Agricultural Economics gets Politico

Update: For the record, I'm actually not against Federal crop insurance.  Like Obamacare, I generally favor it.  But the subsidies are surely much larger than they need to be for maximum efficiency.  And I think premiums could likely be better matched to risk, and that such adjustments would be good for both taxpayers and the environment.



Wow.  Frumpy agricultural economics goes Politico!

Actually, it's kind of strange to see a supposedly scandalous article in Politico in which you know almost every person mentioned. 

At issue is the federal crop insurance program.  The program has been around a long time, but its scope and size--the range crops and livestock insurable under the program and the degree to which taxpayers subsidize premiums--have grown tremendously over the last 20 years.  And the latest farm bill expands the program and its subsidies to grand new heights.

Nearly all the agricultural economists I know regard the crop insurance program (aka Obamacare for the corn) as overly subsidized.  But the issue here is not the subsides but the huge contracts received by agricultural economists moonlighting as well-paid consultants for USDA's Risk Management Agency (RMA), to help RMA design and run the insurance program.

For full disclosure: I used to work for USDA in the Economic Research Service and did some research on crop insurance.  Although, strangely, ties between ERS and RMA are thin to nonexistent. I've met and spoke to both Joe Glauber (USDA's Chief Economist) and Bruce Babcock (a leading professor of agricultural economics at Iowa State) a few times, and know and respect their work. And I used to work at NC State as a colleague of Barry Goodwin's.  I also went to Montana State for a master's degree way back, where I took courses from Myles Watts and Joe Attwood, who are mentioned in the article. I know Vince Smith from that time too.

Perhaps most importantly, some of my recent research uses some rich data resources that we obtained from RMA. But I have never received any monies from RMA.  Believe it or not, my interest is in the science, and despite having no vested financial interest in any of it, I have found myself in the cross hairs of agricultural interests who didn't seem to like my research findings.  Anyway, ag econ is a small, small world...

Okay, disclosures out of the way: What's the big deal here?  So ag economists work for RMA, make some nice cash, and then moonlight for the American Enterprise Institute to bash agricultural subsidies.  Yeah, there are are conflicts of interest, but it would seem that there are interests on many sides and the opportunistic ag economists in question seem willing to work for all of them.  They'll help RMA design crop insurance programs, but that doesn't mean they advocate for the programs or the level of subsidies farmers, insurance companies and program managers receive under them.  We observe the opposite.

I've got some sense of the people involved and their politics.  Most of them are pretty hard-core conservative (Babcock may be an exception, not sure), and my sense is that most are unsupportive of agricultural subsidies in general.  But none are going to turn down big pay check to try to make the program as efficient as possible.  I don't see a scandal here.  Really.

Except, I do kind of wonder why all this money is going to Illinois, Texas and Montana when folks at Columbia, Hawai'i, and Stanford could, almost surely, do a much better job for a fraction of  taxpayers' cost.  With all due respect (and requisite academic modesty--tongue in cheek), I know these guy's work, and I'm confident folks here at G-FEED could do a much better job.  I personally don't need a penny (okay, twist my arm and I'll take a month of summer salary). Just fund a few graduate students and let us use the data for good science.

 

Commodity Prices: Financialization or Supply and Demand?

I've often panned the idea that commodity prices have been greatly influenced by so-called financialization---the emergence of tradable commodity price indices and growing participation by Wall Street in commodity futures trading. No, Goldman Sachs did not cause the food and oil-price spikes in recent years. I've had good company in this view.   See, for example, Killian, Knittel and Pindyck, Krugman (also here), Hamilton, Irwin and coauthers, and I expect many others.

I don't deny that Wall Street has gotten deeper into the commodity game, a trend that many connect to  Gorton and Rouwenhorst (and much earlier similar findings).  But my sense is that commodity prices derive from more-or-less fundamental factors--supply and demand--and fairly reasonable expectations about future supply and demand.  Bubbles can happen in commodities, but mainly when there is poor information about supply, demand, trade and inventories.  Consider rice, circa 2008.

But most aren't thinking about rice. They're thinking about oil.

The financialization/speculation meme hasn't gone away, and now bigger guns are entering the fray, with some new theorizing and evidence.

Xiong theorizes (also see Cheng and Xiong and Tang and Xiong) that commodity demand might be upward sloping.  A tacit implication is that new speculation of higher prices could feed higher demand, leading to even higher prices, and an upward spiral.  A commodity price "bubble" could arise without accumulation of inventories, as many of us have argued.  Tang and Xiong don't actually write this, but I think some readers may infer it (incorrectly, in my view).

It is an interesting and counter-intuitive result.  After all, The Law of Demand is the first thing everybody learns in Econ 101:  holding all else the same, people buy less as price goes up.  Tang and Xiong get around this by considering how market participants learn about future supply and demand.  Here it's important to realize that commodity consumers are actually businesses that use commodities as inputs into their production process.  Think of refineries, food processors, or, further down the chain, shipping companies and airlines.  These businesses are trying to read crystal balls about future demand for their final products.  Tang and Xiong suppose that commodity futures tell these businesses something about future demand.  Higher commodity futures may indicate stronger future demand for their finished, so they buy more raw commodities, not less.

There's probably some truth to this view.  However, it's not clear whether or when demand curves would actually bend backwards.  And more pointedly, even if the theory were true, it doesn't really imply any kind of market failure that regulation might ameliorate. Presumably some traders actually have a sense of the factors causing prices to spike: rapidly growing demand in China and other parts of Asia, a bad drought, an oil prospect that doesn't pan out, conflict in the Middle East that might disrupt future oil exports, and so on.  Demand shifting out due to reasonable expectations of higher future demand for finished product is not a market failure or the makings of a bubble.  I think Tang and Xiong know this, but the context of their reasoning seems to suggest they've uncovered a real anomaly, and I don't think they have.  Yes, it would be good to have more and better information about product supply, demand and disposition.  But we already knew that.

What about the new evidence?

One piece of evidence is that commodity prices have become more correlated with each other, and with stock prices, with a big spike around 2008, and much more so for indexed commodities than off-index commodities.

This spike in correlatedness happens to coincide with the overall spike in commodity prices, especially oil and food commodities.  This fact would seem consistent with the idea that aggregate demand growth--real or anticipated--was driving both higher prices and higher correlatedness.  This view isn't contrary to Tang and Xiong's theory, or really contrary to any of the other experts I linked to above.  And none of this really suggests speculation or financialization has anything to do with it.  After all, Wall Street interest in commodities started growing much earlier, between 2004 and 2007, and we don't see much out of the ordinary around that time.

The observation that common demand factors---mainly China growth pre-2008 and the Great Recession since then---have been driving price fluctuations also helps to explain changing hedging profiles and risk premiums noted by Tang and Xiong and others.  When idiosyncratic supply shocks drive commodity price fluctuations (e.g, bad weather), we should expect little correlation with the aggregate economy, and risk premiums should be low, and possibly even negative for critical inputs like oil.  But when large demand shocks drive fluctuations, correlatedness becomes positive and so do risk premiums.

None of this is really contrary to what Tang and Xiong write.  But I'm kind of confused about why they see demand growth from China as an alternative explanation for their findings. It all looks the same to me.  It all looks like good old fashioned fundamentals.

Another critical point about correlatedness that Tang and Xiong overlook is the role of ethanol policy.  Ethanol started to become serious business around 2007 and going into 2008, making a real if modest contribution to our fuel supply, and drawing a huge share of the all-important US corn crop.

During this period, even without subsidies, ethanol was competitive with gasoline.  Moreover, ethanol concentrations hadn't yet hit 10% blend wall, above which ethanol might damage some standard gasoline engines.  So, for a short while, oil and corn were effectively perfect substitutes, and this caused their prices to be highly correlated.  Corn prices, in turn, tend to be highly correlated with soybean and wheat prices, since they are substitutes in both production and consumption.

With ethanol effectively bridging energy and agricultural commodities, we got a big spike in correlatedness.  And it had nothing to do with financialization or speculation.

Note that this link effectively broke shortly thereafter. Once ethanol concentrations hit the blend wall, oil and ethanol went from being nearly perfect substitutes to nearly perfect complements in the production of gasoline.  They still shared some aggregate demand shocks, but oil-specific supply shocks and some speculative shocks started to push corn and oil prices in opposite directions.

Tang and Xiong also present new evidence on the volatility of hedgers positions. Hedgers--presumably commodity sellers who are more invested in commodities and want to their risk onto Wall Street---have highly volatile positions relative to the volatility of actual output.

These are interesting statistics.  But it really seems like a comparison of apples and oranges.  Why should we expect hedger's positions to scale with the volatility of output?  There are two risks for farmers: quantity and price.  For most farmers one is a poor substitute for the other.

After all, very small changes in quantity can cause huge changes in price due to the steep and maybe possibly backward-bending demand.  And it's not just US output that matters.  US farmers pay close attention to weather and harvest in Brazil, Australia, Russia, China and other places, too.

It also depends a little on which farmers we're talking about, since some farmers have a natural hedge if they are in a region with a high concentration of production (Iowa), while others don't (Georgia).  And farmers also have an ongoing interest in the value of their land that far exceeds the current crop, which they can partially hedge through commodity markets since prices tend to be highly autocorrelated.

Also, today's farmers, especially those engaged in futures markets, may be highly diversified into other non-agricultural investments.  It's not really clear what their best hedging strategy ought to look like.

Anyhow, these are nice papers with a bit of good data to ponder, and a very nice review of past literature.  But I don't see how any of it sheds new light on the effects of commodity financialization. All of it is easy to reconcile with existing frameworks.  I still see no evidence that speculation and Wall Street involvement in commodities is wreaking havoc.

Adaptation with an Envelope

Economists like to emphasize how people and businesses will adapt to climate change.  On a geological scale the world is warming very fast.  But on a human scale it is warming slowly, so we can easily adjust infrastructure and management decisions to the gradually changing climate.  For example, in agriculture farmers can gradually adjust planting times, cultivars, and locations where we grow crops, and so on.

So how much does adaptation really buy us?  As it turns out, probably very little, at least in most contexts. 

Since it is economists who often emphasize this point, sometimes even intimating that otherwise negative impacts could turn positive with adaptation, perhaps we should pause for a moment to consider what basic microeconomic theory says about it.  And we have a ready-made tool for the job, called the envelope theorem (or here), that provides essential insight.

I'll try to make this intuitive, but it helps to be a little formal.  Suppose agricultural yield is:

$ y = f(x, r) $

where $r$ indicates climate and $x$ represents farmers' decisions.  I'm just using notation from a generic case in the second link above.

Farmers' decisions are not random.  With time and experience, we should expect farmers to optimize decisions for their climate.  Call these optimal decisions $x^*(r)$.  So, the outcomes we observe in practice are

$ y^* = f(x^*(r), r) $

Now, to obtain a first-order approximation of the effect of climate change on yield, we need to find $\frac{dy^*}{dr}$, which is just a fancy way of saying the marginal change in observed yield for a small change in climate.  Multiply this marginal change by the total change in climate (the change in $r$), and we get a first-order approximation to the total impact.

If you've taken basic calculus, you learned the chain rule, which says that:

$\frac{dy^*}{dr}  =  \frac{df}{dx} \frac{dx}{dr} +  \frac{df}{dr}$

If the farmer is optimizing, however,  $ \frac{df}{dx} = 0 $.  The farmer cannot improve yield outcomes by changing decisions, because s/he's already optimizing.  So

$ \frac{dy^*}{dr} =   \frac{df}{dr} $

And this gives the heart of the envelope theorem: to a first approximation, we don't need to worry about changes in behavior ($\frac{dx}{dr}$, or adaptation) to evaluate the effect of a change in climate on output.  The fact that behavior is already optimized means that behavioral adjustments will be second-order.

Here's an illustration of the math from lifted from the link above. The black and blue curves hold farmers's decisions fixed at different levels of $x$, optimized at each $r$  The $f^*(r)$ ( or $y^*$) we observe is the "upper envelope" of the all the blue and black curves with different, optimized levels of $x$.

Now, if $f^*(r)$ is highly nonlinear, and we are contemplating a very large change in climate, then adaptation will come into play. But even then it's probably not going to be a primary consideration.

I don't expect this basic insight, drilled into every economist during their first year of grad school (and even some undergraduates), will stop some economists from over-emphasizing adaptation.  But our own basic theory nevertheless indicates it is a small deal.  And it seems to me that the evidence so far bears this out just as clearly as the theory does.

Devise a better net-metering agreement for residential solar

A question for my undergraduate environmental economics students:

Navigate to http://www.uhero.hawaii.edu/news/view/274 and read about the costs and benefits of installing PV, from a household's perspective and from Hawaiian Electric's. Play around with the interactive calculator. Dick Rosenblum, the CEO of Hawaiian Electric, often complains about net metering agreements because homeowners get retail prices instead of wholesale prices for the energy their panels generate. (Also see this article by energy economist Severin Borenstein.) 

As the UHERO blog post points out, a side effect from current net metering agreements is that households over-install solar. As a result, they often pay a zero marginal price for electricity, which discourages conservation. 

Devise a different model for net metering agreements that can address both Dick Rosenblum's complaints and restore incentives for households with solar to conserve energy.

Feel free to help my students out by suggesting answers in the comment section ;-)

Pushing the limit of solar in Hawai'i

Sorry for the radio silence.  Way too much going on.

However, I am doing a little blogging for UHERO, focusing on Hawai'i's interesting electricity situation.  We have the highest electricity prices in the country, about 3.5 times those on the mainland.  That fact coupled with tax credits and a lot of sunshine has given us more solar penetration, by far, than anyplace in the country.  Most statistics you'll find tend to be a bit dated---there's more penetration here than most people know, and it's pushing the limit of our grid.

Anyhow, below are links to my first two posts about the situation.  More to come soon, I hope.

Is Monopoly a Barrier to Hawai'i's Ascent?

Why are Hawai'i's Electricity Prices So High?

Not fit to print, but why?

A brief follow up to my post the other day about the disasterous NY Times article by David Kocieniewski.

Flex Salmon and Jayson Lusk, among others, have written similar and more detailed pieces detailing Kocieniewski's reporting slight of hand.  I really thought this sort of thing was beneath the NY Times.  The editors there certainly deserve some of the blame.

Journalistic malfeasance aside, where is this attack coming from?  Why does Kocieniewski and NY Times go to such great lengths to attack two relatively innocuous academic economists?  Why do they seem to have a bee in their bonnet about commodity price speculation?

I don't know the answers to these questions.  But I'm wondering if momentum on financial regulatory reform may be a bit less innocent that Paul Krugman seems to think. Some might note that the Mike Konczal article that Krugman references mentions the heavy influence of Gary Gensler, chairman of the Commodity Futures Trading Commission.  I wonder if old powerful commodity interests may be an unlikely ally of Elizabeth Warren in the fight to regulate Wall Street banks more tightly.  The commodity groups aren't fans of regulation, and I doubt they share Warren's concern for consumers and market stability.  But presumably they don't like growing competition from Wall Street.  There would seem to be big private interests that favor financial reform.

Yes, I'm reading tea leaves here.  Does anyone have better insight?