Cotton prices are going to fall

Cotton is the third most valuable crop in the US, after corn and soybeans.

Cotton prices have roughly doubled over the last year, perhaps a bit more than other staple agricultural commodities.  The big difference with cotton is that it uses a much smaller share of the land base than corn, soybeans and wheat do.  That makes it a lot easier to proportionately expand production when prices rise.  And since it's a higher-value crop than corn, soybeans and wheat, that land expansion is going to happen, as described here in the New York Times today

... In the United States, the economics of growing cotton vary according to many factors, including regional differences and whether or not the land is irrigated. Farmers in several southern states said that at a cotton price of about $1 a pound, their profit could be roughly $200 to $500 more per acre than they could earn growing corn or wheat. For 1,000 acres planted in cotton, that means an additional $200,000 to $500,000 profit.

“It’s going to be cotton stalks everywhere,” said Travis Patterson, 44, a farmer near Spearman, who was irrigating one of his fields on a recent afternoon with help from his son Zane, 12, in preparation for planting cotton. “The landscape’s going to change,” he said, describing a countryside blanketed with the white of cotton rather than the more familiar green and gold of corn.

It's going to be harder to expand production of corn, soybeans and wheat.  Competition with cotton is just a small part of it.  For these much larger crops there simply isn't much land available on which to expand production.  So, I expect prices for cotton to fall quite a bit over the next year.  I'm less sanguine about corn, soybeans and wheat.

AMS Briefing on Capitol Hill

This morning's slides.  I believe slides with audio of the presentation will eventually be posted here.

Open publication - Free publishing - More agriculture

Using quotas in procurement auctions

I have a new working paper with Daniel Hellerstein and Nathaniel Higgins (both with USDA) on the use of quotas in procurement auctions.

This is a new area for us.  Our motivation came from thinking about the Conservation Reserve Program and a rapidly emerging literature on "payments for ecosystem services." Basically, the government or environmental interests or the carbon market or whatever wants to buy a lot of something--say carbon sequestration services, water quality benefits, wildlife habitat, etc.--from a large and extremely heterogeneous pool of sellers.

One issue surrounding the heterogeneity of sellers is that we need to put the environmental services provided across varied landscapes, locations, and situations on an equal footing, which requires some method of valuing the environmental benefits.  That's a hard thing to do, but it's not new.  And I think people are already doing about as good a job as could be expected.  Or at least I don't think I've got anything to contribute in this area.

Aside from valuation, it seems to me the biggest challenges everyone has been worrying about essentially come down to price discrimination:  The buyers of environmental services want to pay different prices to different sellers according to their opportunity costs for providing those services.  I can see a lot of practical reasons for wanting to do this, even if doing so involves a little bit of inefficiency.  I wrote about this a bit here.

So, how can one go about price discriminating if the buyer knows costs differ across sellers but they don't know how much they differ, or perhaps even who has high costs and who has low costs?  Well, a simple thing to do is to just have a procurement auction and put a modest quota or limit on the share of offers accepted by any observationally similar group of sellers.  This causes sellers within low-cost groups to compete with each other much more aggressively.  And it causes all sellers to generally compete more aggressively because they realize sellers within low-cost groups are competing more aggressively. 

It turns out that solving these kinds of auction theoretically is quite a bit of work.  But if costs do in fact vary a lot across groups, quotas can save the buyer a lot of money.  If groups are actually quite similar, quotas have no real benefit, but no real cost either.

We also ran some experiments and found somewhat greater savings from quota in the laboratory than in theory, and less of an efficiency loss verses standard pay-as-offered auctions.

I think there are many potential applications besides CRP or PES programs, so the paper is pitched more generally.  I also figured out a simple but powerful new technique for solving Bayesian Nash equilibria in asymmetric auctions, but that would only be of interest to a more limited audience.

How much might this kind of auction save the Federal government if they used it for CRP?  I don't think that question is strictly answerable given the available data.  But I think it's highly plausible that it could eventually save hundreds of millions of dollars per year while simultaneously improving environmental outcomes.  Part of this is because the way they currently go about price discriminating looks hugely inefficient (see here). It would be a lot simpler to implement than the current program, too. 

Will they do it?  I'm not going to hold my breath.  But I'm going to shamelessly sell the idea, because I think it would implement exactly what they seem to be trying to achieve in a way that's simpler, would possibly be perceived as fairer, and is almost surely more efficient.  If I could get them to do this, and it actually worked, I'd have concrete evidence that I earned my Wheaties.  Other applications would just be icing on the cake.

Commodity Prices and the Fed

I think Mark Thoma nails this.  What he describes is exactly the way I think about the issue but have been unable to articulate.

To answer the question in the title of this post, it's useful to think of an island with only two goods. One of the goods is non-renewable, but highly desirable. The other good is less preferred, but it is renewable (thinking of renewable and non-renewable energy resources, for example). The key is to distinguish between changes in prices that reflect changes in the relative scarcity of the two goods, and changes driven by increases in the money supply.

Over time, as the stock of the more desired good falls due to consumption, the price of this good will rise relative to the renewable good. Consumers will be hit by increases in the cost of living -- the same basket of the two goods purchased last year now costs more.

But is this the kind of increase in prices the Fed should respond to? No, the price increase -- and the increase in the cost of living -- reflects increasing scarcity of the desired good. The price of the two goods are changing to balance the relative supplies of the two goods. Unless the price of the non-renewable resource does not properly take account of the preferences of future generations -- and it may not -- or there is some other market failure, there is no reason for government to intervene to change the prices. If the prices are correct, they will allocate the resources optimally.

Now consider a different case. Suppose the central bank in charge of money -- sea shells of a particular type identified with the central bank's special mark -- and the money supply is being increased at a rapid rate. This will drive the prices of both goods up, but so long as the price of each good rises in proportion to the change in the money supply so that the relative price of the two goods is undisturbed, no problem. The price level will adjust to the number of sea shells in circulation, but since relative values remain intact, nothing will change.

However, suppose one of the two prices is sticky. It does not change very fast when the number of sea shells in circulation increases. In this case relative prices will be distorted as the number of sea shells increases, one price will rise faster than the other, and resources will be misallocated. In this case the Fed would want to do something about the inflation since it is having negative effects on the efficient allocation of the two resources. This is, essentially, the Fed's justification for activist policy.

A couple of notes. First, it's interesting to think about how technological change that improves the quality or lowers the price of the renewable good plays into this. Such a change could offset the increase in the cost of living that households face. Thus improving technology, not Fed policy, is the key to helping people on the island struggling with high prices. 

Second, this is about the long-run and growth in demand. The central bank may still want to try to offset temporary price spikes, for example when sticky prices can cause problems that persist beyond the spike in the price of one of the two goods (e.g. a spike in the price of oil that leads to long-lived price distortions). But long-run growth that causes the price of one of the goods to rise by more than the other, i.e. relative price changes, is not something the Fed should try to neutralize.

To me right now, commodity prices look to be driven mainly by fundamentals.  The clearest thinker I know when it comes to oil is Jim Hamilton, and he seems to think so too.  Thus, inflation coming from commodity price increases is reflecting something real--an increase in relative scarcity.  The kind of inflation the Fed needs to worry about is of a purely nominal nature.

It's always nice to have your research cited in testimony before Congress

In email this morning I learned that my work with Wolfram Schlenker was cited extensively by Christopher B. Field in his testimony before congress (PDF).

In today's New York Times our findings were obliquely referenced via Field.  Apparently his testimony "piqued the interest of members on both sides of the aisle."  The specific statistics cited in the New York Times come from our research results.  While the NYT is citing Field, you can see from Field's testimony that it comes from our work.

One little quibble with Field's testimony.  He testified as if these are going to be adverse effects to the U.S.  Actually, US crop production getting hammered by climate change may be good for us.  That's because we export a good share of our crops and demand is extremely inelastic.  It's is quite likely that price increases will help farmers far more than the lower quantities hurt them.  The gain in domestic producer surplus could be so large that there could be a net gain for the United States.

But this should inspire the opposite of complacency.  It's the rest of the world, particularly the world's poorest, that would suffer.

Update: Maybe I'm being too oblique here.  I'm NOT sanguine about these potential impacts.  What I'm trying to do by pointing out the big price effects is to show that the economic impacts from climate change will often happen to people and places far different from the physical impact.  When the Midwest takes a hit on corn yields, North Carolina hog and chicken farmers suffer while most Midwestern farmers gain, since prices more than compensate.  With climate change, this kind of economic displacement of physical impacts will probably be common.

Covariances reveal differences between supply shocks and demand shocks

This is for all the inflation mongers out there who think that today's oil price spikes are a prelude to hyperinflation.

Up until a few weeks ago, demand factors were driving oil and other commodity prices.  When oil prices went up, so did the stock market and interest rates.  Aggregate demand shocks, the earlier drivers, were mainly good news about growth, and this drove up interest rates and the stock market.  They also signaled higher prospective inflation, which I saw as good news.  We could use a bit more inflation, given we remain well below target and there is lots of labor to sop up before wage increases (the main part of inflation) kick in.

Over the last couple weeks, prices have spiked more sharply, but for very different reasons, mainly the quickly unfolding events in the Middle East.  Markets are speculating about a possible, if unlikely, major disruption in supply.  While oil prices have spiked, other commodity prices have generally softened, and the stock market and long-term interest rates have declined.  Anticipated downward shifts in supply are clearly bad news for the economy and growth.

And the decline in interest rates shows how little we should be concerned about hyperinflation.

Short-run inflation and perhaps even stagflation are real possibilities in this fragile economy.  This is just a textbook shift in aggregate supply.  Whether or not you're a Keynesian, the textbook says a supply shock to a fundamental resource will cause the price level to increase and output to decline.  But it's not a monetary phenomenon.  It's not the kind of thing that could kickstart a vicious inflationary spiral.  Not with unemployment at 9%.  This is bad news, not too much good news about an overheated economy.  Markets realize this and that's why stocks and interest rates are down.

Hyperinflation remains a truly remote prognostication. The only risk here may be if we shutdown the government indefinitely and default on our debt.  But that has nothing to do with oil prices either.

Update : I'm not the only one who thinks these kinds of changing covariances are interesting.

Ethanol and food prices, again

Last week I served on a panel for the RTEC and gave my usual spiel about ethanol and food prices.

In a nutshell:

1) Both supply and demand of staple grains are highly inelasitic. This means it doesn't take much of a shift in supply or demand to cause a big change in price.

2) The U.S. is hugely important in world grain markets.  With the largest share of world production and a much larger share of world exports, we drive international prices for staple grains.

3) Ethanol uses about 1/3 of the U.S. corn crop, or about 5 percent of the calories produced, worldwide, of corn soybeans, wheat and rice--the key grains that feed the world.  That's even with a bigger corn crop (and smaller soybean crop) that has been brought about by ethanol subsidies and mandates.

4) When prices go up, we in rich countries don't eat much less, since commodities are a trivial share of our food expenditures.  Those consuming less are most plausibly the world's poorest.  If not, who do you think is eating less due to the huge diversion from ethanol?

5) Yes, there are other and possibly larger factors affecting food prices: growth in China and other parts of the world, particularly growth in demand for meat, and bad weather.  These factors accentuate the effects of ethanol; they don't diminish it.  A big problem with all this stuff coming online at the same time is that it has drawn down inventories, making markets far more susceptible to other shocks.

I was challenged by the usual armchair reasoning that doesn't hold up under inspection.  Yes, some of the grain used in ethanol production goes back to farmers in the form of distillers grains. But it cannot be used for all animals.  It's 1/3 the calories, maybe less.  The wet stuff is economical but very expensive to transport.

In the real world there are tradeoffs.  You can't have your cake and eat it too.

One anecdote I wish I mentioned but didn't:  In October, the USDA revised its crop forecast for corn downward by about 5% from the September forecast.  This is a nice thing to look at because it provides something of a natural experiment--a large, clear, measurable unexpected shock to the market.  This supply shock caused prices to go up nearly 10% on the same day.

Consider how large this small adjustment on quantity had on price.  Now consider that this production shock was likely due to late season weather, a temporary phenomenon.  Now consider that ethanol is a permanent shock that is about six times the size on an annual basis.

If you say you don't think ethanol is affecting prices for staple grains and soybeans, you are a fool or a knave looking to mislead.

New, small farms with young hip operators

At least anecdotally, the local and small farm movement seems to be taking hold.

In New Food Culture, a Young Generation of Farmers Emerges

...Mr. Jones, 30, and his wife, Alicia, 27, are among an emerging group of people in their 20s and 30s who have chosen farming as a career. Many shun industrial, mechanized farming and list punk rock, Karl Marx and the food journalist Michael Pollan as their influences. The Joneses say they and their peers are succeeding because of Oregon’s farmer-foodie culture, which demands grass-fed and pasture-raised meats.

 ...The Grange master, Hank Keogh, is a 26-year-old who, with his multiple piercings and severe sideburns, looks more indie rock star than seed farmer. Mr. Keogh took over the Grange two years ago. 

He increased membership by signing up dozens of young farmers and others in the region. He had the floorboards refinished, introduced weekly yoga classes and reduced the average age of Grange members to 35 from 65. 

The young farmers crowded around a table brimming with food they had produced — delicata squash, beet salad, potato leek soup and sparkling mead. On a separate table were two pony kegs of India pale ale.... 

...“Literally, four years ago, this was not happening,” Ms. Jones said, gesturing to the 30 farmers who congregated at the hall. “Now, everywhere you turn, someone’s a farmer.” 

I think we may have a better idea whether this is real or not when the 2013 census comes out. The numbers from the 2007 census convinced me of nothing.

It's hard for me to imagine how these young farmers will make it.  Some people are willing to pay more for more healthful food that is locally grown.  But my guess is that share of the market is pretty thin.  Even if the movement grows, they will find it ever more difficult to compete with large-scale agriculture donning an organic label.  This doesn't seem like the thing that's going to support very many local farms.

I hope they make it. I really do.  But I'm doubtful.

Public and Private Storage of Oil

I've been thinking and studying a lot about storage and commodity markets, mostly with regard to food commodities.  A grad student, Nam Tran, is neck deep solving stochastic dynamic programing models.  I'm pretty optimistic something good will come out of his dissertation--he's focusing on rice markets and the price spike in 2008.

Anyway, the theory for oil isn't all that different.  In the news we're seeing a lot about the US strategic oil reserve.  Obama is thinking about selling some of our reserves.  Would this be a good idea?

The thing to recognize is that the recent price spike is coming from private markets building up their own reserves.  Reserves have gone up about 4% since early January, perhaps a bit more depending on what the next report says. Markets are speculating that there may be an actual disruption of supply in the future.  If that happens, prices will spike, and so it makes sense to store a little more in anticipation of that possibility.  If that speculation is rational, markets are responding in a reasonable and efficient manner to a potential supply shock.  If the speculation is irrational--if too much is being held off the market given the potential threat to supply--a release of pubic inventories may make sense.

It does look to me like Lybia's share of the oil market is too small to pose much of threat to supply.  Other countries could easily make up a lot of the difference, and likely will in order to capitalize on higher prices while anticipating that disrupted supplies will come back online.  But then problems in the Middle East could spread much further.  This doesn't seem like the kind of uncertainty one pin down very precisely in an objective manner.  Moreover, prices haven't gone up that much.  Yet.

On the other hand, I have a hard time seeing the general point of our strategic oil reserve.  I don't know that it serves much if any social good.  This is because it's hard for me to see the market failure in private speculation and storage.  While speculative bubbles seem to have occured in other places, I haven't seen any good evidence to support their existence in commodity markets (except maybe precious metals--a very different thing).  Actually, commodity prices appear to behave in near textbook economic fashion.  So, if the US is going to dump its public reserve and get out of the oil speculation business, now seems about as good a time as any.

One good thing about recent news: the more information they provide about what they will do and the circumstances in which they will do it will help private markets store more efficiently.