Taps Coogan – February 15th, 2022

The following graphic, from Reddit user Jcceagle, visualizes the Big Mac Index since 2000. The Big Mac Index is maintained by the Economist and tracks the price of a Big Mac burger in countries around the world, converted back into US dollars at the official exchange rate.

The logic of the Big Mac Index is best described by the Economist:

“A Big Mac costs 69 hryvnias in Ukraine and US$5.81 in the United States. The implied exchange rate is 11.88. The difference between this and the actual exchange rate, 28.37, suggests the Ukrainian hryvnia is 58.1% undervalued”

The Big Mac index is intended to be taken lightheartedly, but the concept behind it, the Producer Price Parity (PPP) Index that you will sometimes see economists use the adjust GDP figures, is taken seriously. PPP applies the same math as the Big Mac Index to a basket of goods across the economy and then gets to one number that describes how ‘under’ or ‘over’ valued a country’s currency is.

While PPP may be useful in currency trading, measuring real inflation, and various other tasks, yours truly has long had a bone to pick with PPP being applied to GDP.

The most glaring problem with applying PPP adjustments to GDP is that it is an almost perfect proxy for poverty.

Let me explain.

Given no information about a group of countries except how much their currencies are ‘undervalued’ according to PPP (or the Big Mac Index) one can almost perfectly sort those countries from rich to poor, long lifespan to short lifespan, corruption to non-corruption, low GDP-per capita to high, median education level, etc… The countries with the most ‘undervalued’ currencies are almost always the most impoverished ones. You can see it in the Big Mac Index above when it ranks countries from Ukraine, Venezuela, South Africa, etc… to the US, Norway, and Switzerland.

In fact, taking just one country, Ukraine for example, and looking at no data except how ‘undervalued’ its currency is over time according to PPP, one can chart its economic ups and down relatively accurately. The more ‘undervalued’ its currency according to PPP, the more likely it is to be suffering from acute economic problems and recession.

To take the degree of undervalue for a country, let’s say 25% in Ukraine, and then claim that its GDP must therefore be 25% higher (in PPP terms) is a logical fallacy. It is to argue that the more a country exhibits a characteristic that is highly predictive of poverty, the less poor it must be.

It is true that if Norway and Ukraine both produce ten Big Macs, Norway’s GDP will appear higher than Ukraine’s, but then again why shouldn’t it? Norway is more productive than Ukraine. Producing ten Big Macs in Norway produces a quality of life for the people in the ‘Big Mac’ supply chain that is higher than in Ukraine, and the Norwegian economy is productive enough to support the higher cost of doing that. To exclude that reality from the measure of an economy is to exclude the very thing that differentiates wealthy and poor economies from each other. We wouldn’t seriously suggest that because a taxi cab driver in Oslo makes ten times as much as a taxi cab driver in Kiev while producing an equivalent service, that therefore the entire Norwegian and Ukrainian economies are actually the same size (per capita), so why accept the logic when applied to a few dozen things in a PPP basket?

If prices in a country are even lower than would be expected from exchange rates, something is dysfunctional in that economy. Compensating for that disfunction with PPP doesn’t produce more accurate economic statistics. It produces a hypothetical.