Between a rock and a hard place

What would you rather have? Exactly three onions a week for your Sunday-night onion soup, no matter the price you pay? Or you’d rather do without the soup for a few weeks, as long as the price of onions remains stable over time?

Let me rephrase the question: Would you rather have stable prices for whatever you consume but find yourself in and out of jobs as the economy fluctuates? Or you’d prefer to keep your job most of the time, but see prices rise so frequently that you can’t be sure whether you'll be able to afford your dream Caribbean holiday next winter?

These are the kind of dilemmas the Fed battles with on a daily basis. Especially recently, as the ghost of “stagflation” has returned to haunt us. Stable inflation or stable growth and employment? As much as we’d like to have both, life often involves trade-offs and the trade-off between inflation and economic growth is one of them. Or is it?

In the long-run… In the long-run we’re all dead, the world returns to equilibrium and, actually, there is no trade-off between the level of inflation and unemployment.

Mind you that’s not what policymakers thought back in the old days. At the time, they liked to entertain the idea that they could cut interest rates to spur growth and job creation, at the cost of just somewhat higher inflation—nothing wrong with inflation at 4 percent instead of 2!

But didn’t they learn better! Turns out the sustainable level of employment is determined by “real” factors such as technological change and productivity, the nature of labor market institutions or population changes. So if the Fed cuts rates to lift employment beyond the sustainable level, all it will achieve is spiraling inflation…

The lesson? In the long run, the Fed would better aim at keeping inflation low and leaving growth and unemployment alone.

No trade-offs, no problem? Not exactly. Many (though not all) economists believe that a trade-off does exist. But the recent buzz is not about the level of inflation and unemployment; it’s about the trade-off between how much each of the two changes—i.e. how volatile they are.

In this universe, life turns out to be a simple, downward-sloping line: As you slide down the line, you’re basically making a choice: Happier stomach or happier wallet? Parking space, front yard but with suburban routine, or “sex in the city” pizzazz but squeezed in a cubicle of an apartment?

Crucially, volatile inflation or volatile growth? Attempts to stabilize one makes the other more volatile. The implication is that, if a shock hits, a Central Bank like the Fed might not want to leave growth alone in the short-run: Instead, it might choose to tolerate rising inflation for a while, to avoid abrupt changes in growth and employment.

This is especially the case because prices tend to be “sticky”: They respond slowly to, say, a drop in demand. So while inflation today may be high enough to suggest immediate Fed action, this may be deceptive: Underneath the surface, firms may be preparing to lower their prices in response to falling demand, and you're ready to accept zero pay rise, to avoid losing your job.

So how tough is the Fed’s dilemma these days? Turns out that some shocks pose more of a dilemma than others. And the shocks today seem to belong to the “more” category on all counts. Let’s see why.

Demand or supply? Demand shocks tend to be easier to deal with than supply shocks. Suppose we suddenly found ourselves with more money—for example because of an error in the measurement of money supply or because the Martians unloaded tons of greenbacks from a giant helicopter. So we begin to buy more things, growth rises above its sustainable level and prices go up.

The due direction of policy looks unambiguous: The Fed should raise rates to bring growth back to sustainable levels and also lower inflation. Yet a trade-off still exists: How aggressively should the Fed raise rates? Is it worth bringing inflation down fast, if the cost is much slower growth?

Still, it can get worse. Think of a supply shock—like a rise in gas prices to the “unheard of” level of $4 a gallon. Inflation obviously goes up, since oil and energy more broadly are part of our consumption basket. But this time output goes down, since people have less disposable income to spend on other (made in America) stuff.

While the due direction of policy is “up” to stop inflation from rising (remember?.. no Fed impact on growth in the long run?), the Fed is now torn: With growth already falling, it would like to be more subtle with rates. But that comes at the cost of higher inflation for a while, possibly together with higher inflation expectations…

Temporary or permanent? A second complication has to do with whether a shock is temporary or permanent. If oil prices shoot up because a hurricane damaged a few oil rigs in the Gulf, you can reasonably assume it won’t last too long; and the Fed can just sit and watch.

But what if oil prices keep on rising with a dumbfounding determination? At some point, they are bound to start seeping into the rest of the economy. But, gosh, isn’t it reasonable to think that the more they rise, the closer they are to “leveling off”? And with demand falling, could the Fed have a case for “waiting to see”? But for how long? What if prices are “getting ready” to rise but we have not seen it yet because they are sticky?

Starting from bliss? Another complication is that, in most theoretical analyses of the optimal course of monetary policy, the starting point is “equilibrium”: The economy is operating at its sustainable employment level and inflation lies near the Central Bank’s target. But what if the starting point for growth is the “emergency room” after, say, a crash in the housing sector and the financial markets? How do you deal with an oil price shock on top of that?

Where’s the line? Finally, truth be told, the downward-sloping line remains a theoretical concept. So even if it exists, its precise shape, slope and position cannot be known with certainty at all times. And that’s a problem: If the Fed sees an increase in inflation volatility, there are at least two ways to interpret it: It could either be because it has been too lenient on inflation; or because the line itself has shifted—say due to a permanent rise in the volatility of global energy and food prices as demand and supply conditions have become tight. The former might require aggressive Fed action, while the latter less so.

So hey, after reading all this, you might want to show some sympathy for Ben and his crew, and the sleepless nights they spend trying to find the right recipe. Because, admittedly, onion soup with a single onion just doesn’t taste as good..


Glossary: stagflation, trade-off, bliss point, sticky prices, helicopter drop of money, onion soup

Pass-through ails

What do a barrel of Belgian ale and a barrel of feta cheese have in common? How about a dental-extraction forceps and a Rolex watch?

Dying to find out???

Ok ok, I’ll give it away. It’s their levels of “pass-through”: That is the degree to which a depreciation of the dollar will translate into higher prices for you, me and your dentist. As it turns out, the prices we pay for beer and feta are less sensitive to changes in the dollar’s exchange rate (they have a low pass-through), while prices of forceps and watches are more so.

So what determines the level of pass-through? And who cares?

First question first. Since 2002, the dollar has declined 42 percent against the euro and 25 percent against a basket comprising the currencies of America’s main trading partners. Now, you would expect consumer prices to rise as a result—not least because imported products (from Belgian ale to dental forceps) should be more expensive.

So let’s see what happened: Looking at the consumer price index (or CPI), the cumulative increase over the same period has been 22 percent. Hmmm, that’s close to the dollar’s depreciation against the trade-weighted currency basket.

But don’t jump into conclusions: Much of US inflation in recent years has been driven by huge increases in the world prices of food and energy. As an example, the import prices of fuel and energy products have risen a staggering 530 percent over this period—way larger than the move in the dollar. This means that if you isolate the impact of the dollar’s depreciation, you’ll find it to have been fairly small. In other words, you’ll find a low pass-through.

Indeed, studies looking at industrialized countries have shown that the exchange rate pass-through to prices is generally small, industry-dependent, and significantly less than one for one (meaning, if the exchange rate falls by, say, 10 percent, prices will rise by considerably less than that). Importantly, pass-though has been lower in the United States than in other countries. How come?

First of all, there are two stages of “pass-through”: The pass-through from the dollar’s depreciation to import prices; and the pass-through from the change in import prices to retail prices. Let’s take a look at each one:

From Belgium with love: Think of a Belgian trappist monk who aspires to elevate his obscure ale, Westvleteren, to a household name in the US. Abstracting from the fact that he might want to change the ale’s name into something more… pronounceable, the monk decides it would be a good idea if his export prices were not completely out of whack with those of his American competitors.

That was fine back in the good old days when the euro was trading one to one to the dollar: He could sell his six-pack for $8.99 in America and make roughly the same as he made in Brussels—9 euros per pack. But what does he do now that one euro is worth 1.55 dollars? Does he raise his prices to $13.95 to preserve his profit margins in euros? Or does he take a profit hit?

Turns out that most exporters choose to take a hit—they prefer to cut their margins and preserve their market share, rather than raise prices in line with the change in the exchange rate and lose out to competition. That’s what we call “pricing to market.” And that’s partly why the exchange rate pass-through to prices is fairly low, particularly in countries such as the United States, where markets are vast and consumers reliably compulsive.

A Babel affair: Another reason for low pass-through has to do with the globalization of production—the fact that to produce, say, a t-shirt these days, you start in a cotton plant in Texas, move to a factory in Shanghai, then jump to Hong Kong for some finishing touches before your “Economists Rock!” t-shirt travels back to your local Walmart store 1.

Why does this matter? It does because not all exchange rates move together at the same time. For example, while the Chinese renminbi has been appreciating (begrudgingly!) against the dollar in recent years, Hong Kong’s dollar has not moved (because it’s pegged to the US dollar). So import price of the t-shirt would rise only party, since only one stage of production is priced in a currency that moved against the dollar.

Port-to-door: How about the pass-through from import prices to the retail stores? Economists have estimated that storage costs, transport costs and wholesale and retail costs tend to account for between 30-50 percent of a product’s final price 2. This means that, to the extent that distribution costs remain fairly stable over time, they act as “pass-through absorbers:” They cushion the final price from changes in the exchange rate.

So pass-through has been low... But could it rise? And going back to my original question… Who cares? Well, the Fed does.

Taking it personally: You see, the Fed takes the level of pass-through a bit… personally. Here is why: Suppose the dollar depreciates because of a factor beyond the Fed's control--say, oil prices shot up and the US trade deficit widened. If the Fed has a solid track record as a guardian against inflation, the Belgian monks will know the Fed won’t allow the dollar’s move to affect general prices and they will not raise the prices of their trappist brew.

But what if the dollar’s depreciation is perceived as the outcome of irresponsible Fed policies?!! Like... lowering interest rates too much to "bail out" the financial sector?! Everyone, from the foreign monks to the local ale producers, will expect broader prices to go up, and they will be more ready to pass on the dollar’s depreciation to the final prices.

In effect, the Fed sees a low level of pass-through as a signal of people’s trust in its capacity and willingness to fight inflation. So if there were evidence that pass-through has recently increased, the Fed might tilt closer towards raising interest rates in the near future. And that’s when I start to care. You should too, by the way, and you might also want to tell your dentist.


Glossary: pass-through, trade-weighted currency basket, pricing to market, dental-extraction forceps, trappist ale

1 For a colorful account of the globalization of production see the “Travels of a t-shirt” by Pietra Rivoli

2 Jose Manuel Campa and Linda Goldberg have done interesting research in this regard. See here if you’re curious

Dissecting the Oil-Dollar Affair

Don’t we all have a penchant for drawing inferences from patterns! Put that together with a fascination with gossip, and you get all sorts of (wild) stories—great for entertainment’s sake but potentially dangerous if they lead to, say, a suicide attempt or… the wrong investment idea!

Take for example the rumor that Tom Cruise has a crush on… Will Smith . Apparently he has been following him “everywhere” recently... and, let’s face it, Smith is such a charming guy! A pretty harmless gossip, you might think, though not if it were to drive Cruise’s official other-half, Katie Holmes, to a suicide attempt after spending sleepless nights reassessing her skills as a wife.

So here is the latest in gossipville.. Dollar and Oil are having an affair! Yeap, the two have been flirting for years now, but they say this time it looks serious. They have been spotted together way too many times… and their (cor)relation seems much, much stronger than before! Each time the dollar weakens, oil strengthens—and vice versa.

What’s going on?

I decided to do a bit of a detective’s work to find out for myself. No, I’m not jealous, this is not personal! It’s about setting the record straight.

Who is after who? Generally, you would expect the dollar to respond negatively to an increase in the price of oil. All else equal, higher oil prices make America’s imports more expensive. So the trade balance worsens, aggregate demand falls, interest rates are cut to kickstart the economy, returns on dollar assets fall, dollar loses its relative appeal and, long story short, it depreciates. That’s how a higher oil price might bring about a weaker dollar.

Another version looks at the other side of the coin: The oil exporters. Since the barrels of oil they export are priced in US dollars, every time the dollar depreciates the price of their exports goes down, all else equal: The dollars they receive for their barrels of oil will buy fewer Gucci bags, since the latter are priced in euros. So, what can they do?

Well, they can either cut their oil supply, in which case prices will go up, re-establishing their buying power; or they can just raise the price of a barrel of oil outright. If the dollar falls, say, 20% against the euro, they could set the price of a barrel by about as much in dollars, to make sure they can buy as many Gucci bags as before. So that’s how a weaker dollar might bring about a higher oil price.

Both stories are sound in principle (subject to caveats), yet what disturbs me is the following: Both are as much true now as they have been for the past few decades! So why is everyone talking about a stronger dollar-oil correlation NOW? Has anything changed?

So they say. So let’s examine the recriminating evidence.

Gucci or Krispy Kreme? One argument has to do with the fact that America’s exports are not as sought after as before among oil exporters: Back in the early 1980s, for example, the US accounted for around 15 percent of the total imports of oil exporters. Whereas now this has dropped to barely 9 percent. What’s this got to do with the dollar-oil affair?

The idea is the following: As the oil price increases, oil exporters become richer since they receive more money for their barrels. Yet, they don’t seem to be using their new wealth to buy more Heinz ketchup and Krispy Kreme’s. Instead, they’re going after more and more Chinese textiles, Korean semi-conductors and some of those Gucci bags—among other things.

The result would seem to be that, as the price of oil goes up, America’s trade balance deteriorates faster than before: US (oil) imports are more and more expensive while US exports remain stagnant (I repeat, all else equal).

Indeed, this deterioration is much worse that in most other advanced economies: America’s deficit with oil exporters rose by almost $60 billion between 2003 and 2007. This compares with just $8 billion for the Eurozone. And that’s why the dollar should be falling (e.g. versus the euro) these days faster than previous years.

Perhaps… but not necessarily. As we have already seen, oil exporters are becoming a lot richer—as in "530 billion dollars richer" in export revenues in 2007 compared to 2003. Sure enough, they’ve been spending more on imports. But even after you take these into account, you’re still left with an increase in their trade surplus of around $140 billion in 2007 compared to four years before. Right, that’s (a whopping) $140 billion of pocket money! What do they do with it?

Citigroup or Ferrari? Here is the catch. You see, America doesn’t just export movies, ketchup and donuts. It also “exports” investment assets: Like government debt securities (quite a lot of those); shares or bonds of American companies (like Citigroup); debt of government-sponsored enterprises (such as Fannie and Freddie); real estate (like condos in Miami); what have you.

And you might be surprised to hear that oil exporters still fancy America’s financial assets quite a bit, despite their growing intentions to diversify…and despite the shameless collapse of stocks like Citigroup, Lehmans & co. Indeed, according to the latest quarterly report by the Bank of International Settlements (BIS), also summarized here by RGE, oil exporters increased the dollar assets they hold in BIS-reporting banks by record amounts during the first three months of 2008.

What does this mean? It means that whatever deficit America had with the oil exporters continues to be more than offset by flows from these countries back into the US. Ergo, the argument of higher oil-->higher US trade deficit-->higher dollar-oil correlation lacks sufficient corroborating evidence.

Keeping up with Gucci: What about the purchasing power argument? Let's see... If oil exporters had as big a bargaining power as to raise oil prices every time the dollar fell and their (non-dollar denominated) imports became more expensive, why didn’t they do it before? Like, when a barrel of oil fetched just 20 bucks?

More generally, you would have seen oil prices moving up every time oil exporters faced an adverse price shock on their imports, so as to maintain their purchasing power. In other words, you would have seen fairly constant terms of trade (ratio of export to import prices) in these countries. But you don’t see that; oil exporters’ terms of trade have been fluctuating a lot, and very much in line with… oil prices.

The “photos”: Best bit last.. Actually, there is not even a “correlation” to gossip about. Take a look at some numbers: The dollar appreciated during both April and May (versus the euro), yet oil prices continue to rise unabated. This is the opposite direction to the one all those gossipmongers are talking about (which is weak dollar-->strong oil). Sure, perhaps if you look at weekly data, or maybe daily or hourly data, you might start seeing "correlations" that last for… a few days. But, I'd rather call that a "fling," if not "data mining" (the economists' equivalent of "gossip fishing").

Where does this leave us? Yes, dollar and oil have a “thing” going on, for years now. Yes, that “thing” tends to be in the direction of strong-oil-weak-dollar (and vice versa). Yes, had the dollar not weakened (because of the abysmal state of the US economy), oil prices might have been somewhat lower (1/).

But no, there is no compelling reason to believe the correlation has recently increased. Their "status" is at best a fling, and certainly nothing I would bet my money on.

Glossary: correlation, terms of trade, all else equal, data mining, fling.

1/ I feel I should reference here studies by the IMF (in its April WEO report, Chapter 1, Box 1.4) and the Dallas Fed, which have tried to estimate the impact of the dollar’s depreciation on oil prices... Even though I actually find their methodologies lacking in a number of ways that probably deserve a whole other article.

Party TIPS

If you’ve run out of ideas for party pick-up lines, try this:

“Hey precious… how much do you think prices will go up or down over the next 12 months?”

In case you’re dying to ask, I did try it. And, trust me, you’re guaranteed to get at least a few stares!

What you may also get is some spooky numbers. “One percent” said someone (hello? what world are you living in??). Another offered (an obscurely specific) 12.73 percent. True, some of the respondents were either pulling my leg or were already pretty drunk. So let’s discard the “outliers” and stick to the middle ground. The middle response (or median) was near 5 percent. That’s one percent higher than current inflation, which tells me that people expect prices can only go higher… and faster.

Anchors or spirals? Accurate or not, inflation expectations are an important input in the Fed’s decision-making process when it comes to setting interest rates. What the Fed cares about is that people’s expectations of inflation in the medium term remain “well anchored.” “Anchored” as in “relatively insensitive to news about the economy.” Why does this matter?

It matters because it has implications for actual inflation.

Let’s say for example that you’re flipping the TV channels and you hear that gas prices have shot up to nearly $4 a gallon. If your inflation expectations are “well anchored,” you’ll most likely yawn and continue flipping. For a moment, it might even cross your mind to postpone that summer road trip for next year: “Surely the surge is temporary,” you think. Or… “No big deal, the prices of other things will go down, as people spend more on gas and less on everything else.” Or.. “No matter what, the Fed is bound to do something about it!”

Now guess what will happen if your expectations are not “anchored”: Right, you (and your union) go to your respective bosses and demand a pay-rise. Bosses eventually bow to the pressure and your wages go up. But now companies’ wage costs have increased—so they decide to raise their prices even further—a vicious wage-price spiral!

This is exactly what the Fed wants to avoid. And in recent years it has been pretty successful in doing so. But is this about to change?

A penny for your thoughts: There is no shortage of indicators that try to gauge people’s expectations about inflation. Some are based on surveys with questions similar to my party pick-up line—though, admittedly, a tad more rigorous! What they tell us is a story that sounds spooky enough to catch the Fed’s ear.

Take for example the survey conducted by the University of Michigan. It shows that consumers now expect inflation in five years time to be around 3.3 percent. Hey, did I see you yawn? Fine, it’s not “scary-high” but it’s the highest it has been in more than a decade. Moreover, when it comes to short-run inflation expectations (over the next 12 months), these have arguably entered the “frightening” territory: At 5.2 percent, expected inflation is the highest since the early 1980s!

We also have the Survey of Professional Forecasters conducted by the Philadelphia Federal Reserve. “Professional” as in “(supposedly) better informed about prices, by virtue of their profession” (like Wall Street economists!). Once again, we have an increase in inflation expectations in recent months, though at levels that sound more benign—2.7 percent for inflation next year.

How much should we trust these people? I mean, they could well be drunk while the were answering the survey.. or incensed after having just filled up their gas tank.. or, simply, prone to error. Indeed, a historical comparison between the inflation expected in those surveys and actual inflation, points to frequent errors—positive or negative.

Put your money where your mouth is: There is also another indicator of expected inflation that the Fed looks at. That’s the inflation derived by comparing the yield of standard government bonds with the yield of government bonds that protect investors from inflation—the so-called TIPS (or Treasury Inflation-Protected Securities).

The idea behind TIPS is the following: Suppose I invest my money today in the usual (“nominal”) Treasuries, maturing, say, in five years. I then receive a fixed interest every six months and, after 5 years, I also get my principal back. This fixed interest rate will reflect investors’ expectations today for inflation over this five-year period: The higher the expected inflation, the more the interest investors demand, to keep their savings from eroding.

But what if inflation goes up unexpectedly? Yeap, I’m sc$&#*d… the (fixed) interest I receive will not compensate me enough for inflation and my savings will buy less “stuff” five years down the road. TIPS, on the other hand, offer protection against inflation by adjusting my returns every time inflation changes.

So, in principle, the difference between the yield of nominal treasuries and the yield on the TIPS (of the same maturity) should be equal to the market’s expectation of inflation. And since traders bet (a lot of) money into these securities, you would expect the calculation to give us the market’s best guess about future inflation.

Now, in practice, this simple subtraction does not give a clean-cut measure of inflation expectations (if you’re curious why, see here). So the Fed actually makes a couple of adjustments to make sure that apples are compared with apples.

So what do TIPS tell us? The “quick and dirty”, simple-subtraction approach shows that inflation expectations have remained remarkably stable over the past few months. Kind of weird, right? With oil prices double their levels a year ago, and other commodities rising at double digits, you wonder what on earth is going on in traders’ minds… Are they numb? Or do they foresee a calamitous collapse of the economy that will force prices down? But you may not have to go that far. If you see the inflation expectations derived after the adjustments I was talking about, there has been a clear upward move since late last year.

So… what’s happening? Are people losing trust in the Fed? Are we going to start seeing vicious wage-price spirals? Or should we brace ourselves for interest rate increases by the Fed later in the year?

Reading their signals: Truth is, when it comes to the link between inflation expectations and actual inflation, there are still too many question marks for the former to guide policy in a definitive way: For example, how do we, (economic) agents, form our inflation expectations? How exactly do people’s expectations respond to monetary policy? And, actually, are inflation expectations a good predictor of realized future inflation? The understanding of all these issues is evolving, yet far from perfect.

Importantly, the Fed continues to care quite a bit about employment and growth. And with house prices still looking for a bottom, the situation in the labor market fuzzy and credit markets on “ER” mode, controlling inflation expectations might look like a lesser priority--at least as long as the Fed continues to think (/wish) that commodity prices will “level off”... and that you'll keep on yawning.

Glossary: inflation expectations, TIPS, median, anchors, spirals.

Let them swim in rice pudding!

The first serious piece of art I ever bought was a photograph of naked, weightless, visually confounding body parts. Human body parts! To be specific, it was female human bodies, of all sizes and shapes, swimming naked in a pool of… rice starch—the visual result of which is a collection of disconnected body fragments floating in a whitish ethereal medium and conveying a sense of “zero gravity” (the name of the series).

The artist, a soul-searched Austrian with the inevitable sense of irony that Europeans seem to be born with, spent days cooking the rice starch, in order to fill up a two-thousand-gallon tank he set up for the photo-shoot at the rooftop of his New York loft.

That was early 2003. Turns out my piece was a tremendous investment, considering how much it has appreciated in value since then. And this for more than one reasons: First my artistic acumen, as the Austrian is gradually rising to international acclaim; secondly, the phenomenal increase in art prices in recent years, as floods of “new” money rushed to anything that bore the banner “store of value,” from stocks and bonds, to real estate to gold to, yes, art.

But when it comes to my photo, one more crucial factor is at play: The price of rice! Rice prices have more than quadrupled since 2003, for reasons ranging from declining productivity, skyrocketing costs of fuel and fertilizers, the battle for acreage as more land is dedicated to ethanol production, drought here and there or the simple fact that the world’s erstwhile poor are discovering the benefits of three meals a day. The outcome? A nice $4,000 windfall to the value of my photo, strictly on a “production cost” basis!

Yet, what is a boon for me, is a hefty blow for billions (repeat, billions) around the globe. Rice is a staple food for more than half the world’s population. It’s no accident that the Japanese describe “luck” as “having a rice dumpling flying into your mouth!” And it’s no wonder that faced with shortages, inflation and social unrest, governments are getting anxious. And many are reacting! What are they doing?

Bashing free trade: Not that it was ever out of fashion, but free-trade bashing is back in force. Indeed, some "quarters" are blaming trade liberalization, and the concomitant reliance on imports to meet local food needs, as a reason for today's woos. Hmmm.. Let's see why.

You may have heard that import tariffs are bad. Here is why. Import tariffs make goods at home more expensive than the same goods sold abroad. For example, a low-cost Thai rice producer may be willing to sell me one ton of high-quality rice for around 1,100 dollars. But if my government imposes, say, a 30% tariff on imported rice, the total price I pay is $1,430—$1,100 to the Thai exporter and $330 to the government. Evidently, I’ll pass this higher price on to consumers—penalizing all of you, from the simple, rice-and-veggies types to those who love swimming in rice pudding!

But tariffs are bad for another very important reason: They impede the efficient allocation of resources such as land, labor and capital. By (artificially) raising the price of, say, rice, they create incentives for entrepreneurs to shift their resources to rice production. Why use my land to breed cattle or build a semi-conductor factory when selling rice is now at least as profitable a business? Why go through the painstaking (and expensive) process of college education, if I can earn a decent living operating a rice miller? Tariffs therefore help “cosset” a small number of producers at the expense of the consuming majority and, importantly, of productive efficiency and scientific progress.

Countries that saw the advantages of free(er) trade moved to lower their tariffs (at least selectively), and have enjoyed lower prices and a more efficient resource allocation ever since… Up till now. As commendable as it is, free trade works provided countries are willing to trade: If I cut my tariffs on rice, give up on rice production and shift my resources to electronics, I implicitly trust that you, the efficient rice producer, will always sell me your rice. But what if you suddenly decided to cheat?

The cheaters: While you might not think of yourself as a natural cheater, think again when, as a government, you’re faced with skyrocketing world rice prices and food riots on the streets. Allocative efficiency no longer looks like the right priority. The burning issue is self-sufficiency.

And so you "cheat," like a slew of countries have done recently, including India and Vietnam, two of the largest rice exporters in the world. In violation of their “gentlemen’s agreement” under free trade, these countries have restricted their exports in an effort to shield their domestic rice prices from world developments. How does this work?

Export taxes have the opposite objective from import tariffs. Whereas the latter aim at increasing the domestic price relative to the world price (to protect domestic producers), export taxes are imposed to keep the domestic price below the world price.

The “mechanics” is simple: Let’s say I am a rice producer in Thailand and the price I can fetch for a ton of rice in world markets is $1,100. But if the Thai government puts a $550/ton tax on my exports, the price I receive in the end is just $550—the rest goes to the government. In this case, I am indifferent between selling my rice to Americans for $1,100 or to my fellow Thais for $550. The domestic price is thus kept (artificially) low. This sounds good for Thai consumers but it discourages rice production and resources are, once again, diverted to less efficient business activities.

So are the "cheated" right to compain? Take a look at the Philippines: The world’s second largest rice importer and a rice-loving nation, the country has recently had trouble meeting its target for rice imports, managing to cover only half of its needs. I'd certainly complain myself in this case, though slamming free trade (as opposed to the violation of free trade rules) might be somewhat misplaced.

Indeed, export taxes contribute to the problem: In principle, soaring world prices should encourage higher production, helping meet part of the additional demand. But with export taxes keeping prices low, local rice farmers no longer have the incentive to raise their production. Worse, the cheaters have now created a precedent that others might follow. Thailand for example, the world’s largest rice exporter, has so far refrained from imposing export taxes, allowing its exporters to expand their production and benefit from the boom. But if I am a Thai exporter, I may be suspicious about what the government might do next. And this uncertainty may prevent me from taking the risk of investing in facilities to raise production. Production is thus kept low, prices high, most of us lose.

So what next? Rice cartels? Unlikely to work—too many producers, too hard to get them to coordinate, too tiny the rice exports as a share of global production (only 6-7% of global rice production is exported), too difficult to adjust rice supply up or down fast enough in response to world price developments (problems ranging from weather, availability of acreage and lack of storage facilities, to name a few).

A return to autarky? Not really, though with food security the word du jour, governments are spending billions of taxpayer money to promote domestic agriculture and, as Malaysia put it, convert entire regions into “rice bowls.” Unclear where this can end and what will imply for debt accumulation, as rice is only one of the staples facing climbing prices, not to mention fuel and energy. The sustainable solution lies in encouraging private investment to be directed to agricultural research and production, which in turn requires the removal of uncertainty over the investor's horizon--and export taxes can't help!

In the meantime, one thing is certain… it might be some time before the Austrian can have an encore of his rice-pudding party in his loft!

Glossary: import tariffs, export taxes, free trade, autarky, cartels, rice pudding.

From food fights to food wars

You thought your morning latte was irreverently expensive? Well, I have bad news for you. Do not be surprised if you see the price of your favorite Starbucks beverage going up even more in the not-so-distant future. Whether you’re the rich, sweet and creamy kind or just plain, bold and bitter, the spicy, “extra-everything” type or just a placid tazo-tea variety, rest assured, there will be hikes for all.

The reason? “Soft commodities” (“food”, in loose English) are going bizerk. Whether it’s coffee, cocoa, milk or sugar—all quintessential ingredients for your mocha frappuccino—a chart of their prices since late last year looks like the ultimate bliss for an avid rock-climber. Mind you, at stake is not just your frappuccino. Basic staples like wheat, corn, rice and soybeans have skyrocketed, threatening the livelihood of millions of poor around the world. What’s going on?

Emerging needs: First it was oil. Then metals. Now food. Let’s face it, consumption is contagious. And with demographic giants like China, India and Russia seeing rapid and uninterrupted economic growth in recent years, their emerging middle classes have begun to demand not just better roads and bridges but more cars, cellphones and, yes, food.

Take coffee for example. Imports of coffee by the ”emerging economies” rose almost 90 percent between 1995 and 2005, compared to a more “modest” 32 percent in the advanced economies. Sure, the much lower starting levels in the emerging world mean that even a 90 percent growth may not be that breathtaking in terms of actual bags of coffee. But just think what will happen when 1.3 billion Chinese learn how to say “calamel macchiato!”

Guns, strikes and the “battle for acreage”: Then you have supply shortages, of both the sporadic and the structural variety. The former include anything that may disrupt production temporarily, from labor strikes in the Ivory Coast (the world’s largest cocoa producer) to quasi ethnic cleansing in Kenya (a major coffee exporter). The latter are of a more permanent nature and include confined agricultural land; competition for land between agricultural and ethanol producers as high fuel prices continue to make ethanol viable; more frequent floods and other natural disasters, affecting negatively crop yields; or regulations that may discourage investment to make production more efficient.

Coffee or wine? Then you have the speculators. When markets are tight—e.g. limited land in face with growing demand—investors are encouraged to “speculate” that the only way for commodity prices is up, which pushes prices even higher. Indeed, to facilitate making bets on commodities, many investment firms have constructed commodity-linked indices (which track the prices of, say, wheat, sugar and soybeans or composites thereof) with names at least as complicated as a Starbucks drink (such as Barclays’ “Commodities Outperformance Roll Adjusted Liquid Strategy Index”!)

Importantly, investment in commodities has been seen recently as a hedge against unanticipated inflation. Existing investment instruments that help protect your savings from inflation (such as inflation-indexed bonds) do not offer protection against unexpected increases in inflation (quite naturally, since they are unexpected!). So if these unexpected price increases turn out to be persistent, the purchasing power of your savings is eroded.

However, some investors saw that investment in commodities did offer protection—most likely because a hefty part of the unexpected inflation in recent years has come from sharp increases in the prices of commodities themselves (food, energy and metals). So had you kept a few bags of Arabica in your cellar, a few ounces of gold and a few dozens of barrels of crude, you would have been more than protected against the higher inflation that we’ve seen recently. Alternatively, you could have invested in a commodity-linked index and kept that cellar for some fine red wine!

Food war victims: So how long can commodity prices stay at towering levels before we all engage in food fights (sorry, food wars)? While the (US-led) global economic slowdown may put a temporary brakes on prices, the tight market conditions are likely to keep them at elevated levels. Meanwhile, various corners of the world are facing nightmares.

The poor first and foremost. Sure, with prices that high, at least some poor are getting a windfall, namely those in major commodity-exporting countries. To come back to those lattes, coffee producers in Brazil have seen their prices rise 20 percent annually over the past five years. In less “affluent” Ethiopia—the birthplace of coffee—producers saw their prices rise 13 percent annually. That’s arguably a decent pay rise, at least in relative terms.

But one might also want to consider the hundreds of millions of poor who happen to be on the importing side of the story; those who have seen the price of their daily naan climb while living in the same abysmal conditions and with the same miserable, subsistence salaries. The situation is increasingly severe, given that the share of food in a poor household’s total expenditures can be as high as 70 percent—much higher than the 13 percent spent by Americans.

Back home, the combo of lower growth and higher inflation is causing Ben serious headaches. That’s Fed Chairman Ben Bernanke, whose job is to steer the economy towards doing quite the opposite: Higher growth and lower inflation. To the extent that persistence in food inflation might lead you to revise your expectations of future inflation upwards, Ben will have a much harder time cutting rates further to bring the economy out of R_____!

So, actually, we might all be better off if you forget about what you just read, enjoy your cran-apple crumb scone and dream blissfully that next year it can only get cheaper.


Glossary: soft commodities, emerging markets, tight markets, inflation-indexed bonds, naan, reduced-fat pumpkin chocolate chip coffee cake.

If you want to know more:

Why are food prices rising?

UN set to ration food aid as prices soar

Refining the Truth on Oil

I was in Gallup, NM the other day, my kind of place when I seek to escape from urban life. Formerly dubbed “the drunk city”, the night-life sounded promising, so I walked into the most decent-looking establishment, went straight to the bar and ordered a gigantic cheesecake. My order did not go unnoticed by the surrounding guests, who were already on their nth beer, and soon enough we were engaged in the usual introductory chat on where we're from, what we do and how many guns we own.

The conversation took a promising turn to politics, when an avid shotgun owner of three began a passionate Bush-bashing. Intrigued by the apparent inconsistency in values, I probed further, only to get the following response: “Look at where gas prices are! All thanks to ‘effing’ George Bush!”

Hmm.. Of all the things one can blame Bush for, gasoline prices is probably the least pertinent. And here is why:

The market for oil is not entirely different from the markets for other products. There is demand, and there is supply, and there are also a few other factors such as geopolitics, weather or market speculation. So let’s take them one by one.

Blame it on China? Growing global demand for oil is an obvious candidate for higher oil prices. That’s partly true, though demand has not grown fast enough to fully explain the surge in prices. Indeed, despite swelling petroleum consumption by the likes of China and India, these countries still account for just a tenth of global consumption, compared to, say, America, which consumes a quarter of the total. And oil demand here has been fairly stable.

Capacity squeeze. That said, even a small increase in demand can make a difference when the ability to accommodate it is limited. Which turns us to the supply side. Underinvestment has meant that global refining capacity (which is how many barrels of crude can be processed per day) has been expanding by a meager 1% annually over the past decade. This is less than the growth in consumption, stretching the available refining capacity to the limits, and pushing up prices.

And then you have the occasional drops in supply due to hurricanes, unrest in Nigeria, a nuclear Iran and, of course, the Iraq saga.

Back to the futures. This combo of factors has encouraged bets that oil prices will keep on rising, driving up the prices of the so-called "oil futures" (basically contracts that preset the price of a barrel of oil a trader will receive in, say, three months). Oil futures prices have risen even further, as some see them as a vehicle to protect themselves from a falling dollar or from declining interest rates on, say, deposits or US Treasuries. And for reasons that I won't discuss here, oil futures prices play a significant role for the price of oil today.

Finding solutions. So what can Bush do? Kill America’s “addiction to oil”? Hard to see it happen without the use of the “T” word to prohibitive levels or the promise to exterminate every SUV in the country—a measure I would support on purely aesthetic grounds!

Bully OPEC to produce more? Well, diplomatic logistics aside, a recent university study in Germany suggests that the price-setting power of OPEC has diminished, partly because its capacity to accommodate additional demand has declined.

Impose price controls? But why then stop on oil? What about house prices, or even milk prices, which have also surged?

OK, maybe he could have done something to reduce geopolitical tensions... maybe.

Truth is, we'll likely have to live with high gas prices for a quite a bit longer; at least until new investment translates to additional capacity and/or alternative sources of energy take hold.

As for the meantime, the man at the bar had a handy solution on how to fuel ourselves, borrowed from a popular country song: “Whiskey for my men, beer for my horses”.

Glossary: Demand, supply, refining capacity, OPEC, alternative sources of energy, whiskey and beer.

Useful links:

Give me a break: Oil prices

"The $100 barrel" from Economist.com

A primer on gasoline prices