links for 2007-06-20
Guest Lecture on John Maynard Keynes

International Income Comparisons Once Again

John Quiggin muses about international income comparisons across the Atlantic:

John Quiggin: The euro and the dollar: The appreciation of the euro against the dollar has taken the currency close to its highest value ever around $1.35. By contrast, the rate estimated as Purchasing Power Parity by the Penn World Tables International Comparisons Project (ICP) is around $1.00 for most eurozone countries (It’s 1.10 for Italy, 1.05 for France and Germany, 0.96 for the Netherlands. The price differential between eurozone countries is interesting in itself, but that’s another post).

A gap of this magnitude between market exchange rates and estimated PPP values raises all sorts of problems. For example, using the Penn numbers, income per person in the Netherlands is about 75 per cent of that in the US, and this number is often quoted on the assumption that purchasing-power parity means exactly what it says. But using exchange rates, as would have been standard a couple of decades ago, income per person is a little higher in the Netherlands than in the US. Which of these comparisons, if either, is valid?

To some extent, the divergence may be explained by the fact that the eurozone has high consumption taxes, which drive a wedge between prices paid by consumers and international market prices. But it seems clear that a large part of the gap arises from an assessment by the ICP that compared to traded goods, non-traded services are much cheaper in the US than are eurozone services of equivalent quality. Comparisons of this kind are exceptionally tricky. I’ve discussed this before in relation to Walmart.

In any case, comparisons between countries with similar income levels and radically different relative prices only make sense on the assumption of common tastes, and this becomes exceptionally problematic. If Americans like driving long distances to Walmart, with all the implications that has for urban layout, and Europeans prefer shorter trips to smaller and more expensive stores, there’s no obvious way of saying that one set of individual and collective preferences is better than the other.

And there are many different ways of deriving PPP indexes from any given data set. The ICP method is notable for making poor countries look relatively good compared to the base set of European countries. It’s unclear whether there is any similar effect for the US, or which direction it might go in.

One standard test is to look at migration flows, which seem to be small in both directions. For example, the US Handbook of Immigration Statistics show that about 4000 people born in France gained US permanent residency in 2006, and I don’t suppose the flow in the other direction is much different.

All this is good news for the blogosphere. It guarantees that US vs EU comparisons can be carried on indefinitely with no risk of a conclusive resolution.

There are also some interesting problems in relation to trade. On the simple version of the Purchasing Power Parity hypothesis (and even on some more sophisticated versions that take account of the effects of differences in levels), the euro ought to be headed for a big fall.

On the other hand, given that the euro has been well above PPP for several years, the same model would predict that the US ought to show a surplus in bilateral trade with Europe, when in fact there is a substantial bilateral deficit (third countries complicate the analysis, but don’t change the answer). The appreciation of the euro has had some effect, most obviously seen in the shifting fortunes of Boeing and Airbus, but not enough to get back to balance. So, if anything, the long-run equilibrium value of the euro looks to be higher than its current value.

A few comments:

(1) International trade should equalize the prices of tradeable good across the globe--it shouldn't set PPP equal to the average exchange rate. The U.S. has a lot more land per capita than Holland and a much greater degree of competition and freedom to take advantage of economies of scale in the service sector. These should produce a world in which traded goods prices are about the same in the U.S. and in Holland, but in which goods and services that are land-intensive and unskilled labor-intensive are a lot cheaper.

(2) I'm inclined to take the migration data as confirming the PPP numbers: worldwide, the United States is a much bigger immigration target in proportion to its population than Holland or France or Belgium or Germany are--but culture and bureaucracy play a powerful role in that process, in addition to opportunities and living standards.

(3) Differences in taste seem to me to be largely a red herring. Europeans are as happy (or as carsick) cruising up Highway 1 along the California coast in a white convertible as are Americans. The big differences seem to me to be driven much more by differences in cost and regulatory structures than by genuine differences in tastes and preferences. Market economies exist to offer choice: whatever our preferences are, there is money to be made by satisfying them efficiently.

(4) Perhaps the right comparison to make is not the binary Holland-U.S. comparison, but the trinary Holland-parts of the U.S. that feel most like Holland-rest of U.S. comparison. The largest such region in the United States is, of course, New Amsterdam, but the inner urban cores of Boston,San Francisco, Chicago, and Philadelphia are also a much closer approximation to Holland than the rest of the U.S. is. What would a comparison of real exchange rates and real income levels across those two show? And what does a comparison of real exchange rates and income levels comparing New Amsterdam and the rest of the United States show?