China Has Long Been the World's Second Largest Economy: NYT Kills Electrons for Nothing

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Sunday, 15 August 2010 20:15

The NYT is touting the big news. China just passed Japan as the world's second largest economy! This is painful because the piece badly misleads readers about the relative size and importance of China's economy.

Measured by purchasing power parity -- a measure that assigns the same price to goods and services regardless of where they are produced -- China has long been the world's second largest economy and in fact is already more than twice as large as Japan's economy. It is only by using an exchange rate measure of GDP that China's economy ends up being a close rival of Japan.

The exchange rate measure adds up the size of the economy's output in its own currency, then it converts this measure into dollars at the current exchange rate. Of course there is a large arbitrary component of the exchange rate at any point in time. In China's case, the government has a policy of deliberately depressing the value of its currency. Some estimates put the under-valuation at more than 40 percent. If China allowed the value of its currency to rise, then its exchange rate measure of GDP would rise accordingly. In other words, China could have passed Japan in GDP by this measure two years ago if it had allowed its currency to rise by 20 percent against the dollar.

This is why economists generally use the purchasing power parity measure for most purposes. This much better reflects the relative productive capacity of different countries' economies.