- The richer a country is, the more likely its nominal exchange rate is correlated with its real exchange rate.
- According to the "Penn Effect," the absolute level of a country's real exchange rate is virtually an inverse function of real per capita GDP.
- Exceptionally high real exchange rates among rich economies seem to be linked historically with exceptional GDP growth in poor countries over both the long and short terms.
- Miraculous growth in emerging markets and the rise of the Penn Effect appear to be contingent on American dominance of the global economy.
- Were another country to displace America in its hegemonic role, long-term growth rates among the catch-up countries might collapse.
It is often said that nominal exchange rates are highly correlated with real exchange rates, but that is not quite true. Since the end of Bretton Woods, the currencies of rich countries are more positively correlated with their respective real exchange rates than is the case among poor countries. That little fact suggests to me that there is something artificial and unsustainable about the catch-up phenomenon of the last sixty years, whereby we have seen relatively poor countries grow at often miraculous rates. In part one of this article, I talked about how difficult it is to invest in this catch-up phenomenon and the possibility of a panic in emerging markets as the current crisis in global growth continues. In this part, I argue that there will eventually be a systemic breakdown in the catch-up phenomenon as we have known it since World War II, because it depends upon American hegemony. I will shift from the cyclical to the structural here, but the cyclical and structural inform one another to a certain degree.
The Big Mac Problem
The comparative price level (CPL) is the ratio of consumer prices in a given economy relative to the price level in another economy when priced in a common currency (usually, the US is the benchmark). It is also the reciprocal of the real exchange rate (RXR), so that CPL = 1/RXR. So, we can also say that the richer a country is, the more likely its exchange rate will inversely correlate with its comparative price level.
This can get a little confusing at times, so whenever I feel myself feeling discombobulated by positive and negative correlations involving real and nominal exchange rates and so forth, I right myself by simply thinking of the Big Mac Index. The Big Mac Index winkingly illustrates the concept of comparative price levels by comparing the prices of McDonald's sandwiches in various countries (converted to dollars) to the price of a Big Mac in the US.
For example, if a Big Mac in the Republic of Freedonia were 100 shekels and the exchange rate with the US dollar were 33 shekels to $1, then the dollar price for the Freedonian Big Mac would be $3. If Big Macs cost $5, then the CPL would be 60 (i.e., 100 x $3/$5): prices in Freedonia would be 60% of what they are in America.
What determines global price levels? According to economic theory, CPLs are largely a function of relative productivity levels, i.e., relative real per capita GDP. In other words, stuff in poor countries tends to be cheaper than stuff in rich countries. This positive correlation between income levels and price levels is called the "Penn Effect," and you can see it in the following chart for 2010. It has an American cousin, too: "Baumol's Cost Disease," a theory about why inflation for services like health and education is so stubbornly high.
(Sources: Maddison Project, St Louis Fed)
One of the frustrating things about the "cost disease" and the Penn Effect is that they often seem to be regarded as universal laws when, in fact, they are both relatively newfangled. If we look across time, we can see that sixty years ago, there was no discernible correlation between price levels and income levels. For example, in 1962 China, the CPL was over 167 (that is, prices were 67% higher than American prices), while in Switzerland, the CPL was 57 (meaning that Swiss prices were 43% lower than American prices), even though the average Swiss citizen was 12% richer, and the average Chinese citizen 95% poorer, than the average American.
(Sources: Maddison Project, St Louis Fed)
What has happened since World War II is quite remarkable. First, we have what appears to be an accelerating or expanding catch-up effect which we have already reviewed. But, more remarkably, we have had this massive shift in comparative price levels to adjust to each countries' relative income level. Today (or as of 2010, at any rate), the Chinese CPL is 54, and Switzerland's is 153 - effectively the reverse of their positions in the early 1960s. China's relative income level is 74% lower, and Switzerland's 18% lower, than the United States'.
The Chinese/Swiss comparison is extreme, but as the broader correlations show, it has not been atypical, and there are certainly more extreme examples (Israel's CPL in 1952 was 271, Turkey's in 1959 was 181).
What I wish to assert here and what I think may be new is the idea that the catch-up effect and the Penn Effect are two sides of the same coin of dollarized globalization. Consider the Swiss example again. In 1950, Swiss income was only 5% lower than American income, but prices were 50% lower than in the US. Today, Switzerland is relatively poorer, and prices are much higher. Even if we make allowances for the difficulties of indexing prices and income levels across countries and over time, those changes are remarkable.
What I suspect is, insofar as these two effects are concerned, the post-War economic dynamic has been to push growth rates in poor countries, and CPLs in rich countries, higher. If you look back at the scatter-plot chart comparing relative income and price levels for 2010, you can see that a number of rich countries have CPLs above the American level even though none have higher income levels. The reason is exchange rates.
Exchange rates in rich countries have been forced up in much the same way that growth rates in poor countries have been, and as the first chart in Part I - which I reproduce below - showed, they experience the same cyclicality: rich-world currencies strengthen (i.e., the narrow dollar index weakens) when catch-up is strongest.
Instead of saying that rich-world CPLs are too high, however, we could say that their income levels are too low. What would account for suppressed income levels amongst rich countries? Could it be the oft-depreciating currencies of the low-income strata?
I am not sure. If we look at the historical progression of the Penn Effect (the correlation between income and price across countries) using the most consistent set of data across time, it appears to have begun with a jolt in the 1959-1962 period. A handful of countries' CPLs collapsed in those years, including South Korea (down 43%), Turkey (64%), Israel (28%), Iceland (47%), Brazil (25%) and Spain (18%). The adjustments came primarily through devaluations in the wake of balance-of-payments and political crises.
(Sources: Maddison Project, St Louis Fed)
Many of those countries experienced "miraculous" growth in 1962-1975, in many cases credited to the virtuoso economic planning of right-wing dictatorships rather than the respective devaluations. There were other high-growth countries of that period that did not devalue in the 1959-1975 period, such as Portugal, Greece, and Japan, although Greece had already had a sharp devaluation in 1952-1954.
That neighboring states like Portugal and Japan experienced similar booms makes it difficult to argue that devaluations were everything, but there does seem to be a deeper resonance between growth and the Penn Effect since World War II. Using a more expansive but less uniform set of data (that is, more inclusive of countries, but less consistent across time) reduces the impression that there was an overnight shift in 1959-1962 towards the Penn Effect, but by almost any measure, there was a historic revolution in the constellation of economic relations by the early 1970s.
(Sources: Maddison Project, St Louis Fed)
What makes me wonder about the 1959-1962 transition is that a similar sort of revolution occurred within the American economy at roughly the same time:
1. Inflation and yields. In the 1970s, Friedman wrote a paper entitled "From Gibson to Fisher" describing the historic change in the relationship between interest rates and inflation. Last year, I mapped out a shift in the relationship between inflation and stock and bonds yields that began after the establishment of the Fed in 1913, gained steam after World War II, and culminated in a new dollar equilibrium in 1960. Part of this equilibrium was the new prominence of the yield curve.
2. Baumol's Cost Disease. The rise of services prices relative to goods prices described by Baumol, who attributes the phenomenon to the difference in productivity growth in the respective sectors, as I noted before, seems to have begun in the 1950s. In other words, the rise of the negative correlation between productivity and prices occurred almost simultaneously in the US and the world economy.
3. Inflation and profits. The 1950s was also the beginning of the stable expansion of corporate profits and consumer prices in the United States. Up until the 1940s, inflation and profits had been nearly as erratic as commodity prices, but they both suddenly stabilized in the 1950s, presumably because the service sector was displacing the manufacturing sector in America.
4. Stocks and profits. The emergence of long-term stability in earnings growth has coincided with the emergence of secular trends in stock market performance. It is only since World War II that we have experienced 20-year stock market booms. Prior to that, changes in the P/E ratio were due to secular trends in profits, not prices. There also appears to be an upward bias in P/E ratios since the War (along with a downward bias in real commodity prices).
5. Commodity prices and production. In my previous article on the nature of commodity prices, I noted that between World War II and the end of Bretton Woods, there was a dramatic shift in the balance of commodity production relative to prices. The expansion of basic commodity production (of, by, and for the fast-growth countries to no small extent) was not matched by rising prices in certain notable commodities (i.e., gold and oil). Since the early 1970s, this has subsided somewhat, but the rebalancing seems to have occurred primarily on the side of gold and oil prices. In other words, they have adjusted higher in response to the tremendous growth in global commodity production.
I am not prepared to tie these phenomena together in any intricate system, but the synchronicity is hard to ignore. The most important changes seem to have begun, if quietly, in the 1910s and then gushed forward after World War II, finally finding a resting point of sorts after Nixon ended Bretton Woods I. Collectively, these changes seem to be linked to the status (rather than strength as such) of the dollar and, more broadly, the American system.
It seems to me, therefore, that the unusual strength of certain sectors or trends - notably American profits and stocks, emerging market growth, commodity production, rich-country currencies, global inflation, and the service sector - is contingent upon a broader geopolitical and economic order and is, almost by definition, unsustainable in the long run.
Post-war globalization has been stamped by the American dollar, and I suspect that it cannot proceed without America preeminent. At the same time, it appears that the American order is structured in such a way as to create challengers to that preeminence. So far, no one has succeeded in doing so. Every time there is an economic miracle somewhere, people ascribe all sorts of virtues to the miracle economy and vices to the American and claim that the writing is, at long last, finally on the wall.
The world has swung around an Anglo-American axis for a good two centuries that will not disappear tomorrow, but neither will it last forever. The current manifestation of that "axis" is, depending on which characteristic you should emphasize, no more than a century old and not less than forty years old.
The processes that would cause that system to break down, in whichever manifestation you should choose, are rather unpleasant to consider: either a successful challenge from abroad or a breakdown within. And, possibly both.
China, Hegemonic Transitions, and Global Growth
One of the biggest problems hovering above the geopolitical waters is how to manage the re-centering of the world around Asia, especially China, over the next century. By virtue of its population in combination with its economic growth, China seems destined to displace America as the greatest power in the world. The hope is that the liberal trajectory of the post-War international system can be handed off to China relatively smoothly, even though these types of transitions are almost always traumatic and violent. Germany's challenge to England a century ago proved to be a tremendous disaster. If we frame it in a different (and, I think, more proper) way, as the transition from English to American hegemony, the future seems even bleaker, because it suggests just how difficult a hegemonic transition is, even amongst the best of friends.
The present unpleasantness with Russia illustrates the problem. China has thrived under American hegemony, but in order for it to take over the complementary international order, it will have to radically transform itself internally. At present, it has very few of the attributes that would permit it to keep globalization advancing on its current trajectory, except, perhaps, insatiable demand. The notion that China itself can smoothly transition to some sort of liberal democratic order because Taiwan and South Korea did so seems increasingly hollow now that Russia and the West have split over Ukraine. Transitioning from an anti-Western superpower like Russia or imperial Japan to democracy does not seem the same as transitioning from a nationalist client dictatorship to a nationalist client democracy.
This article is not really about China, and the point I am trying to make here is not so much about China as it is the nature of international systems. On the other hand, when we talk about the future of globalization and so forth, we are talking about China, even when we do not mention its name, because China appears to be the most likely beneficiary of continued global growth.
I do not know what will happen to any given country in the future, of course. But, as a rebalancing of economic and geopolitical power occurs, this will undermine the order that engendered that rebalancing in the first place and threaten the growth of those countries that have benefited most from the post-War order. This is a problem that could take ten years to manifest itself or a century, but I suspect it is somewhat closer to the former than the latter.
Investing in global growth is highly problematic. Historically, there has been an inverse correlation between real growth and stock market returns, except over the short-term, when EM returns can be very high.
On the assumption that poor countries like the BRICS and others will continue to catch up to rich-world income levels (or that America is particularly marked for doom), one might reasonably discount the odd history of global equity performance and accumulate EM equities.
But, as I have tried to show, there is some sort of connection between the radical changes in the economic order that occurred half a century ago and the miraculous growth of developing countries.
To repeat: under American-led globalization, growth rates for poorer countries appear to be "manipulated" higher, as are currencies for rich countries. In fact, in the few countries that have transitioned from poor to rich over the last sixty years, we can observe both of these principles.
Look at South Korea, the quintessential catch-up country. In the charts below, you can see that as the country grew richer in relative terms, its nominal exchange rate increasingly correlated with its real exchange rate. (One difference between South Korea and other wealthy countries, however, is its unusually low CPL, suggesting that its currency is still too weak or its economy "too strong.")
(Sources: Maddison Project, Penn 8.0, St Louis Fed)
This relationship between catch up and comparative price levels ("Big Macs") through the good offices of nominal exchange rates is both a secular and cyclical symptom of the post-War order. To bet that catch up will continue indefinitely is to bet on the stability of the foundation of that order: not only American hegemony but the nature of that hegemony itself. If the dollar equilibrium of the last 40, 60, 100 years should fail in some fashion, that does not mean that all emerging markets must fail, as well, but a more convincing case needs to be made.
Investing in emerging markets, whether over the short- or long-term seems most advisable once a crisis is fully manifest, and that does not seem to be the case yet, as bad as things are in certain regions. As the Federal Reserve continues to tighten, I would hesitate to engage emerging market equities until the dollar rises substantially.
In recent articles, I have worried about the possibility of another crash in commodities to be followed by a 1929-style stock market crash occurring in the US in 2016 or 2017. I intend to keep my eye on a number of variables moving forward: oil and gold prices, the yield curve, basic commodity production levels, and the dollar index. Although I expect an increase in volatility, with the potential for substantial corrections, I expect that American stocks and bonds are still going to boom. In the very short term and on a gut level, I would like to see how the ten-year Treasury rate behaves in coming weeks. A convincing break below the 2.40 level would suggest that the scenario I have been sketching in this space is continuing apace.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.