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.

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"Cassandra"
admin
October 30, 2007 at 10:58 AM ×

(in USDs) --------US--- UK----- Can

TopBoardSchl:...35,000...55,000...44,000
Zoo Adult..........14.00....32.00......21.50
Zoo kids........... 10.00.....28.00..... 6.50
(bronx,regentspk & totonto respectively)
Cinema............ 9.50.....22.00.......10.50

Ummmm, spot the odd-man out?

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Macro Man
admin
October 30, 2007 at 11:05 AM ×

Indeed. Rip-off Britain is alive and well...and it's difficult to construct a coherent argument why anyone without a solid positive savings rate would choose to reside here if other altneratives exist.

Hmmmm.....maybe I should tell Mrs. macro that we're gonna wait another year for that new kitchen....

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October 30, 2007 at 12:12 PM ×

Doesn't detract from the point, but the GST is almost always added on at the cash register in Canada, and there could be another 7 or so percent in PST owing - though I can't remember how that works on internet stuff. And yes, business is said to be booming on the Love Canal.

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Macro Man
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October 30, 2007 at 12:32 PM ×

CB, if VAT/GST/etc are added at the register, it just ampliefies the point that much more, as the figures in table 2 ($906 vs $1182) are like-for-like. However, even if we take off another 7% in imputed PST, the Canadian basket still costs US$1046...yowsah!

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bionick
admin
October 30, 2007 at 12:50 PM ×

MM: 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.

You forgot to take into account – medium - income (per capita GDP would not do). Canadian income just went up 15-20% in US$ terms in just the past several months. So did incomes in the Euro zone and GB.

Second, how would higher prices lead to more savings? Keep in mind that prices of essential things, food and gas, are also rising at a brisk pace. A significant downward movement in $ versus RMB would lead to higher numbers on the price tag in Walmart, Target, Macy’s and other places where the so-called middle class shops. Cars (foreign made parts), electronics, furniture, you name it, almost everything masses purchase in the US is foreign made, including iPod and Playstation 3. I am not convinced that the end game would not be a slow slide to inflation, loss of purchasing power, impoverishment of the populace and social upheaval and dislocation a la Soviet Union of a several decades ago.

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cmacculloch
admin
October 30, 2007 at 12:59 PM ×

you touched upon a very sensitive topic right now in the Great White North with retail prices.

The border shopping destinations are indeed going to very well this holiday season.

The rise in the Loonie has been stunning to say the least.For example, the price of the Schweser CFA study notes has gone in a month or so from about CAD950 to CAD850. Lucky for me!


Macro, I notice the AUD is now even approaching parity, any comments on that?

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Macro Man
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October 30, 2007 at 12:59 PM ×

Bionick, the nominal per capita GDP referred to in the post captures the exchange rate effect you mention. The figures linked in the post are as of 2006- even accounting for 2007's exchange rate moves US nominal per capita GDP in dolar terms is still higher.

How would higher prices lead to more savings? Well, if stuff gets more expensive you tend to buy less of it. The assumption here is that the price elasticity of demand is nonzero- if it is, then a weaker dollar will lead to more negative savings. At the very least, it would seem to me that in the face of an apparent negative income shock (the loss of international purchasing power), consumers would be more likely to spend less. The point of this study was to see if such a thing is occuring. Both in absolute and relative terms, the anser to date is "no."

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Anonymous
admin
October 30, 2007 at 1:02 PM ×

Tax rates also have to be taken into acount on this one and the cost of semi necessity goods such as cars (insurance and gas costs) and necessity goods such as clothes. All of which are substantially less in the US, increasing the purchasing power even more as a % of total income

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Macro Man
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October 30, 2007 at 1:05 PM ×

Cmacolluch, the AUD is being propelled by the three fold drivers of terms of trade (hard commodity prices through the roof), carry mongers (Mrs. Watanabe loves 6.5% rates!), and the economic cycle (Mrs. W will love 6.75% even more!)

So while overbought on virtually every conceivable measure, there would appear to be few barriers at this juncture, barring a sustained global downturn, to constrain the Aussie from attempting parity at some point.

Conventional PPP analysis suggests the Oz is woefully overvalued; however, a terms of trade analysis suggests that if anything it may have undershot.

The story's a lot like Canada except a) there's a current account deficit rath than surplus, and b) rates a re a lot higher as a result.

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Macro Man
admin
October 30, 2007 at 1:06 PM ×

Anonymous, yes, from a macro perspective that is a good point. As a percentage of disposable income, the US goods basket is even cheaper to buy.

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Anonymous
admin
October 30, 2007 at 1:21 PM ×

MM,

I noticed that you left the ubiquitous Big Mac out of your basket ;)

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Anonymous
admin
October 30, 2007 at 1:31 PM ×

How does the $ stand in trade-weighted index vs. the last 10 or 20 years ?

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Anonymous
admin
October 30, 2007 at 1:32 PM ×

At what point does "Dutch-disease " infect Canada , Australia , etc. ... ?

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"Cassandra"
admin
October 30, 2007 at 1:35 PM ×

MM said: "Conventional PPP analysis suggests the Oz is woefully overvalued; however, a terms of trade analysis suggests that if anything it may have undershot."

So what about the GCC units vs. already-floating AUD, CAD etc. Are people setting these up for the Pop!

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Macro Man
admin
October 30, 2007 at 1:41 PM ×

Anonymous, there's no Big Macs because a) I don't eat 'em, b) I don't want to condone eating 'em, c) Amazon doesn't sell 'em d) would you really want to eat one if they did?

Anonymous #2, a broad nominal trade weighted dollar is off its highs , but closer to its highs than its lows of the last 20 years. In real terms it is weaker, but still not plumbing its depths. The DXY is not an accurate reflection of the trade weighted dollar.

Anoymous # 3 (or are you # 2 again?), to a degree, Dutch disease has already set in in Ontario, Quebec, New South Wales, etc. This is one of the reasons why BOC governor Dodge in particular has seemed less than enthused about the uber-loony. However, the resource sectors are still dominating the macro data, so there's not a whole lot that the authoities can do in the near term.

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Macro Man
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October 30, 2007 at 1:43 PM ×

C, the GCC is one of the best currency trades out there. Small negative carry = option premium, required reval = potential payout. The economic case is clear to everyone but the sheikhs and the IMF, and the risk/reward is superb.

It makes no sense for the Saudi riyal to be pegged at the same level today where it was in 1986, when oil is much higher and the anchior currency is much lower.

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Anonymous
admin
October 30, 2007 at 6:14 PM ×

You're doing this by selling USDSAR, right? Do you expect GCC will happen on schedule?

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Macro Man
admin
October 30, 2007 at 6:59 PM ×

Yes to the first question and no to the second. I think the GCC nation s are gonna queue up Fleetwood Mac: "You can go youtr own way"

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Anonymous
admin
October 31, 2007 at 1:55 AM ×

Monsieur Macro:
I see the FT had an article about the possibility of the USD becoming a funding currency in carry trades. It struck me as suspiciously similar to your post of the other day (yesterday?). Coincidence? It wouldn't be the first time a journalist cribbed a story from a blogger, anonymous or otherwise.
Peace,
Lumumba

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Macro Man
admin
October 31, 2007 at 10:53 AM ×

Lumumba, much as I'd like to feel righteous indignation, the insight wasn't that outre for those of us congined to following this stuff on a full time basis. Indeed, I'd be concerned about the career prosepcts of anyone who follows currencies for a living who isn't aware of this potential dynamic!

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mOOm
admin
October 31, 2007 at 12:15 PM ×

Commonwealth Securities here in overpriced Oz recently did an iPod index for a whole bunch of countries (30 or so). Brazil was most expensive.

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Macro Man
admin
October 31, 2007 at 12:51 PM ×

Moom, yes I recall that study...hence the irriation that there's no Amazon near the Amazon!

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Anonymous
admin
November 2, 2007 at 8:10 AM ×

Macro Man, I apologize for missing the discussion. Always learning a lot from your pleasant writings and colleagues' comments.

Best prices were captured from local renowned stores, all taxes included:
"Harry Potter e as RelĂ­quias da Morte" - R$46,90/US$26.83
Beethoven - R$154,45/US$88.36
iPod 80mb - R$999/571.51
Vista Home Prem - R$399,90/US$228.78
Playsation 3 (60mb) - R$2299/US$1315.22

Just to remind that our goverment prefers to tax consumption rather than income.

"hence the irriation that there's no Amazon near the Amazon!"
Maybe Amazon.com is bit afraid of how we take care of our dearest Amazon. : )

Cheers,
Ney

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Macro Man
admin
November 2, 2007 at 9:04 AM ×

Thanks for the data, Ney! What is the VAT tax in Brazil, by the way? $1315 for a Playstation seems pretty punchy...maybe the government wants to encourage to go upside and play football!

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Anonymous
admin
November 2, 2007 at 1:55 PM ×

Oh, that is a tough question in the country of football. When it comes to taxation system Brazil is also dominant in confusing and distorting bureaucracy. We actually don't have VAT. Instead our loony goverment use many different metamorphic taxes that vary according to the type of product, service, amount of profit, revenue, bank wire transfers... that give each product and service a very particular story. I wouldn't dare to say a number for an equivalent VAT. Sorry about that.

What I know is that books, papers and magazines have subsidies. Imported softwares have subsidies that imported hardwares don't. This tells a little bit about the disparity between Potter, Vista and the Playstation.

And you maybe right about the goverment conspiracy, I used to play much more football than Atari since it was very expensive to buy new games. : )

Ney

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Macro Man
admin
November 2, 2007 at 1:59 PM ×

Interesting, thanks. That definitely explains the high cost of Playstations, iPods, etc. And perhaps mhe cosnpiracy explains why Ronalda, Ronaldinho, and Adriano all seem to have puyt on lots of weight in recent years; once they leave Brazil and become successful, they can afford to play video games in their spare time (when they aren;t clubbing that is!)

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