The Great Food Price Balancing Act

 29 June 2011.

Rising food prices affect everybody, though obviously certain demographic groups – usually the poor – are affected more than the rest. As food prices continue to retain high levels of volatility, Jeffrey Frankel questions whether food prices can be stabilized and asserts that speculators could potentially act as “detectors of change” or as a “stabilizing force”.

 29 June 2011.

Rising food prices affect everybody, though obviously certain demographic groups – usually the poor – are affected more than the rest. As food prices continue to retain high levels of volatility, Jeffrey Frankel questions whether food prices can be stabilized and asserts that speculators could potentially act as “detectors of change” or as a “stabilizing force”.

CAMBRIDGE – Under French President Nicolas Sarkozy’s leadership, the G-20 has made addressing food-price volatility a top priority this year, with member states’ agriculture ministers meeting recently in Paris to come up with solutions. Small wonder: world food prices reached a record high earlier in the year, recalling a similar price spike in 2008.

Consumers are hurting worldwide, especially the poor, for whom food takes a major bite out of household budgets. Popular discontent over food prices has fueled political instability in some countries, most notably in Egypt and Tunisia. Even agricultural producers would prefer some price stability over the wild ups and downs of the last five years.

The G-20’s efforts will culminate in the Cannes Summit in November. But, when it comes to specific policies, caution will be very much in order, for there is a long history of measures aimed at reducing commodity-price volatility that have ended up doing more harm than good.

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For example, some inflation-targeting central banks have reacted to increases in prices of imported commodities by tightening monetary policy and thereby increasing the value of the currency. But adverse movements in the terms of trade must be accommodated; they cannot be fought with monetary policy.

[quote]Producing countries have also tried to contain price volatility by forming international cartels. But these have seldom worked.[/quote]

In theory, government stockpiles might be able to smooth price fluctuations. But this depends on how stockpiles are administered. The historical record is not encouraging.

In rich countries, where the primary producing sector usually has political power, stockpiles of food products are used as a means of keeping prices high rather than low. The European Union’s Common Agricultural Policy is a classic example – and is disastrous for EU budgets, economic efficiency, and consumer pocketbooks.

In many developing countries, on the other hand, farmers lack political power.

African countries adopted commodity boards for coffee and cocoa. Although the original rationale was to buy the crop in years of excess supply and sell in years of excess demand, thereby stabilizing prices, in practice the price paid to cocoa and coffee farmers, who were politically weak, was always below the world price in the early decades of independence. As a result, production fell.

[quote]Politicians often seek to shield consumers through price controls on staple foods and energy. But artificially suppressing prices usually requires rationing to domestic households. (Shortages and long lines can fuel political rage just as surely as higher prices can.) Otherwise, the policy satisfies the excess demand via imports, and so raises the world price even more.[/quote]

If the country is a producer of the commodity in question, it may use export controls to insulate domestic consumers from increases in the world price. In 2008, India capped rice exports, and Argentina did the same for wheat exports, as did Russia in 2010.

Export restrictions in producing countries and price controls in importing countries both serve to exacerbate the magnitude of the world price upswing, owing to the artificially reduced quantity that is still internationally traded. If producing and consuming countries in grain markets could cooperatively agree to refrain from such government intervention – probably by working through the World Trade Organization – world price volatility might be lower.

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Can Anything Be Done?

In the meantime, some obvious steps should be taken. For starters, bio-fuel subsidies should be abolished. Ethanol subsidies, such as those paid to American corn farmers, do not accomplish policymakers’ avowed environmental goals, but do divert grain and thus help drive up world food prices. By now this should be clear to everybody. But one cannot really expect the G-20 agriculture ministers to be able to fix the problem. After all, their constituents, the farmers, are the ones pocketing the money. (The US, it must be said, is the biggest obstacle here.)

[quote]It is probably best to accept that commodity prices will be volatile, and to create ways to limit the adverse economic effects – for example, financial instruments that allow hedging of the terms of trade.[/quote]

What the G-20 agriculture ministers have agreed is to forge a system to improve transparency in agricultural markets, including information about production, stocks, and prices. More complete and timely information might indeed help.

But the broader sort of policy that Sarkozy evidently has in mind is to confront speculators, who are perceived as destabilizing agricultural commodity markets. True, in recent years, commodities have become more like assets and less like goods. Prices are not determined solely by the flow of current supply and demand and their current economic fundamentals (such as disruptions from weather or politics). They are increasingly determined also by calculations regarding expected future fundamentals (such as economic growth in Asia) and alternative returns (such as interest rates) – in other words, by speculators.

Related: World Food Price Hikes Driven by Speculation and Derivatives

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But speculation is not necessarily destabilizing. Sarkozy is right that leverage is not necessarily good just because the free market allows it, and that speculators occasionally act in a destabilizing way. But speculators more often act as detectors of changes in economic fundamentals, or provide the signals that smooth transitory fluctuations. In other words, they often are a stabilizing force.

The French have not yet been able to obtain agreement from the other G-20 members on measures aimed at regulating commodity speculators, such as limits on the size of their investment positions. I hope it stays that way. Shooting the messenger is no way to respond to the message.

Jeffrey Frankel is the James W. Harpel Professor of Capital Formation and Growth at the John F. Kennedy School of Government in Harvard University. Frankel served under the Clinton Administration as a member of the Council of Economic Advisors and is currently the Director of Program in International Finance and Macroeconomics at the National Bureau of Economic Research.

Copyright: Project Syndicate, 2011

Can speculators really act as a “detector of change” or a “stabilizing force”? Or do they work only to serve their own self interest? Have your say below.