For an excellent 50-page explanation of how commodity markets function and how excessive speculation has negatively affected those markets, please go here. For a simpler introduction to the issue, continue reading.
How did we get to this point?
While most of the solutions to the crisis of high and volatile food prices will be challenging – requiring substantial reworking of our global, fossil fuel-dependent food system to create a more localized and less industrialized one – there is one relatively easy thing we can do that could bring quick, significant help for many of the world’s hungry people.
Excessive financial speculation in commodities futures markets dramatically increases the volatility of prices for a host of commodities, from food crops like wheat, corn and soybeans, to oil and natural gas, to metals and minerals, and tends to make those prices higher. This damaging speculation has increased dramatically in the last three to four years, especially in 2008. But the problem was brought on by simple policy decisions – decisions that can be similarly simple to reverse.
Commodity Market Beginnings
The first commodities market in the U.S. was formed in 1848 when merchants joined to create the Chicago Board of Trade. Before that, selling grains was a very unpredictable and chaotic task. Individual farmers, negotiating with sellers, faced uncertainty and widely varying prices. With the Board, farmers agreed with a buyer to deliver grain at a specific date in the future for an agreed-upon price. This is called a forward contract. In 1865, futures contracts were created. These are similar to forward contracts, but instead of being directly between a producer and a buyer, are traded on an open exchange called the futures market where others can participate, not unlike the stock market.
By the late 1800s, futures markets had been created for various products, with speculators betting on whether prices would rise or fall. But the influx of speculators who were not actually involved in agriculture or food production was a problem. A casino-type atmosphere reigned with huge amounts of money entering and leaving the market unpredictably – producing easy profits for speculators, but subjecting farmers to uncertainty once more. Market abuses and manipulation, from fraud to spreading rumors in order to alter prices to buying inside information, were rampant. Large fluctuations in trading also affected food prices unnecessarily.
After the Depression, several laws were passed to regulate markets in order to prevent another economic collapse. One was the Commodities Exchange Act of 1936, which for the first time put limits on speculative traders to prevent them from dominating commodities futures markets. People directly involved in agriculture and food production could still participate in the futures market at will, but outside speculators had limits placed on the amount they could trade. This allowed speculators to provide needed liquidity to the markets while avoiding speculative bubbles.
Deregulation and Consequences
These limits were maintained until the 1990s when the CFTC began to issue “no action” letters to major commodity speculators saying that the agency would take no action if they passed the speculation limits. The passage of the Commodity Futures Modernization Act (CFMA) in 2000 further deregulated commodity markets.
Pressure from speculators and the administration’s predisposition towards deregulation led to changes in commodities laws – changes that, while appearing small at the time, have had profound effects on food and energy prices today. The Commodity Futures Trading Commission (CTFC), which had been created in 1974 to regulate commodity futures, fashioned loopholes that allowed outside speculators to trade unlimited amounts in commodities with almost no oversight or regulation.
Negative results from these loopholes were first seen when Enron took advantage and traded huge amounts of energy futures, artificially driving up prices while creating huge profits for itself. One of the loopholes has been named the “Enron loophole.”
For most of the twentieth century, large institutional investors were not attracted to the food commodities markets, since they provided lower profits than other investment opportunities and returns were very volatile. This changed after the stock bubble burst in the year 2000. Investors pulled vast amounts of money from the stock market, deflating the bubble. They put much of that money in the housing market, helping create a bubble there. As the housing bubble burst, many investors shifted their money to commodities futures; thanks to the CFMA deregulation, they were able to plow immense amounts of money into these relatively small markets.
Hedge fund manager Michael Masters recently testified before Congress on this issue. He said that institutional investors (pension funds, university endowments, sovereign wealth funds, etc.) have increased their investments in commodities futures from $13 billion in 2003 to $317 billion in July 2008, and the prices of 25 commodities have risen by an average of 183 percent in those five years. He explained that “commodities futures prices are the benchmark for the prices of actual physical commodities, so when … speculators drive futures prices higher, the effects are felt immediately in … the real economy.”
Futures markets tend to be rather small compared to other investment markets. In 2004, the total value of futures contracts in 25 principal commodities was only $180 billion, compared to $44 trillion invested in stock markets worldwide. So when these outside investors, with massive sums of money, enter into the commodities futures markets, they drive up overall prices for those products very quickly. In just the first 55 days of 2008, speculators poured $55 billion into these markets. Clearly these huge inflows of money are having dramatic effects on today’s rising food prices. According to Masters, “[O]ne particularly troubling aspect of … speculator demand is that it actually increases the more prices increase.” We already see this happening as investment advisors increasingly encourage clients to put money into commodities futures. These types of investments could easily increase to as much as $1 trillion if institutional investors switch a greater part of their investments into commodities futures, and that would result in catastrophic increases in food prices.
Masters draws an analogy that is helpful in understanding these complex dynamics: “If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged.” This dynamic currently takes place in our commodities system, driving up food and oil prices. At the time he testified before Congress, Masters estimated that with greater regulation, oil prices could drop from $140 to close to $65 or $70 a barrel within 30 days. Similar drops could take place in oil and food commodities today. For example, currently (Nov 2, 2009), a barrel of oil is selling for close to $80 despite having the highest supply of oil in history and lowest demand in decades. Clearly, supply and demand issues are not behind the high prices.
Luckily, members of Congress are waking up to this reality and have passed the Dodd-Frank Wall Street Responsibility and Consumer Protection Act to address the problem. While there is a good deal of interest in addressing volatile energy prices, the same political interest has not been turned to address food commodities; yet it is important that Congress tackle speculation in both areas. As one wheat farmer recently stated, “We’re commoditizing everything and losing sight that it’s food, that it’s something people need. We’re trading lives.”