Price volatility may seem an arcane subject, but it clearly matters to everybody; whether you’re an OAP in London or a slum dweller in Sao Paulo. So what’s behind it? Is it rising demand in China and India, inventory accumulation in the recovery phase of the great recession or greedy speculators?
One answer all economists agree on is that it’s a complicated business. But the basic issues are neatly summarised in a debate between market fundamentalists and the more heterodox in the profession. Very broadly speaking, the former believe that it’s all about changing the supply and demand relationship for today’s products while the latter argue that large-scale intervention in commodity markets by speculators is the key factor explaining greater price volatility.
Surprisingly, Paul Krugman is more fundamentalist than heterodox on this issue. ‘I was and remain sceptical about the speculation story in 2007-2008’ he has argued on his New York Times blog.[1] By contrast, Professor Jayati Ghose at ANU believes that there is plenty of evidence that speculation is the key driver of food price speculation.[2]
My old colleague, Edward Clay, has produced an excellent short summary of the recent academic literature which looks at the 2008 spike. On the fundamentalist side, he cites current ODI research drawing on the arguments of Irwin & Sanders (2010).
Inter alia:
On a futures market it is wrong to see funds taking long positions as additional demand. Each futures contract is met by a contrary short position: is this then new supply? Of course it isn’t. Prices on futures markets do not determine spot prices. Unless the index funds actually take delivery and store commodity, which they don’t, they cannot influence the spot market. If there’s a bubble driving prices above what they would be in the spot market, then stocks should rise to earn the bubble price. They didn’t: stocks were in decline.[3]
Clay then goes on to say that none of the analysts he cites have been able to take into account the latest 2010 spike in wheat, coarse grain and related soya markers. He argues there is a high level of covariance between movements in food, agricultural raw material, fuel, mineral commodity markets during 2009-10 (see graph) and that this constitutes prima facie evidence for financial speculation amplifying volatility in these markets.
Jayati Ghose focuses on food price volatility, noting that the FAO food price index in December 2010 overtook the previous 2008 peak. She rejects the widely held popular view that the current food price spike is entirely the result of increased demand from developing countries like China and India. To the extent that volatility for all food grains is explained at all, a supply shortfall of about 4% over the past year, mainly originating in developed countries, has been more important than the global consumption increase of about 1.8%. So, while accepting that supply shocks have played some role, Ghose firmly doubts that these are the whole story:
This is simply not possible given the volatility and sharp movements of prices that can be seen from the charts. Once again, it is likely that a combination of panic buying and speculative financial activity is playing a role in driving world food prices up well beyond anything that is warranted by real quantity movements. … [W]e are seeing contagion in these commodity markets, with futures prices higher than spot prices. This is all a repeat of 2007 and the first half of 2008, when prices of these commodities nearly tripled.[4]
As Timothy Wise has noted, some $9 trillion in trades takes place in commodity derivatives annually, nearly all of which is over-the counter (OTC) and outside of public scrutiny. $9tr is nearly one-sixth of world GDP. Five major banks control over 90% of derivatives activity, while the ratio of non-commercial speculators (like index funds) to commercial hedgers – those with a commercial interest in the traded commodity – is by some estimates 4:1, roughly the reverse of the situation a decade ago when speculators accounted for only about 20% of the activity. Index funds were created by players like Goldman Sachs in response to falling returns in other sectors (eg, property). Between 2002 and 2008, the number of derivative contracts has increased more than six-fold.
Wise’s conclusion is hard-hitting. ‘What part of this picture don’t the speculation-deniers see? Finance capital now dominates commercial hedging in futures markets, index funds have become huge investment vehicles in uncertain economic times, and the index funds move with oil and minerals prices, dragging food prices along with them.’[5]
It’s a conclusion worth reflecting on at length, particularly at a time when the Bank of England’s MPC and the European Central Bank are talking about the need to tighten monetary policy because of the danger of inflation. It’s a decision which may very well jeopardise jobs and growth.
Economists like Andrew Sentance, Martin Weale and Spencer Dale are strangely silent about commodity speculation. It would be interesting to know David Blanchflower’s views.
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1 See http://krugman.blogs.nytimes.com/2010/12/28/nobody-believes-in-supply-and-demand/
2 See http://triplecrisis.com/frenzy-in-food-markets/; also Jones, T (2010) ‘The great hunger lottery: How banking speculation causes food crises’, London: World Development Movement, July.
3 See Clay, E J. and S. Keats (2011) “Incorporating Global Food Price Spikes into the Risk Management Agenda” ODI Working Paper, London, Overseas Development Institute (ODI), London (forthcoming); also Irwin, S. H. and D. R. Sanders (2010), ‘The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results’, OECD Food, Agriculture and Fisheries Working Papers, No. 27, OECD Publishing.
4 See http://triplecrisis.com/frenzy-in-food-markets/
5 See http://triplecrisis.com/food-price-volatility/#more-2474; also Peter Popham: http://www.independent.co.uk/news/world/africa/the-price-of-food-is-at-the-heart-of-this-wave-of-revolutions-2226896.html
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You go-getters probably have a lot less time to squander on amateur philosophy than us retirees do, but listening to Melvyn Bragg’s “In Our Time” this morning on BBCRadio4 talking about “Determinism” (and it’s equally unprovable opposite), led me to think how very important randomness and diversity really are to survival. Then by association it crossed my mind that for all the clearly apparent damage the drug fuelled derivative traders have, and are still undoubtedly causing, the consequent volatility and mayhem is reported today to have led to the creation of many more, powerful, individual, multi-millionaires in the BRIC countries than here in the west. All of whom I imagine will now be intent on preaching their new found belief in profligate risk, as the highly successful best route to progress. Every school of thought encourages it’s own esoteric set of definitions, good and bad, while we old ‘students of life’ on the outside are left to generalise, redefine and try our best to understand.