Booms, Busts, and Food Prices
by Gary North
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Maybe you have heard about rising food prices. It is happening all over the world. We hear of Third World rural populations that are trapped by rising food prices.
Why are food prices rising? Simple: because urban people in formerly Third World nations are getting richer. India and China are the obvious examples. As these economies are freed from the regulations that once burdened them, the growing urban middle class bids up the price of food. People with money in their pockets like to eat more and better food. In the bidding war between rural people with little capital and therefore low incomes vs. urban residents with more capital and higher incomes, rural people lose.
The price of food is rising not just in U.S. dollar terms, but in terms of all currencies. This is not a U.S. phenomenon only. This is international.
When we compare the rise in the price of oil since 1999, the rise in the prices of commodities in general (including gold and silver), and the price of food, food remains a bargain. Two charts are here.
COLLAPSE IN 2008
The recession in 2008 drove down the oil price from $147 to $33 in the final five months. This was a collapse. The price of food fell, too, though not to this extent. Silver and gold fell – silver far more sharply than gold. This indicates the degree to which commodities are tied to the worldwide business cycle. Commodity prices fell because the international economy fell.
Commodities are not the initiating force in price inflation; monetary policy is. The prices of raw materials rose in the first decade of the 21st century because central bank policies around the world were expansionary. When the recession hit in 2008, the prices of commodities fell, but not until several months into the recession. (Gold and silver fell in March, before the others fell.)
There is an ancient error, stretching back to Adam Smith, which says that retail prices rise because of cost-plus inflation. Prices for raw materials rise, forcing up retail prices. This was refuted by Carl Menger, the original Austrian School economist, in 1871. He showed that production costs rise in response to bids by entrepreneurs, who in turn expect rising demand for the output of their enterprises. The prices of economic inputs rise in response to expectations.
When, in the second half of 2008, entrepreneurs and speculators finally recognized the extent of the recession, they stopped bidding for as many raw materials. So, the prices of these production goods fell.
It is true that monetary policy affects the business cycle. It is true that QE2 is inflationary. But let us not mistake cause and effect. The increase in commodity prices all over the world ever since early 2009 is the result of simultaneous central bank policies. The Federal Reserve System and other large central banks began inflating in late 2008 to reverse the banking panic by large depositors, not small depositors, who were covered by FDIC rules.
The policies of late 2008 have not produced mass inflation, because commercial bankers have increased their banks' excess reserves at the FED and other central banks. They are not lending all of the money that they are legally entitled to lend.
QE2 has nothing to do with much of anything. Yet.
QE2 AND PRICES
First, QE2 did not get rolling until early in 2011. For most of 2010, the Federal Reserve System was deflating. This is seen in the chart of the adjusted monetary base.
Second, commodity prices rose in 2009 and 2010.
Third, the cause of this increase was the prior monetary policies of central banks, late 2008 to early 2010.
Fourth, the increase in the adjusted monetary base in 2011 indicates that the "exit strategy" of 2010 has ended. Bernanke keeps talking about being ready to adopt an exit strategy when the time is ripe. This is a smoke screen. The FED actually began to adopt a policy that can best be described as an exit strategy in March 2010. It has made a fast exit from the exit strategy in 2011.
That commodity prices could continue to rise in expectation of a QE2-generated recovery later this year is quite possible. It depends on what entrepreneurs expect commercial bankers to do. Will bankers lend? If so, the M1 supply will rise, and so will the M1 multiplier. That will force up prices. But QE2 may fail to persuade commercial bankers to lend. Then the FED will be pushing on a string.
My point is this: you should pay no attention to anyone who tells you that the rise in food prices has been the result of recent Federal Reserve policies. Commodity prices rose in 2010 despite a policy of monetary deflation by the FED. This is rarely discussed by financial commentators.
I think the upward move of commodities will continue until China goes into recession. China's central bank is raising interest rates. As far as we are told, monetary policy remains expansionist. But rising rates for commercial banks will have the effect of making commercial loans unprofitable for some entrepreneurs. They will cease hiring workers. They will cease buying commodities. This is what the Austrian theory of the business cycle teaches. In order to avoid price inflation, the central bank changes course and lets interest rates rise. This ends the boom.
At the margin, Western consumers are not the source of the rise in food prices. The West is rich. It allocates relatively little of its monthly expenditures to food. When Western incomes increase, the bulk of the money does not go to increased consumption of rice, wheat, and corn. This is not the case in the Third World. When people move from the country to work in urban settings, they increase their purchases of food. Their mark of wealth is their ability to buy more food. They bid against each other. They bid against rural residents.
The rising price of oil and food indicates a growing economy worldwide, just as falling prices in the second half of 2008 indicated a contracting economy.
Oil is extremely volatile because of the inability of buyers to store large quantities in reserve. This is not true of foodstuffs. The food is kept in grain elevators. The price of food is less volatile than energy prices, because entrepreneurs who hold grain in reserve can sell into this increased demand. This increases the supply of food available to retail food producers.
DOLLARS AND FOREIGN CURRENCIES
One of the marks of an ill-informed analyst is the absence of any discussion of foreign central bank policies in relation to Federal Reserve policies. Let me explain.
Food in foreign countries is priced in the domestic currency units of those countries. What the Federal Reserve does is not directly relevant to the economies of those countries.
When the FED increases the monetary base by purchasing Treasury debt, this reduces the interest rate of short-term bills, but it can – and did – increase the mid-term rates. This was not what Federal Reserve economists would have imagined. You can see what happened in February.
Higher rates of limited magnitude have little effect on foreign central banks. They buy U.S. Treasury debt for other considerations than a few hundredths of a percentage point in interest. They buy for reasons of mercantilism: subsidizing their export sectors.
The average resident in a foreign nation bids for food, as for all other scarce resources. But he bids in terms of his nation's currency unit. This has nothing directly to do with the Federal Reserve and QE2. The bidding process raises the price of food. Americans must bid more dollars to buy food. But this demand is in terms of consumers' output, not dollars. Japanese residents bid with yen. Americans bid with U.S. dollars. Chinese residents bid with yuan. But to buy yen, dollars, or yuan, residents must sell their output. They are buying food with their output. This is the fundamental fact of all pricing.
The FED inflates the monetary base. This may or may not lead to increased M1 and a higher M1 money multiplier. At some point, Americans will get their hands on some of this new money. They will bid for goods and services. But they will not bid very much extra for increased food. If Richard Simmons had his way, Americans would bid more for a new Richard Simmons DVD on how to lose weight by this or that technique. They would bid more for fresh fruits and veggies and less for snack foods that most people enjoy eating. Snack foods are more about packaging and taste than about the cost of grains to produce them.
So, what matters most for the price of food in a foreign country is the domestic monetary policy and economic output in that country.
If the central bank of some Asian country tries to keep its currency from rising in relation to the U.S. dollar by inflating the domestic currency, this will affect the price of food there. The increased monetary expansion will fuel the boom phase of the boom-bust cycle. This will goose the economy by lowering nominal interest rates. But this effect would not take place if the central bank did not tamper with the money supply or the interest rate on short-term government bonds.
To blame Bernanke and the FED for the rising cost of food is based on a misunderstanding of the currency markets. It blames a cause which is not in fact the primary cause. The primary cause is rising output – increased bids – in Third World countries that are experiencing economic growth. To the extent that this rising output is based on long-term innovation and capital investment, this is positive. To the extent that it is based on fractional reserve banking and central bank purchases of debt, it is not positive. Rather, it is creating a boom that will turn into a bust, just as it did in the second half of 2008.
DESPERATE CENTRAL BANKERS
Central banks inflate to keep government debt markets solvent. That is their official task. It has been ever since the Bank of England was created in 1694.
Central banks inflate also to keep large commercial banks solvent in a financial panic. That has been their unofficial task for at least a century.
They began doing this as a depression hedge in the early 1930s. John Maynard Keynes announced his last career flip-flop in 1936, with the publication of The General Theory of Employment, Interest, and Money. Here, he set forth his recommended cure for the Great Depression: government spending. This could be done through taxes, borrowing, and monetary inflation. He preferred the second, but he was not limited to it, nor have his disciples been limited. Keynes baptized policies that Western governments had already adopted. He invented a new terminology to cover his tracks. He was merely promoting the crackpot monetary theories of Major Douglas and Silvio Gesell, as he admitted (pp. 353-58).
Bringing Keynesian policies up to date, the unprecedented increases in the monetary base of the Federal Reserve, the Bank of England, and the European Central Bank, beginning in late 2008, were the cause of the reversal of the collapse of the financial markets. This reversed the recession. This led to a recovery of commodity prices after 2008. These effects had impact on the eating habits of Chinese and Indian consumers. China and India are part of the international economy. But the effect on food prices was indirect. They rose because demand for Asian exports recovered. The people involved in the export trade were able to bid up the price of food.
There is talk about food being a bubble sector. Given what happened in the second half of 2008, this is a legitimate conclusion: the bubble popped. If the central banks continue to inflate, and the West's economy avoids another major recession, then food prices will continue to increase. Poor people are becoming less poor, and as they become richer, they will eat more. They will also move from bicycles to motor bikes. Motor bikes consume gasoline.
Commodities rise in price when there is increased demand for them as factors of production. There will be increases in technology in these sectors, but the rate of speed at which Indians and the Chinese are getting richer is greater than increases in production of raw materials. This is a bubble in the sense of central bank policies promoting a boom economy through inflated currencies. But the general upward move of commodity prices, as distinguished from consumer goods prices, will likely continue over the next two decades.
There will be a bust at some point, perhaps in the next few years, and maybe before. Central bankers in China and India will separately decide to put on the monetary brakes in order to avoid mass price inflation. There will be recessions in both nations. This will once again force down the price of food. But this will be a buying opportunity. The long-run trend is up, because the long-run trend of Asian productivity is up.
Bernanke is responsible for persuading all of the FOMC members except Hoenig to vote for the expansion of the monetary base. To the extent that this delays the day of reckoning, when capital is finally priced apart from monetary inflation, the FED is responsible for the bubble in food prices. But this increase has been going on for a decade. This is not recent. It has nothing to do with QE2. Yet.
CONCLUSION
The rise in food prices is a mark of deliverance out of poverty for hundreds of millions of Asians. The fact that they are saddled with imitations of the Bank of England, just as residents of the West are, is unfortunate. It will be even more unfortunate when the era of central banking and the welfare state reaches its apogee and collapses.
The universal bankruptcy of the national welfare states will provide a great opportunity for free market economists to say, "We told you so," and perhaps gain their followers a market for the reconstruction of the political order from the bottom up.
There will be a price to pay. The rising price of food in the boom phase of the great transformation is likely. When poor people get richer, they spend money more on food, but less time producing it. The bubble in food prices is indeed a bubble, because Asian central banks are inflating. But in the long run, food prices and oil prices will rise because newly middle-class people prefer to buy food and fuel with their increased output.
The supreme mark of a more productive economy is the increase in the price of land, meaning the raw materials that land produces. Capitalism is reducing poverty today on a scale never before seen. So, food and fuel prices will rise until new technologies are implemented that allow raw materials suppliers to keep pace with the move from the Asian countryside to the cities. Such innovations will not keep pace for the next 20 years.
Be thankful that you are not some middle-aged peasant trapped in the pre-capitalist economy of some Asian village. For him, this vast increase of urban wealth will be no picnic.
February 26, 2011
Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.
Copyright © 2011 Gary North
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