Saturday, May 29, 2004

Currency Watch: The Economist's Big Mac Index

The Economist came up with a clever way in order to sample currency regimes and correct for the real picture of where economies stand by applying PPP - Purchasing Parity Theory - to the universal standardized commodity of the McDonald's Big Mac or as they like to call it in France Le Royale with cheese. The basic idea is that if you have the exact same thing it should theoretically cost the same anywhere you try to buy it, and this is one way of measuring if currency trading regimes are market efficient. They call it the "Big Mac" Index.

HOW fast is the world economy growing? How important is China as an engine of growth? How much richer is the average person in America than in China? The answers to these huge questions depend crucially on how you convert the value of output in different countries into a common currency. Converting national GDPs into dollars at market exchange rates is misleading. Prices tend to be lower in poor economies, so a dollar of spending in China, say, is worth a lot more than a dollar in America. A better method is to use purchasing-power parities (PPP), which take account of price differences.

The theory of purchasing-power parity says that in the long run exchange rates should move towards rates that would equalise the prices of an identical basket of goods and services in any two countries. This is the thinking behind The Economist's Big Mac index. Invented in 1986 as a light-hearted guide to whether currencies are at their “correct” level, our “basket” is a McDonalds' Big Mac, which is produced locally in almost 120 countries.

The Big Mac PPP is the exchange rate that would leave a burger in any country costing the same as in America. The first column of our table converts the local price of a Big Mac into dollars at current exchange rates. The average price of a Big Mac in four American cities is $2.90 (including tax). The cheapest shown in the table is in the Philippines ($1.23), the most expensive in Switzerland ($4.90). In other words, the Philippine peso is the world's most undervalued currency, the Swiss franc its most overvalued.

So once you correct the currency regimes for PPP then how do the world economies look at a glance?

Small wonder, then, that global economic rankings are dramatically transformed when they are done on a PPP basis rather than market exchange rates. America remains number one, but China leaps from seventh place to second, accounting for 13% of world output. India jumps into fourth place ahead of Germany, and both Brazil and Russia are bigger than Canada. Similarly, market exchange rates also exaggerate inequality. Using market rates, the average American is 33 times richer than the average Chinese; on a PPP basis, he is “only” seven times richer.

The way in which economies are measured also has a huge impact on which country has contributed most to global growth in recent years. Using GDP converted at market rates China has accounted for only 7% of the total increase in the dollar value of global GDP over the past three years, compared with America's 25%. But on PPP figures, China has accounted for almost one-third of global real GDP growth and America only 13%.

This helps to explain why commodity prices in general and oil prices in particular have been surging, even though growth has been relatively subdued in the rich world since 2000. Emerging economies are not only growing much faster than rich economies and are more intensive in their use of raw materials and energy, but they also account for a bigger chunk of global output if measured correctly. As Charles Dumas, an economist at Lombard Street Research, neatly puts it, even if a Chinese loaf is a quarter of the cost of a loaf in America, it uses the same amount of flour.[emphasis added]

Why my interest in The Economist Big Mac Index? Two-fold and they both have to deal with what should be every central banker's (or central banking junkie's and devotee's) obsession: inflation. If you look at the PPP corrected economic growth, it's abundantly clear that we are in a situation where we are incredibly vulnerable both to monetary-supply induced inflation from a dollar-regime correction and for more commodity-based inflation than the market is accounting for in either case.

Serendipitiously The Economist in the very same issue has an article explaining the exact impact of failing to do such corrections as the PPP and their impact from such flawed economic tools on decision making policy. This is partly why I love this publication, and the oldman uses the word love judiciously.

HOW big is the world economy? That sounds like a straightforward question. Simply to add up the size of all the world's national economies would seem to be the obvious way to answer it. But how that is done yields radically different results, and therein lies a tale. The most commonly used method is to convert national economic outputs to a single measure, namely the American dollar, using the market exchange rates of all the national currencies. That produces a figure of $36 trillion for 2003. But many professional economists think that it makes much more sense to use what they call purchasing-power parities (PPP), which take account of differences in prices of the same goods between countries, and so tries to measure the real purchasing power of inhabitants in each country, no matter what the world's fluctuating currency markets happen to be doing to exchange rates. Using this method, the world economy last year was worth $50 trillion.

The precise size of the world economy may not matter much from a policy point of view, though a $14 trillion difference is hardly small change. However, which method of measurement is used also affects more important matters: the global rate of growth, the relative size of economies, and the extent of inequality between rich and poor. In these cases, using market exchange rates can produce misleading results and hence stimulate bad policies.

The best reason for not using market exchange rates is that prices tend to be lower in poorer countries, so a dollar of spending there is worth more. Market rates therefore understate their real level of development (see article). Indeed, measured at market rates, developing economies' share of global income has fallen over the past two decades, to less than one quarter. This would back the claims of the anti-globalisation lobby that poor countries are being left behind. Yet measured at PPP, developing economies' share of world income has risen over the same period, to almost half of the total, which gives a more realistic impression.

The results have such important consequences as investigating the amount of carbon-production in the future. For the record, it's the oldman's position that we're already seeing global warming climate changes in the wide-scale weather oscillations. Whether we don't produce quite as much carbon from third-world development in the coming years is going to be a gnat on the elephant already sitting on the scales because the amount produced by developed nations and soon-to-be China and India will be quite sufficient to cook our collective gooses at the present rate much less any increased carbon-emission production. Nonetheless the IPCC scientists should have been more careful about projecting future growth so as not to inflate their already impressive case.

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