What’s causing global food price inflation?

Stefan Tangermann 22 July 2008

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Global food prices have exploded since early 2007, causing major social, political, and macroeconomic disruption in many poor countries and adding to inflationary pressure in the richer parts of the world.1 Concerns about high food prices have been expressed at the highest political level, including during the recent G8 summit on Hokkaido.

What has caused the explosion of food prices? Several culprits have been blamed.

  • Newspapers have cited an internal World Bank document as having found that 75% of the price increase was due to biofuels.
  • Several governments and commentators see speculation as a major driving force.
  • A widely held view has it that rapidly growing food demand in the emerging economies is pushing up global food prices.

Which contributions have these or other factors made to rising food prices?

New evidence on the causes

The OECD has carefully looked at market developments and analysed the implications of biofuel support policies. The analytical framework used is a large-scale partial equilibrium model of agricultural commodity markets in all major countries and at the international level, with detailed representation of the multitude of policy instruments affecting these markets, including those targeting biofuels.

Results were published recently in the OECD-FAO Agricultural Outlook, a paper on the causes and consequences of rising food prices, and a report on the economic assessment of biofuel support policies. The evidence is pretty clear.

It’s not China’s and India’s demand

Food demand in China, India, and other emerging economies is rising as their incomes grow. However, domestic food production in most of these countries is growing in parallel. China, for example, has been a consistent and growing net exporter of cereals (including rice). The Agricultural Outlook expects China’s net cereals exports to decline only very gradually in the coming decade. For India, the picture is similar, though there was significant variability in its net trade position in the past. In short, growing food demand in the major emerging countries cannot be held responsible for the rise in world market prices for cereals.

Market panic, and more specifically “speculation”, may well have played a role on derivative markets for agricultural commodities. The amount of capital invested and the number of transactions observed in these markets has increased very significantly in recent times. Activity on futures markets may, to some limited extent, have spilled over into spot markets.

No hard evidence that “speculation” boosted the spot price

Yet, there is no hard evidence that “speculation” has added much to the price increase on spot markets. After all, it is only when “speculators” actually buy produce on the spot market that they can drive up the price, and this would have to be reflected in growing stock levels – but stocks appear to have declined throughout the period of rising prices.

A different type of panic, though, has without doubt contributed to food price inflation – the barriers to exports that some food exporting countries have imposed in order to keep domestic food prices under control. Yet, the precise effect that this form of government panic has had on short-term price movements is very difficult to quantify.

OECD analysis clearly shows that two factors external to agriculture and food have had, and will continue to have in the years to come, a significant impact on the rise of global food prices.

  • The rapid increase in crude oil prices and energy prices more generally has significantly raised the costs of producing and shipping agricultural products.
  • The weak dollar has contributed to driving up dollar-denominated commodity prices in international trade.

But there is also one policy-made ingredient in the story – the high and growing level of support provided to the production and consumption of biofuels.

Policy-made causes: Biofuels

The use of agricultural products, in particular maize, wheat, and vegetable oil, as feedstock for biofuel production has expanded dramatically in recent years. Between 2005 and 2007, i.e. in the period when food prices began to explode, nearly 60% of the growth in global consumption of cereals and vegetable oils was due to biofuels. Global output of cereals and vegetable oil did not decline during that period, but just grew slower than the rapid expansion of use.

In a situation of depleted stocks and very low demand and supply elasticities, this gap between use and output growth has pushed prices up very strongly. As a large part of the use expansion was due to biofuels, there cannot be any doubt that biofuels were a significant element in the rise of food prices. More specifically, in North America and Europe biofuels cannot be produced, and would be very little used, in the absence of government support through subsidies, tax breaks, tariffs, and use mandates. In other words, biofuel support policies have contributed greatly to the rise in global food prices.

Future price developments: High but not this high

With this perspective on what has happened in the recent past, it is clear that some of the factors identified will continue to play an important role in future developments on agricultural markets.

The OECD-FAO Agricultural Outlook expects prices on international agricultural markets will not remain at the extremely elevated level seen in the first half of 2008. However, prices are not expected to fall back to the low levels observed before the price hike either. For the 2008-17 period, average prices for major agricultural products are projected to remain some 10% to 50% higher in real terms than on average over the past ten years.

The contributions that individual factors are expected to make to this higher level of prices are clarified in the Agricultural Outlook through scenario analysis, the results of which are shown in Figure 1. Again it is evident that biofuels will be an important driver of future food prices. In the absence of further growth in biofuels production (not to speak of a decline), international market prices of wheat, maize, and vegetable oil could be some 6%, 12% and 15% lower than projected under baseline assumptions.

Figure 1 World food price projections

Source: OECD-FAO Agricultural Outlook, Chapter 2.

It is worth noting that the baseline for these projections does not even include the impacts of more recent biofuels policy initiatives such as the Energy Independence and Security Act of the United States and the European Union’s Directive on Renewable Energy. If the further expansion of biofuels production and use due to these initiatives were included, the impact of biofuels on global agricultural prices would be even higher.

Conclusion

In summary, several factors are behind the recent dramatic increase in food prices. But one of them is clearly a result of deliberate policy decisions, i.e. to support the expansion of biofuels production and use. The OECD’s recent report on the economic assessment of biofuel support policies has clearly shown that their effectiveness is disappointingly low, with public support costing between $960 and $1700 per tonne of greenhouse gas emissions saved. In a situation like that, governments have good reasons to reconsider their biofuel support policies if they want to help to calm food prices down.


1 See Esther Duflo on winners and losers from high food prices, Arvind Subramanian on policy responses, and Guillermo Calvo on the causes of commodity price increases.

 

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Topics:  Energy International trade

Tags:  US, China, EU, India, food prices, biofuels, biofuel support policies, speculation, Energy Independence and Security Act, Directive on Renewable Energy

Comments

I find biofuel supporting policies totally useless and as you found, they are a very important piece of the problem, but, what about the concentration in those commodity markets? I think that the same process is happening in the steel and other metals markets as well as in the gas and oil markets, and the same possible reasons arise: strong and increasing demand of emerging economies and speculation, but, how much of these soaring prices can be explained by the increasing market power in those activities?

Rather than biofuels being the cause of the food crisis, one can just as easily place the blame, with the same data presented by the OECD and Mr. Tangermann, on the current market institutions that link food markets to highly liquid financial markets for paper assets such as mortgage backed securities and currencies.

The big hole in Mr. Tangermann's hypothesis that biofuel promotion policies bear the most responsibility for current food price inflation is that rice, which does not compete significantly for cultivated land with maize and soybeans, has also risen dramatically along with the other commodities. Maize and soybeans can't usually be grown on the same land at the same time as rice due to the water-logged growing conditions favorable to rice but not maize or soybeans. This means that rice should not experience the same levels of price increases as maize or soybeans do, yet the price inflation of rice has been just as great, as shown in this article. And the data supports me. There is not a recent shortage, or expectation of a shortage, of rice sufficient to explain the large price movements. Stock-to-use ratios of rice, which declined in 2003 as new world trade rules came into effect, have been stable since that time -- production has matched consumption pretty well. While shortages of corn can be expected due to biofuel mandates, that does not have a very large impact on the supply function of rice.

Also, it is rice, not maize and soybeans, over which people are rioting today. The food crisis is about rice (and to some extent wheat), not maize or soybeans. While maize and soybeans mostly go toward feeding meat -- a food for the wealthy -- rice is the food of much of the world's poor. Not all coarse grains are alike, and it is not because of meat scarcity (which hasn't occurred yet), or of corn or soybeans which mostly go toward meat production, that people in Haiti or Egypt are rioting. The wealthy, who with a few exceptions are the main final consumers of maize and soybeans, are not rioting -- the poor are. (And while wheat does compete somewhat with corn and soybeans for space, the wheat scarcity and price increase last year is easily explained by recent widespread crop failures, something which hasn't occurred in rice, which is still about as plentiful in the world as it has been since 2003.)

If biofuels were really the main cause of food price increases, then we would expect the price of rice to increase somewhat less than the prices of the main biofuel feedstocks, wouldn't we? But this does not appear to be the case.
An alternative hypothesis is that market speculation is the culprit. If by market speculation we mean that financial market traders are fleeing paper (i.e., institutional) investments in currencies and securities in places such as the US in search of real assets, quite possibly due to expansionary monetary policy as well other causes, then we can say that market speculation is a monetary problem and that it should cause a more general rise in prices of most commodities because it is the abundance of paper wealth unsupported by real goods and services that is causing commodity prices to rise, not scarcity of food.

If market speculation is the cause of food price inflation, we would expect to see the price of rice and other commodities that have little to due with biofuels rising dramatically as well, and that appears to be exactly what is occurring. That is, market speculation appears to be more consistent with the general price inflation of most commodities that we are experiencing rather than biofuels, which should impact some food prices, but not most and not equally.

Furthermore, the argument that speculation has not resulted in any increase in stocks of commodities is just too simplistic and has already been refuted on this site and in economics literature by people such as Guillermo Calvo, Jeffrey Frankel and others. If the cause of commodity price inflation is a monetary phenomenon, then rising prices themselves supplant the need for speculators to increase stocks of commodities. That is, market speculation in commodities is an instrument through which monetary expansion and inflation occur as banks finance margin calls through lower interest rates, allowing speculators to bid prices ever higher.

The data presented by Mr. Tangermann is simply more consistent with a belief that markets themselves, rather than biofuel promotion policies, are causing the current food crisis. This presents a policy problem: believing in market speculation (or monetary growth) as the cause of the food crisis means disbelieving in prices as reliable indicators of relative scarcity for the purposes of most food market participants. It means that markets that allow some of the wealthiest people in the world to bid for the same food commodity with the world's poorest are probably not likely to achieve either the equity or efficiency benefits that we tend to provide as reasons for imposing markets and their associated rules and institutions on human economic activity.

I think the more interesting research question coming out of this is not whether biofuels are causing the food crisis but whether markets that allow financial speculators to compete with slum dwellers for the same food commodity (but with different usage intents -- utility) really achieve the policy outcomes of efficiency and equity that most people expect (and have been promised) from markets. That is, the problem may not be that energy competes with food, but rather that current market rules which allow the wealthy to compete with the poor for basic life needs is the problem.

Jim Kielkopf is the economist for AgriBank, FCB, which is the largest wholesale bank in the US Federal Farm Credit system.

Former Director for Trade and Agriculture at the Organisation for Economic Co-operation and Development (OECD)