I also took part in a couple of panel discussions about the Fed on Bloomberg and CNBC.  To watch Bloomberg, click here, and CNBC, here.

Let the Big Mac Index Decide

My "Valuing the Dollar" opinion piece in the Wall Street Journal on March 8, reprinted in my blog as "Lord Give Us a Strong Dollar, but Not Just Yet" apparently didn't rally many troops to the cause of a weak dollar, even temporarily, as it reduces our external deficit and stimulates our economy.  One notable exception, although his support was more implicit that explicit, was Marty Feldstein, one of the top economists in the world, and my choice to succeed Alan Greenspan as Fed Chairman. (No offence to Ben, who is doing a fine job.)  I figure that, with Marty on my side, we almost constitute a majority.

I learned of Marty's position on the dollar when he made brief reference to it in a CNBC interview.  However, he didn't make the rookie mistake that I had made in calling it a "weak" dollar; he said we need a "competitive" dollar. (Imagine the sound of the palm of my hand slapping forehead hard.) Of course, I thought words matter, and his word, was much better than mine even if they meant the same thing.  And, to make matters worse, I had read Frank Luntz's book, "Words That Work: It's Not What You Say, It's What People Hear."  Of course, no one wants a weak dollar, but they might want a competitive dollar.

Our dollar has not been competitive in recent years because capital inflows have kept it from declining to competitive levels, i.e., to levels that would permit us to pay for our imports with exports.  Instead, we've been going into hock to foreigners to pay for them. As I've said in previous postings, the foreign exchange market has produced a dollar exchange rate that equilibrates debits and credits in our balance of payments, but one that includes a huge imbalance in trade in goods and services.  Our dollar has balanced our imbalances, but the imbalances themselves are important.

Economists long ago came up with a concept of the equilibrium value of currencies as exchange rates that would tend to equalize the value of similar baskets of goods and services in different currencies.  The concept is called "purchasing power parity (PPP)."  You have parity in the purchasing power of different currencies if their exchange rates adjust to give similar things a similar price taking exchange rates into account. Our currency has not been permitted to adjust to PPP and thus has been "overvalued" for several years, according to international institutions like the International Monetary Fund.

However, for the past twenty years or so, the Economist has published an index of the relative purchasing powers of currencies substituting a single common item as the market basket. That item is the Big Mac, which is sold throughout the world. Here is the Economist's explanation:

The Economist's Big Mac Index, a light-hearted guide to how far currencies are from fair value, provides some answers.  It is based on the theory of purchasing-power parity (PPP), which says that exchange rates should equalize the price of a basket of goods in any two countries.  Our basket contains just a single representative purchase, but one that is   available in 120 countries: a Big Mac hamburger.  The implied PPP, our hamburger standard, is the exchange rate that makes the dollar price of a burger the same in each country.  [The Economist, July 5, 2007]

The Economist goes on to point out that Big Mac prices depend on many local conditions, and that countries of similar stages of development probably should be used to draw inferences about the exchange rate.  Unfortunately, July 2007 is the last publication of the Big Mac index, which means it won't capture much of the recent depreciation of the dollar.  However, the results in July 2007 are still interesting.

They put the price of a Big Mac in the U.S. at $3.41, which is used as the base for comparison.  (All this would have more relevance to me if it had been the Quarter Pounder or the Fish Sandwich or the Egg McMuffin.  The Good Lord didn't intend for hamburgers to have three slices of bread-too many carbs.)

The weighted average Euro price of a Big Mac just prior to July 2007 was €3.05.  The actual dollar exchange rate on July 2 was $1.36 per Euro, compared to a theoretical PPP exchange rate of $1.12 per Euro.  Therefore, the Euro was overvalued against the dollar by over 21 percent.  Conversely, the dollar would be undervalued against the Euro by 17 percent in terms of Big Macs.

Of course, the Dollar price of Euros has risen significantly since then.  Assuming no change in the local prices of Big Macs, the PPP exchange rate would still be $1.12, but using the more recent exchange rate of $1.56 per Euro, the Euro would be overvalued by 39 percent.  Conversely, the Dollar would be undervalued by 28 percent in terms of Big Macs.

(Admittedly the assumption of no change in Big Mac prices may be unrealistic, especially in the U.S., but I'm not going to Euro land to check.  I couldn't afford it.  However, when I've been there or any other place in the world, no more than two days can pass without my searching out a McDonalds, usually for breakfast.  Of course, I did that in Las Vegas last week as well.)

In Britain, a Big Mac cost £1.99 last July when the pound cost $2.01 (Let's round those to 2 each, shall we?). PPP would have the Big Mac cost half as much in pounds as in dollars, but the ratio was £2 to $3.41-not £2 to $4. The Pound, according to the Economist chart, was overvalued by 18 percent relative to the Dollar-assuming, of course, that Big Macs are typical.

Elsewhere in Europe, the largest currency overvaluations in the Big Mac index were in Switzerland (53%) and Norway (152%).  High prices in Europe don't surprise me.  Think how much bigger these numbers would be if the retail exchange rate on the streets or in the airports were used, rather than the wholesale rates.

At the other end of the spectrum are countries with undervalued currencies against the dollar:  - 58% in China; -55% in Hong Kong.  Interestingly, the undervalued currency group, which usually comprises poor countries, includes Japan (-33%).  The Economist attributes this anomaly to the carry trade, while acknowledging that the Big Mac measure is not representative of Japanese prices, which tend to be high like European prices.

What does the Big Mac index tell us-other than I'm getting hungry?  The dollar is undervalued in many places, primarily old Europe, and overvalued in others, primarily Latin America, China and Russia.  There is no single dollar exchange rate; nor should the dollar move the same way or degree against most currencies. The dollar is the numerare-the currency against which others are measured.  Each should seek its own equilibrium with the dollar.  Perhaps the best way to do that is through Big Mac arbitrage-like gold arbitrage of yore.  But we shouldn't get too religious about it.  No single rate is sacred.  It only balances imbalances, which are not unique.  Let us not crucify man on a cross of hamburger!

Briefly and simply, absolute advantage says we benefit if we do what we do best and trade for the rest.  Smith said the cause of the wealth of nations was the division and specialization of labor, which is limited by the extent of the market.  International trade extends the market enhances the benefits of specialization.

Comparative advantage carries the argument a step further and says that it pays to specialize and trade even if one party can produce everything more cheaply than the other.  My favorite example from school was the executive and his secretary (showing my age with that word).  Even if he can type faster and more accurately than she can, it probably still pays for him to leave the typing to her since his advantage over her as a typist is not likely as great as his advantage as an executive.  Comparative advantage is a most-best or least-worst phenomenon.

Notice I haven't mentioned jobs or trade balances.  The benefits of opening up trade are indicated more by the increased volume of trade than which party develops a surplus or deficit.  It's hard to predict the net impact on jobs initially, but over time it will tend to even out since more imports tend to stimulate exports and more exports tend to stimulate imports.  The net number will tend to end up the same, but presumably they will be in areas of comparative advantage instead of areas protected by barriers to trade.

Bastiat's Petition on behalf of the candle makers to the French Parliament is the classic defense of free trade.  He points out how unfair it is for the French candle makers to have to compete with the sun for the provision of light and argues for a law requiring the shutting of blinds and shutters to level the playing field.  He goes into great detail about the secondary benefits that spread from the candle makers to other related industries and create a general prosperity.  (See Why Bastiat is my Hero in 2001 speeches at http://www.bobmcteer.com/.)

While Bastiat's arguments for free trade are more fun, a more succinct statement was provided by Henry George, who pointed out that protectionists want to do to their country during peacetime (close its borders to imports) what the country's enemy would want to do to it during wartime.   

Most educated people understand the benefits of free trade, and that probably includes educated politicians.  However, many who understand are only too willing to pander to the many more that don't.  The reason many don't is that the benefits of free trade are widely dispersed while the costs are more concentrated.  Free trade helps almost everyone a little bit, but hurts a few a lot.  Furthermore, the higher standard of living associated with, and attributable to, free trade is not easily identified — while a job lost at a plant moving to China is easily associated with it.

Theoretically, those benefited could use a portion of those benefits to help those harmed get trained for the new jobs created by trade.  But, alas, it's easier for politicians to feed the ignorance than to try to educate their constituents, and that seems true for two-thirds of our presidential candidates.

Economists often refer to the U.S. trade deficit and the federal budget deficit as problems of inadequate domestic saving.  They speak of these deficits "crowding out" domestic investment.  They allude to unspecified relationships between these deficits but seldom explain them, confusing everyone.

What is often left unsaid is that the trade deficit (when more goods and services are imported than exported), the budget deficit (when government spends more than its tax revenues), and the balance between domestic saving and investment are related to each other.  In fact, their sum must equal zero.  A change in any of them affects all of them.  For example, tax incentives to encourage saving would likely stimulate investment, lower both the budget and trade deficits, and also reduce reliance on foreign capital.  Think of three fat men filling up a telephone booth.  When one inhales, the other(s) must exhale.

An Economy without Government or International Trade. To understand the interdependence of these three imbalances, first consider saving and investment in an economy with no external trade and no government.  All saving (income minus consumption) and investment (output not consumed) are domestic.  With different people doing the saving and investing, plans for each are likely to differ.  If so, market forces – such as interest rates, prices and nominal income – will adjust until actual saving and investment balance.  In this closed economy, if planned saving exceeds investment, incentives for saving (that is, interest rates) will tend to fall until saving and investment balance.  Likewise, if planned investment is greater than saving, they will be brought into balance by market forces, if the economy is at or near full employment.

Think of saving as a leakage from the income stream which, other things equal, tends to shrink income.  Think of investment as an injection into the income stream (in addition to consumption); other things equal, it tends to increase income.  Income and other variables will adjust until the leakage of saving matches the injection of investment (I = S), as shown in the top half of Box 1 in Figure I.

An Economy with Government.  Introducing government into the equation creates another leakage similar to saving in its impact; that leakage is taxes (T).  There is also another injection into the income stream in addition to investment:  government spending (G).  If taxes and government spending balance – that is, if the budget is balanced (G = T) – the net impact of government on income is neutral, and private saving and investment will also balance.

The leakages balance the injections, but the individual components aren't necessarily equal.  If government runs a budget deficit (Box 2), it will be matched by an equal surplus of private savings compared to investment (S >I).  This is how a budget deficit crowds out private investment, by competing with private borrowers for savings.  A budget surplus (Box 3) will be matched by an equal deficit in saving compared to investment (S < I).

An Economy with Government and International Trade.  Now, add international trade to the analysis.  When we do, payments for imports become a third leakage from the domestic income stream while income from exports become a third injection.  An imbalance in any of the three pairs will be matched by an opposite imbalance in the other two taken together.  The principle is the same as in previous examples, but the interactions become more complex.

As shown in Box 4 (Figure II), any excess of investment over saving (I > S) is matched by a combination of budget and export surpluses (G < T and X > M).  The budget surplus is positive government saving, and capital flows out to be invested abroad.  This economy is sacrificing some consumption today for greater prosperity tomorrow.

The U.S. Deficits.  Box 5 (not drawn to scale), depicts the current situation in the United States:  The shortage of private savings (I > S) to finance domestic investment is exacerbated by negative government saving (the budget deficit, G > T).  However, both these shortfalls are met by the trade deficit – or, more precisely, the inflow of foreign investment that finances the trade deficit.  In other words, the United States is relying on foreign savings to supplement domestic savings.  The U.S. economy consumes more goods and services than it produces thanks to foreign credit.  One result is that each year's external deficit adds that amount to net foreign holdings of U.S. dollar assets.  This is not necessarily a bad thing.  Foreign investment has historically played an integral part in U.S. economic growth and shows that America is attractive to investors.  In addition, external investment mitigates the crowd-out effect of government borrowing by expanding the pool of available credit.

The situation can become unsustainable, however, because foreign investment is funding increasing government budget deficits (government dissaving) and inadequate private saving.  The growth in foreign claims on the U.S. dollar relative to U.S. claims abroad makes the U.S. economy vulnerable to the actions of foreign central banks and, possibly, sovereign wealth funds.  Better to reduce that vulnerability sooner rather than have to go cold turkey later.

Reducing the Deficits.  What are the policy implications of these interdependent imbalances?  Here are three:

-Tax incentives to encourage saving would likely also stimulate investment and lower both the budget deficit and the trade deficit.

-Reducing the budget deficit would reduce the vulnerability of the U.S. economy to foreign creditors; rising deficits could lead to foreigners dumping dollar assets, causing equities to decline, interest rates to spike and the dollar to plunge.

-Reducing the budget deficit doesn't necessarily mean higher tax rates; marginal rate cuts reinforced by slower government spending growth would be ideal incentives.

Unfortunately, the recent tax "rebates" designed to stimulate the economy dealt a setback to budget discipline.  Most people probably understand that.  What they probably don't understand is that the increased budget deficit will also tend to worsen our international balance of payments and weaken the dollar.  The hip bone is connected to the thigh bone; so policymakers need to study these interconnected deficits.  They need to borrow my boxes.

To see some of our panel discussions from the show, click here and here.

And don't forget to check out my latest blog posting below.

The unemployment rate, estimated from a different household survey, rose from 4.8 to 5.1 percent, resulting mostly from a reversal of the shrinkage of the labor force in February which had lowered the unemployment rate from 5 to 4.8 percent.

After 6 solid years of expansion, the first quarter is now likely to go down as the first quarter of a recession, although benchmark revisions in the future may revise the 4^th quarter from 0.6 percent positive to a small negative, making it the potential first quarter of a recession. (That happened in 2001, when, at the time, the 3^rd quarter was the first negative quarter, but later revisions suggested the recession began in March and ended only 8 months later in November. Thus, the recession was ending just when we thought it was beginning.  Not only does the future keep changing, which is confusing enough, but so does the past.)

I heard Marty Feldstein say on CNBC this morning that the last 2 recessions were both only 8 months long while the previous two lasted 16 months.  If he said it, I believe it, and I won't bother to look it up.  Assuming both the 1^st and 2^nd quarter real GDP numbers are negative, there is no telling whether this recession would come closer to 8 or 16, or be milder or more severe.  My guess it will be about as short and almost as mild as the recent two.

One thing real GDP has going for it this time is that the 0.6 growth rate of the fourth quarter wasn't as bad as it seemed.  For one thing, declines in inventories, which are treated as negative investment by the accountants, subtracted 1.7 percentage points from the GDP calculation.  Setting inventories aside, real final sales grew a respectable 2.3 percent.  Assuming the inventory declines were unintended and resulted from above-forecast sales, it augurs well for the near future.

Another bright spot in the recent GDP stats is international trade in goods and services have, under the influence of a more competitive dollar exchange rate, turned from a net negative in GDP calculations to a net positive.  For a long while, optimists have talked about rapidly growing exports while neglecting to mention that imports were growing rapidly too, offsetting the potentially expansionary export growth.  Recently, however, imports have slowed, and helped the surging exports provide net stimulus (defined as less of a drag) to the economy.  Since imports are substantially larger than exports, a smaller percentage in import growth might exceed a larger percentage of export growth in dollar terms.

Let me pause here and briefly address an issue that never gets addressed and one that I'm sure confuses many people.  Having imports subtracted from the GDP calculation, gives the impression that they are somehow negative or bad.  The reason they are subtracted is because in counting the other components of GDP, like consumption spending and investment spending or even government spending and exports, there are import components that haven't been taken out.  It is easier to add them up and take imports out of the total than to do it category by category.  The reason imports are subtracted in the first place is that spending on imports generates income in the exporting countries, not here.

The weaker dollar of late has contributed to the improvement in the net trade balances, and is one reason I'm in no big hurry for the dollar to rise again.  First, we need the stimulus to moderate the impending recession, or avoid it altogether.  Secondly, we need to shrink the current account deficit for its own sake.  Normally, a large excess of imports over exports would push the currency down to correct the imbalance, but capital inflows have prevented that adjustment.  The result has been a balance of payments pattern more suitable for a developing country than for the richest country in the world.  We have been borrowing money from countries poorer than us to finance our excess absorption of goods and services.  The accumulation of dollars abroad has the potential of stoking protectionist fears and fears that "foreigners are buying up our country."  We all feel better paying for our imports of goods and services with exports of goods and services rather than with financial and real assets.

Don't get me wrong, I like a strong dollar normally.  As I've said recently, I feel about a strong dollar like St Augustine felt in his famous prayer about chastity:  "Lord, make me chaste, but not just yet."  I say, "Lord, give us a strong dollar, but not just yet."

I've been honored by an invitation to be a guest host during the second and third hours of CNBC's Squawk Box on April 4, during which time the employment numbers will be released.  I will be on the Squawk Box set if the Dallas rains don't intervene and ground me, as they did last time. 

I'm likely to embarrass myself trying to guess what the employment number will be.  I'll wait until the new claims for state unemployment insurance are released on Thursday, April 3, before formulating my guess, but I imagine it will be a small change one way or another, more likely down than up.

Partly to redeem myself for a bad guesstimate on employment, I hope to have an opportunity to call attention to an aspect of the employment numbers that I wrote about here on July 9, 2007, titled Job Angst: It's the Churn, Stupid.  The point of that posting was to call attention to a little-recognized, but important fact about the job numbers.

My point then, and again now (with more numbers) is that the net changes in monthly employment, even large net changes, are tiny compared to the gross changes in job gains and losses that produce the small net change.  A change of 100,000 net new jobs in March, in either direction, would likely obscure job gains and losses 20 to 30 times larger.  That is an important reason for people's angst about the job situation that seem out of proportion to the size of the reported job changes.  The job churn produces a swift undercurrent even under the best of circumstances.

Let me give you some numbers and calculations derived from a very useful series, but apparently not well known, from the Bureau of Labor Statistics, titled Business Employment Dynamics.  The numbers are for total private jobs only, and thus may not jibe precisely with the numbers you are familiar with.

First, let me make a broad generalization based on those numbers:

In recent years, the quarterly gross job gains and job losses have ranged roughly between 7 and 8 million, or between 2.33 and 2.66 million per month.  Compare that 2.33 to 2.66 million monthly average to the net job gains or losses each month that are usually under 300 thousand.

In 2004, there were 30.9 million private job gains and 28.9 million private job losses, for a net annual increase of 2 million or 171,000 per month.  The gross changes were roughly 14.5 times the net change.

In 2006, a weaker year for net job growth, 30.7 million new jobs were created while 29.1 million jobs were lost, for a net gain of 1.67 million, or 138.6 thousand per month.  That's roughly 16.5 jobs gained and lost for every net job gained.

The even weaker job market in 2007 raises that ratio further.  During the first two quarters of 2007 (the latest data available), 15.2 million jobs were created while 14.5 were lost, for a net gain of almost 700 thousand, or 117 thousand per month.  For each net new job created, over 22 jobs were gained and over 21 were lost.  

No wonder the angst about jobs and the economy seem to bear little relation to the job numbers reported on the first Friday of the month.

It's gross angst.

Lord, give us a strong dollar, but not just yet.

When rock and roller Buddy Holly was four years old, he insisted on playing his toy fiddle in his uncle's band.  It made a terrible sound; so his uncle waxed Buddy's bow.  He could still fiddle, but he made no sound.

Alan Greenspan waxed my bow when, as president of the Federal Reserve Bank of Dallas, I served with him on the Fed's Federal Open Market Committee for almost 14 years.  He wouldn't let me or other committee members, including himself, talk about the dollar.  That delicate task was reserved for the Secretary of the Treasury, who also tried to avoid it, for good reason.  The market always reacted badly.

Now that my bow is no longer waxed, I feel a perverse urge to talk about the dollar.  Unfortunately, my viewpoint currently differs from that of other "talking heads" on financial TV and Radio.  They want a strong dollar, by jingo, as if they could just order it off a menu with everything else they want, no matter their compatibility.  They worry, especially, about the dollar's recent decline against the Euro and the implications for U.S. inflation and prestige abroad.

I think the strong Euro will do more damage to Europe than our weak dollar will do to us.  The cheerleaders for a strong Euro may soon feel like the dog that finally caught the car. What now?

Normally, I prefer the advantages of a strong currency, but, by definition, all currencies can't be stronger than average.  Strong currencies help consumers hold down prices and keep the pressure on producers to remain competitive in the world market.  But, under current circumstances, I feel about the dollar what St. Augustine felt about chastity.  To paraphrase his famous prayer, "Lord, make our dollar strong, but not just yet."

For now, our weaker dollar serves us well in two principal ways.  First, by boosting our exports and discouraging imports, it provides a shot in the arm for our weak economy.  A smaller trade deficit will boost economic growth, and help us avoid or, at least, moderate a recession.  Second, we need to shrink our trade deficit in goods and services to slow the relentless flow of dollars abroad.

Each year's deficit adds that much more to the huge dollar holdings of foreign central banks and others and means greater foreign indebtedness for the United States.  The persistence and size of our trade deficit also lead to calls for protectionism, a cure worse than the disease.

Normally, a trade deficit would adjust automatically through a decline in the dollar.  That hasn't happened yet because the U.S. has been such a magnet for foreign investment.  Foreign capital inflows have kept the dollar too high for trade to adjust.  Only recently has the capital inflow diminished enough to allow the dollar to depreciate, and depreciation's positive impact on our trade is just now beginning.  We shouldn't interrupt that correction prematurely by trying to talk the dollar up, or by intervening in foreign exchange markets, neither of which helps for long anyway, if at all.

The dollar won't fall forever.  The lower it goes, the sooner foreign importers, and, especially, investors will return to take advantage of the bargains.  At that point, the dollar will rebound, but hopefully from a sounder basis of more balanced trade.  So, I repeat my prayer: "Lord, give us a strong dollar, but not just yet."