Will China Overtake the US?

The IMF’s prediction earlier this year that China will have a larger economy than the US in 2016 has gotten a lot of press.  The validity of this forecast depends on two factors — how you value a country’s output or GDP and what your forecasts for GDP growth are.  If China’s economy is valued at today’s market exchange rates and at the costs and prices prevailing in China, then its economy is much smaller than America’s and will not surpass it for many years.  But, if China’s output is valued at what economists call “Purchasing Power Parity” (or PPP), then China’s economy may very well overtake America’s in size in short order.

In 2010, US GDP was $14.7 trillion and China’s $5.9 trillion.  But, valued at PPP, that is, a dollar buys the same basket of goods in the US and in China (which would mean that China’s undervalued currency, kept low to increase exports, would appreciate, and some price differences would adjust), then China’s GDP suddenly becomes over $10 trillion, while US GDP remains roughly the same.  We rely on economists for the PPP adjustment, a step which introduces human error.

The second factor that goes into the forecast is more disputable.  This is one’s forecast for growth.  China has been growing at 8-11% per year for many years and the US economy cranks along at about 2-3% growth, not bad, but not stellar, for a developed economy.  Consequently, many economists straight-line out the growth record for the years to come and say, okay, China’s economy will be larger than the ever fearsome US economy by 2016.  In that year, the IMF forecasts China’s GDP (on a PPP basis) will total $19 trillion and America’s, just a couple of hundred billion dollars below that.

This may well be, but history has shown that economic success stories sometimes turn sour and sluggish dogs transform into race-winning greyhounds.  Witness, poorly growing Brazil’s and Peru’s transformation into fairly robustly growing economies (not to mention sub-Saharan Africa) and “peripheral” Europe’s turn to bust in recent years.

The IMF straight-lines out real GDP growth of 9.5% for China, a questionable assumption given the dragon’s decelerating labor force growth and some considerable risks.  Watch out for a property price bubble in China, the country’s huge, opaque and state-directed financial system, and considerable political risks in the Middle Kingdom.  No one knows how the Chinese economy will fair as it liberalizes, shifting from a state-led, export- and investment-driven economy with capital controls and interest rate caps, to one based more on domestic demand and market forces.  Liberalizers in Asia from Japan to Korea and Thailand have seen their economies plummet due to poorly sequenced reforms.  Many economists see a “hard landing” scenario in China that would result in no less than 6% GDP growth; yet one cannot rule out an even sharper slowdown or outright recession, especially if there is a banking crisis.

As for the US, “declinists” have been wrong before — remember Paul Kennedy’s book in the 1980s about the decline of the US?  He didn’t foresee the tech boom of the late 1990s when America grew by nearly 5% per year.  Likewise, those predicting the decline of the US economy today — with its labor market flexibility, highly developed financial markets, nimble political system (that’s right, compare it to Japan’s) and technological innovation — may be proven wrong again.

And what about power?  Political scientists discuss power in relative terms.  That is, even if the US economy grows nicely, emerging economies are likely to grow more rapidly.  Thus, the US economy will decline in relative terms.  It must.  The US cannot maintain its wealth gap forever.  EM economies will continue to appropriate technology and know-how and grow.  Since a nation’s economy underpins its power, US political and military power will decline relatively.

Power has other dimensions too, including alliances.  It seems implausible that a hostile power could erect in the near term an alternative coalition to challenge US-led alliances worldwide.  Finally, it all depends on whether you are a foreign policy realist, believing in a dog-eat-dog world, or a foreign policy liberal, believing that effective multilateral institutions that include potential adversaries reduce the risk of conflict.  If you believe in the latter, then the relative decline of US power may not yield the insecurity realists would have you worry about. China, India and Russia would have too much to lose.

So, policy wonks, what should the US do?  For starters, cut the fiscal deficit and develop a medium-term plan to reduce entitlement spending and government debt to moderate levels.  That said, the government should invest in infrastructure and education and perhaps in basic research, maybe by freeing up funds through closing tax loopholes and cutting subsidies to farmers and others.  And, once the economy rebounds, let’s put the Tea Party back in the Lipton Tea box, so that we can raise America’s comparatively low tax burden in order to fix those roads and bridges and educate those kids.

On the defense front, the US should attempt to wield military power more effectively, like Les Gelb recommended in a Foreign Affairs last year, by avoiding costly land wars, leveraging alliances and employing more “surgical” tactics.  President Obama’s happily successful (and lucky) foray into Libya, whereby the US played a leading role, but left much of the dirty work to France and Britain, may be a case study.