Food and Finance: a little less speculation, a little more action please…

October 5, 2011

     By Duncan Green     

Some good sense on a polarised topic from Ruth Kelly, Oxfam economic policy adviser and co-author of a new paper on Ruth kellyspeculation and food prices. When they work properly, financial markets are great at greasing the cogs of the food system. Why, then, are so many people blaming speculation for recent food price spikes?   First here’s how markets ought to work. People all along the food supply chain use them to hedge their risk. At the moment food prices are exceptionally high and rising and, as they rise, they are shooting up and down in a completely unpredictable way. So for a premium, speculators guarantee a future price for those buying and selling food, taking a gamble that prices on the market will be higher than the price they have guaranteed so they can pocket the premium without having to cough up – if things go the other way, the speculators may lose but they are big enough to take that risk.   There are other benefits. Since there is very little public information about physical markets in agricultural commodities, buyers and sellers of food rely on financial markets to help them determine the right price. Each speculator comes with a little bit of information that they share by buying and selling, bringing the price of agricultural derivatives very close to the price producers should be charging for food.   Better still, financial markets allow agricultural assets to be turned into cash quickly and easily. This is crucial in a market where assets FAO prices oct 11can only be sold in bulk at harvest, leaving participants with major cash flow problems. Having a bunch of savvy speculators monitoring market dynamics and in response, buying or selling agricultural derivatives, brings liquidity, moving money around while the crops are still in the ground to help the market work more efficiently.   That’s why financial markets are great when they work. But right now, they’re broken: the deals that are being done have lost their grip on the reality of food production and distribution. Even analysts who think that there is no link between speculation and food price volatility admit that the way the markets are working at the moment is making people very nervous. And nerves breed panic and panic inflates bubbles and bubbles eventually burst.   First, socially useless speculation, where agricultural derivatives are bought and sold irrespective of the price, with other speculators following like sheep, can lead to a situation where everyone is buying and no-one is selling and prices keep on spiralling upwards. Instead of bringing liquidity to the market, this type of speculation sucks it out.   Add this to the growing presence of investors with so much money that they can single-handedly move prices independently of supply and demand, at least in the short term. When such speculators pile in on one side of the market with little regard for price, those relying on financial markets to give them the right price may as well be plucking prices out of the air.   And as prices of commodity derivatives shoot out of control and become increasingly volatile, it becomes more and more expensive to hedge risk. Those who rely on financial markets to guarantee prices for their physical crops must pay higher and higher premiums for the privilege. These days, only very large businesses can afford to hedge their risk, leaving smaller producers and traders, who are already more exposed to risk than big agribusiness, without protection. And the increased costs are passed on to consumers.   Expert opinion is evenly divided on another key accusation – whether speculation contributes to volatile food prices. Different researchers make the same data say different things, depending on their underlying assumptions and methodologies. And in any case, the data is full of holes. Nonetheless, the fact that there is so much debate means that there is at least a strong case to answer. Because the risks of letting current practices continue, if the critics are right and they are indeed exacerbating food price volatility, are much higher than the risks of acting to make financial markets more transparent and efficient, a precautionary approach should be taken to regulating socially useless speculation.   inflation and speculationThe first step is to get a better idea about what is actually going on. Publishing comprehensive data will help prevent panic and herding, and allow a better assessment of whether there is a link between speculation and food price volatility. But transparency is not enough. The second step is to regulate markets by limiting certain types and volumes of speculation, to try to prevent huge amounts of money spent by very big players from skewing prices and causing panic. The risks of doing nothing far outweigh the risks of regulating.   Decisions are already being made at the G20, in the EU and in the US. Those with a vested interest in continued volatility are lobbying hard. Those hit the hardest by volatility – small-scale producers whose livelihoods depend on receiving reliable prices for their produce, consumers in the poorest countries who spend up to 75 percent of their income on food – have a much weaker voice. That is why it is so important to listen and to take action over the next few months and beyond. The right reforms will go a long way to making financial markets work for the people who contribute to feeding everyone on our planet.]]>