What's in a number?

People are often sceptical about how anybody can measure the GDP of an economy taking into account the incredible variety of activities going on, and the prices that consumers pay for them, not to mention the fact that so many activities are not even recorded. Yet, with all these and more difficulties, GDP has become the least objectionable way to assess the performance of an economy. It is, clearly, the best among many conceivable alternatives and its utility is enhanced by a continuously evolving set of protocols and standards, which reduce the room for subjectivity and arbitrariness. The System of National Accounts, which codifies these standards, is similar to systems of Generally Accepted Accounting Practices, which provide reliability and comparability to corporate financial reporting.

But, as complicated as it is to measure aggregate activity within an economy, the difficulties multiply when anyone tries to compare performance across economies. The simple expedient of normalising the GDP of all countries to a single currency by adjusting for the exchange rate has obvious limitations because the observed exchange rate itself does not reflect the relative prices of comparable goods and services in the two countries. It is distorted by both policy and, increasingly in today's global environment, capital flows. To deal with the problem of comparability, the World Bank initiated the International Comparisons Project in the early 1980s, which resulted in the so-called Purchasing Power Parity (PPP) exchange rate system. Under this system, the exchange rate was measured by the ratio of the amounts of local currency that it took to buy an identical basket of goods and services in each country. Today, inter-country comparisons of GDP are routinely made using PPP exchange rates, on the basis of which China and India emerge as the second- and fourth-largest economies in the world, with the former set to overtake the US to attain first position in the coming few years.

However, like the measurement of GDP itself, the PPP exchange rate system has been subject to criticism. It is difficult to construct "identical" baskets across countries, given the high proportion of non-tradable goods and services in a typical consumer's spending pattern. From a more practical perspective, recent comparisons have perhaps been diluted by the obsolescence of the current PPP measurements. The World Bank is engaged in an exercise to update the system to reflect the very significant changes in both consumption baskets and relative prices since the process began. The new numbers, expected next year, may change the international rankings of economies, but then again they may not. Meanwhile, it is interesting to see how attitudes to the PPP concept have changed, along with economic conditions. When it was initiated, many countries dismissed it as a conspiracy by the multilateral institutions to deny them their fair share of concessional assistance by artificially inflating their GDP and per capita income. Now, the battle seems to be for bragging rights; whose economy is the biggest? For example, a recent study by a researcher from the Carnegie Endowment for International Peace estimates that the Chinese economy is actually 40 per cent smaller than the current PPP estimates, because domestic prices are not being correctly measured. If so, this would keep the US in first position for several more years. Is it India's turn next?