Tim Worstall has a very good summary of Adam Smith’s explanation of the very useful public service provided by speculators:
Back to food: this is exactly the argument that Adam Smith put forward to explain the activities of a wheat merchant (Wealth of Nations, Book IV, Chapter V, start at para 40, here, for a decent dose of 18th century prose). When wheat is plentiful (although he calls it corn — the English did not call maize corn until some time later), say after a harvest, the merchant buys it up and stores it. He then waits until prices have risen before he sells it. If his expected shortage in the future doesn’t arrive then he’s shit out of luck and loses money. If it does, then the happy populace now have wheat to eat. For, and here’s the crucial point: what our merchant, our speculator, has done is move prices through time.
If we all ate wheat like it was that bounteous time just after harvest all the time then we would run out of wheat entirely before the next harvest. Prices would, at that point, become really rather high. However, by buying in the time of plenty, he’s raised prices in that time of plenty: thus making everyone consume a little less in that Harvest Festival gluttony. He’s also lowered prices in the Hungry Time (in medieval times, the six weeks before the harvest was indeed known as this, it was the worst time of year for food supplies) because he has at least some grain available rather than none.
So we’ve reduced price volatility, stretched the available supply over more time, possibly even stopped some starvation, by someone being enough of a bastard to speculate on food prices.
Now note, this is physical speculation, actual purchase, taking delivery and storage.
Derivatives speculation, using futures and options, has less effect on prices. It gives us information about what people think prices might be in the future, for sure, but it will only affect today’s prices if high future prices lead to that actual physical storage and hoarding. Which could happen, to be sure, but won’t necessarily.
All of this leads us to what people like M Sarkozy are trying to say and what the WDM are screaming about. The latter, in their report linked above, come right out and say that as more people are playing with food derivatives, this is what has been pushing up food prices. This is nonsensical, in the absence of any physical hoarding. For a start, WDM seems not to realise than a futures market is zero sum: for any profit made by someone then someone else must have made an equal and opposite loss. For everyone going long (betting on a price rise) someone else must have made an equal and opposite bet going short (betting that prices will fall). That’s just how these markets are. It really doesn’t matter to spot (current) prices whether three people are betting £50 or 30,000 are betting $50bn: there will be an equal and opposite number of people long as there are short, by definition.
So it absolutely cannot be that “more people speculating increases food prices”.
WDM’s second point is that more speculation means more volatility in prices: something that almost all economists would regard with a very jaundiced eye. For the general assumption is that futures act upon prices as does Smith’s wheat merchant: they reduce price volatility. Fortunately, the WDM, in its own report, provide us with an example of this. In the 2006/8 price rises, it notes that there’s a deep and liquid speculative market for wheat and corn (maize), while there’s only a very thin one for rice. And yet it was rice that was vastly more volatile in price in this period: despite the fact that it was wheat and maize which people were turning into ethanol for cars (the true cause of the price rises) rather than rice.
The price of a good is also a signal of availability: the more scarce the item is, the higher the price will go. The higher the price goes, the greater the incentive to either limit the use of the item or to search for substitute goods. This is a key feature of free markets: without the price change signalling, consumers cannot accurately guage whether to increase or decrease their use of a particular good. This is why the worst possible reaction to a sudden price increase is price controls: remember the first oil crisis in the 1970s? Price controls meant that people could still buy gasoline at the “old” price . . . until there wasn’t enough to go around. Controlling the price creates artificial shortages and fails to rationally indicate to consumers to conserve or limit their consumption.
…a decent dose of 18th century prose It is a little known fact, difficult to verify except for, perhaps, only those most willing to do so because of the inquisitive nature of their characters, and driven to undertake such investigations in veracity, that printers of Smith’s time, bound as they were to the rules of supply and demand for the necessaries of their professional endeavours, often speculated in the supply of, wait for it, commas.
Comment by Lickumuffin — February 11, 2011 @ 16:06
I feel, somehow, that you have a message, hidden cunningly, within the bare text, yet somehow not, quite, apparent to the naked eye.
Comment by Nicholas — February 11, 2011 @ 23:49