How weak is the dollar?

So former Treasury Secretary and Harvard president Larry Summers has put his two penneth into the debate about the dollar, and how the US should address the greenback's weakness. Unsurprisingly, this has prompted a good deal of debate about the subject, some of it thoughtful and some of it hysterical.

Most commentators seem to take it as read that the dollar is weak, and that that weakness is becoming a problem. As an American residing in Europe, Macro Man can confirm that the dollar is cheap when compared to European currencies. Of course, Europe is not all that matters. While the buck clearly appears undervalued against the "big dollar" to its immediate north, the dollar is less clearly cheap against the currency of another close trading partner, Mexico. And of course, the elephant in the valuation room, the RMB, is pretty clearly undervalued against the dollar even at its current "lofty" levels.

But beyond the valuation question, it's far from clear that dollar weakness is a problem. Sure, the private sector has less appetite for US assets than in the past. But if public sector financing were to step away, the subsequent readjustment in US asset prices would produce bond/earnings yields that the foreign private sector would eventually find enticing.

In the bigger picture, the exchange rate should also send important signals to economic actors. The chronically weak RMB, for example, has directed Chinese growth towards investment at the expense of consumption. Current domestic demand in China is growing at a 9% GDP run rate; there's simply no real need to add another 2.5% to growth via the export channel. Moreover, investment contributes substantially more to growth than consumption, to a degree that is difficult to find elsewhere. A stronger RMB exchange rate should not impact aggregate domestic demand, but shift the balance towards consumption and away from investment. This is the sort of rebalancing that the regime claims to desire, and their reluctance to pursue the obvious strategy to accomplish it is puzzling, to say the least.

The US, meanwhile, has the opposite problem. Too much consumption and not enough savings/investment. Personal consumption as a % of GDP has always been high in the US, but the bursting of the tech bubble in 2000 has produced a sharp increase in the consumption share of activity. The chart below explains external imbalances in a nutshell.
So what message should the exchange rate be sending to actors in the US? SPEND LESS! While many commenters, including Macro Man, have fixated on the inflationary consequences of Fed policy and the weak dollar, perhaps we're losing sight of the big picture. Maybe what is required to solve the world's ills is a dollar that is so weak that Americans lose international purchasing power, and thus spend less.

How close are we to such an outcome? It's impossible to say, but Macro Man undertook a little project to get a sense of how much purchasing power Americans really have compared to elsewhere in the world. He took a basket of five discretionary consumer goods and compared prices from a uniform source (Amazon.com) in five different currency regions. The basket is comprised of:

*Harry Potter and the Deathly Hallows
* The 5-CD set of the complete Beethoven symphonies, as recorded by Herbert von Karajan in 1963
* An 80 mb iPod
* Windows Vista Home Premium Edition
* A Playstation 3 (60 mb version)

Macro Man checked the prices of these items in the USA, Canada, UK, France, and Japan. The Chinese site did not have an English option, and, strangely, there is no Amazon available in Brazil. Readers in those countries can feel free to contribute their own price data in the comments section. For some reason the iPod is not sold via Amazon in Canada, so Macro Man got his Canadian iPod price from the Apple website.

In any event, the local currency prices for his basket was as follows:

Of course, such data is meaningless as a basis of comparison for those without an extremely able facility for mental arithmetic, so the table below sets out the basket prices in USD terms using current exchange rates. It seems quite clear that far from suffering from a weak buck, American consumers continue to enjoy the benefits of cheap consumer goods relative to the rest of the world. No wonder they spend so much!

Ah, but there's a catch. Amazon in the US does not include sales tax in its price, whereas other countries impose a VAT at source. Surely these disparities are explained by different tax regimes? Not entirely. Macro Man recalculated the basket, stripping out VAT (6% in Canada, 17.5% in the UK, 19.6% in France, 5% in Japan) from his USD prices. The resulting at-source cost of the discretionary consumer basket is set out in the table below:

Remarkably, for someone who was raised on stories of $100 watermelons in Tokyo in the mid-1980's, the Japanese consumer basket is almost as competitively priced as the American one. That the Canadian basket was the most expensive was a shock, and certainly bodes well for US retailers along the border with Canada this holiday season. It came as no surprise that European goods were dear: that UK Playstation price is "rip-off Britain" in a nutshell.

Of course, some of this disparity can still be explained by the fact that prices have not had time to adjust and that the weak dollar makes the American basket appear cheaper than it really is. However, the US has a substantially higher nominal per capita GDP than the other countries in the study, even accounting for this year's dollar weakness. So this basket of goods represents a smaller proportion of per capita income in the US than it does in any other country in the study.

The dollar may be weak, but it's not yet weak enough to hit consumers in the pocketbook. Until it does, it's hard to see US savings rates rise and a more substantial correction in external imbalances.