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).