Speculating with Lives: How Global Investors Make Money Out of Hunger
Part 2: Every Bubble Needs a Story
Of course, plant-based fuels are increasingly competing with food production, but until now they only made up 6 percent of the global grain harvest. According to the World Bank, biofuels play a much smaller role in price increases than generally assumed. Besides, in June the US Congress voted against further subsidies for biofuel production, a vote that is seen as the beginning of a phase-out.
The same holds true for the new demand for meat in emerging economies. Although meat consumption and, along with it, the demand for feed grain is rising, the Washington-based International Food Policy Research Institute (IFPRI) states that countries like China, India and Indonesia can satisfy their additional demand without significantly increasing meat imports. "We find no evidence that alleged stronger demand by emerging economies had any effect on world prices," a World Bank report concludes.
It is likely, however, that the hysteria over the supposed food emergency is part of a clever investment strategy. After all, every financial bubble needs a story. In the case of the dot-com bubble, it was the narrative of a "New Economy" that seemed to invalidate the traditional economic rules, not to mention common sense. In the case of the US mortgage bubble, it was the myth of home ownership as a supposedly rock-solid investment. And the story, in the case of the food bubble, is the impending shortage of a product everyone needs: food.
The fact that bread and butter are mutating into an object of speculation for Wall Street has much to do with a fundamental shift in the way the food system works, one which the United Nations Conference on Trade and Development (UNCTAD) describes in a recently published study: the metamorphosis of the food market into a financial market.
UNCTAD chief economist Heiner Flassbeck, a former senior official in the German Finance Ministry under then Finance Minister Oskar Lafontaine, has long been concerned about speculation. The walls of his Geneva office, with its view of Lake Geneva, are covered with diagrams, while his latest book on the role of speculators sits on the table.
After the 2008 financial crash, Flassbeck began monitoring changes in the prices of currencies, commodities, government bonds and stocks more closely. When he found that the graphs were noticeably similar, Flassbeck assembled a team to study the phenomenon.
The result of the team's efforts bears the innocuous title: "Price Formation in Financialized Commodity Markets: The Role of Information." But the contents are explosive. The UNCTAD experts conclude that the commodities market isn't functioning properly, or at least not the way a market is supposed to function in economic models, where prices are shaped by supply and demand. But the activities of financial participants, according to the study, "drive commodity prices away from levels justified by market fundamentals."
This leads to massively distorted prices, which are not influenced by real factors but by the expectation that economic developments will improve or worsen.
Most investors involved in the commodities business today have little understanding of the actual products. "Market participants also make trading decisions based on factors that are totally unrelated to the respective commodity, such as portfolio considerations, or they may be following a trend," the UNCTAD report concludes, describing the dangerous herd mentality of investors. According to the report, such behavior has nothing to do with objective pricing.
Gambling with the World's Food
But how did the situation arise that hedge funds and investment banks can now influence the costs of bread in Tunisia, corn meal in Kenya and corn in Mexico? What happened to allow large pension funds and small investors to gamble with the world's food supply? And how did the markets in Chicago, New York and London come to play such a decisive role in determining how many people must go without food?
The fault lies with a significant change in the market that remained virtually unnoticed for several years. The world of high finance made a number of adjustments that turned mankind's staple foods into an object of speculation.
The trade in food commodities was long controlled by the traditional forces of supply and demand. Farmers grew the food that distributors and retailers sold as food products.
A publicly traded futures market developed in the interim. To hedge against price fluctuations, producers sold their harvests in advance at a fixed price, which was usually below the current or spot price. The products were delivered on the maturity date of the futures contract. If the current market price was lower than the futures price, the farmer benefited, and if it was higher, the holder of the futures contract benefited. The sole purpose of these futures transactions was to enable farmers and food processors to hedge their risks. Futures dealers supplied the market with cash, and consumers had access to products at all times.
The players permitted to participate in this market were, for the most part, directly involved in the agricultural industry: farmers, grain processors, warehouse owners, food multinationals. Banks played only a minor role. It was a credit industry of sorts, and it worked well as such. The market remained relatively stable for decades -- until it was discovered by the financial industry.
Change in Regulations
But in order for the financial industry to tap this new business area, market access had to first be expanded. It was strictly regulated, and for good reason. The finance industry's lobbyists got to work, and succeeded in 1999, when the US Commodities Futures Trading Commission substantially deregulated the futures markets. Now banks were permitted to hold large positions in commodities securities.
In 2004, the US Securities and Exchange Commission (SEC) expanded the banks' scope for action when it approved a petition by the investment banks Lehman Brothers, Morgan Stanley, Bear Stearns and JP Morgan to relax equity capital rules. From then on, the financial professionals were able to trade with 40 times as much capital as they held in collateral. Even more play money flowed into the market.
But bets on individual commodities are highly risky, which initially deterred many investors. The banks needed a marketing idea, and Goldman Sachs had one, namely to bundle products together -- an idea that seems suspiciously familiar in the wake of the subprime crisis. Index funds were created that contained a wide range of commodities futures, from oil to wheat. This spreads the risk and enables the funds to obtain a high credit rating, thereby heightening the appeal of the construct for major investors.
The trick is that speculators never convert the futures into real goods. The fund companies sell the contracts, which run for about 70 days, shortly before their maturity dates and use the fresh cash to invest in new futures. The system operates like a perpetual motion machine, with investors never coming into contact with the real market prices.
That's precisely the point, say those who question whether speculators are responsible for rising commodity prices. They argue that the laws of supply and demand remain in force on the real, or spot, market, thereby bringing everything into equilibrium. In their view, whatever happens in the futures markets is irrelevant.
This is a fallacy. In reality, futures prices do affect real market prices, as Maximo Torero, director of the IFPRI's Markets, Trade, and Institutions Division has learned. After taking a close look at the markets for corn, soybeans and wheat, he found that, in most cases, real prices followed futures prices. The anticipated future began changing the present.
Another factor is that rising futures prices encourage those who actually do own real goods to hoard their reserves, fueling prices even more.
In fact, the volume of index fund speculation increased by a dizzying 2,300 percent between 2003 and 2008 alone. According to the FAO, today only 2 percent of commodity futures contracts result in the delivery of real goods. Before that happens, 98 percent of contracts are sold by investors who are interested in turning a quick profit -- and who are certainly not interested in getting their hands on 1,000 pork bellies.
© SPIEGEL ONLINE 2011
All Rights Reserved
Reproduction only allowed with the permission of SPIEGELnet GmbH