Published on Wednesday, 30 November -0001 00:00
May 2008 If there is one thing I've learned from my dealings with economists over the years, it's that their work is very complicated and it's easy for even the smartest people to make incorrect assumptions if they overlook key factors. This might be one reason we hear so many wildly different stories about the interplay between food prices and commodity prices. Many people see food prices going up while at the same time farm commodity prices and renewable fuel prices are increasing. It's natural to make the conclusion that food prices are being driven by higher prices for corn and soybeans. It's also understandable that some people would make a link between the expansion of renewable fuels and increasing commodity prices. From there, it's not a huge leap to assume the extra demand created by renewable fuels production is to blame for rising food prices. But as those economists like to say, "correlation doesn't prove causation." That is, just because two or three factors rise or fall at roughly the same time, it doesn't mean you can assume that one of the factors is causing the changes in the other factors. Often, there is another unseen force influencing all three. This lesson was brought home by a recent study issued by Texas A&M University. The university's Agricultural and Food Policy Center looked at the effects of ethanol on food and feed prices, and found the following: the major force driving these economic changes is overall higher energy costs; corn prices generally have had little to do with rising food costs; important foods like bread, eggs, and milk have high prices that are largely unrelated to ethanol or corn prices, but correspond to global supply/demand relationships; and speculative fund activities in futures markets have brought more money and volatility to commodities markets. I want to highlight the last two points here. Some media stories have correctly identified rising energy prices as a contributing factor for higher food and commodity prices, but I have seen little coverage of the game-changing impact of global demand and speculative investing. The last few years have seen a dramatic increase in the ability and desire of people in developing nations to purchase corn, soybeans, wheat, pork and other commodities. Where in the past few people were able to afford higher-end food items, we are now seeing large increases in demand from India, China and other countries. One recent study I came across found that increased meat consumption in China is diverting billions of bushels of grain per year to livestock feed. The falling value of the U.S. dollar relative to other international currencies also makes U.S. food products more appealing. This means more demand for high-quality U.S. agricultural products, which is good. However, since the market is driven by supply and demand forces, higher demand means higher prices. Speculative investing, the other under-reported factor, may be an even more important factor in the near term. According to a recent New York Times article, weaknesses in the markets for stocks, bonds and real estate have major investors (hedge funds, commercial banks, brokerage houses, etc.) shifting money into commodities markets in the hope of making the kinds of gains currently not available on Wall Street. According to a Chicago-based ag research firm, total index fund investment in corn, soybeans, wheat, cattle and hogs has increased to more than $47 billion, up from $10 billion in 2006. This influx of cash drives up commodity prices, and can create major price volatility that has little relationship with real-world supply and demand forces. That can mean trouble if you are a farmer trying to use the futures markets as a risk management tool. It can also drive up prices in the food sector even beyond the increase we would already be seeing due to higher energy costs and increased global demand. The Texas A&M study further discredits the "blame farmers for high prices" argument by reminding its readers that the farm share of retail food prices - that is, the percentage of each consumer dollar spent on food that reflects the value of the raw product in that food - is just below 20 percent. With the raw input such as wheat or corn comprising so little of the actual retail value of a food product, even significant increases in the value of the raw product should have relatively minor impacts on retail prices. "This research supports the hypothesis that corn prices have had little to do with rising food costs," the study's authors write. I will be the first to admit that any economic analysis, even this one, is subject to varying interpretations. When you're dealing with systems as complex as financial markets, I doubt anyone can fully understand how the entire process works or exactly what influence each factor has on other parts of the system. What I am certain of, however, is that it is a mistake to finger Minnesota farmers or the renewable fuels industry they built as the primary cause for recent increases in retail food prices. I am even more certain that it would be a huge mistake to turn our back on our promising renewable fuels sector at a time when petroleum is setting new records in the neighborhood of $120 per barrel. It's time we move past the finger-pointing and renew our focus on the vital question of how we meet our nation's energy needs in the future without overdependence on foreign fossil fuels.
By the way, I was just recently in the grocery store and noticed that the price of bananas was up about 40 percent. Last time I checked, there was no corn used in the manufacturing of bananas!