The Poison(ing) of Purchasing Power Parity

I had a choice of yelling at clouds or writing this. They’d probably have the same impact, yet here we are. A unit of currency in one place should have the same purchasing power in another—this is very roughly the idea of purchasing power parity (PPP). It’s a valuable insight but, due to the embrace of convenience over accuracy, PPP is so broadly and routinely abused that it’s done more harm than good. PPP is normally applied internationally but a basic implication applies anywhere. Prices of (nearly) the same item can vary widely in New York versus Nevada, or Shanghai versus Shaanxi. You must make more money in New York or Shanghai to have the same purchasing power as in Nevada or Shaanxi. Obvious.   Exchange rates across economies add a major wrinkle. PPP says the ratio of prices in two countries for goods and services tradable between them should match their nominal exchange rate. Illustration: identical cans of cola should have the same pre-tax price in different economies, excepting things like transport costs. If the prices appear quite different, it’s likely due to the exchange rate between economies being distorted. Further, exchange rates can be volatile, making snapshot international comparisons odd or even unusable. Facing these problems, economists turn back to that cola absorbing the same amount of purchasing power in different economies. Instead of using prevailing exchange rates (and simple arithmetic) to make international comparisons, exchange rates are replaced by calculated figures aimed at making purchasing power equivalent per unit of currency. What’s behind equivalent purchasing power is arbitrage. If prices for identical colas persistently differ, they can be bought in the cheap place and sold in the expensive place. This pushes prices back together. What permits arbitrage is open markets, which economists love to assume. It’s a good assumption, but here it’s been stretched beyond reason. This gets a bit complicated, but PPP should not be applied in the same way to whole economies. PPP is rightly grounded in consumer goods. It should not be applied in the same way to tradeable goods and services that move across national or regional lines as to non-tradable goods and services that don’t. The causal mechanism and needed empirical work are very different. Not all economies are open. A few are explicitly closed, like North Korea. Others are explicitly segmented, as with China’s closed capital market . And many are effectively less open due to inefficiency—where those excepted transaction costs are high. The world’s poorer economies often get a large boost in their incomes from applying PPP. But they remain poor in part due to high transactions costs that undermine PPP’s usefulness. Directly related is a measurement challenge. Poorer economies tend to have more distorted price systems, they also tend to have worse price measurements. Abandoning national data in favor of direct observation is a solution but requires much work and is difficult to time correctly across many economies. Global PPP tables are unavoidably somewhat dated when published and always badly dated before the next round is done. Size is another issue. The usefulness of national price indexes for countries like the US, China, and Brazil is already strained. That price difference between New York and Nevada makes national inflation rates less informative. PPP’s comparison of a single price representation for the US to a single price representation for another economy, especially a large economy, is more strained. Currency market distortions may be less misleading. PPP seems to be applied in the same way to all of the world’s economies primarily because it’s convenient. The ensuing list of nearly all economies’ full GDP quantitatively adjusted to reflect purchasing power parity is dubious, at best. Applying PPP to GDP per capita is worse. GDP exists at the national level; the per capita result is notional. It’s not sensible to use actual prices to quantitatively adjust notional per capita GDP. What gave this post the win over yelling at clouds was a cross-national comparison of R&D done by the OECD three weeks ago, unfortunately picked up elsewhere. The OECD compares national R&D spending using the PPP adjustment for GDP. It includes a weak disclaimer, typically omitted by the ensuing pieces. There is very little reason to think prices tied to R&D mirror economy-wide prices. This comparison, and others like it, should not have been done. PPP can be valuable. If done well, it can be quantitatively applied to a narrow range of economies or a somewhat broader range of sectors. Or it can be used as a qualitative caution against distorted or volatile exchange rates. Problem 1 is extending the quantitative adjustment too far due to a desire for artificial precision. Problem 2 is extending quantitative adjustment much too far due to outright ignoring what PPP is. The post The Poison(ing) of Purchasing Power Parity appeared first on American Enterprise Institute - AEI .