In Defence of Speculation

Food prices are soaring. And, unsurprisingly, a number of voices have begun to blame speculators.  According to the New Statesmen a trading frenzy amongst hedge funds and other investors is responsible for the recent spike in food prices.  This letter in the Guardian makes the same point. The finance minister of India has announced that he is considering banning trading in food futures. Vietnam has already done so.

Speculators are never popular. Historically they have been vilified in all societies. Certainly it offends moral sensibilities when big commercial farmers are set to make huge profits out of food shortages that will led to starvation for others. But speculators and speculation are not to blame for the crisis itself. Nor will banning speculation help solve the problem.

Since Martin Wolf provides excellent analysis of the actual reasons why food prices are rising here, we can concentrate on the case for speculation.

The case is quite simple and it was made by Adam Smith. Prices are signals. They signal scarcity. High prices encourage farmers to expand supply and they encourage them provide the crops that are in demand, where demand is greatest. Smith argued that 'The unlimited, unrestrained freedom of the corn trade, as it is the only effectual preventative of the miseries of a famine, so it is the best palliative of the inconveniencies of a dearth'.  It is artificial barriers to trade and the resulting fragmentation of the market that led to famine. This is not to say that policymakers should not respond to famine - they should do on humanitarian grounds. What it is saying is that allowing market prices to respond freely to prospective supply and demand conditions is that only way to ensure that demand is meet in the long run.   And this requires the ability to speculate.

Under what conditions can the ability to speculate or more concretely say for instance, the ability to withdraw food from the market in anticipation of future price rises, become socially harmful?   The answer is when restrictions and regulations are imposed. Tariffs and quotes restrict output and cause prices to rise still further. The combination of artificial restrictions and speculation can indeed led to prices spiralling. It is this possible fragmentation of world trade that makes the food crisis especially worrying and it is this fragment that brings us to the main underlying problem in the world food production.

The problem with food is that governments across the world believe that food is too important to be left to the market. World food production is hindered by tariffs, subsidies, and quotas. As Tyler Cowen argued.

'The reality is that many of today’s commodity shortages, including that for oil, occur because ever more production and trade take place in relatively inefficient and inflexible countries. We’re accustomed to the response times of Silicon Valley, but when it comes to commodities production, many of the relevant institutions abroad have only one foot in the modern age.'

Furthermore, large-scale farming has been discouraged in most of Africa (development agencies and charities are partly to blame here) as Paul Collier argued (see here).  In the EU, farmers are paid subsidies not to produce food.  It is these underlying problems as well as the disaterous special interest politics of bio-fuels - particularly in the US that have made the recent spike in food prices such a problem.  The role of hedge funds and commodity traders in this price spike is largely incidental and their speculative behaviour is only damaging in the context of the rigidity of global food supplies.

Comments

[Liam]

Mark,

I can definitely believe you when you say that it is the rigidity-speculation interaction that is most harmful. But it seems to me there are a couple of reasons why speculation might be harmful on its own. However I'm very ignorant in this area so please correct my thinking if it's wrong.

First, does speculation not increase volatility? Whilst it might not change prices in the long run, it seems to me it's likely to make them more volatile. Without speculation, are prices not likely to move more slowly? I'm not sure that the current prices reflect this volatility necessarily. But in general it seems to me that volatility in the food market is likely to be damaging, because many people cannot insure against high/low prices.

Second, might there be a redistribution effect going on here? The people that can profit out of speculation are those with the ability to store large quantities of food or buy food futures - these people are unlikely to be poor. Speculators increase the price of food immediately and decrease the price of food in the future (because it is then that the food stocks will be sold). Poor producers, on the other hand, may only be able to take advantage of the rising prices with time - e.g. by planning to increase next years harvest. Hence this redistributes some of the gains from rising prices away from small inflexible producers to those that have the capacity to store.

Don't know if either of these sound reasonable - just what comes off the top of my head. First one seems more likely than the second to be a cause for concern.

Liam

[Mark]

Liam,

I think both points are goods and the first in particularly gives a solid second-best argument in favour of banning prohibition i.e. since if insurance markets are incomplete, and farmers are capital constrained, it is welfare-improving to add an additional market imperfection and ban speculation.

My problem with this line of reasoning is that I think that if you don't have speculation you reduce the incentives farmers have to invest in storage technology or other capital equipment and therefore that your argument for banning speculation might become almost a self-fulfilling prophecy.

Concerning the redistributative implications of speculation, I agree, and it is not pretty but is it a strong enough reason to intervene here? Might it not be an argument for the provision of general a social safety net rather than for a specific intervene in food production?

[Liam]

Yes - I agree on both points. Ultimately banning speculation might be a second best measure that we want to try to avoid using (Also, if we did want to discourage speculation, taxing it is probably a better idea than banning it)