Editor's Note: This piece is reposted from the Council on Foreign Relations’ Geo-Graphics blog.
The “law of one price” holds that identical goods should trade for the same price in an efficient market. But to what extent does it actually hold internationally?
The Economist magazine’s famous Big Mac Index uses the price of McDonald’s Big Macs around the world, expressed in a common currency (U.S. dollars), to estimate the extent to which various currencies are over- or under-valued. The Big Mac is a global product, identical across borders, which makes it an interesting one for this purpose.
But you can’t buy a cheap burger in Beijing and eat it in New York. So in 2013 we created our own Mini Mac Index that compares the price of iPad minis across countries. iPad minis are a global product that, unlike Big Macs, can move quickly and cheaply around the world. As illustrated in the graphic above, and explained in the video below, this helps equalize prices.
The Mini Mac Index suggests the law of one price holds far better than does the Big Mac Index. And it has done so consistently year after year since we started it. Both indexes currently show the dollar overvalued against most currencies. But the Big Mac Index puts the average overvaluation at 24 percent—a Whopper. Our Mini Mac Index puts it at only 7 percent—Small Fries.
The Mini Mac Index also suggests that the dollar has become slightly less overvalued (down from 9 percent) since the beginning of the year. The pound is now 12 percent undervalued, after its sharp fall on the back of the Brexit vote. Having been undervalued by 10 percent at the beginning of the year, the yen is now slightly overvalued, threatening to derail efforts to push inflation to the Bank of Japan’s 2 percent target.
No wonderJapanese officials are contemplating currency market intervention to weaken the yen. The renminbi has weakened slightly and is now 7 percent undervalued—a more sensible estimate than the 45 percent undervaluation implied by the Big Mac Index.
The evidence is clear—the Big Mac Index doesn’t cut the mustard.
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This Hedgeye Guest Contributor research note was written by Benn Steil and Emma Smith. Mr Steil is director of international economics at the Council on Foreign Relations and author of The Battle of Bretton Woods. This piece does not necessarily reflect the opinion of Hedgeye.