If we can’t prove that speculation drives food prices, should we regulate it anyway?

One of my more wonk-mind-blowing moments last year was refereeing a debate about financial speculation and commodity prices between Oxfam’s Rob Nash and a UK Treasury wonk who wished to remain nameless. I couldn’t understand either of them (even by international development standards, the language is really weird – try ‘contango’ or ‘backwardation’).  I tried to get them to slug it out on the blog, but the Treasury type declined.

So it’s good news that Stephen Spratt of IDS (right) has written a blog post and 20 page paper on food price volatility and financial speculation – Stephen is a City poacher turned gamekeeper, and one of the clearest thinkers I’ve come across on financial markets.

The paper considers the case for and against the prosecution. Stephen sets out (and tries to answer) the key questions:

• How has the relationship between financial actors and food commodity markets – particularly futures markets – changed in the last ten years?
• What have been the benefits and costs of the increased role of financial sector actors in these markets?
• How might the balance between benefits and costs change in the future?
• What reforms, if any, are needed to ensure that benefits exceed costs?

The paper helpfully unpacks different kinds of ‘speculation’ – lumping them all together is really unhelpful, and assesses the impact of high prices and volatility on different groups (see table).

But the most valuable contribution is his thinking on complex systems. Sure there is a clear correlation between rising food prices, volatility and increased financial market activity in commodities, but proving the causal link between them is a different question. His conclusion: ‘Establishing cause and effect has proven to be impossible.’

The pro-market types consider this enough grounds to oppose regulation of speculation. Stephen disagrees. He argues that we need to think harder about the costs and benefits of action if the critics of financial speculation are right, and if they are wrong. If they are right, and speculation is driving food markets, then regulation would help prevent the extremely damaging social impacts of high and volatile prices. If they are wrong, and we regulate anyway, the damage would be limited. So in a version of the precautionary principle, he comes down in favour of regulation. Here’s his conclusion:

‘The policy responses that different commentators favour are strongly influenced by two things. First, their view on the link between increasing financial speculation in futures market and price movements in spot markets. Second, their view on the relationship between financial market prices and underlying economic fundamentals. Reasonable people take different view on these questions, and it is not possible to answer them definitively. On the balance of evidence, however, we have proposed the cautious use of the precautionary principle, largely because of the fundamental importance of global food markets to the lives of billions of people.

Set against this, the ‘costs’ of placing greater curbs on financial participation in food markets seem relatively trivial. Some argue that reducing speculation would reduce market liquidity, increasing hedging costs. But there has been no reduction in hedging costs as financial engagement has grown. The only real cost, therefore, may be a reduction in the profitability of some financial institutions. Set against the potential benefits, this seems a price well worth paying.’

I’m convinced. You? The next step would be to apply the same precautionary principle/complex systems approach to different kinds of speculation and different forms of regulation – doubtless a very messy argument. Has anyone had it yet?

Food and Finance: a little less speculation, a little more action please…

Some good sense on a polarised topic from Ruth Kelly, Oxfam economic policy adviser and co-author of a new paper on speculation and food prices.

When they work properly, financial markets are great at greasing the cogs of the food system. Why, then, are so many people blaming speculation for recent food price spikes?
 
First here’s how markets ought to work. People all along the food supply chain use them to hedge their risk. At the moment food prices are exceptionally high and rising and, as they rise, they are shooting up and down in a completely unpredictable way. So for a premium, speculators guarantee a future price for those buying and selling food, taking a gamble that prices on the market will be higher than the price they have guaranteed so they can pocket the premium without having to cough up – if things go the other way, the speculators may lose but they are big enough to take that risk.
 
There are other benefits. Since there is very little public information about physical markets in agricultural commodities, buyers and sellers of food rely on financial markets to help them determine the right price. Each speculator comes with a little bit of information that they share by buying and selling, bringing the price of agricultural derivatives very close to the price producers should be charging for food.
 
Better still, financial markets allow agricultural assets to be turned into cash quickly and easily. This is crucial in a market where assets can only be sold in bulk at harvest, leaving participants with major cash flow problems. Having a bunch of savvy speculators monitoring market dynamics and in response, buying or selling agricultural derivatives, brings liquidity, moving money around while the crops are still in the ground to help the market work more efficiently.
 
That’s why financial markets are great when they work. But right now, they’re broken: the deals that are being done have lost their grip on the reality of food production and distribution. Even analysts who think that there is no link between speculation and food price volatility admit that the way the markets are working at the moment is making people very nervous. And nerves breed panic and panic inflates bubbles and bubbles eventually burst.
 
First, socially useless speculation, where agricultural derivatives are bought and sold irrespective of the price, with other speculators following like sheep, can lead to a situation where everyone is buying and no-one is selling and prices keep on spiralling upwards. Instead of bringing liquidity to the market, this type of speculation sucks it out.
 
Add this to the growing presence of investors with so much money that they can single-handedly move prices independently of supply and demand, at least in the short term. When such speculators pile in on one side of the market with little regard for price, those relying on financial markets to give them the right price may as well be plucking prices out of the air.
 
And as prices of commodity derivatives shoot out of control and become increasingly volatile, it becomes more and more expensive to hedge risk. Those who rely on financial markets to guarantee prices for their physical crops must pay higher and higher premiums for the privilege. These days, only very large businesses can afford to hedge their risk, leaving smaller producers and traders, who are already more exposed to risk than big agribusiness, without protection. And the increased costs are passed on to consumers.
 
Expert opinion is evenly divided on another key accusation – whether speculation contributes to volatile food prices. Different researchers make the same data say different things, depending on their underlying assumptions and methodologies. And in any case, the data is full of holes. Nonetheless, the fact that there is so much debate means that there is at least a strong case to answer. Because the risks of letting current practices continue, if the critics are right and they are indeed exacerbating food price volatility, are much higher than the risks of acting to make financial markets more transparent and efficient, a precautionary approach should be taken to regulating socially useless speculation.
 
The first step is to get a better idea about what is actually going on. Publishing comprehensive data will help prevent panic and herding, and allow a better assessment of whether there is a link between speculation and food price volatility. But transparency is not enough. The second step is to regulate markets by limiting certain types and volumes of speculation, to try to prevent huge amounts of money spent by very big players from skewing prices and causing panic. The risks of doing nothing far outweigh the risks of regulating.
 
Decisions are already being made at the G20, in the EU and in the US. Those with a vested interest in continued volatility are lobbying hard. Those hit the hardest by volatility – small-scale producers whose livelihoods depend on receiving reliable prices for their produce, consumers in the poorest countries who spend up to 75 percent of their income on food – have a much weaker voice. That is why it is so important to listen and to take action over the next few months and beyond. The right reforms will go a long way to making financial markets work for the people who contribute to feeding everyone on our planet.

Global price chaos – is another food crisis on the way?

Today in the FT: “Sugar prices suffered their biggest one-day sell-off in 30 years on Thursday, tumbling by as much as 11 per cent after speculators pulled out from the market in the wake of dizzying gains. The sell-off, which came just hours after the sweetener hit a 30-year high, started after the European Commission granted further export licences for the commodity, a move widely expected among physical sugar traders.

But some hedge funds took Brussels’ decision as a bearish signal and began selling heavily, traders said. The selling quickly escalated into a rout as falling prices triggered a string of automatic sell orders on the way down, they said. “It is a total meltdown, totally unexpected. There is no explanation,” one bullish trader said.”

Yesterday: “As economists and central bankers fret about the risk of Japanese-style deflation in the west, commodity traders are warning of a very different phenomenon: “agflation”. Amid supply shortages and panic buying across the globe, prices for cotton, sugar and wheat have spiralled to multi-year highs this week, pushing up sharply the costs of materials for basic foodstuffs and clothes.”

A look at the FAO’s useful food price tracker (left) shows the picture. Food prices are heading upwards rapidly again, approaching the 2008 peak that saw food riots in some 30 countries, and an outburst of concern over food security that triggered a spate of ‘land grabs’ by rich countries in the developing world. It also drastically pushed up the numbers of the roughly one in seven of the world’s population who go to bed hungry every night, (see graph of numbers of hungry people worldwide). The line falls back a bit to 925 million in 2010, according to the FAO, but given the latest price shifts, is surely about to resume its upward march.

This kind of price chaos can mean big profits if you’re playing the market and guess right, but it’s hard to see an upside for either producers or consumers. Is this really the best way to run the global food system?

For more see the Financial Times’ excellent ‘global food crisis’ site.

The UN lays into finance, speculation and the IMF: UNCTAD’s Trade and Development Report 2009

Another day, another UN report, this time the Trade and Development Report 2009, from the UN Conference on Trade and Development (UNCTAD), released last week. It’s surprisingly forthright. Set up in 1964, in the table-thumping days of the New International Economic Order, in recent years UNCTAD had become markedly more cautious, not least under its current secretary general, the distinctly un-fiery Supachai Panitchpakdi, (a former WTO boss). The global crisis seems to have changed all that. Some excerpts from the overview (italicised subheads are my attempt at a summary):

The origins of the crisis lie in financial deregulation:

‘Policymakers also failed to draw lessons from the experiences of earlier financial crises. Like previous ones, the current crisis follows the classical sequence of expansion, euphoria, financial distress and panic….. What makes this crisis exceptionally widespread and deep is the fact that financial deregulation, “innovation” of many opaque products and a total ineptitude of credit rating agencies raised credit leverage to unprecedented levels. Blind faith in the “efficiency” of deregulated financial markets led authorities to allow the emergence of a shadow financial system and several global “casinos” with little or no supervision and inadequate capital requirements.’

Speculation is driving commodity price volatility and needs to be curbed:

‘It is true that deteriorating global economic prospects after September 2008 dampened demand for commodities; but the downturn in international commodity prices was first triggered by financial investors who started to unwind their relatively liquid positions in commodities when the value of other assets began to fall or became uncertain. And the herd behaviour of many market participants reinforced such impulses. Financial investors in commodity futures exchanges have been treating commodities increasingly as an alternative asset class…. In order to improve the functioning of commodity futures exchanges in the interests of producers and consumers, and to keep pace with the participation of new trader categories such as index funds, closer and stronger supervision and regulation of these markets is indispensable. In the first half of 2009, commodity prices rose again, reflecting the return of financial speculators to commodity markets, which appears to have amplified the effects of small changes in market fundamentals.’

Developing country governments have responded well to crisis, but the IMF is holding them back:

‘A number of developing and transition economies also launched sizeable fiscal stimulus packages. On average, their size was even larger than those of developed countries: 4.7 per cent of GDP in developing countries and 5.8 per cent in transition economies, extending over a period of one to three years. The authorities in China were quick to announce a particularly large fiscal stimulus plan, amounting to more than 13 per cent of GDP…. By contrast, some developing and transition economies have had to turn to the International Monetary Fund (IMF) for financial support to stabilize their exchange rates and prevent a collapse of their banking systems. IMF lending has surged since the outbreak of the current crisis, extending to nearly 50 countries by the end of May 2009. However, the scope for expansionary policies to counter the impact of the crisis on domestic demand and employment has been severely constrained by the conditionality attached to IMF lending….. Several announcements were made to the effect that the IMF would recognize countercyclical policies and large fiscal stimulus packages as the most effective means to compensate for the fall in aggregate demand induced by debt deflation. However, in reality, the conditions attached to recent lending operations have remained quite similar to those of the past. Indeed, in almost all its recent lending arrangements, the Fund has continued to impose procyclical macroeconomic tightening, including the requirement for a reduction in public spending and an increase in interest rates.’  

A debt moratorium is needed to avert a new debt crisis:

‘The fallout of the global economic crisis is impairing [low income countries’] ability to service their external debt without compromising their imports…. A temporary moratorium on official debt repayments would allow low-income countries to counter, to some extent, the impact of lower export earnings on their import capacity and government budgets. Such a moratorium would be in the spirit of the countercyclical policies undertaken in most developed and emerging-market economies…. the total amount of such a temporary debt moratorium would be modest, amounting to about $26 billion for 49 low-income countries for 2009 and 2010 combined.’

Financial integration needs to be reconsidered, and the IMF should actively encourage the use of capital controls:

‘The realization that in a globalized world “shocks” emanating in one segment of the financial sector of one country can be transmitted rapidly to other parts of the interconnected system raises some fundamental questions about the wisdom of global financial integration of developing countries in general. The experience with the current financial crisis calls into question the conventional wisdom that dismantling all obstacles to cross-border private capital flows is the best recipe for countries to advance…. Assertions that capital controls are ineffective or harmful have been disproved by the actual experiences of emerging-market economies…. the IMF should more actively encourage countries to use, whenever necessary, the introduction of capital controls as provided for in its Articles of Agreement.’

The TDR also calls for a new international exchange rate system and reserve currency to replace the dollar, a role that could perhaps be played by the IMF’s ‘special drawing rights’ (SDRs). In a short additional section on climate change (every report needs one), it comes up with the new (to me) idea of extending the use of compulsory licensing for climate-friendly technologies, allowing governments to override patents (as they currently can in public health emergencies).