Hungry for Growth

By C. Peter Timmer

The appropriate policy response to high food prices is to find ways to stimulate economic growth.

Prices of basic foods have been highly volatile since 2006. They increased sharply in mid-2007, fell sharply in the first half of 2008, and have since regained a good deal of those losses. By late 2010, high food prices are again a subject of concern. The causes and impact of higher prices are the subject of much analytical and policy debate, with little agreement except on the tragic consequences for poor consumers who get caught in price spikes. While the price panics seen early in 2008 have reversed, global food markets remain very nervous, with prices above long-run trends. Significant micro- and macro-adjustments are in the works. To understand these adjustments, and to assess their impact, we must understand the causes of the recent food price volatility and determine the duration of historically elevated prices (relative to long-run trends).

What happened in 2007 and 2008?

Three separate dynamics with separate causes are involved: a gradual increase in basic food prices since mid-decade, a rapid acceleration in price increases after mid-2007, and a sharp decline in food prices in the first half of 2008, followed by the financial crisis, which contributed significantly to lower commodity prices around the world. The gradual run-up in prices was caused by three fundamental and interrelated factors, and these factors have remained in play at the end of the decade:

(1) Rapid economic growth and structural transformation, especially in China and India, put pressure on a variety of natural resources such as oil, metals, timber, and fertilizers. Demand simply increased faster than supply for these commodities, and prices for non-food commodities climbed steadily after 2004. The financial crisis slowed this demand growth for a year or so, but it has since regained momentum, especially in Asia.

(2) A sustained decline in the U.S. dollar since mid-decade added to the upward price pressure on dollar-denominated commodity prices directly, and indirectly drove a search for speculative hedges against the declining dollar—often in commodity futures. The financial crisis supported the dollar, in its role as a “safe refuge” in times of crisis, but it again seems back on its decade-long decline.

(3) A combination of high fuel prices and legislative mandates to increase production of biofuels established a price link between fuel prices and ethanol/biodiesel feed stocks—corn in the United States, and vegetable oils in Europe. The legislative mandates in both the United States and Europe stem from longstanding efforts to increase agricultural prices in these rich societies to ease the pressure of rapid structural transformation on their rural economies. Again, the financial crisis temporarily severed this link, but energy prices and food prices seem likely to be closely linked in the future.

The causes of the price spikes in 2007/2008 depend on commodity-specific factors, although the underlying tightness in broader commodity markets clearly contributed to market expectations that prices were headed higher. Weather and disease problems affected the wheat harvest in 2007, and soybean supplies (and production of soy oil) were reduced in the United States as farmers switched acreage to corn to meet demand for ethanol production. Rice is the clearest example of commodity-specific price behavior, as the price spike was triggered by a ban on exports, first in India, then in Vietnam. These export bans were intended to help contain domestic food price inflation, but also had the dramatic, if unintended, effect of sharply reducing supplies available to a thin world rice market.

It seems unlikely that basic food prices will return to their real long-run downward trend.

Stocks-to-use ratios for all the basic food grains have remained near historic lows. So even though prices on world markets for these grains are well off their peaks, the vulnerability to even a modest supply shock is clear.

The supply response to rapid growth in demand

The pressing question is whether supply dynamics will begin to match the rapid growth in demand. In past episodes of high food prices and fears of Malthusian crises, supply responses have been vigorous, albeit with a lag, returning world food prices to the long-run downward trend that had stimulated rapid structural transformation and reduced poverty. This time, there may be little supply response left in the system, for three basic reasons:

(1) There is little high-quality agricultural land to be opened, and climate change may be reducing productivity on existing cropped area;

(2) The yield potential of existing agricultural technologies has been static for decades, reflecting a serious lack of investment in agricultural research for over two decades—a consequence of undervaluing the sector by markets, governments, and donors; and

(3) The costs of inputs needed to achieve higher yields are high and rising, especially for fuel, fertilizer, and water. Continued high grain prices may also cause land rents and rural labor costs to rise.

In view of these difficulties, it seems unlikely that basic food prices will return to their real long-run downward trend. A more unsettling prospect is that the new link between food and fuel prices—and resulting high food prices by historical standards—could reverse the process of structural transformation, which has been the only sustainable pathway out of poverty.

Can anything be done about high food prices?

Should policy makers try to do anything about this new equilibrium? Clearly, it was appropriate to do everything possible to prick the speculative price bubbles, especially for rice. Reversing the dynamic of rising price expectations, and the private hoarding that exacerbated price spikes, brought dramatic price relief in just a few months. It is unfortunate that the world does not have any internationally mandated mechanism for stabilizing grain prices, or for keeping large countries from destabilizing them. But that is the world we live in.

Reversing the dynamic of rising price expectations, and the private hoarding that exacerbated price spikes, brought dramatic price relief in just a few months.

Equally, it was also appropriate for the international community to rally resources on behalf of increased food aid to the most affected populations. Safety nets for poor consumers are essential in a world of highly unstable food prices. But no one should be fooled into thinking that such safety nets are a solution to poverty, or even high food prices, in more than a transitory way. The only long-run solution for these households is inclusive, or pro-poor, economic growth that provides reliable real incomes and stable access to food from home production or local markets.

The appropriate policy response to high food prices, then, is to find ways to stimulate such growth. Much of the action will be in the agricultural sector, especially in investments to raise productivity of basic food crops. High food prices now seen in world markets provide plenty of incentives to make those investments. But many investments in rural health and education facilities and in agricultural research and extension would have paid off at the prices of a decade ago if donors and governments had recognized the full social value of rising agricultural productivity. These are political decisions that are driven only indirectly by market realities. Perhaps it is good news that the market is sending very clear signals on what to do.

C. Peter Timmer is a non-resident fellow at the Center for Global Development. He has taught at Stanford, Cornell, and Harvard Universities, as well as the University of California, San Diego.