The new world order in economics as G7 is brought down a size or two

International economists have been labouring for years under an important misapprehension. (At least one]) This was that inferences about the world economy could safely be drawn simply by knowing what is going on in the industrialised countries, and especially in the elite club known as the G7.

This belief was not born out of a lack of interest in the rest of the world. It followed - or so we thought - from the laws of arithmetic.

Until recently, figures for global GDP have shown that the developed economies account for 80 per cent of the world total.

The G7 alone, these figures suggested, produce two-thirds of everything made on the planet. It followed that the rest of the world could significantly affect the global growth rate only by experiencing extraordinary booms or slumps.

All these perceptions must now be changed as a result of the increased prominence that the International Monetary Fund and the World Bank are giving to a different - and almost certainly superior - method of calculating global gross domestic product. This change has had two primary effects.

First, the world as a whole is now estimated to be much larger than previously thought in terms of economic activity. The difference between the new and the old figures is dollars 6,000bn a year, equivalent to the size of the United States economy.

Second, the less developed countries (LDCs) turn out to be much wealthier than previously estimated. As a result, the industrialised economies are now estimated to produce only a little over half of world GDP, instead of the four- fifths previously supposed.

Martin Brookes of Goldman Sachs has recently analysed the new figures in some detail. He explains that the massive changes in the data all follow from a shift in the exchange rates used to translate each country's GDP into dollars so that the world total can be aggregated. Traditionally, market exchange rates have been used for this purpose. Now, it is thought better to concoct a new series of 'PPP' exchange rates to perform the same task.

PPP means purchasing power parity, and PPP exchange rates are the hypothetical rates that would equalise the prices of goods and services between economies.

It seems that market exchange rates, the basis for the traditional figures, have systematically understated the output of the LDCs, especially in the service sectors. This is why. Market exchange rates will tend to equalise the prices of traded goods across economies, and these are primarily manufactured products.

However, because the stock of plant and machinery is so much smaller in the LDCs, manufacturing productivity is obviously much lower than in the developed world. This in turn means that LDC wages must be much lower if prices of manufactured goods are to be broadly equalised across the world.

EU looks much less dominant

So far, this would produce no distortions. But the low LDC wages in the manufacturing sector apparently have the effect of reducing wages and prices in the LDC service sector as well. These low LDC service prices do not affect market exchange rates, which are influenced mainly by manufactured goods prices. Therefore, comparisons made at market exchange rates tend to over- estimate the prices of LDC services, and correspondingly under- estimate LDC service output and GDP. This distortion is eliminated by using PPP exchange rates, which make direct allowance for the low service prices in the LDCs.

So much for the theory. The two graphs show the effects of shifting from market to PPP exchange rates to measure world GDP. We have already noted that, on the new figures, the relative size of the industrialised economies has shrunk considerably. As a result, the European Union suddenly looks much less dominant in the world economy.

Instead of being four times as large as the developing Asian economies, as shown on the old data, we now find that these two blocs are almost exactly the same size. In only a few years, non-Japan Asia will certainly out-strip the EU by a wide margin.

Similarly, Latin America on the old figures was only a quarter of the size of the US; now it is shown to be slightly over two-fifths as big. (No wonder that American foreign policy is increasingly facing west and south, rather than east.)

Or take Eastern Europe. Previously estimated to be smaller than the French economy, it is now shown to be over twice as large. These are indeed big changes in our perception of the economic power of various groups.

Britain is, of course, accustomed to its share of world GDP shrinking - a process that started in the 1860s. But we thought until now that we were still the sixth-largest economy in the world, having been only recently overtaken by France and Italy.

On the new figures, we have also been overtaken by China, India and Russia, leaving us clinging to ninth place, just ahead of a fast-climbing Brazil.

Although, on the new data, the LDCs look less impoverished than before, there is still huge scope for a further period of rapid catch-up towards the prosperity enjoyed by the industrialised world.

This is, of course, the case for countries like China and India which are still peasant economies with GDP/head around dollars 1,500 a year. (The UK earns dollars 16,400, France dollars 18,500, Germany dollars 19,800 and the US dollars 22,200.) But it is also true for rapidly developing economies like Brazil, South Korea and Mexico, none of which has yet attained a GDP/head more than half of that of Britain's. This will not be true for long.

Emerging tigers ready to pounce

The astounding growth of the emerging Asian tigers is best summarised in the following statistic. In 1986, the tigers' share of world exports in manufactures was 11.5 per cent, compared with Japan's 13.8 per cent. By next year, the tigers will produce 19 per cent of world exports, while the Japanese share will have dwindled to 10 per cent. The tigers are almost twice as large as Japan in world manufactured trade, up from almost nothing a couple of decades ago.

The Americans should take note - it is the tigers who enjoy undervalued currencies, not Japan. Meanwhile, Japan continues to be the sole target of US complaints, even though it is already buckling under the pressure of a hugely overvalued yen.

In fact, never has an economy passed as quickly as Japan from non-industrialised backwater, through industrial giant, and now towards threatened industrial dinosaur - all in one generation.

As more and more developing economies scramble to 'marketise', and open their borders to outside capital flows, these gigantic changes to the world economic structure will continue, or even speed up. This is what George Bush should have meant when he coined the phrase 'new world order'.

(Graphic omitted)