Why you should look to hamburgers for the dollar's true value
Aug 21, 2008
Print this article
• This article was written by Karim Rahemtulla for the Smart Profits Report.
A few months ago, I wrote to you about the forecasted demise of the US dollar.
I took the stance that the dollar had bottomed, and that sentiment against it was so negative from my fellow pundits that it would NOT crash yet. Since that time the dollar has rallied sharply and the Euro, Canadian Dollar and British Pound have all cracked.
Of course, it's no big secret that the US dollar is undervalued. But if you read enough conventional media you'd think differently. I go back to what I learned in college about purchasing power parity - and at one gauge in particular.
I, and some of my colleagues like Steve Sjuggerud, have followed this indicator for ages in order to gauge the true "real time" value of the dollar. Of course, travelling around the world frequently confirms this indicator's accuracy. And here's how it works...
On the menu... a Big Mac
The Economist magazine publishes an index called the Big Mac index.
It measures the price of a Big Mac in many different countries including the United States and converts the price of a Big Mac in places such as France, Britain and Japan from their local currencies into US dollars.
Over the past few years, as the dollar has plunged, the price of a Big Mac has soared in these countries. This isn't rocket science. In fact, it's common sense.
So what happens when the cost of a Big Mac gets out of hand? For example, it costs 40% more for the same Big Mac in Paris than it does in New York? Well, that's where that college course in macroeconomics rears its ugly head...
Meandering back to historical norms
What happens is that prices tend to revert to the mean. Unless there are currency controls or massive amounts of taxes (like on gasoline), prices tend to normalize over time for like goods.
Granted, some countries with a socialist bent have to charge more to cover their overly generous welfare systems. But after adjusting for these handouts, prices will fall in higher-priced countries until they reach a level of parity - or close to it.
That's what is happening right now. Currencies that have strengthened too much against the dollar are falling back to levels that more closely reflect what prices are in a free market economy like the US
In simple terms, people don't like paying $1 for a can of Coke in a British supermarket when they can plainly see that the same can of Coke sells for 40 cents at Wal-Mart in the US
It really is that simple. Remember, we're talking about paper currencies that are quite similar in nature when it comes to the economic fundamentals that determine the value. The euro, the pound, the dollar, and the yen are all fiat currencies. They survive based on the faith that people have in the strength of their governments and their economies.
Over time, the value of all these paper currencies will head towards zero because there are no governments left that back the currency with integrity in spending. Rather, they print money and run up deficits, which de-base the currencies over time.
So, where does that leave us in the short-term?
The circle of economic life
It leaves us with a currency bashed lower by a government that intentionally let it fall by hacking interest rates, printing more money, and engaging in heavy deficit spending. And most likely, those actions will continue.
The de-basing was not all in vain, however. Countries facing slower economic growth or recession like nothing more than weakening their currencies intentionally because it results in a boost to the export sector. In turn, this can generate jobs or the stabilization that will ultimately play a part in leading the country out of recession.
This puts importing nations at a disadvantage because their goods are now much more expensive, resulting in another economic term: substitution. The populations of countries with expensive currencies will begin to buy goods that are cheaper, regardless of where they come from. In turn, this sends the country with an artificially strong currency into economic recession, causing them to print money by lowering rates and stimulating their own economies, weakening their own currencies to compete.
Bottom line: The US dollar is too big to fail... right now. The United States is still the driving force of global economic consumption and when we stop spending, the rest of the world still suffers mightily.
So while the pundits hash out the demise of the dollar with glee, just pick up a copy of The Economist and look at the Big Mac index. That way, you'll see what the dollar buys here, versus what it buys abroad, and can gauge the true value of the dollar on the street.
Related articles
-
By John Stepek, Nov 17, 2009
-
By Dominic Frisby, Nov 04, 2009
FREE - MoneyWeek's daily investment email
Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.
