The Big Mac Index computed by The Economist magazine has consistently found the U.S. dollar to be undervalued against some currencies and overvalued against others. This finding seems to call for a rejection of the purchasing power parity theory. Explain why this index may not be a valid test of the theory.
The Economist’s so-called “Big Mac Index” is a tool, and nothing more. Like all tools, it has its uses when applied under specified circumstances, and is considerably less useful when applied under many other circumstances. Even the editors at The Economist would warn against taking its innovative tool too seriously. In a 2003 article, the magazine defined its index as follows:
“Invented in 1986 as a light-hearted guide to whether currencies are at their 'correct' level, burgernomics is based on the theory of purchasing-power parity (PPP). This says that, in the long run, exchange rates should move toward rates that would equalise the prices of an identical basket of goods and services in any two countries. To put it simply: a dollar should buy the same everywhere. Our basket is a McDonald's Big Mac, produced locally to roughly the same recipe in 118 countries. The Big Mac PPP is the exchange rate that would leave burgers costing the same as in America. Comparing the PPP with the actual rate is one test of whether a currency is undervalued or overvalued.” [Emphasis added]
That said, it is fair to ask whether the index’s seemingly inconsistent determinations of the relative value of the U.S. dollar undermine the tool’s credibility. In so doing, however, one is reminded of the fundamental flaw in the purchasing-power parity (PPP) theory of currency exchange rates. The PPP theory, by definition, excludes most goods traded across international borders. The reason for that exclusion is that, when internationally-traded goods are factored in to exchange rate and purchasing power discussions, calculations have to take into account a myriad of oft-times difficult-to-calculate costs, such as the costs of transporting goods from one country to another – a considerable factor when the U.S. Dollar is the subject of examination and many goods are transported across vast oceans, or when one is examining purchasing power in Japan, where basic goods like beef and petroleum are almost all imported – as well as the costs to consumers associated with tariffs and import quotas that arbitrarily increase those costs, sometimes prohibitively.
The “Big Mac Index” is intended to illuminate the relative costs of a commonly-consumed item – the McDonald’s hamburger – that is locally produced, yet follows the same formula globally. In other words, the Big Mac hamburger is a rare example of a non-tradable item consumed globally and that is the same everywhere it is produced and consumed. By assessing its cost in different countries employing different currencies that trade against each other, one is theoretically best able to determine its real value in each of those countries – a value that should equalize given its common ingredients and manufacturing processes.
All of which brings us back to the value of the PPP theory. Economists are known for their inability to arrive at a consensus, and for the propensity for qualifying their findings or conclusions. That is not a fault of the academic discipline, nor is it an indictment of those who identify themselves as economists. It is simply an acknowledgement that international economics involves so many variables, some of which are vulnerable to massive fluctuations depending upon political stability in parts of the world at any given time and to efforts by some political figures to manipulate exchange rates for domestic purposes, that predictive analyses is inordinately complicated. One of the two largest economies in the world, that of China, does not allow its currency, the renminbi or yuan, to fluctuate freely against the U.S. dollar, maintaining a peg or linkage to the value of the dollar that helps it, a country with an uncertain banking system, a centrally-controlled economy, and a penchant for engaging in economic warfare, to protect itself against the kind of economic instability that affects much of the rest of the developed world. In addition, by keeping its currency artificially lower than the dollar, the Chinese are able to maintain a favorable trade balance that keeps its goods cheap in the U.S. while U.S. goods remain relatively expensive in China.
The PPP theory is further weakened in its practical application by U.S. policies designed to manipulate the strength of the dollar, such as occurred during the administration of President George W. Bush, which, despite its denials, did appear to be deliberately weakening the U.S. dollar as a means of increasing American exports in order to grow a weak economy – seriously flawed strategy given the aforementioned linkage between the Chinese currency and the dollar and the scale of the trade imbalance between those two countries.
To the extent that the PPP theory has flaws, they are not a product of the “Big Mac Index” and The Economist’s determinations of the relative value of a small basket of non-tradable, locally-produced goods. The PPP theory has remained widely-used because it helps understand relative value. As long as its inherent limitations are recognized, it remains useful within the narrow confines of its stated purpose.