The economics profession underwent a revolution in December last year, as economic understanding of the world suddenly shifted.
Suddenly the world has more poor. Incomes declined in emerging economies: down by 40 percent in China and India, 17 percent in Indonesia, 41 percent in the Philippines, 32 percent in South Africa and 24 percent in Argentina. For Indonesia, the decline was far worse than the Asian crisis, and for China and India, the decline was worse than the one experienced by Germany during the Great Depression. Yet hardly anyone noticed.
The event was the release of new estimates of purchasing power parity, or PPP. Measured as part of a large international endeavor called the International Comparison Program, PPP aims to accurately calculate a country’s economic power rather than simply dividing total national output by a country’s population.
As every tourist knows, prices of goods and services differ widely between the countries. Poorer countries generally have lower price levels. A nice dinner, a haircut or a concert ticket, using market-exchange rates, cost much less in China or India than in the US or Norway. But the good or service is the same and, in principle, must be valued equally. The objective of the project is to compute difference in price levels, so that each unit of consumption can be valued the same, regardless of where it’s consumed. Only then can true output and welfare differences between the countries be assessed.
Measuring price levels is an immensely complicated project that involves detailed reporting of more than 1000 prices of goods and services in almost 150 countries. A project of this magnitude has never been undertaken before. The most similar project took place in 1993, including data for about 100 countries and a limited range of goods. More importantly, the 1993 survey did not include China, which officially participated for the first time in the 2007 report, or India, which had participated since 1985.
The recent data include not only China and India, but countries that include 95 percent of world population and about 99 percent of world output. The list of surveyed goods and services was augmented, the methodology improved and 146 national statistical agencies collaborated along with international bodies including the United Nations, the International Monetary Fund, the World Bank, Eurostat, the Economic Commission for Latin America, Asian and African Development Banks and others.
Price comparisons are important for at least two reasons:
First, they provide so-called PPP exchange rates, that is, in principle, with one PPP dollar, one can purchase the same bundle of goods and services in all countries. For example, with 100 PPP dollars, I would be equally well off in India and the US, even if that may involve only 30 “real” greenback dollars in India and 100 greenback dollars in the US.
Second, by using these exchange rates, we can convert incomes expressed in local currency and obtain “true” gross domestic product (GDP) per capita, reflecting real welfare and productivity of citizens. All inter-country comparisons, including poverty rates, depend on PPPs. When we say that one-third of the population in India lives at incomes below $1 a day, that one dollar a day is a PPP-converted dollar a day.
For modern global economics, PPP is like oil. One cannot move far without a method of comparison. So on December 17, 2007, this most detailed study of the world economy ever undertaken issued the conclusion that price levels in most Asian countries – in particular India, China, Indonesia and the Philippines – are much higher than assumed by economists, based on the outdated 1993 results. Not everybody’s GDP per capita declined. Incomes in some countries – Russia, Nigeria, Egypt, Lebanon – increased, but the increases were more modest than the declines. For the rich countries, the revisions were minimal, falling within the 2 to 4 percent range.
These new estimates will have far-ranging consequences. Literally hundreds of scholarly papers on convergence or divergence of countries’ incomes have been published in the last decade based on what we know now were faulty numbers. With the new data, economists will revise calculations and possibly reach new conclusions.
With the study’s release, our view of the world has changed. While economists previously thought that US GDP per capita was 6 or 12 times higher than that of China and India, respectively, these numbers have been revised to 10 and 20 times. Until last month, economists thought that China accounted for 15 percent of world economy; it’s now revealed to represent less than 10 percent.
In its December forecast of 2008 global economic growth, the IMF took account of the new numbers, lowering its projected global growth rate by one-half of a percent because high projected growth rates of China and India will pose less of an overall impact. In other words, China’s expected growth of 10 percent will add only about 1 percent to global output rather than 1.5 percent.
These new results may, somewhat paradoxically, help the case of India, China and other poorer countries in having the International Monetary Fund accept using PPP-adjusted GDP to calculate countries’ quotas, which determine voting rights and the ability to borrow from the fund. The new results show that moving to PPP-adjusted GDP does not entail a change as huge as earlier thought, and the rich countries may be more willing to accept it.
Implications for the estimates of global inequality and poverty are enormous. The new numbers show global inequality to be significantly greater than even the most pessimistic authors had thought. Until the last month, global inequality, or difference in real incomes between all individuals of the world, was estimated at around 65 Gini points – with 100 denoting complete inequality and 0 denoting total equality, with everybody’s income the same – a level of inequality somewhat higher than that of South Africa. But the new numbers show global inequality to be 70 Gini points – a level of inequality never recorded anywhere.
Similarly, until last month, the number of people living at less than $1 PPP per day was estimated at just under one billion. The call to action issued at the Davos World Economic Forum still speaks of “980 million people who live on less than 1 dollar a day.” But this was based on old estimates of price levels. Now, we know that the price levels in these and many other poor countries are higher, and the measured number of the poor will jump.
The most famous set of estimates of countries’ historical PPP-adjusted GDP, made by Angus Maddison, is based on the old data. Maddison’s numbers, the only data series of GDP per capita that include practically all the countries in the world, providing estimates for most as far back as 1820, is extensively used by econometricians and economic historians. Its revision will be massive. Much of what we think we know about comparative economic history will be reexamined.
Like in any revolution, the effects will take time to settle, and it will be several years before a consistent and standardized set of GDP numbers emerge. Only when the magnitude of this revolution sinks in will we see the beginning of far greater concern about the true outcome of global economic growth we celebrate. Again as with every revolution, we at least know that we are already living in a different world.
Branko Milanovic is a lead economist in the World Bank's research department and an associate scholar with the Carnegie Endowment for International Peace.
Reprinted with permission from YaleGlobal, a publication of the Yale Center for the Study of Globalization. Copyright © 2008 Yale Center for the Study of Globalization.