There are many flaws and ways in which GDP, Gross Domestic Product, can mislead us in estimating the size of an economy.  Michael Pettis of China Financial Markets uses China to illustrate how two factors can easily overstate a country’s true GDP.  The first way is environmental degradation.  GDP doesn’t count it, yet is definitely an impoverishment of the nation that should be offset against the enrichment that GDP represents. The second way is malinvestment. Malinvestment is when investment spending occurs (Investment spending adds to GDP), such as construction, but the investment is in poorly chosen assets that will not be needed later.  An example closer to home of malinvestment would the large tracts of new housing construction built between 2000-2006 in the deserts around Las Vegas and Southern California. At the time, the construction added to GDP as Investment spending (I). But much of the housing was never used or occuppied – we didn’t need it and now have write it off as loss.  Michael explains the possibility that Chinese GDP might be overstated:

What if China’s GDP numbers seriously overstate the true value of China’s economy?There are at least two very good reasons to believe that they might.  The first is environmental degradation.  To understand why, it is worth remembering that if an individual earns $100, but in so doing destroys $100 worth of his own assets, then a strict accounting would say that he earned nothing.

The same is true with the environment, which has a real economic value that can be adversely affected by certain kinds of economic activity.  For example here is an article that came out four months ago on Bloomberg:

China, the world’s worst polluter, needs to spend at least 2 percent of gross domestic product a year — 680 billion yuan at 2009 figures — to clean up 30 years of industrial waste, said He Ping, chairman of the Washington-based International Fund for China’s Environment. Mun Sing Ho, a senior economist at Dale W. Jorgenson Associates and a visiting scholar at Harvard University in Cambridge, Massachusetts, put the range at 2 percent to 4 percent of GDP.

Failure to spend that much — equivalent to the annual GDP of Vietnam — may cost the Chinese economy half as much again in blighted crops, health costs and pollution-related expenses, He said: “The cleanup can’t catch up with the speed of pollution” if spending is less.

This article suggests that a significant portion of Chinese growth came with a destruction of value that should have been deducted from that growth.  After all, if you create net $100 of chemicals, but in so doing you pollute a nearby river to the extent that future economic production associated with the river is reduced by $100 (there will be less fishing, perhaps, or less agricultural production, or less usable water, or more health care costs), then the net value you created is 0, not $100, although of course you as the polluter might earn $100 today while the rest of the country loses $100 over the future.

There is no objective way to figure out how much of Chinese GDP growth should be reversed because of environmental degradation (and in this China is simply an extreme case – most countries to a lesser extent have this problem), but there is no question that the number is big, and the result is that we overestimate China’s GDP growth today and will underestimate GDP growth tomorrow.  In other words environmental degradation simply causes us to take future growth and count it today.

And it is not just environmental degradation that may require a downward adjustment in GDP.  What about misallocated investment?  Doesn’t that do the same thing?

Of course it does.  If you invest $100 today to create only $80 dollars of value, you will show an increase in today’s GDP that is lower than the reduction in tomorrow’s GDP as you pay the capital cost of the investment.  In that case if you really wanted GDP to account for changes in a country’s wealth, your investment should have shown up as an actual reduction in today’s GDP.  This means, once again, that you would overstate growth today and understate it tomorrow.

Every country wastes investment, but China does it on a massive scale.  I would argue that at least 1-2 percentage points of Chinese growth, perhaps even more, might consist of this kind of misallocated investment-driven growth.

When you add the impact of misallocated investment and environmental degradation, the necessary cumulative adjustment to Chinese GDP might be huge.  For example, if the two adjustments combined range from 2 to 4 percentage points annually, over one decade China’s “true” GDP (whatever that means), would be below the official numbers by anywhere from 16-31%.  Over twenty years official GDP would be overstated by 31-52%.  That means that we are massively overstating GDP today and will experience very low apparent GDP growth for many years in the future as the official number returns to some reasonable approximation of the real number.

These are big adjustments, both above and below the official GDP numbers.  This is why I find the whole horserace to predict the earliest date by which China’s economy will overtake the US to be so silly.  What we are in effect doing is predicting the date by which an economy that is officially $6 trillion, but in reality anywhere from $3 trillion to $15 trillion in size, will overtake another economy that is roughly around $15 trillion in size.

And this is not the first time we have played this game.  Look at Japan.  Fifteen to twenty years ago Japan’s GDP was officially 17-18% of the world’s GDP and it was rapidly catching up to the US.  Today it is 8%, and there seems to be no chance of it every catching up.