Bad math makes China's GDP No. 1

The International Monetary Fund has just reported that China, not the US, is now the world's largest economy. This announcement comes a few years earlier than expected, due to a revision in the IMF's estimate of average prices in China. Chinese inflation, it seems, hasn't been as high as we thought, meaning that more of the nation's growth has been real.

There are plenty of doubts surrounding the Chinese figures, of course. The latest price survey might be just as inaccurate as the earlier ones. Chinese provincial gross domestic product figures are notoriously overstated by job-seeking officials. And the calculation the IMF uses to adjust for price differences, called purchasing power parity, contains a lot of assumptions - using market exchange rates, the US still has the biggest economy.

So when I clicked on a Quartz article entitled Nope, China's economy hasn't yet surpassed America's, I expected to see these concerns highlighted. Instead, what I found was that the usually reliable and perspicacious China-watcher Gwynn Guilford had bought into a dodgy theory being promulgated by the renowned Beijing University professor Michael Pettis.

Pettis's theory, in a nutshell, is that bad investments shouldn't be counted in GDP. Here's how Guilford puts it:

Say a business borrows $100 and invests it in a new factory. The factory, however, only creates $80 in value, leaving the company short $20…Pettis suspects that…China isn't recognising this bad debt...

So instead of writing down the loss or making the business cough up that $20, a Chinese bank will defer the debt payment - called "rolling over" the loan - to the Chinese company...

That means that not only does the $20 loss never show up in China's GDP calculations; but the $80 that the factory created does get counted. And presto-$100 of GDP points that really aren't there.

First of all, this gets the accounting wrong. If Johnson & Johnson spends $100 on a shampoo factory in Pennsylvania, we count that $100 toward GDP. If the factory then produces $100 of shampoo, we also count that toward GDP. Consumption and investment are both part of GDP. No dodgy accounting there.

But suppose the Pennsylvania shampoo factory never produces any shampoo. Does that mean we shouldn't count the $100 that the company spent to build it in GDP?

No. We can't know how productive the factory will be in the future. If we could know that with certainty, investments wouldn't be risky in the first place! That's why we count only current production in GDP, instead of our estimates of future production.

What Pettis is suggesting is that we change the whole way we measure GDP. He wants us to use the discounted present value of assets - in other words, a guess about the far future - as our GDP measure. In other words, he thinks true GDP ought to be a measure of wealth creation rather than a measure of current production.

That's a seductively attractive idea, especially in the US, where we were so recently rocked by a housing bubble. There is an understandable urge to look at the ghost towns created by that episode of malinvestment and conclude that the growth of the mid-2000s was an illusion. There is an understandable urge to see the same thing happening in China, and conclude that its GDP isn't real.

We must resist that urge. If economists start trying to subtract perceived malinvestment from GDP, then estimates of GDP will vary wildly from economists to economist, based on how big each one thinks the bubble is. For example, suppose it's 2007 and I think most of the houses that are being built will eventually be occupied, but you believe that most of them will stand empty and eventually be demolished. If we do what Pettis recommends and subtract our subjective estimates of the percentage of future unused housing from GDP, then you and I will come up with two different GDP numbers!

It's easy to see where this leads. Pretty soon, we'll have no idea how big our economy is, or how fast it's growing. Even if a bubble pops, the uncertainty won't be resolved; after all, what if construction starts up again in a ghost town a few years later?

Investment bubbles are a little like the French Revolution - as Zhou Enlai is reputed to have said, it will always be "too early to say" what the true impact is. We shouldn't change the definition of GDP into something unusual, just to give ourselves a false reassurance that the Chinese economy is still smaller than ours.

Because the truth is, China's economy will be larger than ours. Maybe it's already larger, or maybe it will be in a few more years. But since China has more than four times as many people as the US, it would take an astonishing catastrophe to stop it from becoming No. 1.

The author is a Bloomberg View contributor