An Op-Ed in the Indian Express two weeks ago offered an easy-to-digest rationale for why commodity futures trading can benefit small farmers. Historically, writes Ila Patnaik, a senior fellow at the government-funded National Institute of Public Finance and Policy think tank in New Delhi, trading activity in any given town was dominated by 10-20 powerful families.
These families would often determine purchase prices. Farmers would have little choice vis a vis the price at which they can sell; indeed farmers might not even know prices elsewhere in the country. The futures market is a powerful tool for breaking the market power of these families. Futures trading -- taking place on a transparent, electronic exchange with nationwide access -- brings in a host of new players. Indeed, there are hundreds of people in India who are watching world markets, processing information, and putting trades onto overseas commodity futures markets. Physical proximity to the market becomes a non-issue once an electronic exchange is in operation. Someone in Orissa can be trading guar seed, even though he may have never been to Bikaner which is the traditional trading centre for guar.
(Guar beans, grown principally in South Asia, are a member of the pea and bean family, consumed by both humans and cattle.)
Agricultural commodity futures trading is also a form of insurance. A farmer who can't be certain what the price of his crop will be when it is harvested can lock in a deal months ahead of time by contracting to deliver X amount of Y at Z price. This adds a level of certainty and predictability to a profession at the constant mercy of the weather.
But what happens when that predictability vanishes, because speculators who neither produce nor actually purchase finished goods swoop into the market and send prices haywire? The New York Times has a great story today on the impact of hedge fund commodity traders on agricultural markets. It seems that some of the same energy traders who pushed the price of a barrel of oil way up and then back down over the past year have been moving into the corn and wheat and livestock markets.
The flood of investment has raised concerns among grain traders and agricultural producers that speculative money is gaining an undue influence over their markets, which help set the prices of raw commodities for a host of consumer food products...
The index funds may be stoking volatility, traders and analysts say, because the agricultural markets tend to be far less liquid than other commodity markets, like energy. Such volatility could lead to higher prices for buyers and sellers of agricultural commodities, including food at the grocery store.
The common narrative linking corn and oil is compelling. In both cases, traders are betting (or did bet) that as demand inevitably grew (China and India gobbling up oil, ethanol refineries chasing corn) prices would rise. But by betting en masse on a price hike, the traders ensured that the prices rose far higher and faster than physical, quantifiable reality merited. Whether or not you believe that the Saudis are running out of oil, or the surging price of tortillas in Mexico is ethanol's fault, the implications are serious. Poor people get hit hard when the price of heating oil or corn goes up, and it is appalling to think that those price hikes are the result of Wall Street hedge fund traders' raking in billions for super-well-heeled investors.
It's not too hard to make a cognitive leap from oil and corn speculation to the topic of currency speculation on the globalization stage. Market fundamentalists are constantly pressuring developing nations to reduce controls on capital flows in and out of their countries, and to let their currencies "float" -- in other words, to allow their value to be determined by the laws of supply and demand on global financial markets. But any sane person who views the mob behavior of traders can see very quickly that putting yourself at the mercy of the market does not automatically mean that the correct value for your currency is arrived at through this process. In today's world, hedge fund traders, operating under relatively little oversight, command immense power to warp markets.
We need to be watching them like hawks. No matter how fervent one's belief is in the liberating power of markets, getting them to work for everyone's benefit takes constant tinkering and adjustment and regulation. Patnaik's conclusion about futures trading markets in India could be applied anywhere a trader is about to make a big bet.
The correct response lies in addressing problems, and not banning the market. As we have seen with stock markets, the sound functioning of markets requires complex institutional structures, which requires sustained efforts over decades on drafting of law and regulations, building human capital, inspection capacity, an appeals process, and arriving at a judicious blend of competition, market design, policy and supervision.