Fixing the food price “crisis”

Every economist, expert and commentator I’ve seen seems to be flummoxed (and mildly panicked) about food inflation. The question on everyone’s lips is, “What can be done about high food prices?” The answer to that is fairly simple. I asked Thomas Carlyle’s parrot to explain.

Price is a wonderful number. It contains a lot of information, and alerts both producers and consumers to a variety of facts. Examine each of these signals, and you’ll have a fairly good idea whether a perceived problem really is a problem, and if so, what public policy prescription might help.

The first point to make is that the solution to high prices is high prices.

High prices signal to producers to produce more, because demand exceeds supply. Therefore, the risk of increasing output — namely that the excess will lie unsold — is low. Higher volumes will be sold, and profits will rise. As the supply increases and producers compete for market share, pressure on prices is downwards. Market power swings back to consumers. This continues until prices find a stable level at which supply equals demand. (It is true that a monopoly or cartel can artificially restrict supply to keep prices high. The De Beers cartel is a famous example. This is an argument for another day, because it unnecessarily complicates the issue and anyway does not hold true for food production, in which excess inventory is hard to store, and hundreds of thousands of producers compete.)

What else do high prices do? They signal to consumers to reduce demand, if possible. Food demand is relatively inelastic, because one has to eat, but even so, consumers can respond to high prices by buying cheaper food, forgoing luxuries, buying in bulk, or economising in other ways when they cook. They will respond by reducing demand as much as is reasonably possible. This places pressure on producers, which results in lower prices. Market power swings back to consumers. This continues until prices find a stable level at which supply equals demand.

Both of these signals are distorted if a government steps in to prop up prices in the interest of producers, or artificially keep them down in the interest of consumers. Depending on where political power lies — business lobbies or consumer voters — politicians find such intervention hard to resist. However, subsidies to producers or price floors will cause oversupply and surpluses. Europe is very familiar with this effect. For years, newspapers were filled with stories about the wine lake, the milk lake, the butter mountain, and similar farm produce surplus problems that depressed prices and caused enormous waste in the economy. By contrast, subsidies to consumers or price caps will cause excessive demand and shortages. Zimbabwe is the most tragic example of this effect today: food is price-controlled and affordable in theory, but there isn’t any for sale because it’s not worth it for anyone to produce and sell the stuff.

So price controls, consumer subsidies or production subsidies are not a policy answer. They break the price mechanism, and instead of solving the crisis, compound the problem.

High prices also signal something about the underlying cost of producing food. In particular, it reflects the high price of oil. Since food is very energy-intensive, involving lots of haulage and mechanised production, the high price of oil will cause food inflation. The policy options in this regard are few. Some will argue that base interest rates should be set by the market, rather than by a central bank. That money should be linked to an underlying standard, rather than be issued by government fiat. These are classic arguments for sound money and against inflationary monetary policy, as made by the free marketeers of the Austrian School and by libertarians like GOP presidential wannabe Ron Paul. As far as it goes, these arguments are correct, in particular because a dollar-denominated commodity like oil is sensitive to precipitous swings in the value of the dollar. However, it doesn’t go far enough. Most of the oil price rise is dictated by high demand and risk in supply, neither of which is sensitive to public policy intervention.

What remains? The reason everyone points to, correctly, is biofuels. Most commentators I’ve seen do lament the diversion of productive farm land to the production of fuel instead of food, but sadly, few follow this diagnosis to its logical conclusion.

The problem is not ethanol production per se. The problem is that farmers are subsidised to favour it over the production of food. Biofuels are only profitable because of this subsidy. If there had been no subsidy, the commercial decision between planting crops for food and planting crops for fuel would be weighed entirely differently. If that were the case, and farmers still chose to produce ethanol, one could reasonably conclude that compared to the demand for ethanol, the demand for food is adequately met, and the most productive application of a scare resource — farm land, in this case — would be to plant fuel crops. With the subsidy, however, farmers are given an incentive to produce fuel crops even if the demand for food is not adequately met, and before the market is convinced that the production of ethanol is, in fact, important and beneficial for the world’s environment.

That’s why biofuel subsidies are such an insidious policy. They distort prices, which results in demand not being met by supply. Nobody can blame the farmers for diverting arable land to produce the subsidised crops. Nobody can blame the World Bank when they advise farmers to grow biofuels. It makes economic sense, but only because of a mistaken, market-distorting public policy.

A similar argument goes for other taxes, tariffs and subsidies.

So, what is the best policy option? The political instinct will be to meddle with food prices via subsidies, taxes, or price controls. That would be a mistake, as we’ve established. So leave food prices alone, but eliminate subsidies that prevent the efficient use of a scarce resource such as farm land. Only then can producers and consumers agree on how much food should be produced and at what price. Producers will get an accurate signal of demand, and consumers will get an accurate signal of underlying costs, and both can adjust their behaviour accordingly.

Reducing or removing these trade barriers and market distortions is not only the best policy option, but it is the only policy option open to governments. It’s not simply one thing we might want to consider, if necessary. It’s the only thing that can be done about food inflation.

It should be noted that every subsidy, tariff or tax that is reduced or removed will have a beneficial effect on the ability of the market to balance supply and demand. Including unilateral actions. They should not be seen as bargaining chips, as the developing world often does vis-a-vis Europe, Japan and the US. Developing-country trade barriers are much higher than those in the developed world. So unilateral action on the part of developing countries has a large beneficial effect, both on trade with countries that retain their own trade barriers, and on trade among developing countries themselves. Economist estimate that 80% of the potential benefit of bilateral trade agreements can be achieved if the developing countries were to act on their own. Why give this up, as a bargaining chip to gain the other 20%? The moral high ground should be enough to shame most developed countries into action, and if they don’t, at least you’ve got the bulk of the benefit thanks to your own farsighted public policy.

It’s also worth observing that this food inflation crisis — and it most certainly is a crisis — is a concrete example of the deleterious effect of misplaced hysteria over global warming. Of course, husbanding resources for a productive future is sensible. And the owners of such resources will do exactly that. (If they’re not owned, they’ll be subject to the tragedy of the commons, but that’s another discussion.)

The green lobby argues that environmentalism and the regulation and subsidies that go with it are good for humanity. That it need not depress the world’s economy, and can benefit both rich capitalist and the oppressed poor. The appropriate response to these political activists is to point them to ethanol subsidies. Just show them the people who are now starving or malnourished because they can no longer afford the rising price of food. That’s how good the green lobby is for humanity. That’s how beneficial it is for the global economy. Environmental alarmism is reversing many years of progress in feeding the poor. And now they cry, “Protect the poor from food inflation!”

Thank them politely for causing the very food inflation they decry, and hope your smug expression doesn’t attract violence from the self-anointed saints who thought they had a monopoly on smug.

It’s not that complicated. Economics seldom is. You’d think the alarmist environment lobby would have heard the distinctive call of Carlyle’s parrot by now.