Big Mac index: Is the U.S. dollar overvalued?

We have long been admirers of the Economist magazine’s Big Mac index, whose annual appearance cleverly reduces the issue of exchange rates to one simple measure: the cost of a Big Mac in various countries around the world.

Or as the Economist’s Tom Easton explained when I asked him why the Big Mac is a reliable metric in a 2004 NewsHour story:

TOM EASTON: Because it starts with the package, it has the labeling, it has the sesames, it has the bread, it has the beef, it has the lettuce, and it has the pickle, too. And it has the cheese, which is a dairy product.

So basically you’ve got a huge swath of products all in one little package that is identical, whether you buy it in Berlin or whether you buy it in Paris or whether you buy it in New York.

PAUL SOLMAN: So very roughly, a Big Mac should cost the same everywhere once you adjust for foreign exchange rates. If it costs a lot more or a lot less, that suggests the exchange rate may be out of whack. And today’s prices?

TOM EASTON: For an American, a Big Mac costs about 25 percent more in Europe than it would in New York City. And if you had done this same exercise a couple of years ago, you would have found the reverse: The dollar would have been overvalued compared to the euro.

Well, a decade later, a Big Mac costs a paltry 3 percent more in the eurozone than in the States — an apparent comedown for the euro. But having had 10 years to ruminate on the index, while enjoying the Economist’s annual cornucopia of culinary allusions, and looking closely at this year’s Big Mac index graphic, it occurred to me that the most striking correlation seems to link the wealth or poverty of the countries to the price of a Big Mac, not manipulation of exchange rates. Is Norway’s currency overvalued? Or is Norway just too darned rich? I suspect, in other words, that the Big Mac index is based on a problem in the application of purchasing power parity, as a concept, to a comparison of currency valuation.

“An identical basket of goods and services,” says the Economist. But as anyone who travels in the U.S. knows, prices for “identical” goods and services vary dramatically by region. The house I’m sitting in while typing this, here in Norwalk, Ohio, sits on three-and-a-half acres of land, boasts a heated swimming pool, and is appraised, accurately, at $148,000. If the “identical” spread were in the Boston area — almost anywhere in the Boston area — it would cost many multiples more. As would the cost of, say, painting the house. In other words, both land and labor are key cost components. The fact that they’re cheaper in China, say, or far cheaper in the Ukraine, hardly demonstrates that the renminbi or hyrvnia are overvalued. (The Economist’s concession that “Political turmoil is depressing the hryvnia” is something of an understatement.)

Wikipedia has a really nice discussion of the Big Mac index’s “limitations,” which includes these paragraphs:

…there is no theoretical reason why non-tradable goods and services such as property costs should be equal in different countries: this is the theoretical reason for PPPs [Purchasing Power Parities] being different from market exchange rates over time. The relative cost of high-margin products, such as essential pharmaceutical products, or cellular telephony might compare local capacity and willingness to pay, as much as relative currency values.

McDonald’s is also using different commercial strategies which can result in huge differences for a product. Overall, the price of a Big Mac will be a reflection of its local production and delivery cost, the cost of advertising (considerable in some areas), and most importantly what the local market will bear — quite different from country to country, and not all a reflection of relative currency values.

In some markets, a high-volume and low-margin approach makes most sense to maximize profit, while in others a higher margin will generate more profit.

But hey, The Economist treats its index with plenty of levity. We should all enjoy it.

In 2004, Paul Solman interviewed The Economist’s Tom Easton about the Big Mac index and purchasing power across countries.

And four years later, Solman visited the Not Your Daughter’s Jeans factory in Los Angeles, reporting on how the falling dollar affects imports and exports and inflation. Watch that segment here. Watch Paul’s conversation with former IMF chief economist Simon Johnson about why the dollar drops when the U.S. economy revives.