Big Mac Index: Why My Gold Bug Friends Are Wrong About the Dollar
by Mark Skousen, Chairman, Investment U
Thursday, June 1, 2006: Issue #539
For several years now, I’ve had a big argument with my gold bug friends over the future of the dollar. James Turk, president of Gold Money, and others are predicting the imminent collapse of the U.S. dollar. While a strong case can be made for further weakness, I don’t see a currency collapse for several reasons
One is the Fed’s recent effort to raise short-term interest rates and to tighten money. This alone could boost the dollar against major foreign currencies later this year.
But a more fundamental reason is that the dollar is already grossly undervalued against the euro. Any of you who have been to Europe recently know how expensive it is for Americans. Can it get even more expensive? Perhaps, but a case can be made that the dollar should rally against the euro and other currencies. So, in today’s issue, we’ll take a look at one of my favorite ways to gauge the dollar: the Big Mac Index.
The Big Mac Index Tells All about the Dollar
The Big Mac Index is a great way to demonstrate that the U.S. dollar is deeply undervalued in some places, and overvalued in others. The Economist has been publishing this price index for 20 years now.
McDonald’s produces Big Mac hamburgers in 120 nations, which provides an excellent way to witness price inflation in various countries, and also the Purchasing Power Parity (PPP) between countries. For example, the average price of a Big Mac in the U.S. in 2004 was $3. Now, it’s $3.10. Not much inflation there. But in Mexico, a Big Mac cost 24 pesos in 2004. Now it costs 29, considerably more inflation. Take a look at the entire index below
The Purchasing Power Parity Index helps economists determine how far off the exchange rate is between countries, in terms of citizens’ ability to purchase the same basket of goods and services. In the long run, a basket of goods and services should cost the same in all countries -other things being equal. Economists call this “the law of one price.” But of course, the reality is quite different, due to restrictions on trade, import duties and taxes.
Right now, for example, it costs 2.94 euros to buy a Big Mac in Europe. That’s $3.77 in U.S. dollars, which means that the euro is approximately 25% overvalued against the U.S. dollar! In Britain, the price is approximately 1.94 pounds, but in U.S. dollars, it comes to $3.65.
But in other countries, the Big Mac Index demonstrates that the U.S. dollar is overvalued, especially in Latin America and China. In China, for example, a Big Mac costs 10.5 yuan. In U.S. dollars, this amounts to $1.31, the cheapest place to get a Big Mac in the world! (Russia, by the way, is second, at $1.77). No wonder there’s pressure for China to revalue its currency upward.
Good investing, AEIOU,