The impact of speculation on food prices: What to learn from actual research?

In a thesis, Anna Zuber is currently focusing on the issue of how speculative trading in staple foods is to be assessed from an ethical standpoint. The expert from the University of Zurich agreed to be interviewed for the Responsible Investing Blog, after a study regarding the influence of financial speculation on the agricultural commodity markets led to a surprising result: Scientists at the Leibniz Institute of Agricultural Development in Central and Eastern Europe in Halle, Germany claim that, according to the evaluation of over 35 research projects, the increase in financial speculation has neither leveled the prices of agricultural commodities nor increased their volatility.

Q: Are you surprised by the evidence from the study at the Leibniz Institute? 

No, this evidence does not surprise me. However, I would not back it unconditionally. It is indeed true that the studies, which used econometric methods to examine the causal link between the positions of so-called index speculators (a group of commodity futures market participants who are subject to particular criticism) and the price trend, were unable to prove that such a connection exists. Now, however, the key (and controversial) issue concerns how this result is to be interpreted. There can be several reasons why the existence of a causal effect cannot be proven: The causal connection may not exist in reality, in which case the conclusion drawn by the study at the Leibniz Institute would be correct. However, it is also possible that the methods applied and the data used were not sufficiently adequate to prove that an influence actually exists. This possibility is frequently overlooked, although some studies do include relevant caveats (e.g. OECD (2012), Speculation and Financial Fund Activity: Draft Reports Annex I). Finally, it is possible that speculation does indeed have an influence, but to focus exclusively on a specific group – index speculators – is misleading. This is suggested by at least one study (Stoll, Hans and Whaley, Robert (2009), Commodity Index Investing and Commodity Futures Prices, Vanderbilt University), but more research must be carried out before this suspicion can be confirmed.

With regard to the issue of whether speculation in agricultural commodities exacerbates volatility, the scientific studies come to very different conclusions. Interestingly, it seems as though speculation can both curb and exacerbate volatility. In this instance, it is necessary to clarify two issues in particular: Firstly, under which conditions does speculation exacerbate or curb the volatility of the prices and secondly, whether it concerns short, medium or long-term volatility. Only volatility occurring over long periods of time causes problems for producers and consumers.

Q: What do you think would be the appropriate interpretation of the results of this research?

We should not take the results of the econometric studies lightly, because from a scientific perspective this is the best information we (currently) have – although in many respects it is not good enough to answer such an important question. Criticism of the quality of these studies supports only indirectly the position of those who believe that there is a causal effect, as it qualifies only evidence to the contrary without providing any positive evidence for its position. And as the argument of those critical of speculation is, for the most part, based on much cruder methods of ascertaining the truth, it affects the corresponding criticism to the same extent. Both sides should thus be very wary of presenting their conclusions as certainties.

Q: Despite this positive shift, NGOs such as Greenpeace and ATAC are continuing to accuse banks of “starving people” with their speculative futures market transactions.
Why do you think that this criticism continues to be made?

On the one hand it demonstrates a loss of confidence in the economic sciences and the way they work. The fact that this way of working has been unable to adequately assess the risk presented by certain financial instruments and business practices, and has even – on a number of occasions – resulted in praise for financial innovations which have since proven to be disastrous, makes this critical attitude all too understandable. However, conducting a causal study is somewhat different from correctly assessing the risk associated with a new financial product. The relevant methods have long been used successfully by a variety of scientific disciplines. Of course, this should not prevent us from critically examining whether or not they can also be applied to extremely volatile prices. However, a general suspicion of ideology, of the kind that I sometimes perceive with regard to economic studies, would be an overreaction.

The second reason, in my opinion, is the fear that political measures can be justified only if the detrimental influence of the speculators can be proven with certainty. Although the advocates of speculation often present this as being the case, it is in my view incorrect. Imagine that a meteorite is heading for Earth, but that correctly calculating its trajectory is such a complex process that although it is possible that it will hit Switzerland, this cannot, however, be predicted with certainty. Nevertheless, in this case it seems justified to introduce certain measures to protect the population.

The question of when precautions are justified must therefore be distinguished from the truth issue. As a general rule of thumb, it can be said that the requirements with regard to the evidence are lower the greater the impending threat is. However, the problem in the example of food speculation is now that the consequences of a ban are also uncertain, yet are potentially extremely damaging if the ban were to genuinely exacerbate volatility. Radical measures cannot therefore be justified even on the basis of a precautionary approach.

Q: What kind of regulation has already been introduced and which measures would be useful, from your perspective, to reduce the influence of the financial markets on the price of food?

From an ethical point of view, it is clear that a policy of absolute zero tolerance for speculative bubbles and trend intensification of any kind must prevail on the agricultural commodity markets and the relevant futures markets. In the long term, if prices are too low, this can also lead to serious difficulties regarding supply, as production and, in particular, investment in measures to promote production are no longer worthwhile. Limiting the market power of individual market participants (e.g. by means of position limits), as has been implemented in the USA and is currently being discussed in the EU, therefore seems to be a reasonable measure. However, many smaller players can also cause a speculative bubble by getting carried away by euphoria or panic on the market. In this case, it is worth consulting the economic literature on factors which encourage or deter the formation of bubbles. In particular, a decisive factor in this respect (and also with regard to volatility in general) is price elasticity, i.e. the value that measures the extent of the change in the quantity of a product being supplied and demanded caused by the change in price. Because producers are, for the most part, only able to respond to price changes after a considerable length of time has passed (the decision regarding how much of which grain is planted is made long before the harvest), the supply is considered inelastic. As consumers with rising incomes are now also less sensitive to prices, there are good reasons to assume that the global demand for agricultural commodities will also become increasingly inelastic in line with the rising average incomes in many parts of Asia. For this reason alone, volatility is also likely to increase in the future.

The use of reserves (buffer stocks) is a possible means of countering this trend. These reserves are mostly managed by governments (or are government-subsidized private reserves) and are filled in times of excess supply and gradually emptied again in times of shortage. They thus have a compensatory effect on supply and demand and stabilize prices in this way. However, as such reserves are rather expensive to maintain and the market participants also have the option of protecting themselves against the risk of price changes on the commodity futures markets, the state reserves have increasingly been regarded as redundant. Thus, for example, the US Farm Bill of 1996 cancelled a program to subsidize grain silos (Farmer-Owned Grain Reserve). Nowadays, even the reserves belonging to the Bill Emerson Humanitarian Trust, which have a capacity of 4 million tons, are empty as a result of a majority decision, taken in 1994, not to replenish the reserve after it was emptied.

From the individual perspective of the market participants, commodity futures market contracts are certainly the simplest and most cost-efficient methods of safeguarding against price fluctuations. Paradoxically, however, there are many indications that the resulting reduction of reserves at system level has exacerbated the volatility (and of course, as a result, the risk of price changes). The use of reserves as a means of stabilizing prices has recently received increased attention again, not least as a result of statements regarding the issue made by Justin Lin, the former chief economist of the World Bank, and an initiative of the International Food Policy Research Institute (IFPRI). The IFPRI has, as a supplementary measure to physical reserves, introduced the idea of a virtual reserve into the discussions, which similarly could be applied to the commodity futures markets.

How these measures should be implemented in practice, so that they can develop the appropriate price-stabilizing effect, must now be thoroughly clarified. Of course, this also applies to any adverse knock-on effects.

Q: Can you think of any other approaches by means of which the financial market can have a positive impact on the food supply? 

Leaving the issue of the food supply to the financial markets to deal with alone certainly would not be a good idea. Well-functioning financial markets can take over important tasks, but they function completely in line with market logic. This logic cannot adequately solve the problem of insufficient food supply, as it primarily hides a problem related to the unequal distribution of income. And, in this case in particular, the financial markets tend to move in the wrong direction, promoting the accumulation of capital by a few market participants.

Q: What other measures do you see for a better supply?

The special status of staple foods must be better respected. This means, for example, that they may not simply be used as investments or to produce fuel. Guaranteeing the supply takes clear priority over other interests, such as diversifying the portfolios of some investors. Furthermore, only a combination of measures will be effective in the long term, which must also address the problem of global poverty.

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