Very few people in the USofA have ever worried about currency exchange, at least once they returned from a vacation in another nation. The US Dollar has been a stable rock in the world that simply has not been subject to the ups and downs of foreign commerce as much as other currencies. That may be about to change dramatically, so it’s worth thinking about how currencies move in the mysterious world known as Foreign Exchange (ForEx).
ForEx traders are some of the smartest generalists when it comes to understanding entire economies, but we have the great luxury of treating them as obscure specialists. The reason for this is that the US Dollar is the standard currency of the world. Many commodities, especially oil, are priced in Dollars. People all around the world who buy oil, grain, and a large number of other standard items need to reliably protect themselves against changes in the value of the Dollar versus the Pounds, Kroner, Yen, or other currencies that they use in their daily life. Futures contracts, or the right to buy commodities at a price determined today, tend to lock the Buck into a narrow trading range.
Money, as we know it today, is nothing more than a unit of exchange backed by the central bank of a nation. Our Buck is only as good as the “Full faith and credit of the United States”, which may seem a bit thin to us but is about as good as gold around the world. We’ve had a stable political system and a reliable Federal Reserve that keeps it all keepin’ on. Recently, however, the tremendous amount of “Stimulus” that has been pumped into the economy has brought this into question as we acquire a lot of new debt and the excess Dollars hit the hard realities of supply and demand.
How can we evaluate what will happen? With every major commodity traded around the world, it all tends to even out to a steady state pretty easily. What is needed is a commodity, known everywhere, that is not traded in a way that evens out the price. This would reflect the “Purchasing Power Parity” (PPP) or ability to get what you need to live.
The Economist magazine proposed that one such standard which exists around the world is the Big Mac. The sandwich, invented in Pittsburgh, is crafted with meticulous precision to be as precisely the same everywhere in the world as MacDonald’s can possibly make it. The price, however, has to reflect what people locally will pay. By comparing the price that their local currency is worth on the world trading markets to what it buys on the ground, we can get a measure of what kind of pressure the world markets for currencies are under.
If this sounds silly, it was always meant to be a bit of fun. The real hoot is that it does, at least partially, predict what’s going to happen in currency markets 6 months to a year down the road. The last time the index was calculated, in February 2009, the currencies of South Asia and Australia were shown to buy Big Macs for a lot less than the currency markets would have predicted. Since that time, these currencies have all gotten stronger.
As a measure of PPP, the Big Mac Index is far from perfect. It didn’t, for example, predict the strength of the Euro in 2009. This August, Swiss bank UBS offered an alternative measure that was based on how many minutes a worker making the median wage has to work to afford a Big Mac in major cities. In Chicago, Toronto, and Tokyo, that is only 12 minutes. In Paris it’s 21 minutes, Moscow 22. Singapore clocks in at the global average of 38 minutes. By this measure, the US workers are getting a great bargain compared to other workers around the world. If you assume that it all evens out in the end, the Dollar can only go down from here.
It’s still just a lot of fun in the end, but the Big Mac index highlights something that has been true about as long as I’ve been alive – our Dollar buys us a lot more stuff than people around the world get for their currencies. This is why we have run a massive trade deficit with the rest of the world, which is to say that we find it cheaper to send Dollars abroad for things made in elsewhere than to make them here. We’ve been able to sustain that for a long time because people want and need Dollars.
Our Dollar is only as good as we are. By the Big Mac standard, we get a lot for it. If you think that can continue forever, there’s nothing to worry about. Most of us who follow this don’t think that is reasonable, so we keep an eye on it. The Big Mac Index is one indication that things are about to change.