In the early 19th century there was a debate about whether high wheat prices (often then referred to as “corn”) where a result of high land prices or whether the reverse was true. (See our discussion of “economic rent” on pages 218 to 220 of Economics.)
This issue is in the news again but the economics of this now seems to be generally understood, and it was David Ricardo who first made this clear. Land is an input into the agricultural production process and its supply is inelastic. Demand is a derived demand determined by the value of the marginal revenue product and this is related to the prices of the crops that can be grown on the land. So it is food prices that drive land prices and not vice versa.
This analysis underpins the following news story:
“Land values likely to keep on growing. Where there’s muck there’s brass. Prices for commercial farmland hit record levels in the second half of last year and, having almost doubled in th past five years, are expected to remain on the rise over the next 12 months.
Surging prices reflect the rising prices of wheat, meat and milk they yield. While many food commodities have fallen from their peak, most remain at historically high levels.
According to the latest RICS Rural Land Market Survey……”Land prices reached record levels once again as commercial farmers looked to capitalise on increasing commodity prices by expanding their businesses. With demand continuing to surge ahead and a seemingly low level of land coming on the market, it is easy to see why prices continued to rise so sharply across most of the country.” (Financial Times, 25/26 February 2012, page 3)
Alec Chrystal, Cambridge, February 2012
Commodity Prices in the News: it’s demand and supply init!
In the case studies at the end of Chapters 3, 4 and 7 we discuss the influences on the markets for several different commodities (see Economics by Lipsey and Chrystal, OUP 2011 pages 54, 74 and 149). Those covered are tea and tin (Chapter 3); coffee and sugar (Chapter 4); and cocoa and copper (Chapter 7).
One characteristic of agricultural commodities we reported is that they can be subject to adverse weather conditions or other natural disasters and these negative “supply shocks” usually generate a sharp rise in the market price. Demand for food products generally has both a low price and income elasticity of demand so does not vary much over the business cycle. But when there is a supply shock, the price has to rise a lot to reduce the quantity demanded sufficiently to cope with lower supply. Growing demand can be a driver of higher food prices, especially when combined with supply limits of some kind.
Here are four recent examples of other actual or potential supply or demand shocks affecting agricultural commodities.
“Orange juice prices squeezed higher by outbreak in Texas. The price of orange juice rose by its maximum daily limit yesterday after a destructive citrus disease was found in Texas earlier this week for the first time…..Texas is the third largest orange producer in the US, after Florida and California…..The price of the commodity is up by 25 per cent this year, having hit a 34-year high of $2.1275 a pound earlier this month……The supply concerns come as orange juice stocks left over from the previous season are sharply lower than normal, leaving the market without a cushion if supply fails to meet expectations.” (Financial Times, 21st January 2012, Page 18).
“Live cattle prices touch record after US dry spell. The price of cattle has risen to record highs, threatening to push up the cost of steak and other beef products, following a drought in the southern US that has damaged grasslands……..With meat packers competing for a dwindling US herd, live cattle prices have risen 2.9 per cent this week.” (Financial Times, 21st January 2012, Page 18).
The following story has a close connection to the one above.
“Meatier prices give farmers a rare boost. ….After 40 years in farming Mr Mitchell is finally making a profit after a doubling of sheep prices in two years. ……Demand is growing among the middle classes in emerging markets. As Chinese and Indian consumers are getting richer they are putting more meat on their plates as well as smarter suits on their backs. Supply has not kept up, however. “It’s not like whacking up a factory,” says Peter Hardwick, head of trade development at Britain’s Agricultural and Horticultural Development Board. It takes two to three years to rear an animal. Other factors have depressed supply. These include droughts in parts of the US (where cattle herds are back at 1960s levels), the switching of feedstock to biofuels in the US and South America, and New Zealand farmers exchanging sheep for more lucrative dairy cows.” (Financial Times, 25th/26th February 2012, page 3.)
“Drought raises fears for Brazil food crops; threat of food inflation has been a major concern for policymarkers. Weeks of scant rainfall and unusually hot temperatures linked to the La Nina phenomenon have ravaged crops across Brazil and Argentina, which together account for almost half the world’s soyabean exports and about 24 per cent of corn shipments…..In Argentina, corn has been hardest hit but farmers are bracing for sharp falls in soya output…..Across the south of Brazil, farmers have already written off swaths of their corn crop, but are still hoping for rain to salvage some of their soyabean, which has just started to form pods.” (Financial Times, 18th January 2012, Page 25).
Copper prices have also been in the news, but this is much more a demand side story. Recall that supply conditions tend to be fairly stable in metal extraction industries but demand is highly correlated with the business cycle. The dominant demand side influence over recent months has been the demand from China, as the following report confirms.
“Copper bulls look to $10,000 level on China demand. The bulls are back. Industrial metals such as copper bore the brunt of last year’s financial turmoil…….Now though they are enjoying a renewed wave of investor interest. ….The rally in prices has reawakened talk of copper reaching $10,000 a tonne……Since the start of this year, the red metal has risen 11 per cent to trade at $8,440. The rise in copper, a bell-weather for global industrial production thanks to its widespread uses in construction and manufacturing, underscores a shift in perceptions about the global macroeconomic outlook in recent weeks……commodity traders have become more optimistic about demand in China following record imports in December and signs of looser monetary policy.” (Financial Times, 2nd February 2012, Page 33).
It should be clear from these examples, and from those in the text referred to above, that demand and supply analysis is a very powerful tool for understanding what is going in a wide variety of real world markets. It’s all just demand and supply init!
Alec Chrystal, Cambridge, February 2012
Fiscal Policy and the Greek Debt Crisis
The UK currently has rising unemployment and a GDP gap of around 4-5 percent. This means that current real GDP is well below its potential level. The standard textbook solution to this situation would be for the government to introduce a fiscal expansion. This would involve some combination of government spending increases and tax cuts. However, this is not happening. On the contrary, the UK Coalition Government introduced tax rises and spending cuts in its first year in office, and despite calls for a change of tack (a plan B) they are sticking to plan A. Why is this?
One answer is that they have got it wrong. According to this view the cuts have slowed GDP growth below where it could be and have thus made the budget deficit worse, as tax revenues are weaker than they would be in a faster growing economy.
An alternative view is that the recent slow growth is due to some (exogenous) bad luck. The crisis in the euro zone has made consumers and firms cautious and has also made export demand weak. This means that all of C+I+G+(X-IM) are weak and so slow growth in GDP is inevitable. The solution they say is not to raise G but rather to get government finances under control to restore confidence in the private sector so that C and I will pick up in due course and external demand (X-IM) will pick up once the euro zone crisis is sorted.
It is far from clear in the UK context whether a slightly more expansionary fiscal policy is advisable or not. However, what is clear is that several other countries, such as Greece, have found themselves in a very difficult position with a large fiscal deficit and an economy in deep recession. Here the government has had no other option but to agree even greater cutbacks in government spending. The problem is that the scale of the budget deficit and the accumulated public debt has become so large that the Greek Government can no longer borrow the money to pay its bills.
Greece currently has public debt that is about 160% of GDP and the yield on Greek government bonds is around 30% per annum. If Greece tried to refinance its debt at these rates of interest it would end up paying nearly 50% of GDP in debt interest alone. This would clearly be unsustainable as it would require a very high tax rate and there would be no revenue left to pay public sector workers etc. All this means that the main option for Greece is to borrow on cheap terms from other euro zone governments or from the IMF (and likely both).
This does not solve the problem but it does buy time for Greece to make structural reforms that will get the public finances back under control. The only other option would be a debt default which may also involve Greece leaving the euro zone and reintroducing the Drachma. This would inevitably devalue and be associated with a very rapid inflation. Inflation would help to reduce the value of Greek public debt but it would be at the expense of many people losing their savings, so the social costs would be high.
The lesson in this for macroeconomics is that fiscal policy cannot ignore the financing consequences of accumulated public debt which arise from running a budget deficit over a sustained period of time. What is not clear is the level at which public debt becomes unsustainable. The UK had net public debt of around 250% of GDP at the end of the Second World War but this did not lead to a sovereign debt crisis. Japan has public debt today that is close to 200% of GDP but again this does not seem to cause any problems. Japan is able to finance its debt at very low interest rates so this does not impose an intolerable burden. The UK was also able to finance its debt at low interest rates in the 1950s and 1960s.
Part of the reason why the UK got away with high debt levels after World War 2 is that we had direct controls on international financial flows and on credit flows to the private sector. Thus savers were not free to move their funds overseas. Greece, in contrast, has no ability to direct even domestic savings so it is at the mercy of world financial markets.
I f world bond markets form the view that a particular government may struggle to repay its debts then it will charge higher interest rates to lend. These higher interest rates will in turn make the country’s finances even more precarious. In this respect, the sovereign debt crisis becomes self fulfilling. Even Greece would be in reasonable shape if it could borrow on the same terms as Japan and the US.
This episode is throwing some doubts on the wisdom of the design of the euro zone itself. This had worked well until the 2008/9 banking crisis but has been poor at coping with the fiscal imbalances that followed the crisis itself. This involved substantial increases in fiscal imbalances in many member countries, but there was no mechanism for fiscal transfers between member states (except in some narrow areas such as agriculture and regional infrastructure investment). Accordingly some form of fiscal federalism for the euro zone is now on the agenda. This would involve some taxation and spending policies being determined at a supranational level, rather than within individual countries as they are now.
For the UK the lesson is that the scale of net public debt and the budget deficit should be of concern. It would create financing problems if the government were unable to finance its debt at low rates of interest. This means that budget deficits may boost demand in the short term but they are not a free lunch in the long term. However, it is far from clear what level of debt is problematic. What is clear is that it will be several years before the economy is back anywhere close to its potential level and before the government budget is back to anywhere near balance. It does not need to be in surplus but it does need to be in a position where debt is not growing faster than GDP. On recent official projection, the UK’s net public debt will continue to rise as a percent of GDP until around 2016. Hence, debt and deficits will continue to be headline news for many years to come.
Alec Chrystal, Cambridge, February 2012.
The current eurozone crisis has raised again the question of whether it is better to have a separate currency. This is related to an issue known as “optimal currency areas” and it has many elements to the analysis. However, there are some fallacious arguments for a country having its own currency that can be illustrated by the following newspaper extract.
Cornish groups want to dump sterling and adopt own currency: Cornwall should adopt its own currency to protect itself from economic downturn and keep money in local communities, local groups have urged. Ian Jones, chief executive of Volunteer Cornwall, says the county ….should adopt its own currency. He said Cornwall should consider “radical ideas” to protect itself in the economic downturn…….Mr Jones said “Communities create wealth but too often it is siphoned out. We have to keep wealth local…….we need to start doing something now if we are to avoid being at the mercy of the global storm which is currently raging.” (The Telegraph, 7 November 2011.)
So what is the economics of all this? Would Cornwall really be better off with its own money?
The simple answer is: no. Money can be a form of wealth for an individual but it is not net wealth to society as a whole. Just replacing one circulating piece of paper with another has no effect on the real incomes or wealth of the community as a whole. What matters for real incomes is the value of goods and services produced for sale and what matters for wealth is the total value of assets owned (property, businesses, pension funds etc). The wealth that is relevant for Cornwall is the assets owned by Cornish residents anywhere in the world, and this sum would be very different from the value of Cornish banknotes in circulation. Hence, having a local currency does nothing to “keep wealth local”.
There are, however, two provisos to this argument. The first is that if all the people of Cornwall spend their existing holdings of pounds (and issue themselves with Cornish pounds at no cost) then they could have a one-off increase in consumption but they will have done this by running down a claim on the output of the rest of the UK. This cannot be repeated and a period of lower consumption would be required if they want to rebuild their claims on the rest of the UK.
The second proviso is that, once Cornwall has its own pound it could devalue this against the UK pound and this would make Cornish goods and services cheaper and may temporarily increase their demand. However, this would also cause inflation to be above that in the rest of the UK so the gain in competitiveness would be at best temporary.
Finally, it should be clear that having a separate local currency does nothing to isolate a region or a country from “the global storm”. If it could do that then the UK would not have been affected by the US subprime crisis and neither would Iceland have had the financial crisis it did. Cornwall, for example, receives significant revenues from tourism, and its currency structure will have no effect on potential visitor numbers from the rest of the UK or the eurozone who may take fewer vacations owing to having lower real incomes.
In Chapter 8 we discuss why there is an incentive for companies to get together in order to fix the prices of their products. By forming a cartel, prices can be increased and the joint profits of the members can be raised. However, this manipulation of markets by producers is illegal in most countries of the world. In Chapter 13 we also discuss government policies aimed at preventing anti-competitive behaviour (see Box 13.6 on page 293 for an explanation of UK competition policies).
Companies clearly have to weigh up the costs of getting caught (including the loss of reputation) against the benefits of holding prices artificially high for some time, and it would not be safe to assume that companies always stay on the right side of the law.
A recent European case involved price fixing in the market for washing powder and the guilty parties were two well-known international companies. The following is a report that appeared on the BBC website on 11th April 2011.
“Unilever and Procter & Gamble in price fixing fine
The consumer products giants Unilever and Procter & Gamble (P&G) have been fined 315m euros (£280m, $456m) for fixing washing powder prices in eight European countries.
It follows a three-year investigation by the European Commission following a tip-off by the German company, Henkel.
Unilever sells Omo and Surf, P&G makes Tide, and Henkel sells Persil in certain European countries.
The fines were discounted by 10% after the two admitted running a cartel.
Unilever was fined 104m euros and P&G was fined 211.2m euros.
Henkel was not fined in return for providing the tip-off.
The cartel operated in Belgium, France, Germany, Greece, Italy, Portugal, Spain and the Netherlands between 2002 to 2005, the regulator said.
P&G, the world’s largest consumer products group, owns the Tide, Gain and Era brands of washing powder while the Anglo-Dutch group Unilever makes detergent products under the brand names Omo and Surf.
Henkel owns the Persil brand in most of Europe, while Unilever owns it in Britain, Ireland and France.”
Alec Chrystal, Cambridge, 26 April 2011
World cocoa prices reached a 32-year high of $3,714 per tonne in the first week of March 2011, but by 4th April they had fallen back to a little over $3,000. Even the latter price was very high by historical standards but it represented a sharp fall from the levels seen in later February and early March (see Economics, 12th ed page 149, and 11th ed page 155).
So what was the cause of this high price and its subsequent sharp fall? The answer, as with some earlier episodes of sharp rises in cocoa prices, is political problems leading to virtual civil war in the Ivory Coast (Cote d’Ivoire) which produces around 40 per cent of the world’s cocoa.
Ivory Coast production was sharply disrupted in 2009 by civil unrest, but this settled down for a while when the incumbent president, Laurent Gbagbo, agreed to put himself up for election. In November, 2010 the election was held and Gbagbo was defeated but he refused to stand down. This triggered armed conflict between Gbagbo supporters and those of the president elect, Alassane Ouattara. In late February 2011, Gbagbo declared that he (in the guise of the state) was taking over control of all Ivory Coast cocoa exports (presumably to raise funds for his failing regime). This is the action that triggered the sharp rise in world cocoa prices mentioned above.
As The Times reported (Friday 11th March 2011): “Thousands of jute sacks of cocoa beans are beginning to rot in the port of Abidjan in Ivory Coast. The world’s biggest supplier of raw chocolate has fallen victim to the determination of Laurent Gbagbo to cling to the presidency that the world says he lost in an election last November.
An export ban and an attempt by Gbagbo this week to commandeer the national export industry has crippled trade and cast thousands of producers, mainly small family farms, into uncertainty. The squeeze has left 475,000 tonnes of unexported cocoa beans—more than a third of annual output—sitting at Ivorian docks.” (Times modern, page 5).
The drop in world cocoa prices in late March and early April was almost certainly due to the fact that Gbagbo seemed to be losing the battle to stay in power and it looked increasingly likely that the elected president would take office. Prices may drop even further when hostilities cease and the supply of cocoa returns to something closer to normal.
On Tuesday 22nd March 2011 it was announced that inflation by the CPI measure had reached 4.4 per cent per annum. The inflation target is 2.0 per cent. Surely the Monetary Policy Committee (MPC) should be raising interest rates in order to bring inflation back down towards the target? Yet Mervyn King, the Governor of the Bank of England has said recently that raising rates would be a “futile gesture” and MPC member Adam Posen even wants to relax policy further with an increase in the scale of quantitative easing (the process by which the Bank has bought £200 billion of government bonds in order to increase the money supply). Three other members of the MPC have voted to raise interest rates, but their view has not yet prevailed. MPC members are all supposed to be experts with the same information, so how can the range of disagreement be so wide?
The dilemma currently facing the MPC is well illustrated by the inflation fan chart published in the February 2011 Inflation Report. This shows the Bank’s central projection for inflation in the central band and the range of probabilities around that central projection. It is clear that the MPC was fully aware when it took its decision not to change policy in February that the CPI inflation rate would rise further in the coming months. Hence the rise in inflation announced this week will have come as no surprise to them. Indeed, they are expecting it to rise even further in coming months.
CPI inflation projection based on market interest rate expectations and £200 billion asset purchases
Source: Inflation Report, February 2011, Bank of England.
(The fan chart depicts the probability of various outcomes for CPI inflation in the future. It has been conditioned on the assumption that the stock of purchased assets financed by the issuance of central bank reserves remains at £200 billion throughout the forecast period.)
So why did they not tighten policy in either February or March? The answer is also in the fan chart. They (the majority of MPC members) are convinced that even on unchanged policies inflation will fall sharply to be close to or even below the target in 2012. How can they be so confident that this will happen? The simple answer is that they cannot be absolute sure about anything. However, they do know that one of the main factors behind the inflation rate rise is the increase in VAT that came in in January 2011. VAT is very unlikely to to be raised again the following year, so it will drop out of the inflation rate in January 2012. (Note that the inflation rate is the increase in the price index in one month compared to the price index in the same month a year ago. So a one-off increase in prices stays in the inflation rate for twelve months.)
Another big contributor to measured inflation has been higher energy prices. For energy prices to keep inflation high beyond twelve months ahead, they would not just have to stay high, but rise even further. This is possible, but further rises are not assumed in the MPC projections.
MPC members know that even if they were to raise interest rates now, or reverse quantitative easing, it would take between one and two years before this tightening would do anything to bring down inflation. By that time inflation is expected to be already close to target, so there would be a danger of slowing economic activity much more than is really necessary when there is already a recessionary GDP gap and unemployment is almost certainly above the NAIRU.
The MPC members who have voted for a policy tightening are clearly worried that the current high measured inflation rates may lead to higher inflation expectations and this could feed into a wage-price spiral of a type that a credible inflation targeting regime is meant to prevent. A recent speech by Adam Posen (available on the Bank of England website) looks very carefully at all the evidence on UK inflation expectations and the prospects for wage inflation. He concludes that, while some survey measures of inflation expectations have risen recently, this should not be a major concern as this is not reflected in all measures, has not broken the belief that inflation targets will be met in the medium term, and shows no signs of feeding through into wage inflation (in the context of a very weak labour market).
Overall this suggests that policy tightening is not on the cards for a while yet. It will only become an immediate prospect when inflation projections for 2012 and beyond appear to have risen sharply. In the meantime there are likely to be several months of “no change”.
Alec Chrystal, Cambridge 23rd March 2011.