We’re Number 2: What Happens When China Surpasses the United States as the World’s Largest Economy?

On April 30, a Financial Times article cited new calculations from the World Bank’s International Comparisons Program (ICP) predicting that China is poised to surpass the United States later this year—far earlier than the previously predicted 2019—to become the world’s largest economy. The projections calculate economic size (i.e., gross domestic product, or GDP) based on purchasing power parity (PPP), which more accurately estimates the real cost of living and relative purchasing power of income (as compared to calculations based on market exchange rates) across nations. The ICP figures, updated for the first time since 2005, suggest that by 2011 China’s GDP had reached 87 percent of U.S. levels (up from 43 percent in 2005) and is on course to surpass U.S. GDP sometime in late 2014.

(It should be noted that purchasing power parity comparisons are notoriously unreliable—as this large revision itself shows—although they are generally the best estimates we have. However, because PPP rates show the real costs involved in an economy, they do a good job of comparing actual amounts of economic activity. For example, in terms of economic measurement, a haircut should count for roughly the same amount of economic activity no matter where it takes place, but using market exchange rates a barber in the United States appears to contribute far more economic value than a barber in China. Market exchange rates can also fluctuate rapidly and are subject to many non-market forces.)

Nevertheless, some have argued that not only is the news that China is set to surpass the United States not concerning, but that it actually represents good news. For example, in the Washington Post, Charles Kenny writes that America is No. 2! And that’s great news, arguing that “losing the title of largest economy doesn’t really matter much to Americans’ quality of life,” particularly because it is America’s superior per-capita GDP that matters more than aggregate GDP, and so “living in an America that ranks second in GDP to China will still be far, far better than living in China.” While certainly Kenny is correct that average per-capita GDP is the proper measuring stick, there are actually a number of compelling reasons why China’s impending eclipse of U.S. GDP does not represent the sanguine moment Kenny characterizes it as.

For one, as the United States loses the global economic pole position, it will wield relatively less influence over international affairs and the global economy, constraining America’s ability to shape the global economic system on terms most favorable to us. America will be less effectively able to advocate for a global, multilateral rules-based trading system that expands market-driven trade as a key driver of increased global innovation. As ITIF writes in Designing a Global Trade System to Maximize Innovation, several conditions must exist for innovation to flourish in the global economy, including access to large markets, no excess competition, and protection of intellectual property (IP). The United States has played an important role in pushing back against several countries’ “innovation mercantilist policies” that have introduced market balkanization that limits scale economies, induced excess competition that can reduce innovation, or failed to protect the IP behind innovative products and services, profits from which innovative enterprises depend upon to finance future generations of innovation. As the world’s second largest economy, the United States would be less able to facilitate a global trade system maximally fostering innovation. This effect only worsens if the global economic rebalancing (the report also found India to now be the world’s third-largest economy) results in the United States and other like-minded pro-market/liberal trade countries losing influence in global institutions such as the World Bank, World Trade Organization, and International Monetary Fund, institutions that should be playing a key role in combatting countries’ innovation mercantilist practices.

Further, a nation’s defense prowess is fundamentally predicated upon its economic power. As America’s ability to field the world’s leading economy slips, so will its ability to field the world’s leading military. That’s been made clear recently as budget travails in the United States have led to spending cuts at the Pentagon. But as ITIF writes in Both Guns and Butter? New Study Shows Innovation Benefits from Military Procurement, the United States’ historical leadership in technology development—which has brought significant economic benefits to the nation—has resulted in large part from generous federal government funding for research and development activity (R&D), much of it channeled through military spending. Put simply, military investment in technology has been substantial and therefore any cuts to military spending negatively impact the overall U.S. innovation system. In other words, not only does faltering economic growth constrain investment in a robust defense, it also imperils investments in the leading-edge, pre-commercial R&D activity that has been a critical part of the U.S. innovation ecosystem.

To be sure, Kenny and others are correct that China’s economic rise need not be seen reflexively in zero-sum terms as a wholly undesirable eventuality for the United States. That might be true and it would be one thing if the U.S. economy were performing quite strongly and the reason the United States started to slip behind China was that its economy was performing even better as it radically bolstered its competitiveness by embracing productivity-enhancing and innovation-promoting policies while it played by the rules of the global trading system and eschewed use of innovation mercantilist practices such as currency and standards manipulation, IP theft, and localization barriers to trade. However, it’s quite another when China’s economic growth has stemmed in significant part through mercantilist practices that distort the global trade system, inflicting significant damage on the U.S. and other-third party economies, such as India’s. In fact, the very fact that China’s PPP exchange rates differs so much from its market exchange rate is likely due in part to its strong capital controls and currency manipulation.

And it’s quite another when this news presents just one more piece of evidence demonstrating America’s sub-optimally performing economy.  In other words, it’s one thing to be surpassed if we are in fact running as fast as possible, it’s quite another to be left in the dust when we are in fact staggering along, gasping for breath, hearkening back to the good old days when we are far out in front.

In fact, news that the United States will slip to the second-largest economy fits hand-in-hand with new research from the New York Times finding that the American middle class—long the most affluent in the world—has also ceded that distinction. The Times research finds that after-tax middle-class incomes in Canada have likely surpassed those in the United States. This is no surprise when, as ITIF wrote in its book Innovation Economics, the United States ranked just 17^th out of 21 major economies assessed in growing GDP per capita (using PPP) over the prior decade. In fact, U.S. median per capita income was virtually unchanged during the 2000s (after adjusting for inflation). This even as the New York Times finds that, “citizens of other advanced countries have received considerably larger raises over the last three decades” and notes that during the 2000s median per capita income grew 20 percent in Canada and the United Kingdom and 14 percent in the Netherlands. This also coincides with growing income inequality in the United States, as recently documented by the Congressional Budget Office.

Americans can simply no longer take it for granted that it’s their birthright to live in the world’s leading economy. If the United States is to restore long-term, sustainable, broadly shared economic growth, it will need to introduce a comprehensive package of tax, technology, talent, and trade (the “4Ts”) reforms, as ITIF details in its Winning the Race memos. That the United States has held the title of the world’s largest economy for the past 142 years hasn’t been a simple accident of history. It sprung to a considerable extent from proactive policies that developed a continent-wide competitive marketplace, invested heavily in both basic and advanced education, and cultivated an effective national innovation ecosystem that spawned the development of new technologies and ultimately enterprises and industries that propelled U.S. economic leadership for at least the past half-century. That China should have the world’s largest economy is no more inevitable than that the United States should; it’s a product of the policies that leaders implement to shape the competitive capacity of their economies. And if China were destined to by definition have the world’s largest economy because it has the world’s largest population (and India the second largest), then why hasn’t that always been the case?

The day in 1872 the United States passed the United Kingdom to become the world’s largest economy marked the last day the British economy ever led the world. The United Kingdom never got that title back. The United States shoud not look forward to or relish the day it no longer has the world’s largest economy. In contrast, it should contest for that leadership position fiercely, and do all it can to prevent, or at least postpone, losing that status.