Benn Steil and Emma Smith have a new post on the Big Mac Index:
The Economist magazine’s famous Big Mac Index uses the price of McDonald’s Big Macs around the world, expressed in a common currency (U.S. dollars), to estimate the extent to which various currencies are over- or under-valued. The Big Mac is a global product, identical across borders, which makes it an interesting one for this purpose.
But burgers travel badly. So in 2013 we created our own index—one that better meets the condition that the product can flow quickly and cheaply across borders.
The Geo-Graphics Little Mac Index compares the price of iPad minis across countries. iPad minis are a global product that, unlike Big Macs, do in fact travel the earth with their owners.
. . .
Overall, the Little Mac Index suggests that the dollar has become slightly more overvalued (up from 5 percent) since the beginning of 2015. The euro is undervalued by 11 percent, and the yen by 10 percent. Having been fairly valued at the beginning of last year, the renminbi – following on the heels of China’s large devaluation in August – is now 5 percent undervalued. This compares with an implausible 46 percent undervaluation on the Big Mac Index. Maybe Congress is Lovin’ It, but we think the Economist needs to hold the mustard.
Given recent events, only a complete moron, or Donald Trump, would claim the yuan is undervalued. So that’s a point in favor of the Little Mac Index. But let’s step back and think about what terms like ‘overvalued’ and ‘undervalued’ actually mean. Do they mean the exchange rate is artificially set at a different level from the black market rate? Perhaps in cases like Venezuela, but in most cases these are actual market exchange rates, where you can freely buy and sell the currency in question. So clearly that’s not what the creators of the Big Mac and Little Mac indices have in mind.
But then what does it mean to say an asset price is under or overvalued? Does it mean the market is in some sense wrong, as when there is a bubble? Perhaps, but then why would you expect these “Mac” excises to find the right exchange rate? Yes, PPP predicts a certain relationship between prices, but we have very good economic theories, such as Balassa/Samuelson theory, which explain why we should not expect PPP to hold for all goods. So a deviation from the prediction of PPP actually tells us nothing about under and overvaluation.
Nor is it clear why Steil and Smith think it’s better to use a traded good than a non-traded good. Let’s take that to the logical extreme, and use a good that is so easily traded that the law of one price holds, say gold. AFAIK, the price of gold in New York, London, Hong Kong, Tokyo, Zurich, etc., is virtually identical, when measured in a common currency. So Steil and Smith have picked a good that is more easily traded that Big Macs, but less easily traded than gold. But why is that optimal? Using gold, PPP would always seem to hold true. Even worse, a sudden adjustment in the exchange rate (such as Switzerland’s 15% appreciation a year ago), would leave the price of gold in Zurich exactly the same as before, when measured in dollar terms. In other words, if they had chosen a very easily traded good like gold, instead of Little Macs, Steil and Smith would have found the Swiss franc to be correctly valued right before, and right after, a sudden 15% adjustment. Does that make sense?
It seems to me that if you really want to look for exchange rates that are out of line with PPP, you’d use non-traded goods like Big Macs, not traded goods like gold. Little Macs fall in between, and offer no obvious advantage over either extreme.
In my view all of these exercises miss the point. Exchange rates should not be set to make PPP come true. Nor should exchange rates be set to generate a current account balance of zero. Trying to set rates to make these equalities hold would create a macroeconomic disaster. Exchange rates should be set at a level that provides macroeconomic equilibrium, something like low and steady growth in NGDP. The only meaningful sense that an exchange rate can be said to be overvalued is if it leads to below target NGDP growth (or inflation, if you prefer.) For instance, despite falling from 80 to the dollar, to 120 to the dollar, the yen is still overvalued, as most experts forecast about 1% inflation going forward, which is below their 2% target.
This sense in which an exchange rate can be overvalued is exactly the same as saying the short term interest rate is too high, or the TIPS spread is too low, or the nominal price of zinc is too low. A counterfactual monetary policy that produced on target NGDP growth, would (by assumption) lead to a lower short-term nominal interest rate, a higher TIPS spread, and a higher nominal price of zinc. And a lower domestic currency value in the forex markets. That doesn’t mean the market is “wrong” in a “violation of the EMH” sense, rather it means monetary policy is too tight to achieve macroeconomic equilibrium.
So far I’ve talked about nominal exchange rates. But what about real exchange rates, can they also be overvalued or undervalued? Elsewhere I’ve argued that real and nominal exchange rates are so different that they should not even be discussed in the same course. And yet many people foolishly talk about them synonymously. What would it mean to say the China’s real exchange rate is undervalued? In that case you’d be arguing that China’s government policies encourage too much saving, too little investment, or both. In other words, the policies encourage too big a S-I gap, which of course is the current account surplus. I’m not saying that’s true (I doubt it) but that would be the argument. In that case it would be stupid to adjust the exchange rate (doing so would produce a depression) you’d want to change the saving/investment policies.
Off topic, I love the ambition in this post by C. Harwick, where he derives NGDP targeting from first principles. I don’t know anything about this blogger, but based on this post he seems much younger and much smarter than I am. However I disagree with the final two bullet points in item #13.