According to new figures issued this week by the World Bank, estimating the Gross Domestic Product for countries across the world, the rankings of major economic powers are in for a shake-up.

The new numbers show that China has nearly caught up to the US in economic output; in 2012 its GDP was already over 75% as large as America’s.  If current growth rates are maintained (7.5% per year for China, 2% per year for the U.S.), then China’s economy will surpass that of the US in six years, becoming the largest in the world. India, according to the new figures, had already become number 3 by 2012, bypassing Japan!  Russia, despite its problems, jumps up to become the sixth largest economy in the world, Brazil is at number 8, Mexico at number 11, and Turkey is at number 15, right behind Canada (thus making Turkey’s goal of becoming a top 20 economy a reality). Even more surprising, Iran comes in at number 18, despite sanctions, ahead of Saudi Arabia, and Egypt in 2012, despite its problems, shows up as the 24th largest economy in the world.

Fascinating — but are these numbers believable? This is just one ranking, and an alternative ranking, also from the World Bank, shows very different numbers.  The numbers above are based on comparing economies at Purchasing Power Parity (PPP), adjusting the entire economy for the relative purchasing power of their currencies to buy goods and services in their own economy.   A different ranking arises if we use a measure based on current exchange rates (e.g. how large is the Chinese economy if it’s total output in renminbi was converted to dollars).    One way to think of this is that if China were to sell ALL the output of its economy to American buyers making their purchases in current dollars, how much of the U.S. economy would it be able to buy with the money it raised by selling ALL of its output of goods and services?

In this current exchange rate approach, China’s economy is not 75% as large as America’s, but only 51% as large.  With that ranking, at current growth rates (same as above), it would take 13 years for China to surpass America’s economy; and if China’s growth rate should drop from 7.5 percent per year to average 6 percent per year over that period, it would take 18 years to catch the U.S.   So the U.S. is not really in danger of becoming #2 in the next decade, or perhaps even two, by this measure.  Moreover, in this mode of measuring economies, India’s economy is not larger than Japan’s, but only 30% as large;  Iran shifts from being roughly the same size economy as Australia to being only one-third as large; and Egypt drops to 39th, just behind Israel, whereas in the PPP rankings Egypt’s economy is twice the size of Israel’s.

Clearly, it makes a HUGE difference in comparing economies whether we assess them in PPP terms or in current exchange terms.  Many economists seem to prefer PPP estimates today.  They say this is because currency exchange rates can fluctuate wildly from year to year and even month to month — for example, the Russian ruble sank by 10% compared to the U.S. dollar in the last six months; would you then want to say that the entire Russian economy shrank by 10% relative to the U.S. economy?   Exchange rates can also be manipulated by governments, holding them lower or higher for extended periods.  That is true.  Yet I think that using PPP adjusted figures is the wrong way to compare economies as a whole.

Let us use the example of Russia.  If sanctions cause capital to flee and the ruble to sink, that IS real economic pain.  It may not change what Russians can buy inside Russia with rubles that much (although inflation has undercut that a bit).  But it immediately affects what Russia can buy on the world market with its own resources.  And that does suggest an alteration in its relative economic strength as a nation compared to others.

PPP adjustment takes into account the local costs of goods and services.  So, for example, if a Chinese household needs to buy 10 kilos of rice each week to feed the family, how do we value the income used for that purchase in GDP, versus what an American would pay for that much rice in America?  If we just added it up in current prices, and locally produced rice in China is very cheap, because labor and land are much cheaper than in the US, we would say that 10 kilos of rice consumed in China has much LESS value for GDP than 10 kilos of rice consumed in America.  The same for anything else.  For example, a nice apartment in Guangzhou costs a bit less than a similar apartment in San Francisco; so do we add all the housing costs up and say that housing consumption in Guangzhou is less than in San Francisco even if people have equivalent homes, just because real estate prices in San Francisco are higher?   In other words, PPP adjusted figures try to give GDP in terms of the things people actually have, the physical goods and services people buy each year.  So the PPP adjusted figures tell us that in 2012, the total amount of steel, cement, housing, rice, cars, meat, copper, even smart phones and laptops, actually purchased in China was about 75% of the value of the physical commodities and tangible services purchased that year in the U.S.

Now to my mind, that kind of PPP adjustment is valid, even essential, if we are comparing living standards across countries.  That is, if a Chinese household has a four-bedroom apartment, buys 10 kilos of rice and 3 kilos of meat each week, has a car and takes an international vacation, we want to compare that level of consumption with levels of consumption of households in other countries — regardless of whether the prices of rice and meat and apartments and cars in China is lower or higher than in other countries.  We would want to somehow adjust out price fluctuations and differences in price levels to get at actual consumption, and that is exactly what the PPP adjustment does.

However, when you use that adjustment to measure the consumption of entire nations, major distortions creep in.  After all, while you can compare the consumption of households, nations have VERY DIFFERENT kinds of consumption.  For example, in China today, fully one-half of GDP is investment, bulk purchases (often by government owned or backed companies) of steel and cement and copper and earth-moving and construction equipment to build cities, train lines, and power stations.  In most other countries, investment is a quarter or less of the economy, and consumer consumption is far greater.  So how do you assess the precise mix of goods and services and adjust for the amount and quality of goods that people are actually buying?

The answer is that you usually don’t.  Instead, PPP adjustments are based on a standard basket of commodities and services that is supposed to mirror what most people in the economy consume.  But as economies change and consumption patterns are altered, very VERY big adjustments in PPP corrections are sometimes required.

In 2007, the World Bank suddenly decided it had the consumption bundles in China wrong, and that consumption in an increasingly urban and expensive China was greater, and local prices not generally as low, as it had thought.   So it adjusted China’s PPP measured GDP downwards by 40%.   When compared to the U.S., the adjustment meant that China’s GDP fell from 71% of the US to 43% — a similar adjustment today would again set China back compared to the U.S.

Of course, when you visit any of China’s major cities today — Beijing, Shanghai, Guangzhou, Shenzen — the fancy restaurants, elegant apartment towers, endless ring roads filled with cars, and vast shopping centers filled with quality goods scream that China has caught up with the West.  And it has, at least in the better areas of the major coastal cities.  But that is only a slice of China’s economy and society; and for two-thirds of Chinese, living standards remain much lower.   Whether the overall size of China’s economy is really 50% or 75%  as large as America’s depends on how you value the consumption of that other two-thirds of China; at consumption in local prices at international exchange rates, which are low, or in consumption at prices adjusted for local purchasing power, by which the value of their consumption is much higher.

But perhaps more important is the PPP adjustment for countries like Iran and Egypt — is the former really as large an economy as Australia?  Or the latter really twice as large an economy as Israel’s?   Here the PPP scaled GDP figures make much less sense.

What the PPP adjustments inevitably do is raise the value of daily food and clothing consumption by poor people consuming local products.  In poor economies, food and clothing and most housing is much cheaper than the same items would be in rich industrial economies.  So in international exchange terms, the value of mass consumption by vast numbers of poor people doesn’t count for much.  All the rice consumed by the 1.3 billion people in India, valued at the cost of rice in India, isn’t a huge number in international value terms.  But if you raise the value of that rice consumption to an adjusted figure, say to what the cost of rice would be in Japan, then the value of India’s total consumption shoots up and surpasses the value of Japan’s economy.  By contrast, small but rich countries generate a lot of goods that have high values on international currency exchange markets — the cost of a Nikon camera is high in Japan, Hong Kong, or America, and so where a lot of fancy cameras are consumed, PPP adjustments are small.  But when we are talking about local goods like rice or cotton shirts, which are very much cheaper in local markets in poor countries, the adjustments are quite large.

So large countries with low income per capita and lots of consumption of locally produced and priced goods tend to benefit a lot from the PPP adjustments — Iran and Egypt, for example.  Small countries with high income that consume lots of internationally-priced goods, like Japan and Israel, have small PPP adjustments and thus fall behind larger poor countries when the PPP adjustments are made.

So what is the best measure of reality?  Will China have another major downward adjustment of its PPP-adjusted GDP when the Bank again assesses the complexity and consumption baskets of the country, as happened in 2007?   I should point out that adjustments can also go the other way.  Nigeria this year recorded an 89% increase in GDP — not by any magical super growth, but by rebasing its GDP measurements in current prices, to take better account of production of services, communications, electronics, entertainment and other items that were virtually absent from its GDP index in 1990 when it was last revised.  But that adjustment had no effect on the living standards of the tens of millions of Nigerians living in desperate poverty!

So my advice is: Take all GDP measures with caution.  To compare the real-world power of global economies for nations as a whole, take the GDP in current international exchange rates.  Yes, currency exchange rates fluctuate and can be manipulated, but this is a better measure of an economy’s ability to produce and purchase high-value internationally traded goods and services, whether it is oil, iron ore, and copper or airplanes, cameras, and computers.  But to compare the standard of living of households in different countries, use the GDP/capita measures in PPP adjusted terms, to get more closely at actual consumption levels.  But use caution here too, and look at poverty levels, infant mortality, and income inequality to get a better sense of whether the average GDP/capita is misleading as to how people are faring.

Confusing?  Yes.  But imagine your country’s GDP was suddenly adjusted up by 89%, or downward by 40%, overnight.  You would wake up, and nothing would be changed — except the rank of your country is some tables published by international agencies.  So keep a look out, and remember there are lies, damn lies, and statistics.