Financial speculation on food prices can be very dangerous – raising prices without good reason in times of scarcity. Financial speculation on food prices does not change food prices at all. Both statements are true – it depends on what kind of financial speculation we are talking about.
One of the sadder points of modernity is that there is not enough distinction between the two types. The famine in Bengal in 1943 was an appalling, horrible event. But as Amartya Sen pointed out – his Nobel Prize is primarily for this and other famine-related work – this was largely the result of the bad nature of food speculation. When people took real, existing food and stockpiled it in anticipation of higher prices in the future—that is, hoarding.
This newspaper recently ran an article that doesn’t make the right distinction. Unfortunately, it’s by a “development economics lecturer,” which only compounds the error. Because speculation in futures contracts and food options is said to change real-world food prices. That’s just wrong, that’s not how the world works at all.
Some parts of the analysis are correct – it is true that the existence of these financial and purely speculative markets allows farmers to transfer risk. In addition, consumers of agricultural products bear the price risk – all of which ends up with the speculators. Which is good – we’re always happy when people who don’t want to take a risk don’t have to, when those who want to play with it can.
However, the error lies in this “The price of a physical contract is based on the price of a specific futures contract”.
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We have two systems running. There is the price of the commodity – say wheat – in the physical world. A boatload of wheat is worth a few dollars in this place right now. This is the physical price. Pay it and you’ll get the wheat today—maybe tomorrow—when the check clears.
The second system is all these futures and options and loud men yelling at each other on phones. This is the ethereal market, the speculation. It is much larger, hundreds of times larger than the physical market. You can trade wheat for next week, next year, different types, different places – but all that is traded is the slips.
The claim made above is that futures price changes change the physical price. It’s not like this. All futures, all options, when they reach their expiration date, become worth the physical price. The physical does not rise or fall to meet the future – the future always, but always, meets the physical.
That is of course important. One thought might be that someone working on development issues, well, we want them to know this. But more importantly, all sorts of people think something should be done to curb these speculators. Because look, people who gamble with money hurt us people out there in the real world.
But if that doesn’t happen, if the influence goes the other way, then there’s no reason to limit this kind of speculation, is there? Because the other part still applies – it allows farmers and consumers to shift their price risk to speculators. And if there’s no real impact on physical food prices, why not just let it go? Given that we’re willing to risk being placed with those who want it and being removed by those who don’t, not only would we allow it, we would encourage it.
The other type of speculation, which involves tying up real physical stocks, is another matter. We cannot or do not want this to happen. But the financial speculation in these futures markets? It’s good.
It was Paul Krugman – he also has a Nobel Prize in economics alongside Sen, so we should listen to him too – who pointed out that without rising physical inventories, it is not possible for financial speculation to affect real-world food prices.
That’s pretty much the same statement as the one I just made. All this food futures froth doesn’t change the physical world market price. The futures price approaches the physical, not the other way around.
Tim Worstall is a Senior Fellow at the Adam Smith Institute in London
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