The Economist's Big Mac index provides an alternative to the actual market exchange rate, for assessing the foreign trade competitiveness of different countries. “It is based on the theory of purchasing-power parity (PPP), which says that exchange rates should equalise the price of a basket of goods in each country. In place of a range of products we use just one item, a Big Mac hamburger, which is sold worldwide. The exchange rate that leaves a Big Mac costing the same in dollars everywhere is our fair-value benchmark.” (Cheesed off, 16 July 2009, Burgernomics points to uncompetitive currencies in continental Europe).
Hold it right there
The theory tells us that there is an infinite number of PPP exchange rates, each for an alternative basket of goods. If we choose a basket of internationally tradeable commodities, actually traded by a country, trends of the implicit PPP exchange rate with another currency will be one of the many factors that will determine whether or not a country is internationally competitive and whether its exchange rate will be sustainable. Provided that the reference currency is not itself undervalued, a condition amply satisfied by the dollar today but not invariably by reference currencies. The very notions of competitiveness and sustainability are conditional on a given growth rate: a country may be competitive, and its exchange rate sustainable, at a low growth rate but not at a more ambitious one; the concept of competitiveness is undetermined until a target growth rate is specified. There are other factors affecting the exchange rate and its competitiveness and sustainability, such as Foreign Direct Investment and portfolio investment flows; the stock of public and of private external debt; the sustainability of government deficits; credit-ratings; interest rates and their comparative trends.
What is more, for a given set of all significant factors other than PPP, a country does not necessarily have to be competitive in a wide range of tradeables. It is perfectly sufficient for a country to be competitive in one single commodity, as long as its world demand is sufficiently elastic with respect to price and with respect to income – oil for instance, or microchips – for that country to be internationally competitive, even at an ambitious growth rate and a PPP rate which is overvalued in terms of a broader basket of tradeables. It is completely irrelevant whether a country is or is not competitive on any number of non-tradeables, let alone one single non-tradeable like the Big Mac, whose only attraction is its global homogeneity thanks to stipulations of the McDonald franchises. The price of perishable good, that deteriorates within minutes of its preparation, together with its chips going immediately and irredeemably soggy, is no indication of a country’s foreign trade competitiveness. A country might as well worry about its competitiveness in the export of frozen omelettes.
A hair-cut PPP Index?
It would be much better, at that point, to take into consideration another non-tradeable, such as a hair-cut. For haircuts have a much lower incidence of non-labour costs than a Big Mac, and lower variability of labour productivity in hair-cutting across countries, and therefore at least a better indication of relative wage rates – which are very important factors in affecting international competitiveness. A hair-cut PPP exchange rate has some kind of meaning, instead of being utterly meaningless and irrelevant like the Big Mac PPP. Although its relevance will depend on a country’s incidence of baldness, fashion for hair length and colour, just as the relevance of the Big Mac PPP index will depend also on the incidence of vegetarians, health-minded consumers, gourmets and Hindus (so much so that there is no Big Mac index for India). Moreover in some countries (Russia, Brazil and China) burgers are posh, in other countries they are the pits.
The same considerations, and more, vitiate the use of a one-good PPP index – whether tradeable or not – for another purpose to which PPP exchange rates are commonly put, namely income or consumption comparisons (per capita or total) across countries. With the added complication that the basket appropriate to one country may be inappropriate to another, and diverging results are likely to obtain according to the arbitrary choice of one or another basket. And a basket appropriate for the rich is bound to be inappropriate for the poor. For instance, the recognition that the poor tend to buy lower quality food, in smaller and more frequent purchases, and enjoy lower quality public services, in 2008 forced the World Bank to revise upwards its estimate of the world poor from just under 1 billion to 1,400 million – at a stroke. A classic, thorny, insoluble index number problem. Here too the use of a single good is laughable.
“When demand is scarce and jobs are being lost, no one relishes a strong currency. A country with an uncompetitive exchange rate will struggle to sell its wares abroad and will also cede its home market to foreign firms. A weak exchange rate, by contrast, encourages consumers to switch from pricey imports to cheaper home-produced goods and services. So which countries has the foreign-exchange market blessed with a cheap currency, and which has it burdened with a dear one? The Economist's Big Mac index, a lighthearted guide to valuing currencies, provides some clues.” (CLICK ON THE TABLE BELOW TO ENLARGE, OR ON THE LINK IN THE SECOND PARAGRAPH ABOVE TO ACCESS THE ORIGINAL ARTICLE AND TABLE)
It is not so much that the table above, or the conclusions drawn from it, look serious rather than lighthearted. “The dollar buys the most burger in Asia. A Big Mac costs 12.5 yuan in China, which is $1.83 at today’s exchange rate, around half its price in America. Other Asian currencies, such as the Malaysian ringgit and Thai baht, look similarly undervalued. Businesses based in continental Europe have most to be cheesed off about. The Swiss franc remains one of the world’s dearest currencies. The euro is almost 30% overvalued on the burger gauge. Denmark and Sweden look even less competitive.” According to the table, the Norwegian Krone is 72% overvalued.
It is the reasoning behind the lightheartedness that is faulty: “Care is needed when drawing quick conclusions from fast-food prices. The cost of a burger depends heavily on local inputs, such as rent and wages, which are not easily arbitraged across borders and tend to be lower in poorer countries. So PPP gauges are better guides to misalignments between countries with similar incomes.” Why, are the prices of burgers and hair-cuts easily arbitraged across borders? Bankers, businessmen and students love simplistic, unqualified propositions about economics. But the Big Mac Index is dis-educative and misleading to the point of being dangerous.
“On that basis, the markets have been kindest to British exporters. A year ago the pound was overvalued by more than a quarter on the Big Mac gauge. Now it is close to its fair value against the dollar and looks cheap against the euro. That shift has upset some other EU countries that had relied on selling to spendthrift British consumers. But after years of struggling with an overvalued currency, British firms will feel they deserve a little mercy.”
Silly economics for a silly currency in the silly season. I wish all my readers a good Ferragosto.