The Dollar

Weak? Uncompetitive? Undervalued?

Let the Big Mac Index Decide

My "Valuing the Dollar" opinion piece in the Wall Street Journal on March 8, reprinted in my blog as "Lord Give Us a Strong Dollar, but Not Just Yet" apparently didn't rally many troops to the cause of a weak dollar, even temporarily, as it reduces our external deficit and stimulates our economy. One notable exception, although his support was more implicit that explicit, was Marty Feldstein, one of the top economists in the world, and my choice to succeed Alan Greenspan as Fed Chairman. (No offence to Ben, who is doing a fine job.) I figure that, with Marty on my side, we almost constitute a majority.

I learned of Marty's position on the dollar when he made brief reference to it in a CNBC interview. However, he didn't make the rookie mistake that I had made in calling it a "weak" dollar; he said we need a "competitive" dollar. (Imagine the sound of the palm of my hand slapping forehead hard.) Of course, I thought words matter, and his word, was much better than mine even if they meant the same thing. And, to make matters worse, I had read Frank Luntz's book, "Words That Work: It's Not What You Say, It's What People Hear." Of course, no one wants a weak dollar, but they might want a competitive dollar.

Our dollar has not been competitive in recent years because capital inflows have kept it from declining to competitive levels, i.e., to levels that would permit us to pay for our imports with exports. Instead, we've been going into hock to foreigners to pay for them. As I've said in previous postings, the foreign exchange market has produced a dollar exchange rate that equilibrates debits and credits in our balance of payments, but one that includes a huge imbalance in trade in goods and services. Our dollar has balanced our imbalances, but the imbalances themselves are important.

Economists long ago came up with a concept of the equilibrium value of currencies as exchange rates that would tend to equalize the value of similar baskets of goods and services in different currencies. The concept is called "purchasing power parity (PPP)." You have parity in the purchasing power of different currencies if their exchange rates adjust to give similar things a similar price taking exchange rates into account. Our currency has not been permitted to adjust to PPP and thus has been "overvalued" for several years, according to international institutions like the International Monetary Fund.

However, for the past twenty years or so, the Economist has published an index of the relative purchasing powers of currencies substituting a single common item as the market basket. That item is the Big Mac, which is sold throughout the world. Here is the Economist's explanation:

The Economist's Big Mac Index, a light-hearted guide to how far currencies are from fair value, provides some answers. It is based on the theory of purchasing-power parity (PPP), which says that exchange rates should equalize the price of a basket of goods in any two countries. Our basket contains just a single representative purchase, but one that is available in 120 countries: a Big Mac hamburger. The implied PPP, our hamburger standard, is the exchange rate that makes the dollar price of a burger the same in each country. [The Economist, July 5, 2007]

The Economist goes on to point out that Big Mac prices depend on many local conditions, and that countries of similar stages of development probably should be used to draw inferences about the exchange rate. Unfortunately, July 2007 is the last publication of the Big Mac index, which means it won't capture much of the recent depreciation of the dollar. However, the results in July 2007 are still interesting.

They put the price of a Big Mac in the U.S. at $3.41, which is used as the base for comparison. (All this would have more relevance to me if it had been the Quarter Pounder or the Fish Sandwich or the Egg McMuffin. The Good Lord didn't intend for hamburgers to have three slices of bread-too many carbs.)

The weighted average Euro price of a Big Mac just prior to July 2007 was €3.05. The actual dollar exchange rate on July 2 was $1.36 per Euro, compared to a theoretical PPP exchange rate of $1.12 per Euro. Therefore, the Euro was overvalued against the dollar by over 21 percent. Conversely, the dollar would be undervalued against the Euro by 17 percent in terms of Big Macs.

Of course, the Dollar price of Euros has risen significantly since then. Assuming no change in the local prices of Big Macs, the PPP exchange rate would still be $1.12, but using the more recent exchange rate of $1.56 per Euro, the Euro would be overvalued by 39 percent. Conversely, the Dollar would be undervalued by 28 percent in terms of Big Macs.

(Admittedly the assumption of no change in Big Mac prices may be unrealistic, especially in the U.S., but I'm not going to Euro land to check. I couldn't afford it. However, when I've been there or any other place in the world, no more than two days can pass without my searching out a McDonalds, usually for breakfast. Of course, I did that in Las Vegas last week as well.)

In Britain, a Big Mac cost £1.99 last July when the pound cost $2.01 (Let's round those to 2 each, shall we?). PPP would have the Big Mac cost half as much in pounds as in dollars, but the ratio was £2 to $3.41-not £2 to $4. The Pound, according to the Economist chart, was overvalued by 18 percent relative to the Dollar-assuming, of course, that Big Macs are typical.

Elsewhere in Europe, the largest currency overvaluations in the Big Mac index were in Switzerland (53%) and Norway (152%). High prices in Europe don't surprise me. Think how much bigger these numbers would be if the retail exchange rate on the streets or in the airports were used, rather than the wholesale rates.

At the other end of the spectrum are countries with undervalued currencies against the dollar: - 58% in China; -55% in Hong Kong. Interestingly, the undervalued currency group, which usually comprises poor countries, includes Japan (-33%). The Economist attributes this anomaly to the carry trade, while acknowledging that the Big Mac measure is not representative of Japanese prices, which tend to be high like European prices.

What does the Big Mac index tell us-other than I'm getting hungry? The dollar is undervalued in many places, primarily old Europe, and overvalued in others, primarily Latin America, China and Russia. There is no single dollar exchange rate; nor should the dollar move the same way or degree against most currencies. The dollar is the numerare-the currency against which others are measured. Each should seek its own equilibrium with the dollar. Perhaps the best way to do that is through Big Mac arbitrage-like gold arbitrage of yore. But we shouldn't get too religious about it. No single rate is sacred. It only balances imbalances, which are not unique. Let us not crucify man on a cross of hamburger!