Measure the most important sector of the universe
TIN YEARS A few years ago, Chinese real estate was described as “the most important sector in the universe” by Jonathan Anderson, now a member of Emerging Advisors Group, a consultancy firm. Real estate was a major source of China’s growth, household spending, and appetite for commodities, like iron ore. Today, the sector has become a source of universal concern as home sales have plummeted, developers defaulted and the price of iron ore has plummeted. Chinese observers are hungry for a rigorous measure of the sector’s importance to the country’s economy. And in recent months, the world press has converged on a number: 29% of GDP.
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This estimate, which was quoted in this journal, the Financial Time, the the Wall Street newspaper, Bloomberg and elsewhere, comes from an article by Kenneth Rogoff of Harvard and Yuanchen Yang of IMF. The two economists have impeccable credentials. But their number (28.7%, to be precise) doesn’t count what most people think it does. The most important measure of the most important sector of the universe is largely misunderstood. So how should it be interpreted? To grasp it correctly, you have to go through the ins and outs of the entries and exits smoothly.
Imagine an economy that makes a house and nothing else. The house is the product of the construction industry. But to do this, builders need inputs. They need steel, which is the output of the metallurgical industry. And steel requires iron ore, the production of the mining industry. Suppose these are all that is required. The house sells for $ 1 million, the steel for $ 600,000 and the iron ore for $ 500,000. Now ask yourself how important is the construction industry?
A narrow answer is 40% of GDP. By building the house, the builders add $ 400,000 to the value of the steel they buy. So they represent two-fifths of the million dollar value of the house. Since the house represents the entire economy GDP, a narrow measure of the importance of the construction industry is 40% of GDP.
A broader response is 100% of GDP. The house is the only “end” product of the economy. Everything else in the economy is just one ingredient in this pie. The only reason to make ore is to make steel. And the only reason to make steel is to make houses. These “upstream” industries are therefore closely linked to construction. If the demand for housing declines, the demand for steel and ore will also decline. Thus, 100% of the demand for end products in this economy is the demand for products made by the construction industry.
How would Mr. Rogoff and Ms. Yang gauge the importance of the property? Those who haven’t read their article might assume their figure is similar in spirit to the first narrow answer. They may think it is referring to the value added by the real estate industry (which in their article includes services such as real estate agents as well as developers). People who have taken a look at the document may assume that their approach is more in line with the general response. The real estate sector maintains close links with upstream industries. Therefore, its importance includes not only the value it adds, but also the value added by its upstream suppliers (steel and other inputs) and their suppliers (ore and other materials).
In fact, Mr. Rogoff and Ms. Yang don’t exactly follow either approach. Applied to our simple economy, their method would give an answer of $ 1.1 million or 110% of GDP. It would count iron ore ($ 500,000). It would also count the total value ($ 600,000) of the steel (even if that includes the value of the ore, one entry to the entry). But that wouldn’t count the $ 1 million worth of the house or even the $ 400,000 in value added by the construction industry.
Why not? Their approach is an unusual attempt to correct for double counting. If you were to add construction production (the $ 1 million house), steel production ($ 600,000), and mining production ($ 500,000), you could be charged with double or even triple counting. You would have counted steel twice and ore three times (once on its own, a second time when drowned in steel, and a third time when steel drowned in the house).
The typical and intuitive way to avoid this problem is to count only the value added at each stage of production ($ 500,000 plus $ 100,000 plus $ 400,000 in our simple example). This method gives the “wide” response of 100% of GDP in the economy to a house. The method employed by Mr. Rogoff and Ms. Yang includes some things that are not captured in this measurement and excludes others that are. In the one-house economy, their approach would count steel once, ore twice, and construction not at all. In the case of the Chinese economy, they argue, these inclusions and exclusions cancel each other out in practice. “The direct construction added value that we didn’t include and the inputs we included… are very similar in scale and offset,” Ms. Yang writes. “The alternative (perhaps more intuitive) approach doesn’t change our message.”
In an upcoming commentary on the article by Mr. Rogoff and Ms. Yang, a team of economists from the Asian Development Bank (ADB) including Mahinthan Mariasingham and John Arvin Bernabe took the most intuitive approach, totaling value added by construction and property services, as well as value added by other industries providing them, and by the suppliers of their suppliers. Using the same figures as Mr. Rogoff and Ms. Yang for investments and real estate services (although for 2017 and not 2016), they estimate that the Chinese real estate sector accounted for 15.4% of GDP in 2017. Excluding imports, the number fell to 13.8%.
There is another wrinkle, however. The investment figures used by Mr. Rogoff and Ms. Yang, and the ADB, may be missing some buildings constructed by companies that are not officially classified as real estate developers. Their inclusion, while using the most intuitive approach, increases the importance of the real estate sector to just over 23% of GDP in 2018, according to Andrew Tilton and his team at Goldman Sachs. The sector remains of cosmic importance. But anyone alarmed by the 29% figure can rest about six percentage points more easily. ■
Read more from Free Exchange, our column on the economy:
Janos Kornai understood capitalism by studying its opposite (November 20, 2021)
A thriller on Zillow (November 13, 2021)
Are “greedy jobs” the root of the gender pay gap? (November 6, 2021)
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This article first appeared in the Finance & Economics section of the print edition under the title “Un universe d’amoncre”