Is Commodity Price Volatility Good or Bad? Wrong Question.

There's been a lot of discussion about food commodity price volatility and what governments and NGOs like the World Bank should do about it.

In principle, I don't see the question of price volatility as fundamentally different from a question about price levels.  Sellers obviously like higher prices and buyers obviously like lower prices.  But there is nothing about prices themselves that tell us whether the price is right.  Instead, economists ask questions about how the market is functioning.  Are there any externalities or other kinds of market imperfections that would cause the price level to be different from what would be if there were no imperfections?

Perhaps less abstractly, we might simply ask questions about what makes prices what they are, and whether some artificial force is keeping prices from their natural equilibrium.

The same goes for price volatility.  When someone asks whether price volatility is good or bad--or worse, assumes it's bad and prescribes a policy to control it--my knee-jerk response is that it's the wrong question. We first need to ask why prices are volatile; and, especially, are there some big market imperfections that are causing prices to be more volatile that they would be if markets were functioning well.  We simply cannot know whether prices volatility is good or bad without knowing what's causing the volatility.

Furthermore, even if some kind of imperfection is causing prices to be too volatile, we can't think cogently about reasonable policy options without knowing something about the fundamental cause.  So, asking questions about whether price volatility is good or bad really misses the point.

Here are two quick examples:

First, suppose price volatility is coming about because we've had an unusual stint of bad weather, drawing down inventories.  When inventories are low, just a little bit of news can cause prices to change a lot, since we don't have much of a buffer.  In this situation there really isn't a whole lot that can be done that would improve things.  Indeed, most anything one tries to do is likely to make matters worse and possibly make prices even more volatile.  Put another way, the rise in price and volatility is a symptom of the market trying to deal with the adverse situation.

Second, suppose price volatility has come about from a major exporter suddenly and unexpectedly placed  quota on the volume of its exports.  This would cause world prices to rise, inventories to decline, and volatility to increase, much like a stint of bad weather shocks.  Obviously this would be bad from the vantage point of total economic welfare:  the world would be willing to pay more for a unit of the commodity than producers in the exporting country would be willing to sell it.  There are mutual benefits from more trade and so we have a clear market imperfection.  The best policy response would be to convince the exporting country to drop its quota.

Yes, I realize the real world is more complicated.  And there might be some reasonable "second best" policy options for a real-world problem like an export quota that a country just won't drop.

I'm not saying I've got the answers to these more complex situations.  All I'm saying is that one cannot begin to deal with the situation without first identifying the source of the problem.  Because the prices themselves don't tell us what that problem is.