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Government meddling on food prices

In last week's post on rising food prices, we tried to briefly outline some of the factors behind higher commodity prices and growing food shortages.

While I mentioned things like water shortages, loss of arable land, dwindling global stockpiles of grain, and monetary inflation, I seem to have overlooked a major force affecting prices of agricultural commodities: government intervention.

Government Intervention At Work

Now, while I'm no seasoned observer of the farming and agriculture industries, I have learned enough in recent years to know better. If you've ever heard or read about crop subsidies, food import and export tariffs/restrictions, and ethanol mandates, you know that farming is rife with government intervention worldwide.

So, when I read a clutch of articles on this topic (under the World News heading of "Global Food Crisis") in yesterday's (4/21) print edition of the Financial Times, it was no real surprise to see the theme of government intervention present in each and every article.

Here's one such example, with excerpts from FT's article, "Ethiopian exchange bans trade in futures".

"Ethiopia will open Africa's newest exchange for agricultural commodities this week but, as politicians across the world express concern that speculation is exacerbating food price inflation, it will not permit futures trading.

The state-owned exchange (ECX) was conceived three years ago as a way to alleviate food shortages and promote agricultural development by improving the liquidity, transparency and security of the market for farm commodities...

Politicians in several countries where the poor are struggling to avoid hunger have blamed speculators for stoking inflation, a concern that led the Indian government last year to close futures trading in wheat, rice and pulses.

The article goes on to note that India banned trading in two pulses (dry beans and other leguminous crops), rice, and wheat in January of 2007. Did this ban on commodities trading help matters at all, or quell future price rises? No.

"Prices for the commodities have continued to rise in the country in spite of the bans, suggesting that factors such as demand and supply and not financial speculation are responsible, according to analysts.

B.C. Khatua, chief regulator of India's commodities markets, recently said the bans were a mistake. "In a way the futures market is more a messenger; there is no point in shooting the messenger because the message is not likeable."

India found out the hard way that attempts to abolish futures trading and pin blame for price rises on speculators are foolish, harmful, and counterproductive acts.

The Role of Speculators

Speculators in the commodities markets (or any market) help to ensure liquidity and, through their buying and selling, prices that reflect the market's view of supply and demand fundamentals.

Tampering with these markets will only hurt buyers and market participants, including farmers and commercial users/hedgers, in the long run.

But there are many who still do not seem to understand the role that trading markets play, and the benefits they provide. We see our fair share of this anti-speculation viewpoint here in North America as well, even from those who directly benefit from the process.

For example, take this opening section from the article, "Farmers battered by price distortions".

"Ian Wishart grows beans, corn and canola on his farm near Portage la Prairie, Man., and watches commodity markets closely to see what he'll get for his crops. But he's finding it harder to follow the markets these days because the prices don't always make sense.

"Nowadays it's not sending the same market signals that it used to," Mr. Wishart said. He blames investment funds for distorting prices. "The commodity market was designed to provide a forward pricing tool to protect farmers, not to provide an opportunity for someone else to make profits." "

So in Mr. Wishart's view, commodity markets are designed to provide a hedging function for farmers and producers, but "not to provide an opportunity for someone else to make profits".

It is astounding to hear such a remark coming from someone who looks to the futures market to provide price signals. Does Mr. Wishart think that the speculators who show up every day to trade these markets do so out of the goodness of their heart, just so he can be magically provided with his prices?

Speculators, like anyone else in business, demand a profit incentive to reward their efforts. While the prospect of gain exists for traders, so does the risk of capital loss. To expect any one to show up to the marketplace and trade purely as a "public service" to farmers, or anyone else, is ludicrous and reveals a total ignorance of how free markets work.

Are Speculators Behind Higher Prices?

But a misunderstanding of the role played by speculators and futures markets hasn't stopped a large number of people from blaming speculators for higher food prices. As a result of this public concern over "speculative premiums" in commodity prices, the CFTC today held a public roundtable discussion on recent trends in the agricultural commodities markets.

There has also been some increased concern in recent months over the increased volatility in the futures markets and the role that investment funds and commodity index funds have had in the relatively small commodity markets.

"Many farmers say the price problems stem from a surge in investment fund activity. Investment funds have been in commodities for decades but a key rule change by the CFTC a couple of years ago helped open the floodgates. The commission gave index funds an exemption to limits on commodity trading that applied to market speculators. The change meant the funds were treated like farmers and food processors, who are also exempt.

Experts say that boosted trading volumes in some wheat contracts fivefold. In January, the CFTC said investment funds accounted for 40 per cent of the wheat trading.

The CFTC and CME argue investment funds provide needed liquidity. But others say they do much more.

"The hedge funds swing up and down with the technical signals in the markets, and our markets aren't deep enough to absorb that," said Roy Huckabay, director of market research for commodities at the Linn Group in Chicago. "So we're seeing weekly trading ranges as big as we used to see in a whole year."

What seems unclear is if the problem lies with increased trading and activity from speculative and index funds, or with the classification of these funds as hedgers (rather than speculators) and a policy of enforcing position limits on some market participants, and not on others.

Markets Hampered by Protectionism

Still, in all this discussion over higher prices, little mention is made of the fact that farming and agriculture are industries in which prices and supplies are increasingly influenced by systems of government subsidies, import and export controls, and price supports worldwide.

How can anyone expect farmers to anticipate market conditions when governments and lobby groups create artificial price supports or ceilings and incentives to plant certain crops in favor of others? Can farmers really be expected to supply domestic and international markets with a steady supply of food when governments suddenly move to shut out export markets and the rules of the game are constantly being changed?

To illustrate this point, let's take one last look at the recent Indian experience with these food-related problems.

"Joshi said the measures like imports at high prices, putting restrictions on exports and police raids on stocks are meant to insulate Indian domestic market from global trends,which have not only resulted in indebtedness of farmers, but also given them negative subsidy.

"Any proposal to insulate commodity market from the global market is necessarily anti-farmers," he said. He said if the policy of insulation on agricultural commodity takes place, the question would arise whether agriculture inputs market should also be insulated. "Farmers can't pay input prices according to global market, and get prices according to the domestic market... that is not logical," he said."

Expecting increased food production in an environment of protectionism and decreasing incentives for producers is not logical. So how could any thinking person expect this kind of system to work?

See also:

"Farmers battered by price distortions" -

"Farmers doomed to pay price for export restrictions" - FT.

"Ray Bradbury's chilling message for today's farmers" - FT.

"How the Feds took over farming" - FFF.

"Speculators perform no useful social function" - Mises Blog.

"CFTC webcast: Agricultural Forum April 22, 2008" - CFTC.

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