Thursday 16 Aug 2018 | 23:52 | SYDNEY
Thursday 16 Aug 2018 | 23:52 | SYDNEY

Sheridan wrong about PPP


Mark Thirlwell

5 November 2008 13:44

The Greg Sheridan essay that Sam blogged about earlier today contains this paragraph about the use of purchasing power parity (PPP) to measure China's wealth against other countries:

PPP is basically a con. It rests on the proposition that a man in Peru gets fed, so does a man in France: therefore a bowl of rice in Lima should be given the same economic value as a meal of lobster and filet mignon in Paris. The problem is the world doesn't work that way. Countries interact with each other on the basis of real dollars, not PPP.

No, PPP is not a con. Crudely put, PPP is a means of adjusting for differences in purchasing power across countries. To do this, it compares prices of the same good. In other words, it compares the price of a bowl of rice in Peru with the price of a bowl of rice in Paris. The most famous (and very simple) version is the Economist’s Big Mac index, which compares the price of Big Macs across countries.

Now, a perfectly valid criticism is that there are lots of issues with constructing PPP measures.  Famously, the World Bank recently recalculated its measures and found that the Chinese economy had ‘shrunk’ quite dramatically.  So I am more than happy to concede that PPP estimates of (say) a country’s GDP are very far from perfect (sadly this applies to a great  many economic statistics). 

But critics often neglect to make the obvious point that doing comparisons based on ‘real’ dollars is open to major problems too.  To take an obvious example: the A$ has been gyrating wildly and dramatically against the US$ in recent months.  If you measured Australian GDP in US$, you would think that our economy had shrunk significantly and then – with the latest move – suddenly rebounded. 

Yet in reality those shifts tells you nothing about what’s been happening to Australian output. They just tell you about gyrations in the foreign exchange market. Another obvious example relates to China’s exchange rate: opponents of PPP often refer to the benefits of using ‘market exchange rates’. Yet government policy can influence the rate against the US dollar, so assuming that you have a ‘market determined’ exchange rate is pretty meaningless.

My own response to all this is (hopefully) a pragmatic one:  to try to report both US$ and PPP measures, and let readers or listeners take their choice, albeit with, FWIW, a preference for the PPP measures for comparisons of GDP, living standards and so forth. It is also possible to cross-check these measures with other statistics, as discussed here. Finally, when giving presentations, I also often tell my audience that the choice of PPP vs dollar exchange rates can sometimes be decided by the presenter’s agenda: want to downplay the importance of emerging markets? Then cite US$ estimates of GDP comparisons. Want to emphasise it? Then PPP. Hence the case for reporting both.

For a detailed look at the case for using PPP rather dollar rates, see this paper by Ian Castles and David Henderson.