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?

Comments

[Matt]

Brad said, "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."

But of course tastes and preferences are not independent of differences in cost and regulatory structures (and vice versa.) The idea that there's somewhere a 'pure' set of preferences isn't one worth considering very much. A minnor point in this discussion, perhpas, but one worth repeating, I think.

[trotsky]

I'll be visiting Amsterdam for the first time later this summer, so I cannot yet speak from firsthand experience, but my impression is that New Amsterdam is not much like old Amsterdam. In my mind's eye, it veers more toward Hong Kong, but perhaps I'm thinking too narrowly of the Isle of Manhattoes.

[Matthew]

There are hundreds of complicating factors. Tim Worstall often quotes research that shows that American's don't work harder than Europeans, because the amount of household work they do has fallen faster than their "market-based" work, and is much lower than for Europeans. But if this is true, then it means European GDP understates its true level by more than in the US. And so on.

My view is that the very rich in America are clearly much richer than Europeans (private 737s etc), the median is a little higher, and then the further down you slide it gets worse.

[dsquared]

[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. ]

are there many WalMarts on Highway 1, Brad?

[dsquared]

(sorry, the slightly gnomic remark above was meant to suggest that JQ's point about tastes was that in, for example, the retail industry, which accounts for a suspiciously high proportion of the productivity gap between US and Europe, it is very hard to make meaningful comparisons, because lots of Europeans would find it pretty abhorrent to spend as much time driving to the shops as Americans do, and Americans presumably don't).

Also on a point of Netherlands economic structure, I think that the idea of comparing the Netherlands to urban hubs of the USA seems a bit odd. Agriculture is really quite important to the Dutch economy.

[John Quiggin]

My broader point was that, once you say that differences in relative prices can be explained by population density, you're down to questions about which international income comparisons can't say much.

[johne]

Brad's point (3) is really two points:
At least in Latin America, "cruising" anywhere, in a white convertible or anything else, is seen by most as an unfortunate requirement to getting somewhere: teleportation would be much preferred. Cultural preferences do exist.
As to whether the market invariably and efficiently caters to them -- that is another argument.

[Michael E Sullivan]

Treating the netherlands as a big urban center is foolish, but treating it as roughtly equivalent to a clump of highly urbanized states with significant rural portions (such as New York, New Jersey, Connecticut and Massachusetts). Plenty of agriculture in those states, but most of the population is urban and suburban.

I think such an area would provide a much better comparison for the Netherlands, and frankly most of Europe. The population density of that group of states is around 600/sq. mi, which is comparable to that of the UK or Germany. You could use New Jersey alone as comparison for the Netherlands, although it's about half the total size.

You find that the average GSP per capita in those region is something like 20-25% higher than the US average, but so would generally be the cost of living. It would be very interesting to see PPP comparisons.

[Michael E Sullivan]

Treating the netherlands as a big urban center is foolish, but treating it as roughtly equivalent to a clump of highly urbanized states with significant rural portions (such as New York, New Jersey, Connecticut and Massachusetts). Plenty of agriculture in those states, but most of the population is urban and suburban.

I think such an area would provide a much better comparison for the Netherlands, and frankly most of Europe. The population density of that group of states is around 600/sq. mi, which is comparable to that of the UK or Germany. You could use New Jersey alone as comparison for the Netherlands, although it's about half the total size.

You find that the average GSP per capita in those region is something like 20-25% higher than the US average, but so would generally be the cost of living. It would be very interesting to see PPP comparisons.

[wallie]

'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.'

After losing an estimated 1 billion dollars, Walmart no longer exists in the German market. It seems as if Walmart didn't fit. Here are a couple of reasons why -
1. Walmart had to deal with unions in Germany - and though Walmart may have thought that they could quickly cut costs by firing the union workers, that proved to be a wrong assumption.
2. Walmart actually faced lower cost competitors in Germany. Aldi, for example, makes Walmart look like a bloated nightmare of inefficiency. And since Germans pay attention to price, Walmart's constant repetition about being lower priced, when they clearly weren't, just made them look stupid.
3. Walmart's personnel policies, particularly in terms of who Walmart employees could have romantic relationships with, disgusted Germans - as a court confirmed when Walmart stupidly attempted to argue that since Walmart was an employer, it basically had the right to tell its employees how to live.
4. Walmart honestly believed that Germans would like driving long distances to giant stores carrying mass market products, if they only were offered the opportunity to do so. 1 billion thrown away dollars later, it seems as if Germany isn't America.
5. Germany is much more regional than the U.S. - Walmart's famed market power is meaningless with a regional supplier that is already running at full capacity supplying regional customers products that those customers prefer over international brands which cost more (think maultaschen or spätzle compared to frozen pizza and french fries).
6. And perhaps last, after becoming a fat semi-monopolist in several markets, Walmart assumed that entering one of the world's fiercest retail environments would be simple, believing that Germany was still living in the past. Intriguingly, Aldi now has higher sales in the North American market than Porsche, and I think Walmart may discover over the next decade what a serious competitor they will be facing in the low cost market segment - after all, the American market looks quite ripe for the picking when looked at through the eyes of a company like Aldi, especially after seeing how Walmart failed in Aldi's own backyard.