Tuesday, October 4, 2011

Round Two. Does Speculation Cause High Food Prices?

They've been pouring across my desk lately, the seemingly credible main stream news and high level PDF studies proclaiming that the global food commodity prices are being driven by speculation.

Since my March 2011 post, Are Speculators to Blame for High Food Commodity Prices? No, and this Explains Why, has anything changed? Where is all of this media momentum coming from of late?

Blaming speculators for high food prices has come from recent sources which include der Spiegel, Mark Bittman, Derek Thompson at The Atlantic, Tom Philpott, Tom Laskawy for Grist, The Guardian, Cornell University, and less recently, Oliver De Shutter, and Nicolas Sarkozy.

To begin with, here is a short list of some of the information that's been presented:

1. Just this morning, in Mark Bittman's news items (NYT's), he included this:
Evidence is growing that financial speculators are responsible for the rising price of food. So the Commodity Futures Trading Commission just released new rules to curb excessive speculation, and the result is — you guessed it — a giveaway to speculators.
2. Last Saturday morning, Drumbeat, over at The Oil Drum, began with this top news link:
When food prices rise, some blame investors: Earlier this month, the German news magazine Der Spiegel published an in-depth article, called "Speculating with Lives," looking at what’s driving up food prices. The authors argue that while some of the factors we hear a lot about, such as global warming, biofuels and population growth, are small contributors to rising food prices, they aren’t the main culprit. Instead, the article points a finger at investors who have increasingly fled the financial markets and started trading in commodities such as silver, gold and, yes, food.
3. One of my most valued readers sent me this news link a few days ago, of a new study out of Cornell University:
The Food Crises: A quantitative model of food prices including speculators and ethanol conversion [pdf] — SUMMARY: Recent increases in basic food prices are severely impacting vulnerable populations worldwide. Proposed causes such as shortages of grain due to adverse weather, increasing meat consumption in China and India, conversion of corn to ethanol in the US, and investor speculation on commodity markets lead to widely differing implications for policy. A lack of clarity about which factors are responsible reinforces policy inaction. Here, for the first time, we construct a dynamic model that quantitatively agrees with food prices.
4. From Nourishing the Planet, yesterday:
New IATP Report Shows Excessive Speculation Hurts Farmers and Increases Hunger By Kim Kido -- A recent report published by the Institute for Agriculture and Trade Policy (IATP) describes how and why speculative trading has caused agricultural commodity prices to fluctuate wildly, irrespective of actual supply and demand. The report shows how such price fluctuations negatively impact farmers and consumers, and supports regulations that would stop this from happening.
5. And these last two items go back a bit further, this, from the April 2011 Foreign Policy Magazine:
How Goldman Sachs Created the Food Crisis — What was happening to the grain markets was not the result of "speculation" in the traditional sense of buying low and selling high. Today, along with the cumulative index, the Standard & Poors GSCI provides 219 distinct index "tickers," so investors can boot up their Bloomberg system and bet on everything from palladium to soybean oil, biofuels to feeder cattle. But the boom in new speculative opportunities in global grain, edible oil, and livestock markets has created a vicious cycle. The more the price of food commodities increases, the more money pours into the sector, and the higher prices rise. Indeed, from 2003 to 2008, the volume of index fund speculation increased by 1,900 percent. "What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets," hedge fund Michael Masters testified before Congress in the midst of the 2008 food crisis.
6. From the United Nation's Oliver De Schutter (September 2010):
Food Commodities Speculation and Food Price Crises [pdf] SUMMARY: In this briefing note, the UN Special Rapporteur on the right to food examines the impact of speculation on the volatility of the prices of basic food commodities, and he identifies possible solutions forward. The global food price crisis that occurred between 2007 and 2008, and which affects many developing countries to this day, had a number of causes. The initial causes related to market fundamentals, including the supply and demand for food commodities, transportation and storage costs, and an increase in the price of agricultural inputs. However, a significant portion of the increases in price and volatility of essential food commodities can only be explained by the emergence of a speculative bubble.

So, Once Again, Does Speculation Cause High Food Prices?
Let us review this subject of speculation and food prices and see if any new issues have surfaced. If you missed it, my first post about this was quite simply stated, using easy-to-understand writing by Nevil Speer and some key questions which were answered by Scott Irwin from the University of Illinois-Urbana.

With all of the new articles out there and the media attention given to this subject, I contacted Irwin again, and he graciously replied to my new questions as follows:

Q: In your opinion, has anything changed since my post quoting you explaining that speculation doesn't cause high food prices?
My views have not changed. However, I think some terms are thrown around in a confusing manner. Here is the way I describe the issues. The main point of argument is whether a huge wave of commodity index investment/speculation has overwhelmed the normal supply and demand functioning in commodity markets, including food, and created a massive bubble. It is important to recognize that the charge is a “massive” bubble, leading to, say, crude oil or corn prices 30, 40, 50% above fundamental value. Take your pick. The key is that prices are way above “fundamental” value. I like to call this the “Masters Hypothesis.” If this hypothesis is true it would indeed represent a large and deeply troubling market failure that could signal the need for costly new regulations to “throw sand in the gears” of the markets. I have not seen a shred of compelling evidence that the Masters Hypothesis is valid in any commodity futures market, including those for food products.

But that is not the end of the story. Something else may be going on that it is best considered using the term “financialization.” I use this to refer to the process of opening commodity markets to much wider participation via electronic trading/web access, commodity index investments, and ETFs. It is important to realize that all of these have worked together to increase participation and trading. Think of this as new technology that broke down old barriers and significantly drove down the cost of trading, particularly for non-traditional participants.

The structural changes wrought by financialization may change pricing in commodity futures markets. I emphasize “may” since the research in this regard is just beginning to roll out. It is also important to emphasize that economic theory predicts that these types of changes are not expected to be large but potentially long lasting. For example, a recent paper by Jim Hamilton and one of his students indicates that risk premiums in the crude oil futures market may have been driven down by the forces of financialization. This is a sensible and POSITIVE outcome as risk premiums represent the cost that hedgers pay to speculators to bear the risk they want to avoid.

The basic story is you open the markets to wider participation and the cost of shifting risk goes down. Who would be against this outcome? Other work focuses on liquidity costs and other types of market impacts. It is critical that readers understand that evidence like Hamilton’s has no bearing on what I called the Masters Hypothesis. Proponents of the Masters Hypothesis pounce on evidence like Hamilton’s as “proof” but nothing could be further from the truth.

Q: Do you feel any regulatory changes need to be done (today) to help protect the food commodities from speculation?

No. What has and is being proposed is counter-productive.
Q: If your position remains the same as previously, do you have any words of rebuttal for any of the articles or studies I've listed?

Der speigel: The IFPRI work by Torrero et al has not fared well under careful academic scrutiny. See my own work and that of my colleague Brian Wright. If you want to send readers to just one resource on this issue PLEASE refer them to Brian’s paper found here [PDF].

I have taken a look at the Cornell study. The analysis is simply not credible. Existing Granger causality analysis is simply dismissed with a single sentence. Not cool. Even more troubling is their approach to the inventory question. As is well known by now, if a bubble is created in a market for a storable commodity, the excess of supply over demand at the higher bubble price has to show up somewhere---in inventories. The authors conduct interviews with traders and wave this around as proof on this crucial question. Again, not cool. For the truly cynical, look at their figure on the fit of their model and corn prices I was taught in my first econometrics course was to be very, very skeptical of any model that nearly perfectly fits the data. Draw your own conclusions.

De Schutter: Hand waving and unserious analysis. Starts with conclusion and works backwards to fit the data to desired story.

Since all grain commodity futures contracts which are bought must also be sold, speculation should not cause more than short term price changes although it might contribute to volatility. The non-linearity between price and grain inventories during perceived times of scarcity might be the reason that some jump to the conclusion that speculators are causing rapid price rises during these time periods of real or perceived scarcity.

The work by Brian Wright, which Irwin refers us to states, "The recent history of grain markets supports two conclusions. First, the price spikes of 2008 and more recently are not as unusual as many discussions imply. Second, the balance between consumption, available supply, and stocks seems to be as relevant for our understanding of these markets as it was decades ago."
——Kay McDonald