Spontaneous instability on agricultural commodities markets
by Bertrand Munier,
Chief Economist of Momagri,
Professor, University of Paris 1 and New York Polytechnic
« published in the magazine Paysans » (March-April 2011)
The food riots that took place three years ago in more than thirty countries have occurred again in Tunisia, Egypt and some other areas in recent months. The reason for these uprisings is indeed the same the world over: those on low incomes can no longer feed themselves because of the price of agricultural commodities such as wheat, maize, rice, etc…, and of raw materials generally: copper, steel, not forgetting petroleum. Agricultural products however remain unique: they are, before any of these other materials, sources of human life. In our developed countries, we sometimes suffer from the high prices for fruit, vegetables and meat. But knowing that hundreds of millions of our fellow human beings can not find the bread and oil that help them survive is deeply shocking and intolerable. What to think, what to do?
Rumours and misconceptions
Because these are products that everyone knows well, everyone thinks they understand why their prices are so high. They were not so high a decade ago. So is the changeover to the Euro to blame for the high cost of food (and a lot of other things)? For all the sympathy we might feel for somebody who holds this opinion, we can only reject these views. The fact that prices rose at the same time the Euro was adopted is not in doubt. But the fact that two things happen at the same time does not mean that one is the cause of the other, or that they have a common cause. In fact, even without adopting the Euro, agricultural prices would have followed the same course and prices on our imported products would have increased even more than they did if the Euro was not adopted. So let's not shoot ourselves in the foot by trying to return to the French Franc, if that is indeed possible.
Those who are more informed would argue that growth in emerging countries like India and China, account for the inevitable rise in agricultural prices. Here, it is necessary to make a remark: agricultural prices have certainly risen remarkably since the beginning of the decade 2001-2010, but they have mostly fluctuated, with a speed in fluctuation never seen before. So if consumption in the above mentioned emerging countries undoubtedly pushes prices up, this long-term trend is coupled with volatility in agricultural prices that can obviously not be explained by rising consumption in countries emerging from poverty and whose large, now wealthy populations (the population of India is 18 times that of France, that of China, 25 times) want to align their diet to that of the West. So what are the causes of this volatility?
Previous causes of agricultural price volatility
When we examine the history of agricultural prices over a thousand years – information is only available from approximately the year one thousand on - we see that they evolved in a wave-like fashion: small, brief movements, limited in scope, covered by larger, less frequent movements, which themselves are sometimes covered by the very large waves which make the sea undulate. On an agricultural market, the small, brief movements are the result of changes in temperature and the short-term changes in climate conditions and business methods: these waves have always existed, on almost all markets, indeed on agricultural or horticultural ones, and most of us even try to take advantage of them - literally - that is to say buying when things are a little cheaper, or if we are producers, selling when they are a bit more expensive. We all have dozens of examples. However, seasonal movements come in larger, less frequent waves, they are the result of either an abundance in, or a lack of crops, mostly related to the year's natural disasters to the last very cold winter, to a "rotten" summer, or to unexpected rains followed by an extremely hot summer, with of course, plant disease that results in the loss of much of the harvest, when it's not frost that kills the buds in early spring. Thus, there has always been substantial change in agricultural prices from one semester to the next, or from one year to another.
Finally, the movements that come in very large waves are the result of extreme natural disasters, such as when several large regions suffer simultaneously from plant disease or some region to extreme climate hazards. In events like these, right from the 17th century, economists had begun to notice that farmers were reaping in a lot of money even without a harvest, while the common people went hungry, but the reverse often occurred during the years of abundance, where farmers couldn't make ends meet and the people found it easier. This law, "King's law", named after the English economist who first popularized it, is nothing more than what we call today – in a pretty abstract term - "low elasticity" of short-term supply and demand in agricultural commodities. This short-term low elasticity is the reason that higher price movements are shown as higher in percentage than the variation of the year's supply - and inversely.
All this has been observed for hundreds of years.... Right up until the last third of the 19th century, or the 1860s to be somehow more precise. Since then, variations of the same type are still being observed, but they are no longer associated as simply and directly as before to natural epidemics, animal epidemics and climate variations.
The impact of technology on market behaviour
Two things happened just over one hundred years ago: a dramatic improvement to inland waterways, to roads and rail thanks to the steam engine. Then came the internal combustion engine along with progress in plant and animal biology. Progress in transport has dramatically changed the lives of towns and even villages: now it has become possible to transport massive amounts of grain or fruit from one region to another, so that crop failure in one region can be partly offset by a good harvest in a neighbouring country. Remember Turgot, the French Superintendent from Limousin in the late 18th century, was in despair because he was unable to build canals because of a lack of funding, there were no safe, passable roads, no energy (no engine!), just oxen to pull carts. It was impossible to transport a crop more than thirty miles, except in very rare cases and each "country" lived on local agriculture, which resulted in very significant price movements. Similar cases can be found, still today, in remote parts of Africa.
Advances in animal and plant biology and progress due to mechanical force, have led to previously unseen movements: an increase in crop yields, a dramatic increase in food processing productivity (mechanical milling) have led to downward price movements, which sometimes persist over whole periods, with irreversible changes in industrial organization. Initially, this led to the ruin of water mills and windmills, but also to a remarkable decline in the price of bread, followed by, incidentally ... a drop in the consumption of bread in France by our great-great grandparents – contrary to what might have thought those who believe in the naive, simple version of the "law of supply and demand". Secondly, these technical changes also led to major increases in yields and also something which would have hardly been thought possible even a century and a half ago... periods of a downward trend in prices for some twenty or even thirty years. And this continued right into the turn of the century, during the thirties and later during the "Glorious Thirty" year period between 1945-1975 and finally until the late1990s.
This a bit lengthy historical detour demonstrates that on the one hand, the variability of agricultural prices, for a little over a century, is neither pure "climate" nor even "natural" volatility, but that the two above mentioned key factors have completely changed the course of agricultural prices. It also reminds us that to interpret any increase or decrease in agricultural prices in terms of "supply and demand" is sometimes acceptable, but sometimes it leads to mistakes. Yet this is the only argument used by some raw material "gurus", who lack any economic background (one of them, who enjoys a good reputation in France, wrote in April 2008, that wheat prices would remain stable or increase by 3% during the remainder of 2008, whereas they dropped by nearly 60% over the next six months). The same goes for Pascal Lamy when he boasts about the lifting of custom tariffs and the elimination of all subsidies on global agricultural markets. It is this economic naivety that can sometimes cost the people very dearly... and this brings us back to the beginning of this article.
The radical novelty of the decade 2001-2010: financialization
We are witnessing a different transformation of agricultural markets to that of the last one hundred and fifty years, but a transformation that is equally important. This transformation is called "financialization". It was triggered by the last American "Clinton Law", the "Commodity Futures Modernization Act", passed by Congress in 2000. Up until then, futures markets for agricultural commodities were organized and reservedly frequented by financial investors who brought the necessary liquidity to forward markets. Rates on these markets evolved therefore without any real connection with financial assets and even in the opposite direction to major stocks. It is precisely this last aspect, together with the gloom in financial markets, which brought attention to raw materials: it allowed investors to make "averages", or more accurately, to compose "portfolios" limiting global risk. The above mentioned Clinton Law gave them every facility to operate on raw materials, including outside organized markets ("over the counter").
This is how agricultural markets gained the unique distinction of being markets for traditional products, created from the factors for production that are labour and capital, but also from a natural factor, land, even though their products play the role of "underlyings" to financial contracts. As from 2004, this evolution was marked by a dramatic change in the volume index for options contracts on agricultural products. Through these contracts, an investor buys the privilege to buy (or sell) to his or her interested counterparts, a pre-fixed amount of any agricultural product, be it grain, livestock, dead or alive, fibrous plants, fruit or vegetables etc…, at a price determined as soon as the transaction is done.
The result is that agricultural commodity markets have become markets for expectations and psychological attitudes. For example, last summer, before Mr. Medvedev could even inform his services that he was going to limit Russian wheat exports, wheat prices soared as soon as he declared the situation. In Asia, it was enough for the Japanese government to say in mid-2008, they were going to sell rice inventories for its price to drop by 40% in just two or three days, etc.. This is no longer quantity against quantity, supply against demand, but anticipated supply against anticipated demand. And yet, anticipation of either is far from perfect and the result is that investors' behaviour, far from stabilizing markets, in fact increases volatility.
This last point is very important in order to understand why the gurus who believe the market is agriculture's "saviour" are wrong: they imagine that investors as well as farmers and other market participants are perfectly rational and anticipate at least the average real value of next period spot prices. If this hypothesis were valid, then, "pure" investors and even speculators would have only a minimal impact on prices, they would simply shake a few points up or a few points down... But we, investors, are the first to realize that this supposition is not a good description of what actually happens. Investors as well as farmers certainly have an "idea" of the direction that prices are taking, but it is only a quite approximate one.
From all this, we have statistical evidence that has gradually emerged, though it was not available in 2008. Without going into detail, it is easy to remark that the cumulative investment flows calculated by Tang and Xiong at Princeton since 2006, have a strikingly parallel evolution to that of the Goldman Sachs general index for agricultural products and livestock.
A recent report by the International Monetary Fund revealed a similar parallel between the high quality wine index and the same short-term investment flows, as well as a parallel with oil price curves and the amount of cumulative investment already mentioned. As a consequence, the average oil price curves and the average price of high quality wines have evolved in unison since 2006, which is somewhat unexpected, as reported in an article in The Economist in February! As the authors (Cevik and Sedin) of the International Monetary Fund stated in the previously mentioned report, the concomitant rise in oil prices and the price of fine wines occurs even when the supply of oil was higher than demand over the entire period (2006-2010), just as the supply of wines was with regards demand. Supply and demand are no longer simple explanatory variables in these markets! In fact, since 2003, investors have flocked to agricultural commodities listed on major indexes (Goldman Sachs and Dow Jones-AIG), and have turned them into items of speculation. They have polarized expectations on the price of their transactions in one way and then the other.
Two arguments are presented to try to minimize the scope of the analysis, the main points of which are presented just above (a similar analysis is used by the Momagri model, designed as a simulation tool for global agricultural markets). The first argument asserts that for there to be speculation, there must also be variations in global inventories. However, world agricultural inventories, as in the oil sector, are only known with very rough approximations and statistical errors are particularly severe in these areas. Moreover, the OTC markets mentioned above do not require the inventories variations required by organized markets such as commodity exchanges (for reasons we will not pursue here). A second argument was presented in a paper presented to the OECD by two of our American colleagues, Profs. Irwin and Sanders, both from the University of Illinois in Chicago. They try to demonstrate that all covariations in the curves we mentioned are just coincidences, far from revealing causal links. I will limit myself here to saying that the statistical tests they use are unsuitable for a series of such very volatile prices, which disqualifies their results. Unfortunately, few politicians have sufficient statistical training to assess these results and spray around these conclusions, and few make the effort to listen to scientists if it is not physical or organic research. Consequently the work of the OECD is considered as a sort of bible, a consideration that it might not deserve.
A three-stroke engine
We can symbolize the volatility of agricultural markets using the image of a three-stroke engine:
- Natural hazards, here and there, act as the initial spark
None of these three points is solely responsible for volatility in agricultural prices. But the role of speculation, even though it is only high from period to period, has a devastating effect on the functioning of these markets by significantly increasing the amplitude of price changes. While volatility on agricultural markets is no longer a "natural" tendency, it remains an inevitable and "spontaneous" pattern from these markets, unless it is controlled.
- Boundedly rational expectations by market participants make them unable to control the spark, starting the spread of fire
- Investors transform what would have probably been, without their intervention, a limited and temporary flame and turn it into a forest fire with all its related problems
It is therefore urgent that the G20, working on the financial scene, pave the way for regional mechanisms for stabilization. This is the objective that the future CAP should achieve with regard to Europe, but the G20 will have to prepare the groundwork. Faced with this spontaneous volatility of markets, agricultural policies will no longer be possible without any prior financial regulation.