The usual way we look at the global economy uses market exchange rates, and the US clearly emerges as the world’s largest economy. But there is a more three-dimensional way of viewing today’s world and from this perspective, China is now the world’s largest economy, having overtaken the US around 2016.
I was once shown an annoying book called Magic Eye by a six-year-old. In it were a collection of kaleidoscopic images which otherwise meant absolutely nothing to me. They reminded me of those Ishihara tests for colour blindness or perhaps one of Georges Seurat’s pointillism paintings.
But that all-seeing six-year-old could see Shrek, Darth Vader and Thomas the Tank Engine. Eventually, via a cross-eyed squint, I too saw the images. And yes, what emerged were indeed three-dimensional images of the aforementioned characters. It was a startling revelation!
My sense is that the global economy today is somewhat analogous to one of those Magic Eye pictures. The usual way we look at the world today tells us the US is its largest economy. I call this perspective “viewing the data through the ‘Atmosphere of Capital’ (AoC)”.
This method uses market exchange rates, and as a result the US clearly emerges as the world’s largest economy. But, like looking at one of those Magic Eye images, there is a more three-dimensional way of viewing today’s world and measuring its economic statistics: I call this via the “Atmosphere of Trade” (AoT). And here the currency that is used is purchasing power parity (PPP). From this perspective, China is now the world’s largest economy, having overtaken the US around 2016.
I realise that many South African readers breathe only the AoC: often their job mandates them to do so, and their everyday lives and economic well-being seemingly depend upon it. And I am not in any way disputing the fact that this AoC approach still rules global finance.
But not seeing the world from that other perspective – via the AoT – may blind one to the New World arising and thereby leave one unprepared for when it does.
(As an aside, of all the emerging markets I have visited, only Argentina, Lebanon and Zimbabwe are more dollar-fixated than South Africa. But we still have some way to go; Johannesburg house rentals are not yet US dollar-denominated as they are in Buenos Aires, Beirut and Harare. Of course, this country list does not include those who have gone the whole hog and dollarised completely, notably Ecuador, El Salvador and Panama.)
So large is the US budget deficit that, in 2023 and again with only 4.2% of the world’s population, the US accounted for more than 42% of all budget deficits worldwide.
There are many consequences of these two perspectives. Those breathing the AoC usually cite – appropriately – the market value of America Inc first. During January 2024, the US weight in the MSCI All Country World Index for equities rose to more than 70%, leaving the rest of the world at under 30%.
For proponents of this AoC perspective, this is a “game, set and championship” point all in one: to them, PPP is but fantasy money. And, accepting the two-dimensional perception of the AoC, their argument is indisputable. Reinforcing evidence would be that the US has the world’s largest military budgets and many of its richest men (even if Elon Musk is no longer the richest of them all!).
But there is an aspect to all these measures that we take for granted: they are all denominated in the US dollar and so the value it represents against other currencies.
Understanding the mechanics of how the US dollar is valued reveals the Achilles heel of America.
Last year, the US – with 4.2% of the world’s population – ran more than 50% of its current account deficits. That shortfall was financed through broadly matching inflows on its capital account. Result? The US dollar held its international value. But without the privilege of possessing “the world’s reserve currency”, the value of the US dollar would likely have fallen.
And where did those foreign capital inflows go? Looking at the long-term trends captured in the Treasury International Capital System (TICS) data, overwhelmingly into the US fixed income market, with far less into the US’s celebrated equity market. In the latter, and on a net secular trend basis with occasional positive fluctuations (such as November 2023), the degree of foreign investor enthusiasm has actually been declining since 2014.
No matter; ballooning US budget deficits over the past 15 years have provided ample Treasury paper for foreign investors to park their surplus cash. It seems that, for this “checking account facility”, foreigners far prefer the US public sector over its private sector.
Just how large these US budget deficits have become and the quantum of aggregate national debt they leave behind needs highlighting. Forgive the forthcoming number deluge but grasping the scale is critical.
The annual deficit to the end of fiscal year 2023 (September 2023) was 6.3% of GDP; the first quarter of fiscal 2024 (to December 2023) saw a shortfall of $510-billion, suggesting the deficit might rise to 7.5% of GDP in the current fiscal year, 2024. Not since World War 2 – and never in peacetime and doubly so not when near “full employment” has prevailed – has such US government profligacy been recorded.
In the 16 years since 2008’s global financial crisis, US debt has quadrupled from $8-trillion to more than $34-trillion. The outcome is that intragovernmental debt holdings are $7.1-trillion (21% of total) and debt held by the public (DHBP) $27-trillion (79%). Of the DHBP, foreigners own $7.6-trillion (22% of total or 28% of DHBP).
So large is the US budget deficit that, in 2023 and again with only 4.2% of the world’s population, the US accounted for more than 42% of all budget deficits worldwide. Another metric measured in a global context is that the US owns 34% of all the world’s sovereign debt in issue.
In 2023’s hottest area – AI – China leads in four out of six of its subsectors. In the two where the US still leads... its advantage over China is marginal.
With DHBP currently 98% of GDP, the Congressional Budget Office’s (CBO) most recent forecast sees it rising to 110% by 2030. The CBO also forecasts nominal GDP in 2030 to be $35.5-trillion, implying a 2030 $39-trillion total debt burden, an increase of $1-trillion per annum every year from today’s $34-trillion. These CBO forecasts (made only in June 2023) already flatter to deceive: last year’s deficit was $1.7-trillion while this year’s is heading towards $2-trillion.
The January 2024 update from the US Committee for a Responsible Federal Budget (CRFB) has DHBP rising to 125% of GDP by 2030 (its median forecast). With a GDP of $35.5-trillion, this implies total debt at $44.4-trillion, up from today’s $34.1-trillion. This means $10-trillion over six years equating to about $1.7-trillion per annum. Again, this is likely too optimistic as it only matches 2023’s outcome and assumes no growth from this base!
Only their pessimistic scenario – DHBP at 130% by 2030 or a total of $146-trillion – would equate to a deficit increase of $2-trillion per annum. But this assumes no increase from 2024’s projected base: looking back six years, to 2018 and so pre-Covid, the US’s budget deficit was $779-billion and so only half of what it is today.
Two trillion here, two trillion there and soon you are talking real numbers!
I was much struck by a conversation in January 2024 between Jamie Dimon, CEO of JPMorgan, and Paul Ryan, former Republican Speaker of the US House of Representatives; it occurred at the Bipartisan Policy Center.
If this runaway federal deficit was not reined in, Dimon predicted a US bond market rout: “When it starts, markets around the world – by the way, because foreigners own $7-trillion of US government debt (latest estimate $7.6-trillion) – there will be a rebellion, and that is the worst possible way to do it. It is a cliff, we see the cliff. It’s about 10 years out.”
Ryan agreed: “This is the most predictable crisis we’ve ever faced.” (I am less optimistic about this time frame. In particular, Donald Trump’s re-election would likely fast-forward it. CRFB estimates the former president added $8.4-trillion to the deficit (25% of the $34-trillion total) including the trailing effect of his much-vaunted middle-class tax cuts.)
Were this “most predictable crisis” to materialise, the fragile equilibrium that underpins global finance would be shattered. Congress shows no signs of addressing the ballooning budget deficit issue, with Democrats hell-bent on raising Federal spending and Republicans similarly hell-bent on not raising and preferably even cutting taxes.
January 2024’s “Tax Relief for American Families and Workers Act” – agreed by both sides of the House in a 357-to-70 vote – will cause the budget deficit to rise a further $78-billion: the Democrats got childcare credit for their electoral base; the Republicans got corporate tax breaks for theirs.
Were Dimon’s bond market rebellion to happen, the risk would be that not only would foreigners back off (via their funding of the US’s current account deficit) providing new funding for the ongoing US budget deficit, but these foreigners may also even start selling US assets as well. And that – if it happened – would likely undermine the value of the US dollar.
There is another cliff on the horizon that few in the US dare mention: in 2033/2034, actuaries predict the US’s social security fund runs out. In 2022, the fund paid out benefits totaling $1.24-trillion. After 2034, beneficiaries will receive only 77% of what they are entitled. Will Congress then move to top up the difference? In 2022, that would have added an extra $300-billion per annum to spending and so to the deficit.
Were this bond market rebellion to occur, expect the difference between the value of the US dollar measured by market rates to start converging down towards the value of the US dollar as measured by purchasing power parity. And this would shrink the difference in the relative size of the US economy to that of the Chinese economy. The dragon hiding in one of those Magic Eye pictures would then start to come into sharp focus.
But the implications of a US bond market rebellion go far beyond the ramifications for the US dollar’s value. US Treasuries are the linchpin of global finance. They derive this status from the yield on the 10-year US Treasury Bond being regarded as the world’s risk-free rate, the opportunity cost of capital. Echoing Archimedes’s lever principle, that yield is the fulcrum about which the world of global finance moves. (Bloomberg recently highlighted the work of Charles Gave of Gavekal which shows that, since 2018, the Chinese Government Bond has been a far better risk-free asset than its US counterpart: a 30% higher return with much lower volatility.)
Meanwhile, in modern China, a very different country profile is emerging. What many foreign observers of China’s economy miss – especially those with doomsday prognoses – is that China is decisively changing gear. Under Deng Xiaoping, the mantra was “Growth or Bust”… and in the end, growth AND (property) bust was delivered.
China decisively leads in all areas where AI is applied to industry and manufacturing processes.
Under Xi Jinping, the mantra is “National Security”. And this does not mean only the traditional Western definition which focuses on the military aspects. In fact, China’s principal foci centre on delivering technological, energy and (relatedly) environmental security.
Combined, these forces will deliver economic security, military security and yes even – albeit lower than the 2000-2019 go-go years – economic growth. In fact – see below – they are already the single-largest driver of GDP growth.
For those prepared to do that Magic Eye squint, a startling picture of China comes into focus. And it is not simply because China has become a manufacturing powerhouse, producing annually three times more than the US and indeed more than the next eight countries combined.
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China has become a technology powerhouse too. Twice yearly, the Australian Strategic Policy Institute releases its Critical Technology Tracker update. It now monitors research in 64 technologies: China leads in 53; the US in 11.
The US still leads in high-end computing and chip design (though not the intriguing field of photonics), biotechnology and space technology. In five out of those 11 sectors where the US is number one, its advantage over China is marginal.
And in all these 11 sectors, China is always placed second. Correspondingly, if the US is not first, neither is it always second: India beats the US in five categories; South Korea in one. In every sector focusing on automated manufacturing and industrial processes, China leads.
In 2023’s hottest area – AI – China leads in four out of six of its subsectors. In the two where the US still leads – advanced integrated circuit design and fabrication and natural language processing – its advantage over China is marginal.
This status in the AI race is also echoed in the findings of Stanford University’s 2023 Artificial Intelligence Index: peer-reviewed journal publications from China (with 40% of the world’s papers) far outnumber the US’s (10%). Likewise, Stanford notes that nine out of 10 of the top universities ranked by peer-reviewed journal publications are Chinese: only the Massachusetts Institute of Technology makes the Top 10 ranking… at number 10.
While the US is weighed down with the detritus of its past... China is investing heavily in a new future.
If there is a bias in AI knowhow, the US still excels in many consumer-facing apps like ChatGPT, ClickUp and Whitesonic. But this consumer app lead does not extend to AI-assisted online shopping where even Amazon’s US operations are now feeling the heat from Shein and Temu and to online gaming where NetEase and Tencent are challengers to the Activision-enriched Microsoft.
Otherwise, China decisively leads in all areas where AI is applied to industry and manufacturing processes: it is telling that of the 553 industrial robot installations in the world in 2022, 290 (52%) were in China versus 263 (48%) elsewhere.
Finally, China is at the forefront of the green energy revolution, one which will have profound consequences for the country and its environment and, by extension, our planet at large. China now has more than half of the world’s capacity in solar power and a quarter of it in wind power. This position derives from having just under 70% of the world’s manufacturing capacity of new energy products, including solar panels and wind turbines. China also produces more than 70% of the world’s lithium ion batteries.
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This gargantuan volume of production has driven down Chinese unit costs to 50% or less of foreign competitors. (Naturally, the EU is complaining bitterly about “dumping”.) Lower costs mean lower prices which further boosts demand which only reinforces this virtuous cost-cutting and so price-lowering circle.
The latest example of this is in electric vehicles. In 2022, 60% of EVs sold worldwide were sold in China. (Almost every EV was made in China and with very few imported components.) This cost advantage helped China’s 2023 EV exports increase 57% to 1.7 million units. And this surge has allowed China to surpass Japan and become the world’s largest car exporter, “traditional” and EV combined.
Xi’s priority in achieving energy independence is already contributing to China’s growth. In 2023, clean energy sectors accounted for 2.2% of China’s 5.2% GDP growth.
With China more than doubling solar capacity in 2023, and with its wind power capacity increasing by 66%, the Centre for Research on Energy and Clean Air now believes China could reach peak emissions not in 2030 but 2027… and this is despite ongoing and considerable investment in coal-fired power stations. China – the world’s largest polluter – is doing far more than any other country to bring about environmental security both for itself and, by extension, the world at large.
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In conclusion, while the US is weighed down with the detritus of its past (a $34-trillion debt mountain which is now rising by $2-trillion every year), China is investing heavily in a new future. China’s focus is on enhancing its technological capabilities and securing a home-sourced green energy supply: sunshine and wind are not classified as imports!
This suggests that sometime in the mid-2030s, some of us will no longer need to use a Magic Eye squint to realise that China is the world’s largest economy: it will be plain for all to see, even using market exchange rates.
And that the world’s largest economy might no longer be the US must worry Jamie Dimon even more than his impending bond market rebellion… though I sense he highlighted the latter because he realises it may help cause the former! DM