Making my way through the economic system of the Philippines, and noting the ways in which it differs, has gotten me onto thinking more about international economics. Especially this notion of buying power. By most measures, my peso has much more potential in my slum community (where I can buy a small meal for 10-20pesos (30-60¢) than in the local mall (where the price of a meal ranges from 40-400 pesos ($1-$10)). And even there, unless I go to a very westernized restaurant, my dollar has much more power than in Canada, where even the cheapest food is usually more than $5 per meal, and sometimes $20 or $50 per meal. Of course I have noticed this trend for more than just meal prices. And I’m sure the contrast is more stark in Malawi.
So my question is this: why do currency exchange rates not reflect actual buying power? And to what degree is this dynamic hindering international development?
Your question strikes at the heart of classical economics: Why doesn’t the invisible hand work? Just to review, classical economics says that if a Filipino slum dweller is selling a meal for 50¢, then all the rational people will buy from her rather than going to the mall for a meal that costs ten times as much. Soon, she’ll start to charge more until the mall lowers their prices to get their customers back. Why hasn’t this happened on a global scale?
This is where one of my favourite metrics comes into play: the Big Mac Index.
The Index (cousin to the Golden Arches Theory) examines how much it costs to buy a Big Mac in every country where they are sold. For example, you could take your $4.79 and change it into 303.82 Indian rupees, and buy two Big Macs* with change to spare (interactive).
This is the essence of your question: If we can get 2.6 Big Macs in India, why doesn’t everyone keep changing their dollars into rupees until the exchange rate levels out? Why isn’t the invisible hand working?
There’s a lot of reasons why the invisible hand moves slowly. I’ll run you through five.
The first is obvious: no American is going to go all the way to India to get a Big Mac. Geography is one of the biggest barriers to markets acting as they should, which is why many landlocked countries have such a hard time developing.
The second thing is that even for something as timeless as a Big Mac, you aren’t paying for the exactly the same thing in Jakarta as you are in Geneva. Beef patties, health inspections, and bored teenagers cost a lot more in Switzerland than they do in Indonesia. Similarly, the 50¢ bowl of rice and vegetables is not a comparable good to the stir-fry at your mall that costs ten times as much.
The third thing has to do with the type of examples we’re thinking about. Big Macs (and Balut) are unique because even if you packed a shipping container full of them in Hyderabad and brought them to Los Angeles, people wouldn’t buy them because they would be all moldy (actually Big Macs would probably be totally fine, but that’s beside the point). The point is that markets don’t work like we think they should because many of the things we make are non-tradable goods, so prices don’t adjust perfectly.
Of course Big Macs don’t drive exchange rates. What about comparable, tradable things like t-shirts and sandbox toys? Why would a company set up shop in Canada when they could come to Malawi and get labour and materials for half the price? Again, geography is a factor, but more important is that investment is extremely risky in a place like Malawi; high inflation, unreliable utilities, corrupt officials, and political instability all increase the chances that your t-shirt factory might tank. In a recent ranking, Singapore topped the list as the easiest place to do business, while Eritrea was at the bottom. Malawi was 141st out of 189.
Finally, some of the differences in buying power has to do with the way that countries make rules. If you want there to be burger flipping jobs, you’re going to make rules about who can bring burgers into your country. On the other hand, if you’re running Malawi, you may want to export lots of burgers. In that case you might devalue your currency by buying all whole bunch of dollars. When you do this, there are lots of kwacha out there so they aren’t very valuable, which makes people want to buy your burgers (which they pay for in relatively cheap kwacha). Problems that can happen when you do that, but we won’t get in to that.
So there’s five quick reasons for why exchange rates aren’t perfect: geography, comparability, tradability, risk, and rules.
So now: “To what degree are these things hindering international development?” If you define development broadly as “macroeconomic growth” then of course imperfect markets do indeed hinder growth. But that’s obvious. Here’s some more interesting conclusions:
If you’re a Libertarian, one takeaway is that the rules we make are just one of a whole host of factors that make markets act imperfectly. If you’re a Socialist, perhaps a takeaway is that connecting the world by improving transportation, technology, and trade won’t be a terrible thing for the world’s poor.
But before you go, I have two pictures and two charts to restore your faith in the invisible hand. This first I took five minutes away from my house:
This is Bingu International Stadium, probably the largest structure in the country, set to open next month. This is what happens when Chinese builders realize they can build a stadium in Malawi for a fraction of the price of making one in China. It is an example of foreign direct investment (FDI) and it causes economies to grow and currencies to equalize. A similar phenomenon is portfolio investment, when people don’t actually build factories or stadiums, but invest money into foreign companies where returns are higher.
Second is a picture of Roberto and Nelson, two of Australia’s 225,000 Filipino immigrants. This is what happens when people realize that instead of working 4.4 hours to buy a Big Mac in Manilla, they can work 18 minutes and buy one in Australia. When capital (FDI) doesn’t equalize things, migration will occur and these laborers will send money back home where it has more purchasing power.
What these pictures highlight is that despite shoe leather costs and barriers to trade, economies are indeed equalizing! The graph to the right breaks down the almost $2 trillion that flows into the developing world every year. Foreign aid plays a tiny role compared to the massive amounts of investment and remittance.
So, why does any of this matter? The reason that this is so important to me is because the way you see the problem shapes the solution you design. For example, I just wrote a project proposal for funding to train citizens in local governance. This will increase accountability of leaders, hopefully reducing corruption (risk).Understanding the principles above help me think about how to best support development around the world.
*Okay, so Indian McDonald’s don’t sell beef, but the Maharaja chicken burger is almost the same thing.