Krugman misses the mark on food speculation
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.
@Angus – Given that futures markets are used as a benchmark for the physical market, they should theoretically be the most reflective indicator of the true market price of agricultural goods. It also appears that for most of the time these markets were made up of commercial traders that is what they did. Now that these markets have become dominated by financial speculators they do not perform this role, as financial speculators inflate prices and increase volatility, creating price bubbles in the futures markets.
Also, given the price volatility of agricultural commodities, and the fact that many food producers do not have a strong market led approach, there is a reasonable amount of evidence to show that food producers do not react strongly to changing prices to adjust production, instead basing decisions on previous years’ performance.
Futures markets should help to resolve the issues of imperfect information, however due to the presence of financial speculators not trading based on the fundamentals, they no longer do this effectively. Instead the impacts of speculators in the futures markets whose trading decisions are not based on supply and demand lead to changing the price of food.
You dismiss Krugman’s supply-demand model on the basis that it makes the assumption of perfect information.
You then explain that producers then use futures markets to set their prices and, in this way, futures markets influence the price of agricultural goods.
Does this not imply that futures market are the most reflective indicator of the true market price of agricultural goods? If they were not roughly centralised around the equilibrium price, producers would produce too much or too little.
If this reasoning is correct, 2 conclusions can be drawn:
1) Futures markets partially resolve the issue of imperfect information in agricultural markets.
2) The value of agricultural futures roughly reflects the conditions in agricultural markets. If they did not they would not be attractive to investors (obviously excluding bubbles) and they would not be used as a price setting tool by producers.
This implies that futures markets do not artificially inflate food prices.
I’d be very interested in any responses to this argument.
Interesting article. As is often the case, whats written in the textbook doesn’t work practically.
PS. None of that is not to say that in a world of finite resources the price will not go up in the edium and long term…….it’s just that producers who currently, and briefly, have the upper hand, funded by money borrowed interest-free from fearful fund investors.
Krugman is not the only one missing the mark, Murray, but you are in good company.
In my view speculators are investors or traders who put their capital at risk in search of transaction profit. They are agnostic as to the absolute level of price: what they need is volatility, and indeed their activities are instrumental in causing it.
While they are active in markets in the short term, and thereby may cause spikes in either direction, they are absolutely NOT responsible for persistent high prices. They simply are not deploying the level of capital which would enable that.
While physical supply and demand sets the ‘spot’ market price it is the ability to store physical commodities which enables financial purchases to take place by investors. In some markets eg metals this is much more straightforward than others eg crude oil.
The futures markets exist to enable market participants wishing to purchase or sell physical commodities at a future point in time to ‘hedge’ the risk that the physical price will move against them. Where a futures contract is deliverable, then the prices of the future and the physical will converge so that the futures contract becomes a spot contract upon expiry.
But the fact is that it is the futures market which converges on the spot price, and not vice versa, as you imply. A commodity futures contract is not called a ‘derivative’ for nothing, since it ‘derives’ from the price of the underlying commodity.
What is actually going on in the commodity markets right now is that it is risk averse investors who make financial investments in stocks who are inflating the price, and enabling producers to support it over time.
Firstly, as you observe, we see public investment in reserve stocks, which is a risk averse ‘hedge’ on behalf of their population.
But secondly, and responsible for the correlated financialisation of all organised commodities we a new class of risk averse financial investor in the form of Index Funds; Exchange Traded Funds (ETFs) and related ETCs and ETPs.
Investment banks – and Goldman Sachs led the way in 1995 with its pioneering GSCI fund – have managed to sell to the public the concept of ‘Inflation Hedging’ ie getting out of $, £ € and other paper currencies and into other more tangible assets.
Once dollar interest rates fell to zero, and the Fed added insult to injury by printing gazillions of new $, a tidal wave of tens of billions of dollars have swept into anything: precious metals; base metals; energy; and soft/ agricultural commodities.
The fact that these carry no income is irrelevant at a time when the dollar does not either.
So in a nutshell it is not greedy speculators who are responsible for sustained high prices, but the opposite: fearful ‘inflation hedgers’ investing a many $ billions of risk averse capital in the commodity markets.
The outcome is that these inflation hedgers are causing the very inflation they wish to avoid. There is a massive transfer of wealth from consumers to producers.
For financial speculators such as hedge funds commodity markets are a less than zero sum game.
The other big winners are the physical traders, banks, brokers and exchanges who get the croupiers’ cut in the commodity market casino, on what is a pretty rigged wheel.
Finally the inflation hedging Joe Public – who have been sold a pup by investment banks and fund managers – will, before long, lose gazillions when the commodity bubble pops as physical demand is destroyed by the high prices their financial purchases are driving.