Monday, April 7, 2008

Biofuels: Revenge of the Anchovies?

On the board in intermediate macroeconomics today:
Supply shocks
1973: Oil price shock; Food price shock

The students were already familiar with 1973 OPEC embargo from an earlier discussion of the productivity slowdown, but second shock required some explanation. So I told them the story about the failure of the anchovy harvest (next time I'll get the details right - it was off the coast of Peru due to the 1972 El Nino) which contributed to a worldwide spike in food prices because of the anchovy's role as an ingredient in animal feed and fertilizer. This is an example of "cost push" inflation which would shift the Phillips curve upward.

Former St. Louis Fed president William Poole is not a fan of the anchovy story. In a 2004 speech, he said:
In the four decades since the beginning of the Great Inflation of the 1960s and 70s, economists and central bankers have acquired a much better understanding of the source and consequences of inflation. When the Great Inflation began, it was common to cite one or another idiosyncratic events as the driving force behind the observed change in prices: OPEC, steel prices, anchovies and forth. Anchovies? Few today will understand this reference, so I’ll have to explain that some analysts argued that the disappearance of anchovies from the coast of Peru in 1972 had something to do with rising inflation in 1973. Today, however, economists universally accept the proposition that sustained inflation or deflation is, in the words of Milton Friedman, “everywhere and always a monetary phenomenon.”
Note the word sustained - we generally accept the quantity theory of money as an explanation of movements in the price level over the long run, but things like harvests and oil price shocks may matter in the short run. (To abstract from transitory volatility due to food and energy prices the Fed often focuses on "core" inflation measures; see this earlier post).

The anchovy story seemed particularly relevant today, after reading Paul Krugman's latest column, "Grains Gone Wild":
These days you hear a lot about the world financial crisis. But there’s another world crisis under way — and it’s hurting a lot more people. I’m talking about the food crisis. Over the past few years the prices of wheat, corn, rice and other basic foodstuffs have doubled or tripled, with much of the increase taking place just in the last few months. High food prices dismay even relatively well-off Americans — but they’re truly devastating in poor countries, where food often accounts for more than half a family’s spending.

There have already been food riots around the world. Food-supplying countries, from Ukraine to Argentina, have been limiting exports in an attempt to protect domestic consumers, leading to angry protests from farmers — and making things even worse in countries that need to import food.

The increase in food prices is attributable, in part, to the (misguided) fashion for biofuels, Krugman explains:

Where the effects of bad policy are clearest, however, is in the rise of demon ethanol and other biofuels.

The subsidized conversion of crops into fuel was supposed to promote energy independence and help limit global warming. But this promise was, as Time magazine bluntly put it, a “scam.”

This is especially true of corn ethanol: even on optimistic estimates, producing a gallon of ethanol from corn uses most of the energy the gallon contains. But it turns out that even seemingly “good” biofuel policies, like Brazil’s use of ethanol from sugar cane, accelerate the pace of climate change by promoting deforestation.

And meanwhile, land used to grow biofuel feedstock is land not available to grow food, so subsidies to biofuels are a major factor in the food crisis. You might put it this way: people are starving in Africa so that American politicians can court votes in farm states.

So, 2008: Oil price shock; Food price shock? Are biofuels the new anchovy story?

In 1973, sharp rises in the energy (green) and food (orange) components of the consumer price index contributed to the rise in the overall index (blue):

More recently, energy prices are clearly rising, but the food component is tracking the overall index relatively closely:

It might be that the retail price of "food" may not really have much food in it. That is, the prices we pay at the grocery store reflect some amalgamation of the costs of distribution, advertising, chemicals and packaging, in addition to the food itself, with the latter being a relatively minor part. Indeed, the retail price of "food" (red) seems to bear little relationship to the prices obtained by producers of "crude foodstuffs and feedstuffs" (blue):

So, while there may be other reasons to worry, there is little sign of food-price driven inflation.

For developing countries, it may be a more serious matter. However, food price increases cut both ways: while, as Krugman noted, the real incomes of consumers falls, the agricultural sector, which is large in many low income countries, benefits. As Dani Rodrik discusses here, it is precisely the point of many arguments for lowering rich-world agricultural subsidies to raise agricultural prices for the benefit of developing world producers.

Meanwhile, China is struggling with its own food price shocks - but Michael Pettis makes a case that China's inflation is a ultimately monetary phenomenon.

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