Monday, May 5, 2014

De-paranoia-ing: China's GNP

Let’s do some de-paranoia-ing. I’m not sure if that’s a word, but it should be... de-paranoia-ing: To point out some obvious things the fearmongers kept hidden so they could scare people. Today's edition involves this ridiculous idea that China has overtaken our economy. Top of the World, Mong! Let's debunk.

Ok, riddle me this, when is 9.7 trillion larger than 16 trillion? Answer: When you want to scare people. You may have heard this weekend that China has "finally" overtaken the US in terms of GNP. Apparently, we’re all second class now... put a fork in us, we’re done. The problem is, this is a false claim. The US economy produces GNP of $16 trillion per year right now. The Chinese economy produces GNP of $9.7 trillion. See the problem? 9.7 is not greater than 16! So how can they claim that China’s economy is miraculously bigger than ours? By adding a fudge factor to China’s economy to convert the real $9.7 trillion figure into an imaginary $16+ trillion figure.

Sadly for them, this approach is ridiculous.

The fudge factor in question involves what they are claiming is an adjustment for the difference in cost of labor between the two countries. In other words, since Chinese labor is cheaper, China can buy more of it for the same amount of money. Thus, even though our GNP is bigger, we can’t buy as much stuff as the Chinese for it. Ergo, our economy is actually smaller.

Here’s the thing though, the $9.7 trillion v. $16 trillion already accounts for the difference in labor costs. And what the people advocating the fudge factor are ignoring is productivity. Consider this: a Chinese employee may demand a smaller wage, but that is because their labor isn’t as valuable as American labor. The principles of international trade assure us of this or ALL the jobs in the US would flee to China. Instead, only the lowest level American jobs left for China and that stopped about a decade ago as China became too expensive compared to America for more to leave.

Let me see if I can make this more clear. Between an American high school grad and a Chinese laborer, the Chinese laborer will be much cheaper to employ if I’m looking for someone to dig a ditch. It is this assumption which these “experts” are using to claim that China has this advantage which requires us to double their GNP because China can afford so many more ditch diggers than we can. Said differently, China can employ about two laborers to dig a ditch for the same price we would pay to an American. Ergo, China’s economy is really twice as strong as it appears because they get twice the bang for the buck that we do.

The problem is, that's wrong. This formula may work if you're purely talking about basic physical labor, but it definitely does not work once you move beyond that and the reason is productivity. Take the example of an engineer. A Chinese engineer may be paid two times less than an American engineer, but the American engineer is capable of turning out 10 times more and better work than the Chinese engineer. If that weren’t true, then engineering jobs would be racing to China, but they aren’t. The only jobs racing to China are unskilled labor jobs, and even those are now leaving China.

What this means is that when you look at building something, it actually takes 10 Chinese engineers to produce the same product as the American does. That may only cost 5 times more because of the cost of labor, but it still costs more. This is what the "China are beating us" advocates are missing. They are just looking at the wage difference without factoring in productivity. In fact, I could flip their argument around by ignoring price and looking only at productivity and then declare that our economy should be doubled in size and China's considered even smaller. But that wouldn't be right either because I would be ignoring the price difference.

So how do we compare price and productivity? Well, it turns out we already know the difference. The difference is captured in the exchange rate which gives us the GNP measures of $16 trillion v. $9.7 trillion.

Think about it. Our GNP and China’s GNP represent the value both countries were able to produce in the last year given the cost of labor, the cost of regulations and real estate and other inputs, and the offset for productivity. That’s what these numbers are: the total value each economy is capable of producing. And as productivity or costs change, the exchange rate fluctuates to reflect the lost value to the economy and the $16 and $9.7 trillion figures will shift accordingly. Trying to impose a half-assed adjustment on top of that only doubles up on a single adjustment that has already been factored in by the laws of economics. Hence, this idea is of adjusting China's GNP is simply false.

Moreover, the method they are advocating completely ignores the fact that the official exchange rate is what these countries will pay to buy foreign goods or services and what they will be paid to export their own. Thus, even if we accept that there is some logic to the idea of the fudge factor for local products (there isn’t), the fudge factor still needs to be ignored for anything the country does that involves other countries. In other words, even if costs are cheaper in China, that doesn’t get them a discount when they import an Audi nor does it get them a bonus when they export a television set. About 60% of China's economy is direct exports or imports, so you tell me if the advocates are right to dismiss this idea?

And on that point, consider this. To compare GNP from two countries, the only meaningful way to do it is to ask yourself what it would cost for some third party country to buy up everything they produced that year; to figure out what an arms-length buyer would spend to buy each. That gets you an objective value which you can then use to compare the two. That's the only way to make a straight up comparison, because it wipes out subjective valuations that may exist within a country but nowhere else. If you don't do that, then you aren't comparing anything real... it's like comparing the value of two family photos, which may be priceless to each family, but meaningless to everyone else. The exchange rates do this automatically. That's why you use them to make the comparison.

Finally, to prove to you just how silly this idea is of using this fudge factor, consider this: if we consider their argument valid, then the American economy would be better off if we closed all of our schools and disallowed anyone from working in an industry where they could demand a higher salary than anyone else off the street, i.e. if we converted all of our labor to unskilled labor. Then wages would crash and we would have the same “advantage” China has. Does that pass the sniff test? It shouldn’t. No one anywhere in the world thinks that degrading their workforce is a good idea. Hence, there is obviously something fundamentally wrong with the idea.

What this is, is an attempt to scaremonger you. They want you to believe that China is somehow better than we are, even though their GNP is stuck at about half of ours. Some Chinese miracle.


Tennessee Jed said...

good post, Andrew. I am trying to figure out why the scaremongering? Will check back in the a.m.

AndrewPrice said...

Jed, I think this comes from the doomsday impulse that so many people have. Every time any challenge arises (economic, military, breakdown of order, environmental, increase in poverty, increase in unemployment), a certain group of people want to predict the end of the world.

Critch said...

Great article. I really have a hard time understanding how people can read articles, such as the one about us being Number 2 and just swallow them hook, line, and sinker. There is a fairly large group of people in this country, some hard core Leftists, the other hard core Right Wing nut-jobs who think this is a terrible place to live and will jump on anything to prove it.

AndrewPrice said...

Thanks Critch! I thought this was well worth pointing out.

I think people believe it because they assume that others, like economists and journalists, are simply telling them facts rather than advocating theories as fact. Plus, most people are simply trusting of authority. It's a human failing. Even people who think they make up their own minds often are kidding themselves.

And you're right that the left and some on the far right want to see the US as a terrible place because the public doesn't conform to their ideas of ideological purity. And that's nothing new. You see this every ten years or so as there is yet another outcry that the US is a horrible failing place. It's never been true.

Critch said...

If you ask 3 economists a question you will get 5 different answers....Economics is a social science, not a hard science, most of their opinions are based on how the data is interpreted; and I can guran-damn-tee you they will change their opinion within 3 months.

AndrewPrice said...

Critch, Very true. But most people don't get that. They think that economics must have certain rules that make it consistent. They don't realize that it's as murky as psychiatry.

Tennessee Jed said...

makes sense, Andrew. Since almost everything today seems tied to political brinksmanship, I was probably assuming this one originated from someone with a specific ox to gore or agenda to push. It may be just that simple though (as you suggest) e.g. people needing to go the chicken little route at a moment's notice.

Anonymous said...

So next time someone asks me how many Chinese people it takes to screw in a lightbulb, I should say, "Ten times as many as it should"? :-)

And you're right that the left and some on the far right want to see the US as a terrible place...

To say the least. I had no sympathy for the "We're turning into Nazi Germany!" crowd during the Bush years and I have no sympathy for the "We've become a Communist country" crowd now.

AndrewPrice said...

Jed and Scott,

This is an old issue that has many, many, many hopeful advocates. You've got the far left (America has become a fascist country) and the far right (America has become a communist country!). You've got the Biblical end times people. You've got the "we are a nation of slaves!" types. You've got the grumpy "things were better when I was young" types. You've got the college age "this country is no utopia!" types. You've got the "we should copy everyone else" business community types. You've got the military who back this idea to demand more spending. You've got the Fortune 500 who back this to get more subsidies. You've got the unions who back this to demand an end to international trade. You've got talk radio who wants you to know that Obama has destroyed America and has Chinese troops sleeping under your bed. You've got anti-American elitists who want to see us "made less arrogant." You've got economists (left and right) who back this as a reason to impose their policies. And so on.

There are millions of people who want this to be true, and they've been gushing for about a decade now that China was going to put us in our place. I guess they got tired of waiting for that train to come in and they decided to lying instead.

Critch said...

Things are getting better. The water and air are cleaner, crime is down, people are living longer; there's so much that is right that I'm confused how people come up with this silliness. I guess they aren't happy if they have something to be happy about.

AndrewPrice said...

Critch, I would say these people fall into three categories.

1. People who have an economic interest in the public being scared. They know this isn't true, but just don't care because they make money on it.

2. People who have an obsessive ideological belief (e.g. anti-abortion, pro-union, crazy environmentalist, etc.), and who are very angry that the rest of the public just doesn't care about the issue and in fact happily goes along ignoring them. They see America as suffering a moral failure for not doing what they want.

3. People who are personally unhappy and who then project that unhappiness on the world at large. Basically, "my life isn't turning out how I wanted it to turn out, ergo, something has gone wrong with the US at large. Things aren't what they used to be."

That's my guess. In any event, I agree with you completely. So many things are getting better and better. There are millions of things to be happy about. Life is great. So why be unhappy?

tryanmax said...

The frustrating thing is that economics doesn't have to be as murky as psychiatry. I doubt it will ever be as concrete as chemistry, for example, but there are many reliable and predictable aspects of economics that, at least to my eye, many economists prefer to ignore. (I'm looking at you, Paul Krugman.) It generally comes down to some credentialed individuals saying, "this is how I'd like economics to work, so that's what I recommend."

Maybe someday in the future when economics are better agreed upon, people will look back on the economics of today the same way we look back upon geocentric astronomy.

AndrewPrice said...

tryanmax, Sadly, I must disagree. I think the problem is the lack of ability to test. In medicine or physics, you come up with a theory, design a test, and prove yourself right or wrong. Economics can't really do that. All they can do is theorize and then look for verification throughout history. Unfortunately, the other side can wipe out your verification just by saying, "You are wrong, it was something else that did it." Thus, no consensus forms and each side can maintain their prejudices without ever having to admit they are wrong.

You just couldn't have the same thing in medicine or chemistry or physics because you either cause what you intended or you don't. And if someone claims it was really some other cause, then they need to prove it or get pushed aside. But in economics, it's impossible to dismiss counter-views.

To give an example, I still remember at the end of the Reagan years, the left claimed that his amazingly strong economy had nothing to do with deregulation and lower taxes, but was instead about his massive spending following Carter's reforms. That was obviously false, but the left said it, bought into it, and kept pushing it. And with no way to prove that they were wrong, you ended up with competing views even though the correct answer was obvious to anyone of good faith.

That's why economics will never be a true science.

tryanmax said...

No, I don't expect economics to get nailed down like chemistry or physics (inasmuch as they are nailed down). But I do think that much of the disagreement is sustained by a general economic--or maybe even mathematic--illiteracy. I cite Freakonomics' 'two laws of punditry: First, for any issue, there’s always at least one idiot willing to claim the spotlight to argue for it; and second, that idiot may sound more respectable if he calls himself an economist. I don't expect economics to be an area ever devoid of disagreement and varying interpretations, but at the moment, there seem to be an unlikely number of "economists" asserting outlandish and even impossible things simply because they are able to assert them over most people's heads.

Kit said...


AndrewPrice said...

Kit, Ironically, in this instance, it's "THE SKY FELL LAST WEEK!!" ...and yet, nothing changed.

AndrewPrice said...

tryanmax, Agreed. Economics won't ever be fully nailed down, but maybe certain principles will finally be accepted by all.

I also agree that the problem is that there's always someone willing t assert the insane idea and there's always a media willing to agree. The outliers in fields like medicine tend to be ushered to the sides fairly quickly.

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