Whenever I or someone else suggest that we need higher defense spending, there is an incredulous response from critics: US military spending equals the outlays of the next eight countries combined…
But there’s another way to make the conversion from local currencies to dollars, called purchasing power parity, or PPP. It assumes that things of equal value in different countries should have equal prices. Two comparable jet fighters in different countries should have the same price.
That was from Samuelson in the Washington Post.
Unfortunately, Samuelson and most other observers are missing the point. I think people who want higher defense spending gravitate to the PPP and those who want lower spending prefer the Market Exchange Rate. I wonder if a good application of economic theory can create a consensus, one way or the other.
I presented a framework for thinking about the PPP vs Market Exchange Rate a couple weeks ago. I’d like to see someone address that analysis.
I’ll pick on Samuelson a bit here for sloppiness. He said that the PPP “assumes that things of equal value in different countries should have equal prices.” By this, he means that a red delicious apple in the US priced in dollars should equate to a red delicious apple in China priced in renminbi. The consumer would need that conversion ratio to preserve purchasing power in red delicious apples. But the price ratio for integrated circuits might be different. If we add a lot of consumer commodities to our “basket,” and calculate the “average” price ratio, then we arrive at the PPP.
Yes, well, if Samuelson had read the SIPRI report cited in his article, then he’d know that “jet fighters” are not represented in the PPP’s consumer basket. He’s not addressing their concerns, that the PPP measures price differentials of consumer commodities. It does not measure military outputs such as aircraft, ships, satellites, and so forth.
Now, I argued in the link above that you don’t want to measure military outputs, because that confounds the question with the quality of decisions made by military planners. We want to know the amount of real resources laid at the feet of military planners. So we want to know what costs military planners actually face. What are the labor and capital costs they must pay, which they then recombine into military unique output?
We should want a PPP based on production inputs to convert Chinese and US spending. A national measure would be fine, because military planners are recombining elements from the broader economy. (Of course, we know that military planners in the US could actually afford far less than that suggests because we pay a high transaction cost from regulations, among other issues).)
A bigger point is that the Market Exchange Rates are actively manipulated by the Chinese, in addition to other issues that I cite. So the PPP probably does a better job than the MER, even if it is imperfect. But we can never have perfect, even if the Chinese advertised their budget.
Perhaps the conversion is largely meaningless. Arnold Kling’s observations on disaggregating the economy show how prices for different goods and services are diverging everywhere. The relevance of a single number to measure changes in price, like exchange ratios between prices, is becoming increasingly irrelevant.
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