New "Big Mac Index" Pokes Yet Another Hole in China Currency Hawks' Boat

One of the more mainstream, if admittedly crude, measures of the relative value of countries' currencies is The Economist's "Big Mac Index."  As the magazine explains, the index "is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries."  For years now, people seeking aggressive unilateral action by the US government to "force" China to appreciate its currency have cited to the Big Mac Index as further proof that the Yuan is, like, totally undervalued and hurting the American economy (insert ominous music here).

For example, the AFL-CIO's "China Currency Coalition" cited to the Index in its 2004 petition to the US Trade Representative under Section 301 of US Trade Law, demanding that the United States impose "across-the-board tariffs on imports from China and to take measures to offset the disadvantage to U.S. exports to China."  More recently, the Fair Currency Coalition, an alliance of businesses, farmers and unions seeking similar actions by the US Government, approvingly cited to the Big Mac Index in a 2010 blog post, and several angry journalists have also relied on the index in order to complain about China's allegedly pernicious behavior (and, of course, politicians' refusal to "get tough" against the dirty commies Chinese).

The House Ways and Means Committee also has used the Big Mac Index to support its interventionist trade policies.  In September 2010 the Committee, Chaired at that time by Rep. Sander Levin (D-MI), issued a briefing memo to journalists showing that the Yuan was undervalued (based, in part, on the index) and that this alleged undervaluation is harming the American economy.  As you may recall, that memo was issued right before House Democrats spearheaded the unprecedented congressional passage of (anti)China currency legislation.  Even reputable economic journalists like the New York Times' Catherine Rampell have discussed the Big Mac Index as a respectable measure of the Yuan's significant undervaluation.

So, clearly, all of these folks think that the Big Mac Index is a worthwhile measure of countries' respective currencies, and thus I'm expecting them to be all over this new report from the folks at The Economist about the new and improved Index (emphasis mine):

At market exchange rates, a burger is 44% cheaper in China than in America. In other words, the raw Big Mac index suggests that the yuan is 44% undervalued against the dollar. But we have long warned that cheap burgers in China do not prove that the yuan is massively undervalued. Average prices should be lower in poor countries than in rich ones because labour costs are lower. The chart above shows a strong positive relationship between the dollar price of a Big Mac and GDP per person.

PPP signals where exchange rates should move in the long run. To estimate the current fair value of a currency we use the “line of best fit” between Big Mac prices and GDP per person. The difference between the price predicted for each country, given its average income, and its actual price offers a better guide to currency under- and overvaluation than the “raw” index. The beefed-up index suggests that the Brazilian real is the most overvalued currency in the world; the euro is also significantly overvalued. But the yuan now appears to be close to its fair value against the dollar—something for American politicians to chew over.

Be sure to check out the great charts at their site.  Very interesting stuff.  If you're still a little confused about how things changed so much, the Wall Street Journal provides some helpful detail and commentary (again, emphasis mine):

The index is based on the theory of purchasing power parity (PPP), essentially the idea that goods should cost the same in markets around the world no matter what currency they are priced in. Since Big Macs sell for 44% less in China than the U.S., the yuan is therefore figured to be 44% undervalued against the dollar.

But PPP only applies to tradable goods that are easily exchanged across borders, like commodities or electronics. Other, less mobile goods like labor and land may well cost different amounts in different markets, and in particular in developing countries where productivity and wages are much lower. Since labor and land are important inputs into the production of Big Macs, these differential costs feed through into the final cost of the burger.

Hence the new Big Mac index, which adjusts for GDP per capita, and thus takes into account the lower costs in poorer countries. As the magazine notes, China’s average income is one-tenth what it is in the U.S., meaning China’s burgers really ought to be substantially cheaper.

New York Senator and prominent yuan critic Chuck Schumer might want to make sure he’s sitting down before he checks out the Economist’s results, which show that on this basis the yuan is actually overvalued against the dollar by 3%. Against a group of various currencies, the yuan is still figured to be undervalued by 7%. which the Economist says is “hardly grounds for a trade war.”

Yes, based on this news, I totally expect Senator Schumer, Rep. Levin, the currency coalitions, and every other currency hawk who has ever approvingly cited to the Big Mac Index to loudly and immediately retract their earlier statements/reports criticizing China's currency policy, or to just drop their breathless protectionist demands altogether.

Riiiiight.


In all seriousness, the point here is not to boldly assert that the new Big Mac Index undoubtedly proves that the Yuan is no longer undervalued.  It's instead to caution, once again, against trusting anyone - whether it be a campaigning politician or a labor union lawyer or a lazy journalist - who aggressively seeks dangerous protectionism based on unequivocal claims that China's currency is significantly undervalued, and that such undervaluation is destroying the US economy.  The facts simply prevent such certitude, and often reveal currency hawks' ulterior motives.

Something to remember now that the 2012 election season is almost upon us.