Murray Worthy is Policy Officer at the World Development Movement.

Paul Krugman is an economist I have huge respect for, and one with whom I often agree. This made it all the more disappointing when I read his recent post for the New York Times dismissing the role of speculation in current high food prices. Sadly Krugman’s arguments, apparently lifted from an economics primer, fall far wide of the mark when it comes to the reality of food markets.

The core of his argument is his simple price graph, indicating that the current price of any physical commodity will be based on the exact balance of supply and demand. Krugman dismisses the role that speculation can play in affecting commodity prices unless banks or other financial speculators take delivery of food: “plays in the financial markets can only move the price to the extent that they affect physical flows and stocks.”

While this model is nice in theory, even the textbooks admit that price formation based on a perfect balance of supply and demand can only happen when:

a) there is perfect information about supply and demand.
b) participants are well (if not perfectly) informed about supply and demand.

However in the case of food this is simply not the case. As the UN Food and Agriculture Organisation has noted (pdf), there is a lack of reliable and up-to-date information on crop supply, demand and export availability and insufficient market transparency at all levels.

So, how do farmers and buyers work out prices in the absence of the supply and demand data so neatly displayed in Krugman’s graph? The answer; futures markets. As the US regulator, the Commodities Futures Trading Commission, notes in its explanation of the purpose of futures markets and how they work:

“Futures contracts are often relied on for price discovery as well as for hedging. In many physical commodities (especially agricultural commodities), cash market participants base spot and forward prices on the futures prices that are “discovered” in the competitive, open auction market of a futures exchange.”

So, speculators in futures markets don’t ever need to touch a bushel of wheat to change real food prices. The prices they drive in futures markets have a direct link to the prices of real physical food.

Krugman also argues in his piece that in the case of high prices we would expect to see stocks rise as physical traders seek to benefit from high prices. Again, good in the textbook but irrelevant in practice. Aside from assuming that a rational response to a food crisis is to hoard food, this statement ignores the fact that huge amounts of global food stocks are publicly owned. These stocks aren’t private individuals seeking to profit from high prices, but government managed stocks designed to be used up when prices are high to reduce domestic price volatility and guarantee supply to consumers.

While Krugman’s attempts to dismiss the role of speculation in high food prices may make sense in a textbook they bear no relation to what is actually happening in today’s food markets.

In fact, the price of food is directly linked to speculation in financial markets. There are long-term underlying pressures such as climate change and demand for biofuels, and Middle Eastern dictators buying up food to prevent social unrest has helped push up prices in recent months. But financial speculation is pushing these prices ever higher, betting on the long term rising prices. Financial traders also increase volatility, riding on every rise and fall. Limiting food speculation alone won’t solve world hunger, but it will help make food prices more affordable and more stable and it can be achieved now.

Find out more about WDM’s food speculation campaign here.