Front Page Titles (by Subject) XV. A Criticism of the Purchasing-power Parity Theory 1 - Studies in the Theory of International Trade
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XV. A Criticism of the Purchasing-power Parity Theory 1 - Jacob Viner, Studies in the Theory of International Trade 
Studies in the Theory of International Trade (New York: Harper and Brothers, 1965).
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XV. A Criticism of the Purchasing-power Parity Theory1
Owing more, probably, to good fortune than to superior insight, the classical economics escaped almost almost completely the fatal error of formulating their theory of the international relationships of prices in terms of simple quantitative relationships between average price levels. But since 1916, Professor Gustav Cassel has expounded, and obtained wide acceptance of, a simple formula purporting to express the relationship to each other of national statistical price levels, which he called the purchasing-power parity theory. Some writers have found in this formula nothing but a restatement of the English classical theory, but it differs substantially from any version of the classical theory known to me.
The following citation embodies an early formulation of his theory by Cassel, and the one which first gained for it wide attention:
Given a normal freedom of trade between two countries, A and B, a rate of exchange will establish itself between them and this rate will, smaller fluctuations apart, remain unaltered as long as no alterations in the purchasing power of either currency is made and no special hindrances are imposed upon the trade. But as soon as an inflation takes place in the money of A, and the purchasing power of this money is, therefore, diminished; the value of the A-money in B must necessarily be reduced in the same proportion.... Hence the following rule: when two currencies have been inflated, the new normal rate of exchange will be equal to the old rate multiplied by the quotient between the degrees of inflation of both countries. There will, of course, always be fluctuations from this new normal rate, and in a period of transition these fluctuations are apt to be rather wide. But the rate calculated in the way indicated must be regarded as the new parity between the currencies. This parity may be called the purchasing power parity, as it is determined by the quotients of the purchasing powers of the different currencies.2
Cassel has expounded the theory primarily in terms of paper currencies and with special bearing on the effects of currency inflation on exchange rates. But if true for paper currencies, there is no apparent reason why it should not apply equally to gold standard currencies. Since under an international gold standard the possible range of variation of the exchanges is narrowly limited by the gold points, it should follow that under such a standard the possibility of substantial divergence of movement of price levels, in direction or in degree, in different countries is correspondingly limited. It would seem further that if substantial relative changes in the purchasing power of two currencies must generally result in corresponding inverse changes in the rates at which these currencies exchange for each other, then under equilibrium conditions metallic standard currencies must have equal purchasing power in terms of units of identical gold content,3 unless adequate reason can be found for holding that all the factors other than relative price levels capable of exerting an enduring influence on the exchanges were already present in the year arbitrarily chosen as the base year, had already exercised all of their possible influence on the exchange rates, and would never disappear or weaken. It is easy to conceive, however, of changes in cost or demand conditions or both, in one or the other countries, or both, which so change the relative demands of the two countries for each other's products in terms of their own as to bring about an enduring and substantial relative change in their levels of prices, including the prices of domestic commodities and services, even under the gold standard. The existence of non-transportable goods and services in one country which have no exact prototype in the other, moreover, makes it difficult to see not only how there could be any necessity under the gold standard that the price levels be identical in the two countries, but how the two price levels could be compared at all with any approach to precision.
Cassel nevertheless accepts readily the corollaries of his doctrine:
Even when both countries under consideration possess a gold standard, the rate of exchange between them must correspond to the purchasing power parity of their currencies. The purchasing power of each currency has to be regulated so as to correspond to that of gold; and when this is the case, the purchasing power parity will stand in the neighborhood of the gold parity of the two currencies. Only when the purchasing power of a currency is regulated in this way will it be possible to keep the exchanges of this currency in their parities with other gold currencies. If this fundamental condition is not fulfilled, no gold reserve whatever will suffice to guarantee the par exchange of the currency. Under stable currency conditions and when no radical alterations in the conditions of international trade take place, no great or lasting deviation from purchasing power parity is possible.4
Some writers have held that the purchasing-power parity theory is invalid if applied to general price levels, but that it could be made acceptable, and in fact reduced to the status of a truism, if it were confined to the price levels of commodities directly entering into international trade, and if abstraction were made, as does Cassel, from relative changes in transportation costs or tariff rates. The following quotation from Heckscher is representative of this point of view:
The conception that the exchanges represent relative price levels, or, what is the same thing, that the monetary unit of a country has the same purchasing power both within the country and outside it, is correct only upon the never existing assumption that all goods and services can be transferred from one country to another without cost. In this case, the agreement between the prices of different countries is even greater than that which is covered by the conception of an identical purchasing power of the monetary unit; for not only average price levels but also the price of each particular commodity or service will then be the same in both countries, if computed on the basis of the exchanges.5
Cassel, however, rejects this view, and insists that the doctrine will not hold if applied to international commodities alone, since if the prices of all B's export commodities were doubled, all other prices in B and all prices in A remaining unchanged, the exchange value of B's currency would fall by much less than half. Before the exchange could fall to this level, other commodities hitherto produced only for home consumption could be profitably exported by B, and its imports of A's commodities would have fallen, and thus a further drop in its exchanges would be prevented.6
Cassel is right in maintaining that the doctrine need not hold if applied to the price levels of a variable range of international commodities. But it need not hold even if applied to a fixed assortment of international commodities. Suppose that there are only two countries, that no new commodities enter into international trade, that no commodities already in international trade change the direction of their flow or disappear from trade, and that there are no tariffs or freight costs, so that all international commodities command idential prices in all markets, in terms of the standard currency when this is uniform and exchange is at par, or in terms of the currency of either of the countries converted from the other, when necessary, at the prevailing rate of exchange. Even in this case, the doctrine that the exchange rates will vary in exact inverse proportion with the relative variations in the index number of prices of international commodities in the two countries would not only not be atruism, but would not necessarily or ordinarily be true if, as would be most appropriate, weighted index numbers were used and the basis for the weighting were, not the relative importance of the commodities in international trade (which, with only two countries, would mean identical weights for both countries) but their relative importance in the consumption or the total trade, external and internal, of the respective countries. In fact, it would be possible for the exchange rate under these conditions to change even if no change occurred in any price, provided there were changes in the weights in the two countries, or even if no change occurred in any weight, provided there were any changes in prices, notwithstanding the necessity under the conditions assumed that any price changes should be identical in both countries.
The only necessary relationships between prices in different countries which the classical theory postulated, or which can be formulated in general terms, are the international uniformity of particular prices of commodities actually moving in international trade when converted into other currencies at the prevailing rates of exchange, after allowance for transportation costs and tariff duties, and the necessity of such a relationship between the arrays of prices in different countries as is consistent with the maintenance of international and internal equilibrium.
The one type of case which would meet the requirement of exact inversely proportional changes in price levels and in exchange rates would be a monetary change in one country, such as a revaluation of the currency, which would operate to change all prices and money incomes in that country in equal degree, while every other element in the situation, in both countries, remained absolutely constant.7 Cassel, however, argues for at least the practical validity of his theory, as applied to actual history, on the ground that it is substantially confirmed by the facts, since under the gold standard there do not occur even over long periods wide divergences in the trends of the indices of different countries, and under fluctuating paper currencies the divergences between the actual trends of the indices and the purchasing-power parities calculated in accordance with his formula are not great and tend to disappear. He claims that the disturbances such as capital flows or tariff changes which operate to prevent purchasing-power parity from establishing itself are rarely powerful enough, as compared to the influence of the comparative purchasing power of the respective currencies, to result in a wide divergence from purchasing-power parity and are moreover likely to be temporary in character. His defense of the theory is essentially empirical rather than analytical.
It is no doubt true that the comparative purchasing power of two paper currencies in terms of all the things which are purchasable in their respective countries is at least ordinarily the most important single factor in determining the exchange rate between the two currencies and must ordinarily be powerful enough to keep divergences of the exchange rate and purchasing power parity from reaching such lengths as, say, a rate only 50 per cent or as much as 200 per cent of the rate called for by the purchasing-power parity formula. It is also true that the exchange rate, which means approximately the comparative mint prices of gold, is ordinarily the most important single factor in determining the price levels of countries on an international gold standard. But the divergences between actual exchange rates and those required by the purchasing-power parity formula are in fact frequently substantial, and the “disturbances” from which such divergences result need not by any means be temporary in character, so that a longer period would lessen the divergence, but may in fact be progressive in character through time. Nor can these divergences be satisfactorily explained by defects in the available index numbers. On the contrary, the indices ordinarily used are unweighted wholesale price indices, and these are notoriously heavily loaded with the staple commodities of international commerce, whose prices are most likely to have uniform trends in different countries. Examination of such few indices as are constructed on a broad enough basis to give some representation to domestic commodities and services indicates, what is to be expected, that the more comprehensive the index the wider tends to be the divergence of the actual exchange rate from the purchasing-power parity rate. Use of weighted indices also ordinarily results in a widening of the indicated deviation of the exchanges from the purchasing-power parity rate.
Cassel's theory purports to be not merely a statement of relations between quantities, but also an explanation of the order of causation, with exchange rates being determined by relative price levels, rather than vice versa. Under an international metallic standard in the long run, for any one country, and especially if it is a small country, its price level will be determined for it largely by factors external to it and impinging upon it through specie movements.8 Under paper standards not substantially pegged to gold, whether de jure or de facto, it is impossible to formulate the issue intelligently without reference to the principles on which the quantity of money in each country is regulated, and if, as is, however, rarely the case, there is no clear governing principle, and the play of circumstances, such as the state of the national budget, pressure from business, or more or less arbitrary or traditional discount policies, are allowed to be the determining factors, there will be mutual influence of prices on exchange rates and of exchange rates on prices, with no satisfactory way of apportioning to each set of influences its share of responsibility for the actually resultant situation.
Cassel has defended his failure to give attention to the factors which even in the long run can operate to create divergence between the actual exchange rate and the purchasing-power parity rate on the ground that his theory threw the emphasis on what was during the war and post-war period of extreme inflation overwhelmingly the most important factor in determining exchange rates, namely, currency inflation. Under such circumstances, the proper procedure for the economist apparently is to forget about the minor factors:
The art of economic theory to a great extent consists in the ability to judge which of a number of different factors cooperating in a certain movement ought to be regarded as the most important and essential one. Obviously in such cases we must choose a factor of permanent character, a factor which must always be at work. Other factors which are only of a temporary character and may be expected to disappear, or at any rate can be theoretically assumed to be absent, must for that reason alone be put in a subordinate position.9
No objection can be made to this, if it is to be understood to mean merely that minor factors should be treated as minor factors. But if it is presented as justification for the omission of mention of minor factors, and even for express denial that they are operative, on the ground that their recognition weakens the persuasive power of one's argument, then this amounts merely to saying that bad theory may make good propaganda, and is a debatable proposition at that.10
THE INTERNATIONAL MECHANISM IN RELATION TO MODERN BANKING PROCESSES
... many writers have perplexed themselves and their readers by founding theorics on exceptional circumstances. Others have been led astray by statistics—the characteristic form of modern research....—G. Arbuthnot, “Sir Robert Peel's Act of 1844 ... vindicated,” 1857, p. vii.
The critism presented here corresponds in most respects to that to be found in the following, among other, sources: G. W. Terborgh, “The purchasing-power parity theory,” Journal of political economy, XXXIV (1926), 197-208; T. O. Yntema, A mathematical reformulation of the general theory of international trade, 1932, pp. 18-19; C. Bresciani-Turroni, “The ‘purchasing power parity’ doctrine,”, L'Égypte contemporaine, XXV (1934), 433-64; Howard Ellis, German monetary theory, 1905-1933, 1934, part III. Cf. also Jacob Viner, “Die Theorie des auswärtigen Handels,” in Di Wirtschaftstheorie der Gegenwart (Wieser Festschrift), IV (1928), 117-18.
Gustav Cassel, “Memorandum on the world's monetary problems,” International Financial Conference, Brussels, 1920, Documents of the Conference, V, 44-45. (Italics in the original.)
I.e., using the same symbols as in note 2, supra:
Cassel, Post-war monetary stabilisation, 1928, pp. 31-32.
E. F. Heckscher (and others), Sweden, Norway, Denmark and Iceland in the world war, 1930, p. 151.
Cassel, Theory of social economy, 1932, pp. 662-63. Cassel proceeds to make a concession which seems to me to involve a surrender of the one element in his theory which differentiates it from other theories, namely, his insistence that the long-run exchange value of a currency depends solely on the average level of prices in the two countries. He says: “However, the general internal purchasing power of the B currency has, of course, fallen, and to that extent one must expect a corresponding fall in the rate of exchange. Over and above that, there will perhaps take place a further fall in the rate as a consequence of a distribution of the general rise of prices which may be particularly unfavorable for the external value of the B currency.“(Ibid., p. 663. Italics not in original.) Unless Cassel has in mind only a temporary effect, he is here conceding that the exchanges need not move in the same direction or degree as the relative change in general price levels.
Cf. T. O. Yntema, A mathematical reformulation of the general theory of international trade, 1932, pp. 18-19.
Cf. Robert Adamson, “Some considerations on the theory of money,” Transactions of the Manchester Statistical Society, 1885, p. 58: ... I cannot read the literature of this subject without seeming to feel that in the ordinary explanations of prices by reference to fluctuations in the quantity of money, and of circulation, etc., are not only curious reversals of the true theory, but practical dangers. They concentrate attention on the secondary factor, assign all importance to it, and tend toward the practical doctrine that remedies are to be sought in some artificial manipulation of the money system. I would not deny [sic] for a moment that the money system of a country is without influence on the course of its prices; no two facts can coexist in mutual dependence without some reciprocal influence being exercised, but the influence seems to me to be secondary in its action and relatively insignificant. It only acts because, through deeper lying causes, there is already a determined range of prices. The comparative efficiency of a country as one member of the great trading community is what in the long run determines the scale of prices in it, and it is to the variations in the conditions affecting its efficiency that we must turn for final explanation of the movements which on the surface appear as changes in an independent entity, money.
Cassel, Post-war monetary stabilization, 1928, p. 29. Machlup has recently expressed similar views in the course of a review of Ellis's book: The purchasing-power parity theorists, of course, overstated their case of unilateral causation (inflation-prices-exchange rates). But it was necessary to do so at a time when the monetary authorities tried to deny any responsibility for the depreciation by maintaining that the intense “need” for imported goods and the misbehavior of wicked speculators were to be blamed. The concession that, under dislocated currencies, certain shifts in the relative intensity of the demand for the other countries' goods may bring about a (slight) change in foreign exchange rates was entirely out of place at a time when foreign exchanges were continuously rising to some fantastic multiple of their original level. (Journal of political economy, XLIII , 395 Italics mine.)
Cf. R. G. Hawtrey, Currency and credit, 3d ed., 1928, p. 442: But to recommend a dogma on account not of its inherent validity but of its good practical consequences is dangerous. When people discover its theoretical weaknesses they may not only reject the dogma, but neglect the practical consequences.