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How Did We Get Here?

C. Peter Timmer

Prices of basic foods have increased sharply since mid-2007. 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 the nutritional and health status of poor consumers. Fortunately, the price panics seen early in 2008 have reversed. But price levels remain well above long-run trends and significant micro and macro adjustments are in the works. How did we get here?

What Happened?

Two separate dynamics, with separate causes, are involved: a gradual increase in basic food prices since mid-decade, and then a rapid acceleration in price increases after mid-2007. The gradual run-up in prices was caused by three fundamental and interrelated factors:

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.
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.
3. A combination of high fuel prices and legislative mandates to increase production of bio-fuels established a price link between fuel prices and ethanol/bio-diesel feed stocks—corn in the U.S. and vegetable oils in Europe. The legislative mandates in both the U.S. 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.

The causes of the price spikes 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 soyoil) were reduced in the U.S. 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 very thin world rice market. Commodity markets are now global even if their impact remains country-specific.

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, reduced poverty, and significantly increased life expectancy. 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. If so, hunger and malnutrition will rise.

Can Anything be Done about High Food Prices?

Should policy-makers try to do anything about this new equilibrium? Clearly, it was appropriate to prick the speculative price bubbles, especially for rice, even if ad hoc measures were used. 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.

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 in 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. That is doubly true now.

 

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C. Peter Timmer is a fellow at the Center for Global Development and a visiting professor in the Program on Food Security and Environment at Stanford University. This article is drawn from the author's recent works: A World Without Agriculture: The Structural Transformation in Historical Perspective, Wendt Memorial Lecture (2008), American Enterprise Institute, Washington, DC., and Causes of High Food Prices, Chapter 2 in Asian Development Outlook Update, September, 2008, Asian Development Bank, Manila, Philippines.