The arbitrage strikes back

For better or for worse, speculators are just trying to figuring out what the future holds.

John Vidal at The Guardian (which seems to be holding our attention this week) wholeheartedly condemns food speculation. I was going to write a lengthy post about the basic economics behind speculation (i.e. arbitrage across time), and I might still do so, but in the meantime I felt that this comment by Tim Worstall on the blog sums up my feelings really, really well:

This really does so damn irritate me. The World Development Movement are loons on this issue.

So, imagine, there’s going to be a future shortage of food. Doesn’t matter what’s going to cause it, could be biofuels, could be climate change, could be population growth.

OK, so there’s going to be a future shortage of food.That will mean that in the future some people will die from starvation. This is not a desirable outcome.

So, what do we want to happen? We want to pull those future high food prices into the present. Instead of finding out that we’re short 10 million tonnes of grain in 2012 (or 1 million in 2015, or 100 million, whatever and whenever) we’d like people to be aware of this future food shortage. And getting lots of people to do two things.

1) Among consumers, we want people to substitute away from the foods that will be in short supply. Eat potatoes, or polenta, instead of bread or pasta. Cassava instead of rice. We also want people to be a bit more careful about the food they buy: not waste so much of it. A high price now does this.

2) We want farmers to plant more land, also to farm more intensively so they get a larger crop from each acre they do plant. A bit more weeding, a tad more fertilser, this sort of thing. A high price now makes this happen.

So, we want high prices now to reduce consumption and increase production so that we don’t in fact run out of food in the future.

So that people don’t starve to death, right?

And it is speculators that achieve this desirable goal. They are the people who bring the future high prices forward in time and thus stop the starvation.

It’s all laid out by Adam Smith in his book The Wealth of Nations. Book VI, Chapter 5, start at paragraph 40. Here.

That book was only published 235 years ago. You’d think that people would have managed to absorb the point by now really. But apparently not.

Update: Lest it be thought that I think private speculation is the answer-to-all things (see Liam’s comments below for some very good reasons why it probably isn’t) – I think the main thing to take away from Worstall’s counterargument is that speculation isn’t fundamentally bad in theory, as I think Vidal probably believes, not that it is necessarily the first-best solution to food price volatility.

Malawi, like many SSA countries, has as strategic grain reserve, which is held in case there is a massive food shortage during the lean season. The Malawian government loads this reserve with some assumptions about the future supply of food, whilst also reducing supply in the short term. This is still speculatory behaviour, even though we prefer to think of it having a social purpose (with any profits accrued to the government instead of international investors).

8 thoughts on “The arbitrage strikes back

  1. Mathias Schwartz Kirkegaard

    January 24, 2011 at 1:27pm

    It’s the same about worrying about running out of oil: We will never run out of oil! At some point it will just be to expensive to squeeze the last drop from our soil, and then we will substitute to a cheaper energy source. Whatever it will be. Of course it might be some other countries that produces this energy, but we don’t have to worry about having power to cook an egg.

  2. Liam

    January 24, 2011 at 3:48pm

    Whilst I agree that there are attacks on speculation that do seem to miss the fundamental idea, there are a lot of reasons why it could be bad once we move away from assuming perfect markets:

    - Bubbles: A key question with speculation has to be its affect on volatility. In terms of food prices, volatility is I think the thing everyone can agree on is bad (since both high and low food prices are good for some people). Of course, speculation has the possibility of smoothing volatility (indeed, in some sense `it should’). But is there evidence that it does? Perhaps it smooths out the little bumps, but makes bigger crashes. I mean, isn’t the financial crisis enough to show that allowing people to make bets on future prices of goods might not be a wonderful volatility reducing thing?

    - Vicious cycles: We saw in the last food price rise that this stimulated export bans and the like, which inefficiently raise the price of food. So, supposing there were in fact no pressures on food prices, speculation might rise the price despite no rise in (real) cost. This is like short-selling bank shares.

    - Equity: There are a whole load of arguments here, but to take an extreme one, let’s consider I’m a staunch Rawlsian and I only care about the poorest person on the planet who can’t tolerate any rise in food prices. Suppose there’s a 50% chance of food prices rising in the future (and 50% staying the same). Without speculation, I live now and die with a 50% chance. With speculation, I certainly die.

    I could go on, but the point is that, like, after the financial crisis, economists really can’t go around attacking people who dislike speculation on the grounds that, you know, in theory, if markets worked well, it should make the world a better place… Can we discuss the evidence please?

  3. Matt

    January 24, 2011 at 4:10pm

    Liam -

    All excellent points – if I had written a full post I would have mentioned the same things. My only point in citing Worstall is that speculation is not *inherently* bad, as I think is the assumption in The Guardian article – not that private speculation was a first-best for food prices.

    And you’re right – it is a discussion sans evidence, but then again, so is the assertion that speculation is driving food prices.

  4. geckonomist

    January 25, 2011 at 1:23pm

    Dear Liam, unlike you, I am a food trader & processor.
    So let’s bring up some evidence.

    There are are people out there, at this very moment, negotiating prices and buying tons and tons of food for me.

    This buying of food is speculating. The pure thing. Because I am at this very moment – or when you are reading this – going long on the food I am buying.

    If later today and in the next weeks, years, nobody wants to buy my food any more for whatever reason, I am wiped out.
    I lose all my investment plus costs. I guess that is the absolute proof I am nothing but a speculator.

    I hope that when that happens to the whole sector, you have figured out a way to purchase food from farmers 10 or 10.000miles away from you without someone “speculating” involved.
    Good luck.

    But of course, since I am pretty risk-averse and I hate being wiped out, I make contracts beforehand with my customers. Ideally, i’d sell about half of my food beforehand (short), and keep half (long) in my warehouses, such that the spot price can not wipe me out. Second degree speculating!

    The evidence that this works, is out there. Over the past 17 years, I am not wiped out, while more than two thirds of my direct competitors went silently and unspectacularly bust. Margins are thin in food trading, believe me.

    But Liam, do you think I give a fiddler’s fart who exactly the counterparty buying my future is?
    As long he/she is trustworthy and able to pay for my goods, I am quite happy to buy this insurance from him/her, whether it is a lad from Glencore, Goldman Sachs or whatever hedge fund.

    You allege that the chaps from GS or the hedge funds cause bubbles instead of merely providing liquidity.
    Well, there might be lots of evidence for this – you don’t even have to show it, Liam – but can you tell me who gets into most trouble when the bubble deflates and the spot price crashes?
    not the farmer: he can always plant something else while living from his windfall profits during the bubble time;

    not me: I am hedged.

    not the retail food company that is enjoying cheaper inputs & higher margins.

    But…he who can’t process or sell the food, the “real speculator”.

    Any idea how the investment banker feels when the shipping company enquires where exactly in Manhattan those 50 containers of food (perishable!) should be delivered, tomorrow?

  5. Murray

    January 25, 2011 at 2:56pm

    I think its important to point out that Vidal’s argument is specifically framed in terms of the now de-regulated commodity derivative markets and therefore is against excessive unregulated speculation, not speculation in general.

    The real failure of this speculation is that it is not based on the fundamentals and as pointed out above, trying to send signals to the physical market, its based on wider economic factors or technical analysis. As was reported in today’s FT on energy derivative traders moving into soft commodities:

    “But people are trading derivatives more than the fundamentals of any commodity,” said Mark Benigno of Hudson Capital Energy, an options dealer. “It’s a portable expertise.”
    http://www.ft.com/cms/s/0/ff5fc2ac-27dc-11e0-8abc-00144feab49a.html#axzz1C2ccJpmk

    When your traders aren’t looking at the fundamentals they are distorting the price. So you need regulations to reduce speculation and tie derivatives more closely to the fundamentals. Otherwise you get bubbles, volatility and over-priced commodities.

  6. slavek

    January 25, 2011 at 6:50pm

    “So, what do we want to happen? We want to pull those future high food prices into the present. Instead of finding out that we’re short 10 million tonnes of grain in 2012 (or 1 million in 2015, or 100 million, whatever and whenever) we’d like people to be aware of this future food shortage.”

    The moral logic is unassailable: starve a few people today so that the many can thrive in the future. Stalinism, anyone?

  7. terence

    January 25, 2011 at 10:04pm

    Hi Matt,

    In addition to agreeing with Liam’s points I’d add that part of the problem with the type of speculation that Vidal is taking a tilt at is that it drives up the rate of increase. Under natural circumstances as demand exceeds supply in increments we ought to see relatively slowly rising prices (especially as rising prices themselves will help bring more land into cultivation). It’s much easier for people to adapt to relatively slow price changes than it is to sharp speculative spikes*.

    Also, were I given a choice of high food prices now, or high food prices in the future, I’d opt for the latter. We’ll be living in a wealthier world then, with more people, more able to bear the price burden.


    * Granting that speculation isn’t the only thing that can cause food price spikes of course.

  8. Sam

    January 26, 2011 at 8:37pm

    I thought the prices were rising essentially because the demand is rising faster than the production. Speculators win only when going with the flow, not when going against it. When betting the price will rise, and it goes down, they go down with it.

    So in essence, policy should reply to the long term trends, and its causes. Didn’t the development community ask for so long to bring down the subsidies in Europe and US? aren’t we happy now?

    Naturally, short time shocks must be addressed too.

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