JOQ with Brett
Jeffrey Frankel, a Harvard economist and professor with a PhD from MIT, as well as a former Council of Economic Advisors member in the 1980′s and 1990′s to President Bill Clinton, has already made quite an impact upon the Mezimbite Magazine readership community:
Jeffrey recently answered my question on food speculation and it’s relation to food prices. Since then, internet traffic to this site, comments to Jeffrey’s post and interest in the general topic of food prices have all accelerated notably. I have received emails on this topic from many of you – curiosity and opinion on this issue has clearly struck a chord.
Food prices can cause food riots and can sometimes lead to starvation and even violence and fatalities as was evident in Maputo, Mozambique a couple of years ago.
Food price debates can sometimes get quite charged around the globe amongst a diverse group that includes policy makers and observers, as is evidenced by the smattering of comments in response to Jeffrey’s recent article. Some excerpts:
“It has been said that famine in Africa isn’t due to a lack of food. Its due to a lack of access to food. In other words, people can’t afford the food because the price is too high. Aren’t local speculators essentially buying up large quantities of these crops and hoarding them until the price raises?”
“..the problem is not speculation, for all speculation is not created equal. The problem is a new, very different speculative dynamic.”
“..it is difficult for me to see speculators as stabilizers because they are coming into a country to make a profit..”
Wanjiku Karanja, Managing Editor for Africa, Mezimbite Magazine
“Our research at the New England Complex Systems Institute has analyzed food prices and found that they cannot be accounted for by supply and demand.”
Yaneer Bar-Yam, founder and president of New England Complex Systems Institute
“We are all in the habit of blaming somebody else for our problems, like the ‘evil speculators’ with food prices. … so take a market position on population increase or degrade in land or keep your zipper closed!”
Allan Schwarz, founder of Mezimbite Forest Centre, Mozambique
Regardless of whether we observe Allan’s dictum and keep our zippers closed, what is of more interest to the Editor of this magazine is that we keep our minds open to diverse views:
In this spirit, I invited along Allan’s fellow South African, London-based journalist Brett Scott, to add his views to this growing dialogue around food prices and food speculation.
Just One Question
How do you respond to Jeffrey Frankel’s recent response to me about the fact that food speculators can be a stabilizing factor in determining prices?
Response from Brett
The information we get from those in the markets is often very different. Jeffrey’s post emphasizes that speculators have the potential to smooth volatility in markets. Indeed, many economists frequently invoke this idea, and claim that speculators increase liquidity (which is finance-speak for the ability to transact quickly and easily in a market), and improve price discovery. The general point made is that speculators make markets more efficient.
This is true to a point:
I’ve worked in derivatives markets and I’m very aware of the positive effects that certain levels of speculation can have. That said, we don’t live in a world of linear relationships. What I mean by this is that it is not true that more and more speculation naturally equates to more and more efficiency. Key to the debates around ‘food speculation’ then, is whether the degree and nature of the speculation has gone past the point of being useful, and to a point of being damaging.
A central part of Jeffrey’s argument is the characterisation of speculators as being ‘merely the messengers’ and that we ‘shouldn’t shoot the messenger’. There are many problems with this characterisation though.
Firstly, a slightly pedantic point: Someone is only a true ‘messenger’ if they are actually in possession of accurate information. Jeffrey uses a story about Cal betting on beans as a way to prove his point, but this example only ends up proving his point if Cal ends up being correct about the US entering the war. What if the US didn’t enter the war – how then would Cal’s speculation have improved the market? Indeed, following his argument, the increase in price would then have caused overproduction, which would then lead to a crash in price. The most we can say about speculators is that their trades reflect their best guess at the time of making a trade, nothing more.
Even this weaker form of the term ‘messenger’ is problematic though. Calling speculators ‘messengers’ assumes that they base their trades (‘the messages’) on fundamental information and analysis about the state of a market. In Jeffrey’s example, Cal makes an educated guess about bean markets, presumably by analysing the political situation relative to the current supply of beans, probably while factoring in other variables like weather. In many modern commodity markets though, many of the speculators do not base their decisions on fundamental factors like that. Rather, many of them are ‘technical traders’, who make their decisions based purely based on statistical charts and the patterns of prices created by other traders. The most extreme form of technical trading is undertaken by so-called ‘high-frequency’ algorithmic traders, who programme computers to make trades at huge speeds, based purely on minute price patterns in the markets, with absolutely no input from fundamental analysis (see this excellent TED video on the topic).
Frankel does admit that ‘speculative bubbles’ can occur when self-referential trading gets out of hand, but suggests that most big swings in price mainly occur due to changes in fundamental supply and demand factors in the real world..
Now, while it is true that these speculators will always increase liquidity in markets, there is very little reason to believe they necessarily make those markets more efficient. Perhaps a market with 30% speculation would be more efficient, but imagine, as a thought experiment, a market where 95% of the activity was by speculators, and that of those, 80% were technical traders. Now imagine a situation where most of those technical traders were high-frequency hedge funds using computers which made trades by analyzing the trades which were made by other computers analyzing the trades made by other computers. It’s easy to see that those could become be self-referential markets, not rational price-discovery markets. This might sound far-fetched, but the CFTC (US futures market regulator) in fact recently report that in oil markets 95% of trading was by short-term speculators, of which many were high-frequency traders.
Frankel does admit that ‘speculative bubbles’ can occur when self-referential trading gets out of hand, but suggests that most big swings in price mainly occur due to changes in fundamental supply and demand factors in the real world, such as the often-cited changes in meat consumption in China (which increases demand for soy beans and corn to feed livestock). Something like a change in dietary behaviour in China though, is a long-term, incremental process, and should not express itself in shorter-term price swings. While some have pinned the rapid run-up of food prices in 2008 on an apparent sudden increase in demand from China, others have suggested that perhaps those price rises might have also had something to do with investors piling out of the declining real estate market and piling instead into commodity investment products.
Which leads to another important point (also made by Frederick Kauffman in the comments): Jeffrey uses Cal as an example of a speculator, but the involvement of financial players in food markets has moved beyond short-term traders like Cal. Hedge funds and ‘proprietary traders’ are the stereotypical speculator, betting on markets and betting against them, but the biggest development in commodity markets now – which was not present in Cal’s time – is that lots of the money flowing into commodities is not from short-term ‘speculators’ per se, but rather from large pension funds that are investing in structured commodity investment products like commodity index funds and commodity ETFs (these are products created by investment banks which allow investors to invest money in a fund and to receive a return reflecting the change in price of a basket of commodities).
Many traders are highly dismissive of academic theories about how efficient markets are supposed to be.
A pension fund has a very different rationality to a short-term speculating hedge fund. They don’t spend their time on day-to-day betting, and don’t bet against things. They are ‘long only’, which means they buy things to invest for the long term. Furthermore, you might think that a pension fund invests in things because it believes the price will go up, but many pension funds actually invest for diversification purposes, which means they do it in order to spread their overall risk (in everyday life, we call this ‘not putting our eggs into one basket’ – i.e. a pension fund might put money into commodities to balance the money it has put into shares, bonds and property). This is different to a hedge fund taking high-risk bets on single trades, and it also means that pension fund managers don’t necessarily care what is going to happen to prices in a market in the short-term. To use the parlance, they are ‘price insensitive’. Indeed, they are often referred to by short-term traders as ‘dumb money’, because they plough money into things with little regard for short/medium term price outlooks.
Big institutional investors like pension funds have only comparatively recently had access to commodity markets via commodity investment products, and many are only now getting comfortable with doing this. There is much herd mentality in their investing, and this poses serious potential issues for efficiency of markets. Efficient price discovery only works if no individual participant can make a material impact on the market, but what if a herd of pension funds simultaneously decide to start allocating blind money to commodities because that happens to be the flavour of the month? In that case there is the potential for major swings in price across a whole range of commodities at once, which might lead to further herd effects in short-term players who want to ride the momentum. Indeed, Paul Wooley from LSE is currently doing much work on the effects of herd ‘momentum’ in markets. His work as an academic is closely informed by his life as a fund manager, where, in his own words, he spent his time making money of the inefficiency of supposedly efficient markets.
Wooley is not alone in this. Many traders are highly dismissive of academic theories about how efficient markets are supposed to be. In a recent Telegraph article, an executive from physical commodity trading giant Glencore suggested that index investing by pension funds could distort prices:
“…while Mahoney thinks hedge funds’ short-term buying, dipping in and out of the market, has not made much difference to underlying food prices, he does think the flood of long-term investment into agricultural commodities, via instruments such as exchange-traded funds (ETFs), has had an effect.”
Unlike purely financial players in London and New York, Glencore has access to vast physical commodity assets and is particularly well placed to notice if the futures markets were out of kilter with the realities of physical supply and demand on the ground.
Jeffrey also seems to imply that there is consensus among economists on the issue of speculation. Quite aside from the fact that consensus should never be taken too seriously (there was a fair degree of consensus among economists in the run-up to the financial crash that everything was fine), there isn’t actually academic consensus on this issue at all.
In the political discourse in the UK and USA it is presented as if there was consensus, with politicians such as George Osborne being dismissive of calls for regulation, claiming that there is no evidence to suggest there is a problem. Worryingly though, those who are against regulation all tend to point to a single paper by Scott Irwin who suggested there was no real issue and that regulation was unnecessary. This paper has been critiqued extensively, but there is little political will to recognise that the issue is still very much alive and kicking among academics close to it. This is not the right forum to go into the technical arguments (that is what Yaneer Bar-Yam can do), but it is inaccurate to characterise this as academically uncontentious area.
Furthermore, even if economists were in general unconcerned, that would be no reason to not be concerned about the future potential for disruption. Belief among some economists that the issue is ‘resolved’ seems to imply a belief in static truth, but financial markets are constantly evolving and changing. Frankel’s general argument might be true in some financial markets, but not all, and certainly not all at all times.
Most importantly, it is crucial to apply the ‘precautionary principle’ to the situation: This means that just because a potential problem is not yet conclusively proved, does not mean we should not act in a cautious manner towards it. We have enough analysis, market evidence and intuitive knowledge about speculation to know that it is a potentially very serious issue, even if it remains unclear to what extent it is an issue. For example, if you were to have ‘proven’ in 2002 that securised products had not distorted the market in real estate, that would have been no reason to be unconcerned. That would have simply been ignoring the very real intuitive concerns for their future disruptive potential, which of course ended up in the greatest financial crisis of modern times. When it comes to commodity markets, developments in high-frequency trading and the influx of pension funds into commodities previously inaccessible to them have the potential to completely alter the ‘rationality’ of these markets.
Belief among some economists that the issue is ‘resolved’ seems to imply a belief in static truth, but financial markets are constantly evolving and changing. Frankel’s general argument might be true in some financial markets, but not all, and certainly not all at all times.
And this leads us to the crux of the issue: It is not like this is related to some exotic area of finance that doesn’t necessarily impact people in their everyday lives. We’re talking about food here, something that has massive potential welfare impacts. The precautionary principle should apply especially strongly here.
And then there’s Mezimbite and Mozambique. The degree to which any specific country is exposed to these effects is difficult to know. Can the activities of futures traders on the Chicago Mercantile Exchange affect the price of local food in Mozambique? Well, that’s something that would need to be looked at whilst taking into account the other factors at play. Jeffrey emphasised the importance of looking at supply and demand issues, and many of those might be local. That said, Mozambique is not isolated from the international markets, and international markets are certainly impacted by global finance, especially when multi-national players are involved in producing, exporting and distributing the food.
It is not like this is related to some exotic area of finance that doesn’t necessarily impact people in their everyday lives. We’re talking about food here, something that has massive potential welfare impacts.
In my experience, traders are very aware of the changes taking place and they are finding ways of taking advantage of them. In metals markets, physical metals are directly benchmarked to futures prices, and metal traders have expressed real concern about the impact of pension funds buying up all the contracts. In other areas, commodity traders like Cargill, Bunge, Glencore and ADM are already taking advantage of dis-ruptions between derivatives markets and physical markets, because, unlike most financial traders, they are uniquely placed to engage in arbitrage, drawing on their network of real world commodities to offset against fluctuations in futures prices. And, despite what theory might say, those involved in commodity futures markets frequently cite an increase in volatility, posing problems for those trying to hedge their production or consumption (see this speech by famous trader Paul Tudor Jones, and this interview).
Whether these financial fluctuations end up getting embedded in the price of the specific loaf of bread you use for a sandwich requires a lot more research, and we shouldn’t automatically assume that they do. It would however, be very unwise to treat such an issue lightly.
For more discussion of this, please see my 2011 article in The Ecologist.