Idle specualtion?

This is part 2 of a two part blog entry. The first was concerned with the farmers dilemma and the traditional approaches that mitigated it. This part is now getting to the point I meant to discuss in first place. Namely, that speculation can serve an important purpose.
In the 16th century Netherlands a very different system to mitigate the dilemma has been around. Of course, by this time large scale transport was possible, so long as it involved ships and the Netherlands were the hot spot of this development – because we are talking about a market-based approach and without transport, there is no such thing as a significant market.

If the harvest was bad in a region in some year, it became possible to simply get food from another region that had better luck with its weather. All this was, of course, paid for with money. This could have some straightforward implications that I already lined out in the first part.

Prices are the result of supply and demand. If supply is much larger than demand, prices are very low – if supply falls short, prices rise up.

A bumper harvest will drop prices much more than the increased harvest could ever compensate. It is, in fact, quite conceivable that farmers were ruined by such great harvests. (Unless there was some sort of a bad harvest elsewhere to export large quantities of the crop – keeping prices up.)

On the other hand, a bad harvest would bankrupt the customers and leave farmers rich … or so you would think, because if the people didn’t get enough food on their tables, they would get quite upset, inducing local politicians to mandate maximum allowable prices (or disowning them outright) and farmers might, again, be ruined.

But at some point, a new system developed that would not leave farmers bankrupt. They would sell their harvest before the actual harvest – before they would even know how much grain they would have to sell, they’d already have sold part of it for a given price on contract.

If the harvest was good and market prices would drop, the contract ensured that a certain amount of grain could be sold at a reasonable price. If the harvest turned out to be bad, people would have a contract that limited the prices that farmers could demand and ensure a certain supply.

We’re not just talking about a system to ensure that farmers would always have a living. Agriculture has always been a line of business that requires a large amount of investments both in terms of work and money. If money wasn’t forthcoming, necessary investments to maintain a field and its yield would not be done. A streak of “good” harvests could mean that not enough investments were done to keep the yield up and subsequent “bad” harvests might simply be down to that lack of investments. Such contracts can be a counterweight to such systematic shortfalls of harvests.

But again, that’s not the whole story, because there is also the other side – the buyers. In a bad harvest, buyers on contract are clearly privileged, because they pay lower prices than the rest of the buyers. But in a good year, they are burdened by the high price they have to pay.

This is why they will try to get rid of the obligations to buy the product – and sell their obligations, if they think market prices will be lower than the price they are obliged to pay. They might even pay money to get rid of their obligations! Phrased in another way: if they speculate that the price is going to be lower, they will try to get rid of their obligations. On the other hand, buyers without such contracts will try to get hold of a contract if they speculate that the price they have to pay on the contract will be lower than the market prices they expect to pay. Which is all very straightforward and reasonable behaviour.

In the end, the impact on the market prices depends on the inefficiencies in the market of those contracts and the grain itself. It is generally small, but obviously an overhead of derivates (speculating on speculations etc.) and influences from other markets trying to hedge losses etc. will increase inefficiencies. But that’s not a matter of the speculation itself in that market.

In fact, such speculation has been quite beneficial. It has been around at least since the 16th century. And even though it occasionally goes awry – the Tulip Mania was all about such speculation – it has consistently turned out to be better than the alternatives in the long run. (Feudalistic systems lacked incentives and money to invest and increase yields, centrally planned economies failed to match up supply with demand … I’ll write about this sooner or later.)

But this doesn’t change the fact, that it can still go badly awry and often enough for entirely foreseeable reasons – like preventing the importation of grains even during a bad harvest. Which was the case in Great Britain until the famous repeal of the corn laws, that had caused numerous famines in Ireland.

Unfortunately, we have run into another foreseeable problem in the world grain markets these days. This kind of speculation works best for the markets as a whole, when supply and demand are relatively stable. Reserves provide stability in supply and until recently demand was relatively stable because all demand eventually came down to people eating food.

However, reserves these days are at record lows and demand now depends not just on people eating food, but also to an increasingly large part on food being burned as fuel. The USA alone is responsible for half of the worlds maize (corn) harvest. Of which almost half (40%) is turned into bioethanol to replace a small share of the oil it is using. When almost a quarter of one of the worlds most important crops is removed from the market, this has repercussions all over the world. It is one of the reasons why countries like China, India, South Korea and several European ones are buying farmland in Africa – to circumvent the markets and ensure their own supply (both of food and biofuels). And we’ve merely been talking about the fuel used by the USA, not Europe nor Brazil which are very enthusiastic users of biomass derived fuels.

But those price increases have little to do with the speculation they are being blamed on and a lot to do with increasingly distorted markets on which those speculations take place.

4 thoughts on “Idle specualtion?

  1. Nice post. always nice to beat the press.

    India always says, there is no famine in a democratic country.

    Agricultural trade has always been a sensitive topic in the world. In Europe, there is common agricultural policy, similar agricultural protectionism policies can be found in the US and Japan and other advanced countries as well, for the sake of food safety (Japan with mad cow disease protection or GM food in Europe) or protection of beautiful countryside landscape (Switerzland and France) and other excuses. We all understand how trade protection can distort the market.
    The Doha Round in WTO trade-negotiation finally allowed complete withdrawal of tariffs and subsidies on SUGAR ONLY. How about other items, cash crops like cotton, coffee, or some basic crops, like corn, wheat.

    The grain consumption can only go up because of continuous increase in meat consumption as China and India is getting richer. If you examine the diet and calories consumed in China in 1985 and the present day you would be surprised how much vegetables the Chinese ate before and now every parents in Asia demand their children to drink more milk. In the US and Europe there was a generation drinking milk instead of water. Of course global warming only means less and less good quality arable land.

    The main purpose of advocating converting food to energy is to destroy the concept of food storage, according to some conspiracy theories. Oh yes, in Africa there are indeed lots of forums talk about that.

    That is why some fund managers said the good investment in the next 20 years is agriculture, particularly when the interest rate is so low these days.

    • I’m always skeptical when it comes to absolutes. Yes, certain restrictions distort markets. But not all distortions are necessarily bad. Often, you can just turn the argument around. For example:

      Adam Smith had this nice example of the unification of England and Scotland in the early 1700s. Scotland had a strange problem, because of large swaths of the Highlands where agriculture was difficult or impossible, but cattle could be kept with little effort, meat prices were very low. Farmers in the low lands, where agriculture was possible, had no reason to go to the trouble of raising cattle. But back then, the dung of the cattle was the only fertilizer for fields. Thus, the cheap price of meat led to low yields and poverty. of the farmers.

      This situation was alleviated when the Highland herdsmen could sell their cattle to the much larger market of England. Suddenly, it was worthwhile for the lowland farmers to keep cattle and fertilize their fields. Free Markets for the win? Not so fast. What if Scotland was a much larger market than England? In this case, the cheap meat from Scotland would have ruined the market in England and only a secession, and the blockade of trade this would have entailed back then, could have brought this imaginary England out of its misery.

      This is what is happening to some African poultry farmers today. Africa is getting drowned in cheap European “soup chicken” and the less favored parts. (Chicken Wings are only a popular snack in the US.) Those are left over from poultry farms, bred for eggs instead of meat – they have tougher meat that needs more cooking and less meat per chicken. Perfect for soups and stews – exactly what people don’t care to cook in western countries these days, because it takes a few hours of cooking. But it ruins the African markets – and trade restrictions or tariffs would be just what the economist ordered to improve the situation. The impact on European countries would be marginal – perhaps the cheap prices would help them develop a taste for Chicken Wings though …

  2. I enjoy chicken wings much and I have the same observation. When I go to the supermarket in Scandinavia, I notice that the chicken wings and legs costs a lot less than the breasts. So sometimes I just buy the whole chicken, give out the breast to the others and keep the legs and wings to myself. Chicken breast tastes less because of less fat. Animal fat is always tastier, and not so healthy. Sometimes the whole old hen is so cheap that I just make soup of it using the pressure cooker. You just need to boil the soup to the boiling point on the stove and then put the whole kettle into the pressure cooker and lock it for several hours. It is nice to do it in the morning, like boiling for 30 mins and then go to work. No extra energy when using the pressure cooker. It uses some kind of vacuum, ok, I am not good at physics. And after work there is always ready nice dinner waiting, better than ordering a pizza I think.

    The influx of European chicken wings does hurt the African farmers, a lot, but at the same time cheap chickens could benefit the consumers and children to have more nutrition, and do better at schools. It is always a conflict between consumers and farmers, if urbanization (increase in productivity) continues in Africa, consumers are more important than farmers.

    In the Scotland example, if Scotland is a much bigger market than England, yes, the food price would increase and less Englishmen enjoy food, riots occurred, that is why a bit of reserve is necessary. Even the world most free market as the present day Hong Kong has a law that rice import companies must keep 45 days of rice reserve. (I think they have just got rid of that law I am not sure.) Reserve is needed when the demand and supply are very price-inelastic. Luckily it is quick to grow food in the present days: 40 days for young chicken in Europe, 90 days for old hen. 180 days for young piggy, or children pig. a year for a grown up pig in China. Two and half months for cabbage and 4 months for wheat. Food productivity is much lower without machines before the industrial revolution and transport cost is much higher, trade for cheap food is unprofitable, salt or sugar is used for food preservation. No modern refrigeration. Supply is very inelastic. It was necessary to have more reserve. But today food transport is much cheaper.

  3. oh the correct term should be thermal cooker, using vacuum flask cooking technique. not pressure cooker. Pressure cooker is an old technology.

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