Odd claims that biofuels were responsible for skyrocketing commodity prices
The blog Uneasymoney, posted an article this morning claiming that policies which encouraged the production of biofuels was responsible for the crazy run in commodity prices throughout the 2000’s and was ultimately responsible for the 2007/2008 crash.
The post refers to an article in the Journal of Economic Perspectives, which I am reading now but the results of which are summed up here:
the research of Wright et al. shows definitively that the runup in commodities prices after 2005 was driven by a concerted policy of intervention in commodities markets, with the fervent support of many faux free-market conservatives serving the interests of big donors, aimed at substituting biofuels for fossil fuels by mandating the use of biofuels like ethanol.
What does this have to do with the financial crisis of 2008? Simple. ..the Federal Open Market Committee, after reducing its Fed Funds target rates to 2% in March 2008 in the early stages of the downturn that started in December 2007, refused for seven months to further reduce the Fed Funds target because the Fed, disregarding or unaware of a rapidly worsening contraction in output and employment in the third quarter of 2008. Why did the Fed ignore or overlook a rapidly worsening economy for most of 2008 — even for three full weeks after the Lehman debacle? Because the Fed was focused like a laser on rapidly rising commodities prices, fearing that inflation expectations were about to become unanchored – even as inflation expectations were collapsing in the summer of 2008. But now, thanks to Wright et al., we know that rising commodities prices had nothing to do with monetary policy, but were caused by an ethanol mandate that enjoyed the bipartisan support of the Bush administration, Congressional Democrats and Congressional Republicans. Ah the joy of bipartisanship.
So then, what I’m gathering here is that the Fed was obsessive about commodity prices fearing inflation, despite the fact that the Fed was in no position to influence commodities markets. This distracted the Fed from focusing on the real causes of the crash and the Lehman disaster, making a bad situation worse.
I’m not sure that this correctly connects the dots, given that there is little evidence that the run in commodity prices had anything to do with biofuels. Even as biofuel consumption increased throughout the 00’s, overall production of corn and yield per acre also increased. Assuming that commodity prices are in part dictated by supply, I would (from an armchair economist perspective) assume that prices should remain somewhat constant.
I’m interested to see that the article disregards financialization of commodities, following a loosening of rules of speculation on ag products in the 90’s and the move toward commodities following the equity bust of 2000 as not being a major factor in the rise in corn prices. This is particularly strange when we consider that non-energy commodities also exhibited rapid price increases and violent fluctuations throughout the 00’s. I fail to see how energy policy could result in increases and volatility in, for example, copper.
It’s a tempting thesis, and made more tempting by the explicit identification of individuals who suggested and implemented such policy, but not one borne out by the data, in my limited, amateurish opinion. The list of potential factors which influenced the run in commodities is a long and confusing one (climate change, increased demand from China and India, global instability, etc. etc.), but I don’t think that the effect of Wall Street greed can be discounted as a major determinant. Interestingly, despite the overall themes of the paper, the author does a poor job of discounting the effect of financialization in the creating of commodity price bubbles.
In reading this paper now, I’m somewhat confused. On the one hand, he confirms many of my initial suspicions that the rising price of food is unrelated to supply and demand factors as growth of both supply and demand were more or less constant, despite localized climate shocks. On the other, he seems to blame a rise in prices during the crash to a shift in energy policy toward biofuels, while overlooking that commodities were already volatile and rising, beginning with the crash of the tech bubble in 2000. I am thining that much of the rise in commodities during 2007/8 was due to panicky speculation as real estate markets tumbled, not to any change in energy policy. Certainly, it may be the case the the policy influence traders to try to exploit potential areas of growth, but it’s hard, then, to discount the effect of financial speculation in commodities outright.
I can at least agree with this:
The rises in food prices since 2004 have generated huge wealth transfers global landholders, agricultural input suppliers, and biofuels producers. The losers lobal landholders, agricultural input suppliers, and biofuels producers. The losers have been net consumers of food, including large numbers of the world’s poorest ave been net consumers of food, including large numbers of the world’s poorest peoples.
I posted the following over at uneasy money. What follows is actually, just one of several comments on the subject.
All of my posts have attempted to make a set of related points.
1. The $0.45 per gallon subsidy for ethanol, that people make so much of, could not and can not reasonably account for all of the effects observed in the corn market from 2005 onwards. Given the corn to ethanol conversion ratio, that’s equal to $1.25 per bushel as an upper bound.
2. The octane/oxygen legal mandates were almost certainly a more significant factor in driving ethanol adoption as a gasoline blending agent. Notably, the oil industry did not favor ethanol at the outset and preferred MTBE. MTBE is made from a C4 (4-carbon) FCC (Fluidized Cat Cracker) output stream and can be blended at a refinery (because it is not hygroscopic) and shipped via pipeline. By contrast, ethanol has to be blended at a gasoline terminal. Eventually, MTBE was banned in many states (including the big ones) leaving ethanol as the octane/oxygen blending agent of choice.
However, even without the octane/oxygen mandates, the value of any gasoline blending feedstock went up as crude oil prices soared in the 2000s. In other words, even with no regulatory mandates the value of ethanol for gasoline production was going to rise in tandem with global crude oil prices.
3. In a typical recent year, about 29% of the corn crop (not half) is consumed to produce ethanol. Higher numbers typically ignore that a substantial fraction (1/3rd) of the corn that goes into an ethanol plant comes out as non-ethanol products (DDG).
4. Actually, ethanol production does have a positive energy yield. Check http://en.wikipedia.org/wiki/Ethanol_fuel_energy_balance for a long list of studies and statistics. However, the net energy balance is actually not very relevant. Ethanol plants don’t use petroleum (as in liquid petroleum) to produce ethanol. They take corn and natural gas as inputs and produce ethanol (and DDG) as outputs. In other words, they transform materials than can not be used as transportation fuels into a transportation fuel. Since transportation fuels have much higher values per joule than solids (corn) and gases (natural gas), the economics are net dependent on any net energy balance.
To use a modest analogy, a typical oil refinery has a negative energy balance. The joule content of the outputs is below the joule value of the crude oil. However, it can still be profitable because very few machines can run on raw crude oil.
5. The energy density of ethanol is 67% of gasoline, not 50%. See http://en.wikipedia.org/wiki/Gasoline_gallon_equivalent for a source.
6. A tariff was imposed on imported ethanol so that the subsidy would accrue to U.S. producers. In any case, it was small on a per-bushel basis. Note that foreign ethanol was not excluded from the blending mandate. It was simply ineligible for the per gallon subsidy.
7. The statement “We now know that rapidly rising food prices were caused by the ethanol mandate” is not clearly true. As stated above, the value of ethanol as a gasoline blending agent would have tracked crude oil prices even without any regulatory intervention. The mandates and subsidy were (and are) germane. However, rising crude oil prices make all transportation liquids more valuable.
8. The average (nominal) price for corn per bushel in 2005 was $1.96. In 2008, it was $4.78. That’s not a tripling. However, 2005 was a low point. The average nominal price in 2004 was $2.47 and $2.27 in 2003. The all-time low (in real terms for all of human history) was 2000 at $1.86. Note that the average nominal price in 1995 was $2.56. However, in 1996 the average nominal price was $3.55. In real terms, the 1996 peak slightly exceeded the 2008 high point.
9. Imported ethanol from Brazil could have never replaced the U.S. supply. U.S. ethanol production exceeded Brazil’s output from 2006 onwards. By 2009, U.S. ethanol production was 50% greater than Brazil. Indeed, the U.S. exports ethanol (huge quantities) to Brazil in some years. Even if 100% of Brazilian ethanol was shipped to the U.S. it would not have been enough. Of course, Brazil was never going to export more than a modest fraction of their production.
10. As sanity check, let’s see how much of global grain production was diverted into ethanol production in 2008 by the U.S. ethanol program. In 2008, global grain production was 2.521 billion metric tons of which 403.5 million tons were produced in the U.S. Note that these numbers exclude global production of 1.959 billion tons of sugar (only 49.427 million tons in the U.S.). From 2006 to 2008, U.S. grain consumption (corn) for ethanol production grew from 35.9 million tons to 62.8 million tons. That’s an increase of 26.9 million tons. From 2005 to 2008, the gain (in corn used to produced ethanol) was 35.7 million tons.
Both numbers are just over 1% of global grain production. Is it really plausible that a 1% shift in global grain product into ethanol production in the U.s. transformed a global market for grains? Note that these percentages would be considerably smaller if I included sugar production (which can be used to produce ethanol and is also used as food in much of the world).
Moving on, is it really plausible to suggest that the weight of a 2% Fed Funds rate was so burdensome that the economy cratered? Note that real interest rates were negative in 2008 with inflation running at 3.8% (2.8% for 2007, 3.2% for 2006).
Perhaps an economy that couldn’t withstand a negative real Fed Funds rate of -1.8% had bigger problems than Fed policy. Perhaps deep market failures in finance, real estate, consumer borrowing, trade, immigration, etc. had created a House of Cards doomed to fall in faint breeze.
To test this theory lets compare apples and hand grenades, specifically corn and AIG. From 2005 to 2008 corn rose by $2.82. The corn crop was roughly 12 billion bushels in those years so the increase in value was roughly $33.84 billion dollars. By contrast, AIG alone lost $99 billion in one year (2008).
Let me offer a “different” model of “what went wrong”. This model suggests that pervasive market failures in finance, real estate, consumer borrowing, trade, immigration, etc. created a debt-ridden, fragile economy that was doomed to fail, with the only question being when.
From 2000 onwards the dominant political economy model of the United States was based on the deliberate hollowing out of the productive core of the U.S. via trade, outsourcing, etc. Note that the U.S. trade deficits in this period reached the highest levels in U.S. (6% of GDP) and world history (in dollars). Jobs losses in the productive sector were large. See “Import Competition and the Great US Employment Sag of the 2000s” for some detailed information. Of course, this was quite bad for the U.S. economy. For ordinary Americans, the situation was considerably worse, because of massive, on going immigration (legal and illegal). The overall job market was dismal (driven down by trade policy). Given the flood of immigrants, employment for Americans fell with stunning declines in the employment / population ratio and LFP (Labor Force Participation).
The political system was not unaware of the pervasive malaise consequential to its preferred policies. but was (and remains) deeply wedded to the status quo. The political system (both parties) responded to the quasi-crisis by promoting an ever larger bubble in real estate, sub-prime real estate, and more generally FIRE (Finance, Insurance, Real Estate). Real estate prices soared and lending standards were relentlessly ratcheted down. Finance as a percentage of corporate profits reached unimaginable levels (44% in 2002).
Real estate was a natural target for a bubble given the non-tradable nature of the product. Real estate prices soared and investment in real estate (construction) rose accordingly. The rise in real estate investment created enough jobs to partially offset the economic hollowing out described above. However, the true value of the real estate bubble was in MEW (Mortgage Equity Withdrawal). The bubble turned homes into ATMs that sustained consumption growth considerably greater than income growth. At its peak, MEW was funneling most of a trillion dollars a year into the economy.
Of course, the FIRE bubble, the housing bubble, and the MEW bubble (tied to the housing bubble) were all based on debt and leveraging, not investment in productive assets and new sources of real income. Like all debt bubbles this one came to a devastating end.
What makes this political economy credible is not just the historical accuracy of the facts, but the scale of the numbers. Trade deficits did run to large fractions of a trillion dollars per year. MEW approached a trillion a year at peak. Sub-prime lending was many hundreds of billions or more. These are numbers big enough to cripple an economy as large as the United States (which they did). Compare them with a $33.84 billioni gain in the value of the corn crop and you have your answer.