If you convert Chinese military spending using Market Exchange Rates, then the US is outspending the Chinese on its military by a factor of three. But General Mark Milley claims that the comparison is not accurate:
Milley claims that these comparisons don’t account for the higher cost of labor and military manpower in the United States, seemingly arguing that these comparisons should instead be based on something called “purchasing power parity.” For those who didn’t take economics, purchasing power parity attempts to compare how much foreign currency would be required to buy the same amount of goods and services (i.e. labor) as a U.S. dollar would in the United States.
If you convert using the Purchasing Power Parity (PPP), then Chinese spending is twice as high as when measured otherwise. Meaning Chinese defense spending is closer to the US than is usually reported.
The Stockholm International Peace Research Institute (SIPRI) defends its use of using Market Exchange Rates (MERs) over the PPP:
… the reliability of such PPP rates is lower than for MERs, since PPP rates are statistical estimates, calculated on the basis of collected price data for a basket of goods and services for benchmark years. Between benchmark years, the PPP rates are extrapolated forward using ratios of prices indexes, either GDP deflators or consumer price indexes. Like all statistical estimates they are subject to a margin of error…
PPP rates are designed to reflect the purchasing power for goods and services that are representative of spending patterns in each country, that is, primarily for civilian goods and services. Military expenditure is used to purchase a number of goods and services that are not typical of national consumption patterns. For example, the price of conscripts can be assumed to be lower than the price of a typical basket of goods and services, while the prices of advanced weapon systems and of their maintenance and repair services can be assumed to be much higher. The extent to which this data reflects the amount of military goods and services that the military budget can buy is not known.
And here’s a general observation:
PPPs are generally favoured for their closer link to welfare, but MERS are necessarily the basis of international trade, so it is difficult to choose between them.
Now that we’re all caught up, I’ll explain why General Milley has the stronger case. China’s military spending is more fairly to be represented by PPP normalization, which roughly doubles the dollar value of Chinese military spending compared to the standard quotes using the MER.
What do we mean by military spending?
To understand why the PPP is a better measure than the MER, we must first clarify out objective. We are concerned with the comparative size of military spending between two nations. In other words, how many resources are laid at the feet of military planners in the US and China?
The effectiveness of decisions made by the military planners is not of our concern. That is a very interesting and important question, for sure. But it is of no relevance to us. We want to know the quantity and quality of real resources that US and Chinese military planners have access to through their spending.
We are evaluating whether the PPP or the MER is preferred when converting Chinese spending into dollars. In short, does the PPP or the MER better reflect the relative price level of the labor, capital, and materials made available to military planners in China and the US?
Military spending is not reflective of the flow of international trade.
Market Exchange Rates are based on the supply and demand for currency. It is generally associated with the flow of internationally traded goods and services, including tee-shirts and integrated circuits, as well as financial services such as foreign direct investment. Generally this is the amount required to make foreign transactions. The MER is thus a function of international trade.
But that is not all that determines the MER. Like other prices, they are subject to various expectations about current and future economic conditions, trust in the currency issuer, capital controls, interest rates, and so forth. The exchange rate is subject to the competitive bidding that can move around based on animal spirits and irrational exuberance. It is not necessarily reflective of the opportunity cost of resources available to military spenders.
Even when MERs are open to free market activity, the exchange rate only reflects the value of goods and services that are internationally traded. It does not reflect all the labor and material costs that are geographically localized. Here’s Tim Callen from the IMF:
Another drawback of market-based rates is that they are relevant only for internationally traded goods.
For example, most Americans work in the US for managers who operate in the US — even if they report elsewhere. To say that differently, managers in the US usually hire American wage labor. The shipyard manager can’t hire foreign labor very easily. And if the shipyard manager and all other managers could employ foreign labor, it would mean that they face a very different set of input prices; it would also move the MERs toward a different set of values.
But managers in the US usually cannot easily employ foreign labor — particularly for the DOD and its contractors. The MER doesn’t reflect many of the most relevant prices facing military planners.
With China, the MER does worse.
The problems above arise even for countries that are not currency manipulators. China intentionally hold down the Market Exchange Rate of their currency to boost exports. It is not representative of a free-market for the currency. The People’s Bank of China fixes its currency’s value to a desired level relative to the US dollar, and that is generally considered below “fair” market value.
This means that a MER comparison of defense spending makes China’s spending appear artificially lower than it really is, even by MER standards, because in price-fixing cases the MER does not represent the relative prices underlying trade flows.
That’s the whole point of currency manipulation, to stimulate trade by distorting the price level faced by decision-makers in other countries. Using the MER in this case is perpetuating the deliberate distortion.
Suppose that China let its currency float freely in foreign exchanges. Well, the point of the matter is that the US does not trade weapon systems with China; it doesn’t even trade most of the resource inputs into defense expenditures, such as military and contracted labor.
So the MER has some major flaws. But the SIPRI research method rejected the PPP because of two problems, which we will now address:
1. Statistical foundations.
SIPRI found fault in the PPP for being based on statistical sampling. Yes, but that also means there were real life observations of prices in China and in the US. The PPP is thus based on empirical evidence.
Of course not every price can be observed, and its quality measured, but the studies capture a broad scope of different goods and services. Even the crude Big Mac Index seems to be pretty robust as it incorporates many of the production inputs required by other firms to produce competing products. The PPP’s represents the amount of a currency you’d need to buy a constant-quality basket of consumer goods and services.
In contrast to the PPP, the MER is based on the Chinese directives by fiat. The MER reflects empirical evidence only as it is run through the bias-producing machine of the People’s Bank of China. And though subsidies may play their part to bias the PPP, it is unlikely to be as great a distortion as reflected China’s control of its currency and capital flows.
In the case of US and China, the statistical nature of the PPP may be superior to the political nature of the MER.
2. The PPP’s consumption basket.
The other problem with the PPP that the SIPRI research methodology pointed to was that the PPP largely measures consumer goods and services, not military outputs. And yet as described above, the MER is also not reflective of military outputs, so this can hardly be a fault.
Recalling our objective, it turns out we don’t want a PPP (or an MER) based on military outputs, because then we would be measuring the quality of military decisions that resulted in the capabilities and price of military outputs. Again, this is not our objective. We care about the real amount of resources made available to military planners, regardless of their competence. After all, military outputs are merely a re-combination of labor, capital, and materials provided from the broader economy.
The question is then: Does the PPP’s relative price level for consumer prices also reflect the relative price level of inputs to the production process?
If we had a PPP of producer prices, then we would have the most desirable index to normalize US and Chinese military spending. Engineers, assemblers, and logisticians in China face the opportunity to work for either Huawei or the People’s Liberation Army. Steel, microprocessors, and transport vehicles are used in both the military and civilian economies. A PPP of producer input prices would better reflect the amount of real resources made available to military planners for a unit of currency, because military planners draw from national stock of labor, capital, and materials and recombine them into military-unique outputs.
Well, measuring producer inputs is problematic. The PPP consumption basket is fixed across countries in terms of the goods and services measured. A PPP of producer prices would have to adjust for the quality of labor and capital in each nation, not just materials like steel. That would be very difficult and speculative.
But it turns out that in the US, consumer prices have tended to correlate pretty strongly with producer input prices. The same goes for China. The two are interdependent, a competitive price paid for consumer products reflects efficient rents paid to productive inputs.
For example, let’s say that the consumer price of electronics increases due to higher demand. Managers of electronic firms respond by increasing the price they’re willing to pay to labor, capital, and materials so that they can increase output. And we can frame it the other way. Say the price producers’ pay for oil goes up, then the price consumers pay for energy intensive products will go up.
Effects of Technology.
Differences between consumer and producer prices are perhaps derived from technology change. If the price of oil went up, and firms discover more fuel efficient processes, then consumer prices may be held down.
So a critical aspect to the critique of consumer prices as a proxy for producer prices is differences in technology between the US and China. Now, let’s assume that US firms are more productive than Chinese firms with the same resource inputs. This means consumer prices are lower in the US compared to what they would be at Chinese levels of productivity.
To make a long analysis short, if you were to make a PPP based on producer prices, the expected result would be even further away from the Market Exchange Rate than the PPP based on consumer prices. That is because technology allows the US to generate lower consumer prices at the same producer price level.
It is interesting to quibble over technology. But if we want to assume equal levels of technology and skills in the US and China (e.g., one US engineer = one Chinese engineer, the former isn’t “more productive”), then the PPP is conservative. China’s spending would appear even higher because they can afford more “butts in seats” for the price of the same consumption basket.
Conclusion.
We ask how many resources military planners can afford with the funding made available to them. We do not ask how military planners re-combine the resources they’ve afforded to produce fighter aircraft, warships, missiles, and so forth.
In the case of China and the US, the PPP is preferable to the MER. There are three major reasons. First, the Market Exchange Rate only reflects the relative prices of goods and services traded internationally. Second, China manipulates its currency and distorts the signal of underlying price levels. And third, the PPP for consumer prices is a fair approximation of the price-level that producers face in each country, and to the extent that they might diverge, it would have the effect of making China’s military spending look even larger.
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