June 27, 2017

The Big Mac and other Purchasing Power Parity Indices
- Use and Abuse

Does the "Big Mac Index" that The Economist regularly publishes indicate if a country's currency is over- or under-valued compared to the rate needed to balance its external trade? 

Far too often, the popular press -- and even serious policy makers --assume that this is true. However, neither the light-hearted Big Mac indices nor the very serious Purchasing Power Parity (PPP) indices have any significance in the context of determining if exchange rates are consistent with balanced trade. 

Purchasing power parity exchange rates indicate the degree to which the current market exchange rate overstates or understates the ability of the average citizen with average income to purchase the average basket of goods and services typically consumed in each country. In contrast, fundamental equilibrium exchange rates are the rates that will bring a country’s trade into an acceptable balance. 

The most important global work on PPPs is done through the International Comparisons Project (ICP) led by the World Bank. The following caveat, stated clearly on the ICP website, is very important to our analytical work: “PPPs should not be used as indicators of the under- or overvaluation of currencies. They do not inform what exchange rates "should be." ”  

A key reason for this warning is that calculated PPPs are driven primarily by the prices of goods and services that are only traded domestically. Since they are not traded internationally, or are traded only at the margin, they have no real impact on actual exchange rates or trade balances.

A cheap knock-off on the PPP concept is the Big Mac Index that The Economist magazine created in 1986. As The Economist states clearly, the Big Mac Index is “based on the theory of purchasing-power parity (PPP)” and “was never intended as a precise gauge of currency misalignment.” Rather, it was invented as a teaching device to “make exchange-rate theory more digestible.” How sad that it has thoroughly confused exchange rate discussions and policy conclusions! 

Besides being irrelevant to the assessment of currency over- and under-valuation, the Big Mac Index is a cheap knock-off because it is based on the price of a single “luxury” product -- a hamburger bought in a restaurant that is far more upscale than the average person in poor countries can afford. In contrast, the PPPs produced by the ICP are based on repeated multi-year global exercises that develop truly representative consumption baskets that can meaningfully be compared across countries. 

The irrelevance of PPP indices for estimating the misalignment of currencies with respect to their trade-balancing equilibrium exchange rates is highlighted by the fact that Norway and Switzerland consistently have “the most overvalued currencies” according to the Big Mac Index. 

This clearly does not square with the fact that both countries consistently have among the largest current account surpluses in the world!  It is impossible for a country to simultaneously have a consistently large current account surplus and an overvalued currency. 

The irrelevance of the Big Mac Index to discussions of trade-balancing equilibrium exchange rates is also seen in the undervaluation estimates ranging from -50 percent to -70 percent that the Big Mac Index assigns to poor countries like India, Indonesia, Mexico, Taiwan, Malaysia, Egypt, and others -- many of whom run significant trade deficits, not trade surpluses as would be expected if they actually had undervalued currecies. 

For these and related reasons, the -44 percent Big Mac index estimate for China has absolutely no meaning in the context of formulating U.S. trade policy and should not be part of any serious discussion regarding the exchange rate that China should have to balance its external trade.

The only thing these purchasing power parity numbers tell us is that people in relatively poor countries can buy more in their local markets with their meager incomes than would appear to be possible when their incomes are converted into dollars at market exchange rates. Likewise, the elevated domestic price levels in rich countries like Norway and Switzerland mean that high per capita incomes there don’t buy as much as you might expect. If you don't believe this, try spending a night in Geneva!

In short, the Big Mac numbers are irrelevant to our discussion about the U.S. trade deficit and we should not refer to them. What is required instead are measures of Fundamental Equilibrium Exchange Rates (FEERs) as calculated by the IMF and by Bill Cline of the Peterson Institute for International Economics. These will be the topic of a separate posting.

America Needs a Competitive Dollar - Now!

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