After Wall Street figured out a way to make investments in commodities look a lot like investments in stocks, food prices jumped. Is there a connection?
What’s driving food prices higher?
There are plenty of suspects — bad weather, competition from biofuels, a growing demand for meat in developing countries.
Another potential culprit is Wall Street.
The argument is that investors are putting huge amounts of money into commodity funds. The funds buy stakes in goods, from oil to flax to copper. As increasing amounts of money chase a limited number of goods, prices rise.
Frederick Kaufman tells this story in the latest issue of Foreign Policy magazine. “It took the brilliant minds of Goldman Sachs to realize the simple truth that nothing is more valuable than our daily bread,” Kaufman writes. “And where there’s value, there’s money to be made.”
In 1991, as Kaufman tells the story, Goldman Sachs created a commodity index fund. Investors would buy shares of the fund and the fund would purchase contracts on a basket of goods. If the price of coal, corn and iron ore rose, so did the price of the fund. Commodities were a way to diversify a portfolio beyond stocks and securities.
This was a perversion of the system, according to Kaufman. Futures markets developed to take some of the volatility out of agricultural markets that were inherently unstable. They allowed farmers to lock in prices for future harvests. Having a set price today for tomorrow’s crop came in handy — like when it was time to get a loan to finance planting.
There were two players in these markets, Kaufman writes. There were those who had a stake in the product. There were farmers who produced the wheat and there were the companies that bought the grain, like Pizza Hut.
And there were speculators, the second group of players in the market. Speculators played the market’s ups and downs. They’d bet on price increases AND decreases. Speculators added liquidity to the markets and helped even things out.
The result was, overall, more stable markets. The real price of wheat decreased over the course of the 20th century and farms produced surpluses.
The commodity index funds introduced first by Goldman didn’t play the markets. They weren’t speculating on increases and decreases in prices. The index funds made a one-way bet — that the prices of commodities would increase. In a sense, they treated commodities like stocks.
Money began to pour into commodities, mostly energy and metals, but also, around the edges, food. In 2003, the futures market for commodities totaled $13 billion, Kaufman reports. By July 2008, the markets totaled $318 billion.
Kaufman contends that this created a bubble in food prices, which increased 80 percent from 2005 to ’08. Kaufman writes:
Today, bankers and traders sit at the top of the food chain — the carnivores of the system, devouring everyone and everything below. Near the bottom toils the farmer. For him, the rising price of grain should have been a windfall, but speculation has also created spikes in everything the farmer must buy to grow his grain — from seed to fertilizer to diesel fuel. At the very bottom lies the consumer. The average American, who spends roughly 8 to 12 percent of her weekly paycheck on food, did not immediately feel the crunch of rising costs. But for the roughly 2-billion people across the world who spend more than 50 percent of their income on food, the effects have been staggering: 250 million people joined the ranks of the hungry in 2008, bringing the total of the world’s “food insecure” to a peak of 1 billion — a number never seen before.
Kaufman’s argument is not accepted by all. There are several scholarly papers that find no relationship between the influx of commodity index fund money and rising food prices. Two Illinois economists say their studies “fail to find any causal link between commodity index activity and grain futures prices.”
There is quite a bit of scoffing at the notion that index funds produced a bubble in food prices.
University of Tennessee ag economists Daryll Ray and Harwood Schaffer say that the “jury is still out” on the “index fund effect” on farm commodity prices. But Ray and Schaffer say the logic that index funds push up farm commodity prices is still sound.
Index funds buy commodities only on the long end, they wrote in a recent column. These funds are largely invested in energy (oil, gas, coal) and minerals. As speculation on energy prices push more money into funds, however, the indexes also buy more grains. Energy speculation drives commodity investments, the two economists write, and “grains are along for the ride with little-to-no regard for what is happening in the grain sector.”
They continue: “Since the resulting price increases in agricultural commodities had virtually nothing to do with their market conditions, the record level of activity in the futures market by index funds would seem to make index funds a logical source of possible price overshooting.”
By the end of January, Standard & Poor’s index of commodities had increased by 24% in the last year, and Reuters was reporting that the total fund investments in commodities at the end of this year would likely be close to $420 billion.
Bill Bishop is co-editor of The Daily Yonder.