Tuesday, 13 March 2012

Of Toast & the Precautionary Principle: Commodity speculation revisited

Globalisation can lead to surreal situations. For example, several weeks ago I got a call from a Kenyan guy called Karim Ajania, who's based in San Francisco, and who runs a website for a Mozambican forestry project called Mezimbite. You'd think the website would be focused on, well, Mozambican forestry, but it features contributions on a variety of topics from some pre-eminent global economists, including Sir Partha Dasgupta and Oxford's Paul Collier. Karim told me that he'd managed to get respected Harvard professor and former economic advisor to Bill Clinton, Jeff Frankel, to write him a short blog on commodity speculation. Karim wanted me to write a reply.

Karim had seen a previous article I'd written on food speculation, where I'd suggested that excessive involvement of financial players in agricultural futures markets could distort prices of real food, potentially leading to negative impacts on the welfare of the world's most vulnerable people. My views ran counter to those of Jeff Frankel, who suggested that commodity speculation probably wasn't a major problem, and that most economists didn't see much reason to be concerned. Jeff's argument, like many economists, rested on the assertion that, in general, speculators make markets more efficient.

It's not so much that I disagree with all his points, but I took exception to which points he emphasised over others. He seemed to gloss over much of the ongoing academic debate. He admitted that speculation could be a problem, whilst nevertheless implying that it isn't. If Jeff were an armchair commentator I’d be happy to let his casual approach fly, but given that he’s an internationally respected academic who’s opinions are likely to hold more weight than the average person, I felt the position that speculation 'probably isn't a problem' wasn't satisfactory. So, I wrote a piece as a counterpoint to his.

If you're interested in the details, please go take a look at the article. It's quite long (around 2000 words) but contains, if nothing else, some rhetorical flourishes and useful links. If you want the summarised version though, I make an argument in three parts:
  1. On the techical side, I challenge Jeff's characterisation of the nature of speculation and how it operates. I think he's defined it too narrowly, failing to address some serious new elements of markets (including the activities of index funds and high-frequency trading).
  2. On the socio-epistemological side (is that  even a word?), I challenge the idea that there is academic 'consensus' on the issue of speculation, pointing out that a) there isn't academic consensus, b) that certain politicians try to claim that there's consensus for political reasons, and c) that even if there was consensus, that would not be reason to not be concerned for the future (indeed, I point out that there was apparent 'consensus' in the early 2000s that securitised mortgage products were a force for good).
  3. On the philosophical side, I assert the fundamental necessity of applying the precautionary principle to the commodity speculation debate. In a nutshell this means that society should be cautious of activities that have the theoretical potential to negatively impact welfare, regardless of whether there is definitive 'proof' that the activity is dangerous. Many financial pundits often focus on how it is not yet 'proven' that speculation is unsafe, when really the burden of proof should be on the financial sector to prove that it is safe. Using the example of the financial crisis again, the inability to 'prove' in 2002 that securitised products were dangerous, looks in hindsight to be a pretty weak reason to have gone ahead with rampant securitisation.

I don't think Jeff would necessarily disagree with these points, and to be fair, he's a busy guy with lots of global macroeconomic issues he's more focused one. I suspect though, that if he got time to respond he'd assert the necessity for regulators to keep a close watch on the issue.

Still, the idea that the burden of proof should rest on regulators is problematic, and my point about the precautionary principle is echoed by CFTC (the US derivatives market regulator) commissioner Bart Chilton (see video below). He's got a lilting twang and hair that puts him somewhere between a cowboy and a surfer, but his message is a deeply serious one:  The potential effects of high frequency traders (the 'cheetahs') and index fund investors (the 'massive passives') needs to proactively investigated. It's not good enough for financial professionals to say 'this is too complicated for you guys to understand, just trust us'.

Bart is not the only one expressing concern. NGOs have been concerned for a long time, but mainstream commentators are increasingly taking concerns about commodity speculation to heart. Hedge funds (see comments at 10:20 in the video), CTAs (see comments at 13:07 on the video) and physical commodity traders are all suggesting financial involvement in agricultual trading could be problematic, albeit using cautious language to do so. The text-book economics answers used to theoretically reason away questions about speculation using assumptions of market rationality are being challenged.

A toast to the futures
On a slightly lighter note, Karim also asked me for a quote on the absurdity of the English toast rack for another Mezimbite article written by Thomas Thwaites. Thomas started something called the Toaster Project, drilling down into the commodity foundations of all the goods we use in everyday life, smelting his own iron ore in a microwave to make a toaster. The article generated 104 comments. Take a look at comment 19 (and the subsequent comments) - it's truly unbelievable, and has also led to me being invited to Claridges Hotel for a free breakfast, to test whether the commenter's claims are accurate.

I'll put a photo up about that once I've gone, but in all seriousness, regardless of whether you like you toast cold or hot, this issue of speculation needs to be taken seriously. Bread embodies lots of price elements. The cost of a loaf is subject to a startling array of factors, from deeply imbedded cultural reflexes of ritual and taste, to the price of natural gas (which is the raw material for ammonia-based fertilisers that farmers use on their fields), and the price of oil, from which petroleum is obtained, which is used to fuel the vehicles that transport loaves of bread from factories to cities.

And maybe, thousands of kilometers away in huge cities like New York, Chicago and London, traders, computers and pension funds entering into bets on the price of wheat, oil and natural gas via derivatives contracts, might, through their actions, be tweaking those elements that constitute the price of a piece of bread in a toaster. It's one thing taking unchecked risks on property prices (aka. the financial crisis), but it's another taking unchecked risks on the foundations of human welfare. I reckon the precautionary principle should apply especially strongly here.