Understanding food prices

Business Standard, 24 May 2008

There has been a sharp rise in worldwide food prices. While this has led to renewed Malthusian fears, it is likely that a big supply response is on its way. Sharp responses of prices to small changes in supply reflect the insensitivity to price of food consumption of an increasingly wealthy world. While price volatility is not inherently bad, commodity futures markets and hedge funds operating on these markets will help reduce price volatility.

With high food prices, we are - yet again - in the midst of memories of Malthus: fears of the inability of the planet to support the ever larger population. As with each edition of this story that has played out in recent centuries, such fears are misplaced.

The simple fact is the average global yields are far, far below what is possible with contemporary science. Vast tracts of land in the world - e.g. in India - have extremely poor yields. High prices generate the incentives for increasing yield. This process, of prices sending out signals and yields then going up, has been going on for centuries.

The socialist vision sees humans as inflexible and slightly stupid, who then need to be told what to do by the government. The single great idea of economics is that people respond to incentives. When prices change, far-reaching changes take place in response. There are reports that in Afghanistan, farmers have switched from growing opium to growing wheat owing to higher wheat prices!

Some elements of this response are already visible. Global production of wheat and rice will reach record levels this year. World wheat production in 2008-09 will be up 8%. Much more will come by way of this response as individuals and firms rethink how to play a world with higher food prices.

While high food prices are seen as a problem, it is important to emphasise that these very high prices are doing the work of sending out incentives for higher production and lower consumption. Prices are the messenger. Our attempts at artificially preventing price volatility amount to shooting this messenger, and thus preventing the adjustments in the real economy which solve the problem. It is fashionable in India to think that volatility is bad, to think that there is a dichotomy between the "real" economy and "financial prices". But volatility - i.e. changing prices - is the essence of how the market economy works. The people who dislike volatility are perhaps yearning for a socialist paradise where prices do not change. This is not how the market economy works.

Why did prices go up so sharply in the last three years? Many hypotheses that are getting a lot of press, such as the role of futures markets, rising demand in India and China and the shift to biofuels, should be viewed with caution. The growth acceleration of India and China dates back to 1978-1979. Futures markets have been around for centuries. The land that has shifted to biofuels is tiny.

One element of an explanation is based on focusing on the imbalance between supply and demand. There were some small supply shocks (the shift to biofuels; ten consecutive droughts in Australia). How much do prices have to move in response? Prices have to move by as much is needed to equate supply and demand.

This makes us ask? How much do prices have to rise to crimp off demand? If you are buying a naan, the embedded wheat cost in it is roughly Rs.1. A 50% rise in the price of wheat only increases the wheat cost to Rs.1.5. A large change in wheat prices does not substantially change demand for naan. With growing affluence, the price elasticity of food demand goes down. Hence, when a small imbalance came along, prices had to move sharply in order to clear the market.

This reasoning links up to demand for meat. Making a kilo of meat requires between 2 to 8 kilos of grain. In a poor country, when food prices go up, people cut back on meat consumption, thus freeing up a lot of grain. But as the world becomes affluent, price sensitivity goes down; people eat meat even though prices have gone up. When a supply-demand imbalance appears, large changes in the price are required to eliminate the gap.

This same price inelasticity will operate in the reverse direction. When the supply response comes about in 2008 and 2009, food prices will have to drop sharply because consumers are so price insensitive in their demand for food.

It thus seems that as the world gets more prosperous, food price volatility goes up. In the olden days, there would have been calls for more government commodity stabilisation funds. But we now know that these government interventions in agriculture do not work.

The right way to confront volatility is to emphasise commodity futures markets and hedge funds. Commodity futures markets produce early warnings about future supply-demand imbalances. Hedge funds have the ability to put capital behind the job of holding buffer stocks. When the futures markets show a high price at a future date, hedge funds are uniquely able to carry inventories into that future date, thus smoothing out price fluctuations, and vice versa. The integration between the world of commodities and financial firms is thus a critical element of the response to this new world of high commodity price volatility. There is a good long-term business potential in the fields of global commodity futures and global hedge funds focused on commodities.

Recent events have demonstrated that there is only one food market: the world food market. Through imports, exports and smuggling, Indian food prices are increasingly integrated into the world. Events all around the world are now tightly interlinked. It should be a wake up call for the Indian private sector and agricultural bureaucracy, which has tended to view India as an island that is unconnected with the world. What we now need is an unabashedly international perspective on production, prices and commodity futures trading. We need to position ourselves as an integral and important part of the world economy when it comes to food. We should be using the world as our buffer stock, exporting when our harvest comes along and importing at other times of the year.

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