty clearly you would have guessed that the first country would be running a large deficit and the second a large surplus. And if the current accounts balances were reversed, you would probably assume that there was significant trade intervention, right? If so, it is hard to see why we would believe that the currency isn’t still undervalued.

      • But wouldn’t all that have to happen is for the high growth country to be saving more than they are investing; while investing at a very high rate?

        This doesn’t feel quite right particularly as labor costs have risen quite sharply in China over the past decade.

  15. The issue you raise, and frankly all the economic debtates that have been taking place for the past decade (without noticeable progress, sadly) would be greatly illuminated if countries would publish their consolidated balance sheet as they publish their consolidated accounts. Do you know why this is not the case? I can’t see a good reason apart from the fact that it might not be deemed convenient politically.

  16. “A measure! A measure! My kingdom for a measure!” Ultimately this most informative piece from Professor Pettis ought to warn us against the danger of metaphors when describing complex social realities – and we know that GDP and PPP and inflation measured against a “basket” (surely a “shopping basket”?) of goods, we know that all these are metaphors used by those in power to gauge, however imperfectly, the degree of political control they have over society. King Richard the Third’s last pathetic cry in Shakespeare’s tragedy only serves to underline the absurdity of buying a “kingdom” (itself a metaphor) from a king who is in desperate need of a “real horse” so as to save his own life! Think about it! This lends real meaning to the old saw about “the emperor’s clothes”. (Incidentally, I am currently working on a study of Joseph Schumpeter’s methodology and the use of metaphors in Neoclassical economics that will be soon be posted. Regards.)

    • Agree. National Income and National Assets can only represent orders of magnitude. But, even with this limitation, a consolidated national balance sheet would be very useful. When Consolidated National Assets are ~4-4.5x Consolidated National Income, it is not useless to know that Consolidated National Debt is ~ 3x National Income and growing and that, therefore, equity in the system is 1-1.5x and shrinking. In fact, that would be most useful to these kings – and modern equivalents – interested in lasting.

    • This is a constant refrain in my classes. Much of what we study in economics is implicitly about the US economy, and so economic “laws”, or even rules of thumb, are not nearly as universal as we are taught to believe. Any application of “economic theory” to the Chinese economy must start with an attempt to tease out those parts of economic theory that are implicitly only about the US or similar economies (the UK, Canada, Australia, etc), and so can only be applied to China with significant modification. We are usually too lazy, or perhaps unimaginative, however, to do the modifications.

  17. I think that the Chinese government did not want to celebrate it mainly because it does not want show the domestic audience that country focuses on GDP but not people’s living quality. If the Chinese position by GDP is exaggerated people may question where the money go, and may feed the current dissatisfaction.

    Number 1 or not by GDP is less important than how people in China feel. Reading too much of GDP numbers in the media by the public only creates troubles to China. Chinese have had enough of GDP in politics and news and it has been mocked “chicken butt” which is pronounced similar to GDP in Chinese. It suggest that people think that the government is using useless measurement to show their achievement while some people are still suffering. Chinese people actually does not like the words GDP anymore.

  18. Thank you for teaching me… every single entry you made I learnt something . I believe you are the best economic thinker of our time and I really appreciate the fact that your work is available for people that want to learn, not only for people with money . My respects and gratitude Dr Pettis.

  19. Both ways of measuring the relative size of economies contribute to our understanding economic weight. Indeed there probably is no alternative to show the results of both and note the difference between them. I have written a little about this topic over the years (;

    Recently I have pondered how we might combine the two, by providing a proportion each for the domestic and external economies. This would reflect the extent to which each was relevant to the reality of a country’s relationship with the world economy. PPP could be used for the domestic economy and exchange rates for the external economy. But what proportions would need to be applied? We need to work out a weighting in relation to the impact on an economy of its foreign ‘exposure’. PPP measures the relative prices of production and consumption, but doesn’t account for the costs imposed by having to purchase goods and services and access credit from other countries. Alas working out the balance requires some further thinking and as you show, Michael, problems with the PPP calculations may make it less accurate anyway.

  20. Very useful insight for common man like myself. But how much GDP will be knocked off from USA if one has to consider bubble assets fueled by QE and exploding debt (ex higher house prices, employment) which should (will it?) ultimately burst and result in write off losses.

  21. Wilson Nascimiento

    China has long ago overtaken the US as the largest economy, as the US financial services sector accounts for about 20-22% of its GDP. As the US financial services are proven to SUBTRACT, rather than add, value and are just a looting mechanism for the US elites, it should be disregarded from any realistic GDP comparisons. In fact, the US is insolvent and stays afloat only through the projection of military power.

    • I think these kinds of statements are fun to say, and have been said regularly by the very disgruntled since at least the 1950s, but they are not terribly useful because they don’t really mean anything. Insolvent countries cannot stay afloat through the projection of military power, whatever that means, except perhaps to the extent that they use the exigencies of war to force their citizens to cut back on consumption, which happened in Germany after 1939. I am pretty sure, however, that no one thinks Americans have been forced to cut back on consumption.

      As for relative sizes, the US has the largest services sector in the world, while that of China is quite small, even excluding banking and real estate, which are far too large in both the US and China. The US also has the largest manufacturing sector in the world, although there the gap with China is much smaller, with the latter second (with a lot of overcapacity). I think the US has pretty easily the largest agricultural sector in the world, and China, the same size geographically, has less than one-third the arable land and is much less productive. I wonder how your calculations show otherwise.

      • Michael Pettis wrote: ” I think the US has pretty easily the largest agricultural sector in the world, and China, the same size geographically, has less than one-third the arable land and is much less productive. I wonder how your calculations show otherwise.”

        This is not correct.

        (1) China has the largest agricultural sector in the world. India is second and the US is third, as people can verify by looking up Wikipedia for “List of countries by GDP sector composition”

        (2) China’s arable land is around 2/3 that of the US. The US does have more arable land and higher productivity than China, but it uses less of its available arable land (i.e. it has huge spare capacity of arable land that is not being used for cultivation) than China. This can also be verified by searching for ‘Arable Land’ in Wikipedia.

  22. Michael, this was such a great POV on PPP. I especially like the accounting analogy, it was very illuminating.

    Personally, I have never been very comfortable with the concept of PPP since it is not clear what questions it is trying to answer. For instance, the first assumption of a similar basket of goods claims to be asking which country has a better living standard. However, if cows are cheaper in India than the US because due a lack of demand in India, then a basket that compares the US with India on PPP basis does not account for the lack of demand for beef in beef prices in India. Hence, PPP is not really asking which country has a cheaper living standard as much as it is asking, where can the average American live better on his current annual wages. Hence, PPP is really conflating the forces of supply and demand in two places and claiming there is no loss of information along the way. I think this kind of conflation is similar to the way neo-Marxists/post-modernits claim that capitalism homogenizes individuals into consumers while constantly inventing new things to entice people to stand out as individuals. Given that China is a developing economy, US is a developed economy, their supply and demand dynamics are informed by different needs (not mention wholly different cultures) which should stop anyone in their tracks from making a PPP comparison of the two as if the average Chinese and American consumers were interchangeable.

    Obviously, it is much simpler using the exchange rate as a basis for comparison. Which has a clear logic in using an international reserve currency to let us know what it would cost if one wanted to buy China. Hardly any mix up there.

    Thanks again for hashing out the fine print.

  23. What about bullshit us gdp figures? All that money printing led to asset inflation such that the us financial markets are the biggest ponzi schemes in the world. Don’t even get me started on the bullshit innovation in silicon valley and the sham shale oil & gas backward leap. The us gdp is overstated grossly. Start deducting the rollover forever social security debt and bullshit pension assets and you’d hv only scratchef the surface. Strip out the military spending to keep otherwise unemployable young angry men abroad and you’d start to see the true ugly picture. Us asset returns are bullshit, inflated by money printing, suspension of accting rules and market manipulation. There’s nothing rosy about rotten America. Glad I don’t live there anymore.

  24. What Professor Pettis describes is true wether you compare GDPs in nominal or PPP terms.

  25. as a lay man iam not in a positon to understand how gdp ppp calculated they have mentioned that due to the complex procedure they do this act once in 6 years ?is that true i dont know?if that is the case an official report come every 6 years only right ?they last declared gdp ppp on 2011 then the next result may be in 2016 ?.so before getting a officially declared figure i know that all arguments are useless,again if the results are officially known as mathamatical figure then also they have not explained in simple terms the selection of basket of items,the rural and urban areas used,inflation,exchange rate,and above all thebenifit of this figure to a native china man or usa man with this calculation.why because a native china or american or any country man will buy his choice of food that naturally available in abundance and that is the reason why it might be cheaper this case is applicable to all lower middle class,to poor class whose number dominates 70% when compared o the upper 30% who leads a global standard they go for villas at the same rate of usa ,,uses brended items ,travels in royal cars ,so gdp ppp is a cosmatic presentation gdp per capita is the one that tells littile more than gdp ppp as a whole ,if any body can explain in a lay mans language the matahmatics behind this comparison it is great,i feel this can help certain countries to show their muscle over other unnecssariy or to tarnish the image of a successful countries fate ,we are in a modern world where money in your house hole counts not the nation in that aspect qatar is financially stronger as a country in gdp per capita and such small countries where usa too stands number 8 or 9,i hope this will go on this fashion atleast for a few decades

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