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.

Matthew Kahn has a more optimisitic view

I guess Wolfram Schlenker and I have become the modern day Malthusians and doomsayers when it comes to potential impacts of climate change on agriculture.  I often try to emphasize that we are not in fact doomsayers; we are simply laying out the range of possibilities, and show strong evidence that the downside is indeed bad.   But we also maintain that there is room for adaptation in ways we cannot yet model or cannot yet anticipate.  We're a long ways from Malthusians--he had a different kind of doom in mind and was much more certain about it that we are. Uncertainty is large.   But, as Brad Delong often points out (and with whom I agree on this point), uncertainty is not our friend when it comes to climate change.

Matthew Kahn, esteemed professor at UCLA, leading specialist in environmental economics, and author of the new book Climatopolis, recently wrote about our work and offers a more optimistic view.  He argues that our work provides a clear incentive for innovation.  It shows us that we need more heat tolerant crops and that those who invent such crops will profit from inventing them. Thus, pointing out such potential problems lets us "escape" from the impending catastrophe.

Maybe Kahn is right.  I believe similar credible arguments have been made about past doomsayers: they showed the then-current paths to be unsustainable and thereby allowed our society to avoid the doom they had once prognosticated.  Maybe Rachel Carson made our water cleaner.   Maybe worries about resource shortages in the 50s and 60s pushed Norman Borlaug to foment the Green Revolution.

But what if it's not possible.  What if growing enough grain at low enough cost to feed a world with as much income inequality as we will surely have is not physically possible.  What if it's as difficult to grow crops in 33+ C temperatures as it is to currently grow crops in Siberia?

Human innovation and technological change has been stupendous.  But also quite varied.  In some ways productivity grows at seemingly interminable exponential rates, as Ray Kurzweil likes to emphasize.  But somethimes innovation looks like innovation in battery technology--stubbornly slow and halting.  Erk.

It is also important to note that some of the human response to social problems like pollution comes from policy. Libertarians often point out how much cleaner our air and water in the US are today compared to 30 or 40 years ago, which is true.  But at least some of that improvement surely came about from the Clean Air and Clean Water Acts.

So.  Maybe Kahn is right and we shouldn't worry about climate change. The problems will take care of themselves.

The question you may want to ask yourself is: Do you feel lucky?

Coping with High and Volatile Food Prices

So high and volatile food prices may be with us for awhile.  What should we do about it?

At the end of my Room for Debate column I wrote:

The best immediate response to these problems would be to reduce barriers to international agricultural trade, and to develop mechanisms to protect the world’s most vulnerable from inevitable price spikes. Such protections, if credible, might convince markets that crude market interferences like export bans were less likely, which would reduce speculative inventories and prices today.

Economists almost always favor free trade.  I'm not quite as ideological about this as the headline "Open Up Trade" may have suggested (NYT chose the titles).  But in this case I think free trade is the right answer, but with an important caveat:  I think the international community (UN, FAO, rich nations, etc.) need to develop a clear, credible, anticipatory mechanism for delivering aid, perhaps in the form of food subsidies, for the poorest people in the most vulnerable places in the event prices do spike.

What I'm suggesting here is a form of market intervention.  Call it a conditional cash transfer that depends on food price levels.  Such commitments from the international community might be offered in exchange for commitments not to interfere with trade in other ways, like tariffs, export quotas, taxes or bans.  I think these kinds of conditional transfers would be a more efficient way of dealing with the problem than other policies being suggested, like public storage projects.  And they would likely have fewer unintended consequences.

For example, I worry that public storage projects would be managed in erratic and unpredictable ways, and thus attract private speculators and storage in addition to public storage, no matter the size of public storage projects.  The more we store, the more eventually spoils, which ultimately means higher average prices.   And in the process of building up public inventories we would effectively be increasing demand even more.  This would be an easy thing to screw up and make the food price problem worse than it is already.

Furthermore, I don't perceive any evidence that commodity markets are storing in insufficient quantities.  Indeed, commodity markets look remarkably efficient to my eyes.

Now, by guaranteeing low food prices for the poor we would, in effect, cause demand to be artificially  more inelastic than it is already.  Thus, guarantees could, indirectly, cause larger price spikes.  I believe private markets would quickly recognize this and respond by developing larger inventories on their own--a speculative bet that would pay off when price spikes do happen (and they *will* happen).  Guarantees for the poor would mean that prices would have to rise to the point where the relatively more wealthy would have to reduce quantity demanded.  But the relatively wealthy can afford it.  We can find other things to eat besides grain fed beef and chicken.

Most importantly, however, such a policy might do a lot to stave off the most destructive policies, like export bans.

Right now, this is the best idea I have.

Debating Food Prices at the New York Times

We're live at the Room for Debate:

Bad weather is clearly influencing food commodity prices. So is demand growth, most notably from rapidly emerging economies like China, where people like grain-fed meat and dairy products as much as we do, and many now have incomes to afford them. Then there is the increased demand from subsidized and mandated ethanol production.

Price spikes like the current one can and will happen regardless of whether the climate has changed or will change. It is just the nature of these kinds of markets: bad weather shocks draw down inventories, which make prices higher and more volatile. A few good weather years could replenish inventories and bring prices back down.

Thankfully, rice prices haven’t spiked -- yet. Historically, market forces have caused spikes in rice prices to follow those of corn, soybeans and wheat. These four crops provide the caloric basis for most food worldwide.

Here in the U.S., we won’t notice high commodity prices in the price of food we buy at stores and restaurants. The price of our food is comprised mainly of the labor involved in processing, transporting and marketing. Indeed, this fact helps explain why commodity prices can increase so much so fast -- we’ll buy little less even if commodity prices double or triple from current levels.

High commodity prices matter mainly for the two billion or so living on $2 a day or less and spend the bulk of their income on food. Some of these people will buy less food as prices rise, because they simply won’t be able to afford as much. I wouldn't be surprised to see more civil conflict as more people go hungry.

Productivity growth will need to accelerate from historical trends to keep up with F.A.O.’s predictions for population and income growth. If it doesn’t, prices will trend higher, perhaps a lot higher.

Markets must be worried that the weather shocks we have recently experienced are not transitory, but rather tidings of more permanent and significant changes. Climate models predict that extreme weather events, like the ones recently experienced in Australia, Russia, the United States and China, and potentially much worse, will begin happening with greater frequency, and possibly much sooner than many people expect. Looking ahead, we need to start dealing more realistically with the risks posed by climate change.

The greatest hopes against truly catastrophic declines in crop production are a possible boost from CO2 fertilization and improved productivity through breeding or genetically modified crops. But there is increasing skepticism that these factors can compensate for the negative effects of a warmer climate and growing demand.

Trade restrictions remain pervasive and help to keep commodity prices high. Recent research by Jeffrey Reimer and Man Li indicates prices could fall by 57 percent if all countries were as open to trade as the United States. Particularly acute examples, like the recent ban of wheat exports by Russia, India’s rice export ban in 2008 and subsequent Philippine hoarding, can greatly exaggerate the effects of weather shocks on world prices. Such policies likely come about from efforts to keep food affordable for a country’s most disadvantaged. Their ultimate effect, however, is to keep food prices higher worldwide, and make more people hungry. To make matters worse, market speculators likely hold greater inventories in anticipation of possible future export bans or hoarding.

The best immediate response to these problems would be to reduce barriers to international agricultural trade, and to develop mechanisms to protect the world’s most vulnerable from inevitable price spikes. Such protections, if credible, might convince markets that crude market interferences like export bans were less likely, which would reduce speculative inventories and prices today

My piece was a lot longer than they requested, and they still kept nearly all of it with only minor and helpful edits.  The one key piece that was cut in editing was my dig at those tying to tie commodity price increases to monetary policy and fears of broader inflation.  One of the links makes that point, so I guess that's okay.

The first debater, Raj Patel, makes no sense to me whatsoever.  Knorr seems thin.  But I see little to disagree with from anyone else.

Update:   To the tireless inflation mongers out there:  Today is different than the 70s.  There's more than I have time to get into at the moment, but the two big differences are:

1) Commodity prices make up a much smaller share of our economy today than they did back in the 70s.  The one place to look at to see this is energy consumption expenditures as a share of the economy.  That's the big one, and it's still much smaller today.  Food commodities were trivial back then and are much smaller now.

2) Unemployment.  It's higher today than when prices spiked in the 70s while the natural rate is probably lower.  If you think wages are going up any time soon in this country you are smoking some really strange grass.  Without a wage-price spiral, we're not going to have inflation.

If you don't believe me, then by all means, go short on traditional treasuries and long on inflation-indexed treasuries, and if you're right and I'm wrong, wake up next year a very rich man or woman.

I think the market has this about right: historically low inflation for the next 5 years or so.  Which is too bad. I think a bump up in inflation to 3, 4 or 5 percent would do our economy a heck of a lot of good.

It's not about us.  Really.  It's about poorest 1-2 billion in the world, and those folks don't live in this country.

The price of cotton in your shirt

Yesterday the near month futures price of cotton closed at $1.83/lb.  That's pretty high, more than double the price of just a year ago.  Before this year, I'm not sure cotton prices ever exceeded $1.20.  But that's in nominal dollars. Adjusted for inflation cotton prices were a good clip higher back in the early 80s.

How much do these high prices matter for the prices we pay for clothes?

Not so much.  Consider that there is about 0.6 lbs. of cotton in a typical man's shirt.  So that $1/lb increase in cotton prices over the past year means it costs an extra 60 cents to make the Brooks Brothers shirt for which I paid $40.  On sale.

Would it be so hard for the news media to put this kind of perspective on things?

Aw shucks, Hoss... It's so much more fun stoking inflation fear and general hysteria.

Take the New York Times, for example, one of our last and best shining stars of high-quality media.
Stephanie Clifford, Mokoto Rich and William Neuman:

A package of Oscar Mayer cold cuts. A pair of Nine West boots. A Whirlpool washing machine.

By the fall, people will most likely be paying more for each of them, as rising prices hit most consumer goods, say retailers, food companies and manufacturers of consumer products.

Cotton prices are near their highest level in more than a decade, after adjusting for inflation, and leather and polyester costs are jumping as well. Copper recently hit its highest level in about 40 years, and iron ore, used for steel, is fetching extremely high prices. Prices for corn, sugar, wheat, beef, pork and coffee are soaring. Labor overseas is becoming more expensive, meanwhile, and so are the utility bills to keep a factory running.

“There are cost pressures from virtually everywhere,” said Wesley R. Card, the chief executive of the Jones Group, whose brands include Nine West and Anne Klein. After trying to keep retail prices flat or even lower during the recession, Jones says prices for its brands will climb 15 to 20 percent by autumn.

When commodity prices started to rise last summer, many manufacturers and retailers absorbed the costs, worried that shoppers would not pay higher prices during the competitive holiday season or while the economy was still fragile.

Many big companies, including Kraft, Polo Ralph Lauren and Hanes, say they cannot hold off any longer and must raise prices to protect some profits..... 

I don't think so.  Especially not for name brands like these.  They have a lot of market power and the profit maximizing thing for them to do is to absorb much of this (quite modest) cost increase.  The price of my Brooks Brothers shirt will probably go up less than 60 cent cost increase from higher cotton prices.

Their nod to reality-based journalism comes at the bottom of page one.

The cost of raw materials accounts for a small portion of the cost of most consumer goods, as labor, processing and packaging tend to make up a larger share of the price at the cash register. Foods like coffee, meat and milk, which are closer to raw materials, will probably show some of the biggest price jumps.

But no facts to put this in perspective.  Too little, too late.

There is, in fact, another and far more plausible reason why firms will raise prices this year: increasing demand.  Especially for brand-name companies like the ones mentioned in this article, prices will be more sensitive to demand than they are to cost.  They've probably been holding down prices due to the recession.  Now that we're recovering (albeit slowly), demand is somewhat higher and they can raise prices a bit.

Update: A lot more on commodity prices here.

Climate Change and Elasticity

 Elasticity---the responsiveness of production and consumption to price---is important to keep in mind when thinking about potential climate change impacts on agriculture.  Sadly, much of the profession doing empirical work on potential climate impacts seems to ignore this part of the equation.  I'm thinking particularly of this paper and this paper, both of which have other issues (see here and here).

On a global scale, supply and demand of staple commodities are highly inelastic.  Demand is inelastic mainly because commodity expenditures comprise a small share of the price of most consumption goods. Supply is inelastic because there's only so many places where it makes sense to grow certain crops. As a result, commodity prices can be very sensitive to shifts in supply or demand.  If climate change causes a big inward shift in supply, it could cause a huge loss in consumer surplus.  But if climate change were to cause a big outward shift in supply, the welfare change would be modest.

This is a key reason why uncertainty with climate change matters: the potential downside is so much bigger than the potential upside.

Sadly, what we often see from economists are references to the tiny share of agriculture in world GDP Thomas Schelling is a famous example (he makes good points about the bargaining problem). But GDP is no welfare measure.  And the difference between GDP and welfare is going to be large, mainly because it doesn't count a huge consumer surplus.

Elasticity and Climate Change
Now, it is true that a lot of the loss in consumer surplus will be offset by gains to producer surplus.  The U.S., with its large land base, excellent soils and climate, produces and exports more than anyone else in the world.  A doomsday scenario for food production doesn't look so bad for us--we'd be the ones gaining a lot of that producer surplus.

But in other places, particularly in certain developing countries with large urban populations, demand is not quite as inelastic. This is because the urban poor spend a large share of their income on staple food commodities, and when prices change a lot, it changes their real incomes a lot, and they spend less. So a lot of the loss in consumer surplus is likely to land on the people who most value that surplus---a dollar of surplus to a typical person in India is worth a lot more than it is to us.

A contemporary case in point: As I recall, Egypt imports about half its wheat and about half the people live on $2/day or less.  Today's high wheat prices must be doing a lot of damage to their real incomes.  And they are letting the world know about it.

Update:  I'm not the only one thinking about commodity elasticities.  I think I posted mine first. But the other guy always puts things much better than I do...

Update 2:  Krugman made this issue a headline column.  He's basically outlined my current research agenda. 

Why hasn't the price of meat gone up?

On an earlier post someone asked:  Why, with commodity prices so high, hasn't the price of meat gone up?

I have two basic answers.

1) Meat, especially if we're talking about meat you buy in the grocery store, is ultimately derived from commodities like corn and soybeans, which are the primary source of animal feed.  But there are a lot of steps involved with raising the animals and processing and marketing them.  So the price of meat, like most everything else we buy, is mostly made up of labor costs along that chain, not the price of the raw material inputs.  This is why we here in rich countries hardly perceive the effects of rising commodity prices (except maybe for gas), but folks in places like Egypt who are living on $2 day can feel the higher price of wheat in a way we just cannot comprehend.

2) There can be a long lag between the time when corn and soybean prices rise and meat prices rise.  In fact, in the short run, meat prices can fall because meat producers, squeezed by higher input costs, are forced to liquidate their inventories.  That is, take their breeding stock to the slaughterhouse.  Thus, in the short run prices may fall as the market is flooded.  But in the longer run, with a smaller breeding stock, the supply of meat shifts in, ultimately driving up meat prices.  The opposite can happen when commodity prices fall, since meat producers must reduce supply in the short run in order to increase breeding stock and supply in the long run.  The key issue here is that animals are both a consumption good and capital, which can give rise to cattle cycles.

Update: I don't follow meat markets as much, but I just took a gander and noticed that while live animal prices haven't gone up as much as other commodities, they are up.  But frozen pork bellies are up a lot.  What's the difference?  Frozen pork bellies, like basic grains, are storable, which allows anticipated higher future prices to be realized right here and now.

Commodity price rises are fundamental, not monetary

I liked Paul Krugman's column today.

One thing he did not exactly say but I wish he had:  Commodity price rises have little to do with monetary and currency policies in the US and around the world.  To the extent that they are connected, they are connected through the market's attempt to correct long-held imbalances, particularly China's undervalued currency.  China's inflation is the market fighting that undervaluation, and that inflation is helping to spur demand for commodities.  But what's important to note is that the underlying demand is fundamental: it would have been there long ago except for China's past suppression of it through currency policy.  By the same token, China's inflation is helping to balance our trade deficit.

We'd be wise to think about possible collateral damage of higher commodity prices, since I suspect high prices could be here to stay.  But this really should have no bearing on monetary policy.

Commodity prices and speculation, again

The other week I got a list of questions from a journalist at China's Life Week, which is presumably the country's biggest news magazine.

The journalist asked:

1.     The U.N. Food and Agriculture Organization's index of world food prices rose 32 percent in the second half of 2010, topping the peak of June 2008. In your analysis, what are the major reasons for such a great increase in a short time?

2.       In your analysis, how much does the food speculation influence current high food price?

3.       Money began to be taken out of the index funds in the couple of months before food prices began to fall dramatically in mid-2008. What about the situation in 2010? If the moneys pour into the field again, why?

4.       In the past 2 years after food crisis in 2008, how did the biofuel develop around the world?

5.       In your analysis, how much does biofuel influence current high food price? How?

6.     U.S. government makes great effort to develop biofuel. What are the government’s concerns?

7.    A EU-World Bank analysis of the causes of the 2007-2008 food price crisis blames energy prices and financial speculators for the hikes. Will the same situation happen in 2011? Is there any difference between the situation in 2008 and now?

I was busy at the time and so a bit late in my replies, which were as follows:

1. I think prices are rising mainly in response to increased growth and demand in the Southern Hemisphere and Asia, but particularly from China.

2. Speculation is an important part of commodity prices, but as far as I can tell, only in good ways. For example, if the market expects demand to rise in the future, prices may go up today, since some of today's production will be placed in inventories in anticipation of higher future demand.  Without speculation, we wouldn't have markets trying to maneuver production from times when it is less valued to times when it will be more valued.

Note that speculation does not necessarily imply a speculative bubble.  I do not think there is a speculative bubble in commodities, nor do I think has been one in recent history.  I agree with the likes of Paul Krugman who has pointed out several times, that for there to be a speculative bubble in commodity prices, there needs to be a general buildup in inventories.  We have not seen such a buildup in inventories.  It's been quite the opposite: prices have gone up in response to declines in inventories.  This is what happened in 2008 as well.

3.  I don't think the money coming out of index funds has anything to do with commodity prices.

4 & 5  I think biofuel demand, artificially stimulated by government subsidies, was a big factor in the 2008 rise and one factor keeping prices high today. In my work with Wolfram Schlenker (currently under revision for the American Economic Review) we find the *long run* effect of the biofuel demand on the world's major staple commodity prices is on the order of 20-30 percent.  But in the short run, the spike could have been larger.  It also had the effect of drawing down inventories which made market prices far more susceptible to temporary weather or other kinds of shocks.

6. I think U.S. biofuel policy is misguided, mainly for the reasons outlined in 4&5--these costs to the world, especially the world's poorest, are just too high.  Also, I'm very skeptical that biofuels actually reduce CO2 emissions.  The one benefit I see is that by subsidizing ethanol it may lead to innovation of other biofuels that make more sense.  I hope that happens.  Still, if that is the goal, a better policy would be to directly subsidize research and development, not production of the fuel itself.

7. Energy prices were a big part of the 2008 price spike, mainly due to the ethanol link.  Speculation was not, as described above.  Another big factor was global demand growth, much like it is today.  For most of the last 75 years, growth in crop yields was faster than demand growth.  That's no longer the case.  Demand is growing faster than supply, and so prices are rising.  It's hard to see what will reverse the new trend.

Today Krugman writes about commodity prices and makes some similar points.  But I didn't know about the cotton hoarding in China.  That may or may not be rational speculation--I just don't feel I know enough to venture a guess.

A different kind of commodity price boom

The other day I wrote that even blind optimism doesn't imply declining resource prices.  Let me try to flesh that idea out a little.

A key idea in natural resource economics, called Hotelling's rule, says that non-renewable resource prices (oil, natural gas, coal, etc) should rise at about the rate of interest. The basic idea is that natural resources held in the ground and not sold need to earn a fair return, just like any other asset.

That hasn't happened.  The long-run trend has been flat or downward (the last few years exempted).

Most economists have argued that the reason prices haven't increased is because extraction costs have declined.  There have also been some complicated stories about depletion effects on extraction costs.  These cost-related factors are very important for individual extracting firms, and may explain falling prices for a little while.  But costs cannot really reconcile broad resource price trends with Hotelling's rule, which actually holds up pretty well, even with complex cost functions and rapid technological change (see this paper for technical detail of this important yet obscure and often overlooked point).

In my rapidly aging (and unpublished) dissertation, I argued that a key reason prices haven't trended up is because prices have covaried negatively with the stock market and the aggregate economy.  Here are two illustrations of this phenomenon from this (also obscure) article of mine with Peter Berck: the long-run relationships oil price changes and coal price changes with returns of the S&P 500, both adjusted for inflation.

This suggests holding oil is a negative beta asset.  Negative beta assets are quite unusual.  Such assets are more like insurance than stock market bets, because they pay off most in bad times rather than good times.  This means they have negative risk premiums, not a positive one like stocks.  With a modestly negative adjustment for risk, Hotelling's interest rate may have been zero.

If that's been the case, it's an easy way reconcile the historical trend (or lack thereof) with the basic theory.  But it's also quite possible that non-renewable resources are no longer negative beta assets.  Today it seems commodity prices are moving up as the stock market and world economy move up. Prices are rising most in response to unexpectedly high growth, especially in Asia.  This is a sharp contrast to past price shocks that have been driven by supply shocks or fear of impending shocks.

If natural resources are now positive-beta assets, like stocks, Hotelling's rule predicts prices will start trending up, perhaps more then ever before.  But that's not a prediction of impending doom, at least not for the developed world.  It just means there's more uncertainty about aggregate growth than there is about natural resource supply.

I do worry, however, about rising food prices.  Not that this will much affect world GDP growth or the lives and livelihoods of most in the developed world--we'll hardly notice.  Really.  But the poorest third of the world, especially those living in urban places, cannot be happy at all about today's corn, soybean, wheat and rice prices....  But that's a different story.

Tyler Cowen on Resource Prices

Even a Libertarian thinks resource prices may rise:

How robust are Julian Simon's predictions?

Not the ones about population, the ones about falling real resource prices.
Here is a simple model: it is easier to transfer technologies of resource extraction than it is to transfer most other technologies.  In other words, Nigeria has low TFP but still their oil rigs work pretty well.
If that's true, when the wealthiest economies are opening up a commanding lead in terms of living standards, real resource prices should be falling.  Nigeria can supply a lot of oil without demanding very much.
When most of the growth is catch-up growth, the poor countries demand more resources but supply technologies are not racing so quickly ahead.  Real resource prices are more likely to rise.
There is a long history of falling real resource prices, but is this simply reflecting the fact that the last three hundred years don't offer many periods of catch-up growth?  Now, an era catch-up growth seems to be upon us.  So why should we be so confident that Simon's predictions will continue to hold?

One doesn't need to be a Malthusian to think resource prices will rise.  In fact, it's quite the opposite.

This is somewhat related to the thesis of my dissertation: For a long while perhaps the greatest uncertainty with resource prices had to do with supply, either physically or in its distribution.  Today it seems a lot of the uncertainty is demand driven, stemming from uncertainty about growth in South America, Asia and possibly (hopefully) Africa.  When demand uncertainty is greater than supply uncertainty, natural resource prices are likely to be positive beta assets.  By this I mean prices will rise most following good news, like more growth in the catch up countries than expected.  This is quite the opposite of past price spikes, which were linked to bad news about supply, say an embargo or war in the Middle East, which had made resources negative beta assets.

According to Hotelling's rule, to a first approximation, prices of nonrenewable resources should go up at the rate of interest. So, now with likely positive betas and higher risk-adjusted rates of return needed for resource investments, prices are likely to go up a lot more.  When resource prices had negative betas, that risk-adjusted interest rate may have been close to zero.  Today it's looking quite positive--yet another reason resource prices are likely to rise.

Why Julian Simon was so convinced of ever decreasing prices, I do not know.  It just doesn't fall out of the basic economics.  I'm not even sure it follows from blind optimism.

The Right Graph Makes All the Difference

I'm a huge proponent of the idea that the right graphical presentation of data makes all the difference.  Our eyes interpret mathematical data much better than reading numbers could, even if you're a mathematician.  Sometimes graphs can lie, like statistics, but the the lie is usually easier to spot.

Case in point: A graph of the log income distribution and why the rich don't feel so rich, via Catherine Rampbell (always awesome), Brad Delong and Paul Krugman.

I've read zillions of statistics and have seen a lot of excellent graphs on the income distribution. But this really brings it home in a salient way.  Indeed, I hadn't even realized the graph of log income looked like this.  And I've seen the data a lot of times in a lot of ways.

People usually hang out with people more-or-less like themselves, in terms of income and other demographics.  Now, if you make 250K/year, it's likely that a lot of your friends make twice as much or more than you do.  That's a lot less likely if you make just 50K a year.  So, if you're judging your income and wealth relative to your friends, you may feel much worse at 250K than you do at 50K.  Or maybe even 25K/year.

Update: If you're not familiar a natural log scale, one point difference on the vertical axis, say 9.5 to 10.5, indicates a doubling of income. Also, a single "tax unit" is basically household filing a tax return.

Some say the rise in income inequality is all about education.  The convexity of that graph at the upper tail tells me there's a lot more to the story.

So, I'm about to give my first lecture this semester to principles of economics students, and to tell them about the tradeoff between efficiency and equality.  But these days I wonder if we can't have at least a little more of both efficiency and equity, at least as measured in utility.

Update: This also seems to help make sense of the finding in the psychological literature that suggests households with about 75K of income are happiest.  Clearly, more income is better all else the same. If you have much below 75K you're, well, poorer, but the relative distribution of wealth nearby isn't much different than if you made 75K.  If you go much above 75K, you're likely drooling with envy at some proportionately much, much richer friends and acquaintances, which takes away a lot of thrill of being richer.

Food fights, price bets, and the difference between linear and exponential trends

Dot Earth just did a nice piece on my recurring focus:  Food commodity prices.  I found it from a link via Paul Krugman.

The long trend down in commodity prices has come about through tremendous, technology-induced growth in crop yields.

What is often overlooked, however, is that that yield growth, while impressive, has been linear.  Demand growth, in contrast, has been exponential, or at least rapidly accelerating.  For the last 70 years, the rate of yield growth has generally exceeded the rate of demand growth.  But that accelerating demand growth has now caught up and surpassed yield growth.  And so now prices are rising, not falling.

So, it's just not enough to point to historically falling prices and say that's going to continue.  Show me how yield growth is going to start accelerating like demand growth.  Show me how we're really going to do that and deal the detrimental effects of climate change.

The more I look at the specifics, the more I think progressively higher commodity prices are in our future.

Prospects of higher prices will surely induce greater efforts at innovation and land expansion.  But we've already tapped the low hanging fruit.  I'm an economist and I think supply curves slope up.  Prices are going to rise.

US Corn Yield, 1980-2010

This is a super simple plot of yields from the world's most successful crop: US corn.

Yields have been trending up in steady linear fashion for a long time.  The last five years are a continuation of that trend.

But consider:  Prices were at an all time low, in real terms around 2005-2006, trading at less than $2 bushel, and they have been above $4/bushel most of the time since late 2007.  That's a solid doubling or more of prices for a sustained period of time.

Now, if yields respond a lot to prices, shouldn't we see some kind of acceleration in the trend?  After all, prices were pretty much falling through most of the period from 1980 to 2005, and since then have increased substantially.

Like I said the other day, I sure don't "see" a big price effect on yields.  Do you?

There's a lot more data where this came from at www.nass.usda.gov

Note that I usually don't believe "statistical significance" that cannot be seen with a compelling graphical presentation of the data.

Oh, and fertilizer was pretty cheap last year, too.

Update: Sorry, I've been out of commission for awhile and not checking the ol' blog.  I concur with James Giese's points about fertilizer use and the trend in yields.  I've played around with these data a lot, most of it unpublished. That experience tells me that one cannot reject the null hypothesis that yields are a trend from breeding and genetic improvement plus random weather variations.

The "right" amount of fertilizer is key, and too much can sometimes be a bad thing, not just for the water, but also for yields.

One side point: From an economic perspective, it is often optimal for farmers to"over" apply fertilizer vis-a-vis the agronomic maximum.  This is basically a gamble that the weather will turn out in such a way to make use of that extra fertilizer, even though it often won't.  From the vantage point of farmers' profits, the economic downside of applying too much agronomically is small compared to the extra profits if the weather is such that the extra fertilizer is actually needed by the plant.  This is an important point made by Babcock and others way back in the 80s I think.  This has nothing to do with "risk aversion" as sometimes described in the literature, but rather the option value associated with the possible high marginal productivity of fertilizer.   Now, given all the literature on "too much" fertilizer use, we should be pretty skeptical about a big fertilizer-induced yield response to price.

The anonymous commenter--who suggests that land expansion may be driving down average yield when prices go up--may have a point.  This is something we are exploring.  I'll just say for now that this kind of effect, though long hypothesized, is very hard to see in the data.  While there is a clear acreage response to price, it is a small one.  And especially for corn, that acreage margin isn't necessarily bad land.  It's mainly diversions from soybeans and cotton--pretty high value stuff.  So it's hard to see how this influences the aggregate yield very much.

Finally:  A graduate student has been trying to replicate Houck and Gallagher.  So far not so good:  He can't even get the same sign.  We're missing some of the early data, but using the more current data that are available, the same regressions say yields decline with price.  I think there are some tough statistical issues here that Houck, Gallagher, and the broader field have thus far neglected.  Nevertheless, I've seen enough to be extremely skeptical of earlier findings.

Scarcity and Strategic Trade of Rare Earth Minerals

China has a near monopoly on rare earth minerals used in all kinds of manufacturing.  These kinds of commodities must have extremely inelastic demand.  Thus, it's not surprising to see China, which possesses about 95% of know extractable deposits, curtailing exports.

Curtailing exports will raise prices on the amounts they do export, and also raise the international market value of goods produced in China using rare minerals.  While some may interpret the action as a slight against free market fundamentalism, a much easier and more compelling explanation is that China is simply asserting its market power for nationalistic gain.  To me, anyway, this looks like a textbook example of strategic trade.

How much do crop yields respond to commodity prices?

There's an old paper by Houck and Gallagher that examines how corn yields respond to price changes.  They found corn yields went up 21 to 76 percent with a 100 percent increase in price, presumably a response to increase fertilizer use.  In econ speak this is called an "elasticity" between 0.26 and 0.76.  The total supply response would be this elasticity plus the land area response.

The middle estimates in that old paper are being used by some to justify relatively benign effects from ethanol policy on food commodity prices.

Some recent updates to that old work are finding numbers at the lower end of that range, but also find large acreage response elasticities.  Those arguing for a big yield response acknowledge that the land response is small, around 0.1.  But there are lots of folks saying that the overall, yield plus land area, supply response to price is between 0.5 and 1.

These results contrast sharply with my own work with Wolfram Schlenker.  After accounting for endogeneity bias (which makes elasticities too small) we find the yield-plus-land elasticity to be around 0.1. It's also hard to reconcile a large supply response to some basic facts about commodity prices and production. 

Consider:

(i) It's a truly global agricultural commodity market; 

(ii) global production of agricultural commodities is very smooth (weather shocks mostly average out);

(iii) consumption is smoother than production due to storage ;

(iv) prices vary a LOT and are highly autocorrelated (a price shock sticks around for a long time), which is due mainly to (iii);

(v)  prices change sharply, and persistently, in response small, transitory production shocks (e.g., bad weather or USDA forecast updates). 

These facts tell me that both supply and demand must be very inelastic.  If supply response were as elastic as 0.5, we just wouldn't get big, persistent price shocks in response to small weather surprises.  This is because production shocks could be so easily smoothed with inventories and greater or lesser production in future time periods.  Indeed, commodity price behavior by itself implies a total economic response (that's the supply elasticity plus demand elasticity) on the order of 0.2 or possibly much less (this can be traced to the famous work by Deaton and Laroque, or to more recent work by Cafiero et. al, that I've mentioned before on this blog).

Also, if you just look at yields, you will find they look like random noise (weather) around a linear trend.  There's no autocorrelation there while there's a ton of autocorrelation in prices.  I certainly can't "see" a big price response (although there may be a small one).

So, I'm super skeptical.  I need to do more crunching to figure out how these folks are getting such crazy numbers.  But there's something fishy here.  These elasticities just don't add up to the stylized facts we all know well. 

Cynical me is thinking about those economists who believe that all elasticities lie between 0.5 and 2, and so hunt around for a specification that gives them the answer they expect.  Also, the real number is probably so small that it can't be estimated with statistical significance, which makes it difficult to publish.  So, all we see in print are the big "statistically significant" numbers from badly specified models.

Update :  There is also the problem with finding the mechanism for a large yield response to price.  We have experimental data on yields in relation to fertilizer applications and yield simulation models put together by crop scientists.  Both show a highly non-linear link between fertilizer and yield.  That is, yields go up sharply with higher application rates up to a threshold, above which fertilizer has little or no marginal influence.  The steepness of the yield/fertilizer link below the threshold suggests farmers will generally apply at near-threshold levels over a broad range of output prices (the threshold depends a bit on the weather, and weather effects output price, so statistics here can be tricky).  Anyway, the point is that if farmers apply fertilizer at near yield-maximizing rates even when prices are pretty low, so it's hard to see how prices could cause a very large yield effect via fertilizer inputs, even though a modest effect is plausible.

Commodity prices: scarcity bites

Today Krugman writes about commodity prices (oops, missed the link the first time).  To me, anyway, he looks right on all counts.

1) I've seen no evidence that the spike in 2008 was a speculative bubble.  That goes for the current fledgling rise as well.

2) I don't think the commodity prices bear significant influence on inflation.  Most of what we buy is comprised of domestic wages and rent, neither of is likely to much influenced by commodity prices, so inflation will remain subdued.

I wonder if Julian Simon were alive today, whether he would be willing to make another bet with Paul Ehrlich. We'll never know.  But if he were alive, and he were to repeat that bet, this time I think he'd lose.