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.