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3 High food prices: trends, causes and impactsso-called index funds, used by institutionalinvestors to track a representative index ofcommodities, were holding US$120 billion ofagricultural futures contracts, according to oneestimate (Young, 2008).Push and pull factors seem to be at work. Lowreturns on stocks and bonds, low interest rates andfinancial turmoil in developed country housingmarkets have pushed money into commodities.Investors have been attracted because, historically,returns on commodities have compared well withand been negatively correlated to returns on stocksand bonds, providing good portfolio diversificationand risk reduction (Garton and Rouwenhorst,2004).Some economists believe that speculation can beexcessive or destabilizing, giving rise to aspeculative bubble. The fundamental characteristicsof bubbles are usually the same, and include risingprices, leading to profit opportunities andattracting more investments. More investmentpushes up prices, creating positive feedback, and abubble. The critical characteristic of a bubble is thatit cannot be supported by fundamental economicfactors, and generates a psychological element,often described as a mania, hysteria or irrationality(Kindleberger, 2000; Shiller, 2000).A mania can easily become a panic, transformingthe bubble into a crash. There are also positivefeedback loops. When prices and profits decline,the value of collateral declines as well. Loansbecome more difficult to obtain, and peoplewithdraw money, exacerbating the price decline. Afamous example of this boom–bust scenario is thetulip mania in the Netherlands in the 1630s.Another is the housing bubble, whose bursting inthe US triggered the current global financial crisis.It is difficult to distinguish a bubble fromfundamental economic factors. As explained in thischapter, a number of structural demand and supplyfactors can explain the worldwide rise in foodprices of recent years. Many of these factors havebeen changing rather gradually, however, making itdifficult for them to explain a jump in rice prices (ofThai, 5 percent broken) from less than US$400/MTin January 2008 to about US$1,000/MT in May2008, or an increase in wheat prices (of US hardred winter) from about US$200/MT in May 2007 tomore than US$500/MT in February 2008, followedby a fall to about US$250/MT in May 2008.It is particularly difficult to distinguish a bubblefrom fundamental factors before it bursts.Uncertainty about the future creates plenty ofspace for psychology. An important feature offutures markets is that market participants do notknow the true value of the contracts or assets theyare trading. As a result, they act on averageopinion. Traders act according to what everybodyelse believes. If everybody believes that a particularasset a trader owns is overvalued, s/he will be wiseto sell, irrespective of whether s/he agrees or not.This kind of mechanism can easily create herdbehaviour – and bubbles and crashes.New information – true or false, positive ornegative – can lead to reactions and overreactionsin commodity markets. One expert suggests a linkbetween the emergence of speculative bubbles andthe advent of newspapers in the 1600s (Shiller,2000). He draws attention to information cascades,when one story, perhaps at first judged minor,leads to others. Through these cascades, averageopinion changes and bubbles can emerge. Mediacoverage of the biofuel expansion and rising foodprices seems to follow this pattern: a Googlesearch for “biofuel food price” got 3,070,000 hitson 25 July 2008, 85 percent of them dating fromthe previous year. It is too early to drawconclusions, however, and scholars will have todetermine the precise unfolding of events and thefactors that contribute to it.Is there evidence that a speculative bubble hasbeen building? Some facts imply there is. First,large amounts of new money from institutionalinvestors have moved into commodity markets (seethe figures on page 47). Second, the share of noncommercialtraders has increased in many of thesemarkets (Sanders, Irwin and Merrin, 2008). Third,index traders expect prices to increase for 90–98percent of the contracts they hold (“longpositions”), compared with 20–65 percent ofcommercial traders who think that prices willdecline (“short positions”) (Sanders, Irwin andMerrin, 2008), even though the percentage ofcontracts outstanding (“open interests”)attributable to index traders has been relativelystable (Sanders, Irwin and Merrin, 2008). Fourth,there is some evidence that the ratio of volume toopen interests influenced futures prices for rice andwheat, and that the ratio of non-commercialpositions to short positions influenced futuresprices for maize and soybeans (von Braun, Roblesand Torero, 2008).However, other facts imply the opposite. First,commodity prices have also increased forcommodities not traded on futures market, such asedible beans and durum wheat, or not commonlyincluded in index funds, such as rice. Second, some46