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?

Are food prices becoming more volatile? Yes, says the FAO (but it doesn’t know what to do about it)

The latest in the excellent two pagers from the FAO’s ‘Economic and Social Perspectives’ series looks at price volatility in agricultural markets. It finds that over recent decades, staple food prices have indeed become more volatile. The graph shows a measure of volatility – the market’s expectation of how much the price of a commodity might move in future. The two pager doesn’t say where the data comes from (and the paper on which it is based isn’t out yet), but it seems to measure subjective expectations, a bit like business confidence indices.

As the paper points out, a bit of price volatility is a good thing – it’s part of ensuring that supply shifts in response to changing demand, but excessive, or excessively short-term price swings deters farmers or companies from investing – especially given the timelag between investing in a new crop, and harvesting it.

Why has volatility increased?

“Increased vulnerability is being triggered by an apparent increase in extreme weather events and a dependence on new exporting zones, where harvest outcomes are prone to weather vagaries; a greater reliance on international trade to meet food needs at the expense of stock holding; a growing demand for food commodities from other sectors, especially energy; and a faster transmission of macroeconomic factors onto commodity markets, including exchange rate volatility and monetary policy shifts, such as changing interest rate regimes.

What is more, financial firms are progressively investing in commodity derivatives as a portfolio hedge since returns in the commodity sector seem uncorrelated with returns to other assets. While this ‘financialisation of commodities’ is generally not viewed as the source of price turbulence, evidence suggests that trading in futures markets may have amplified volatility in the short term.”

Alas the ‘so what’ section of the paper does not live up to the diagnosis, merely calling for better coherence and coordination between different institutions (governments, multilaterals etc), transparency and monitoring, safety nets and faster disbursing funding during price shocks – an even more restricted menu than Robert Zoellick’s recent FT piece. The FAO seems to be accepting growing volatility as inevitable and merely trying to cushion the impact a bit.

So do food price spikes cause riots or not?

I’m a big fan of Chris Blattman’s blog (as the number of ‘hat tips’ – [h/t] – on this one demonstrates), but he lost it a bit in his recent post on food riots. Here’s what he says:

‘Globalization and growth should reduce price spikes in future. More countries are producing crops. Climate shocks in Argentina are not that tied to climate shocks in Russia or China, and so price volatility from supply shocks should be going down. Falling transport costs also mean that more substitutes are available, further reducing price volatility. So things should be getting better over time, not worse, especially if trade allows countries to diversify their diet. Envision a future of diminishing instability.’

This reminds me of the apocryphal French diplomat arguing in a Brussels punch-up ‘I can see it works in practice, but does it work in theory?’ Here’s the practice – you can clearly see food prices pretty smooth up til 2007, then going haywire.

Time to adjust the theory, rather than deny the reality, Chris?

Where I agree with him is that the triggers for food riots, as for most things, are often local rather than global – government policy, bad policing etc. And not just in developing countries – the incompetence of the Seattle police was in my mind largely responsible for the collapse of the WTO ministerial in 1999 – they had plenty of tear gas but no crash barriers (see pic). But it’s the interaction between local and global phenomena that we need to understand better – price rises in 2008 did coincide with a wave of food riots, no doubt all with their local contributory factors too. And to argue that this was mere coincidence isn’t very credible, in my view – A at least partly caused B. So yes, worry about local politics, but worry about the graph too.

[h/t Richard King, both for the graph, and for clicking the wrong button and posting this a day early!]