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Thought for Food: the Causes and Consequences of Soaring Food Prices
The Elliott School of International Affairs
The George Washington University
September 24, 2008
by Nora Lustig
Introduction
After three consecutive decades of decline, world prices of food commodities have risen over the past five years at an alarming pace. (Figures 1 and 2) Between 2003 and 2008, world prices for meat and poultry nearly doubled, corn and wheat prices more than doubled, and butter and milk prices grew three times. An extreme example is the price of rice, which doubled in the lapse of only four months!
Soaring food prices are a cause of major concern because they bring significant and immediate setbacks for poverty reduction, social stability, inflation and a rules-based trading system. Rising food prices increase poverty for millions of poor (and near-poor) people throughout the developing word. If high food prices persist, there could be irreversible damage to the human capital of the poor and a significant reversal in the progress made towards achieving the Millennium Development Goals. The damage to human capital, if large and persistent enough, could in turn have a negative impact on long-term growth particularly in the poorest countries.
High food prices are a source of social unrest and many countries have faced food protests and riots, some of them quite violent. Persistent high food prices could also become a contributing factor to new conflicts or relapses in post-conflict countries. More vulnerable cases are likely to exist in areas where food production or marketing, or the pain of higher food prices, is concentrated in certain geographic areas and/or in certain ethnic or religious groups. High food prices can also exacerbate the devastating consequences of conflict by undermining access to food for the poor and vulnerable. As the World Food Program has demonstrated, increased prices have created severe budgetary difficulties for food aid programs and made planning for food relief excruciatingly difficult.
Rising food commodities prices pose significant macroeconomic challenges and policy dilemmas to developing countries. Both commodity exporters and commodity importers must grapple with inflationary pressures. And both confront the dilemma of how much of the food commodities world price increases should be passed through to domestic consumers.
Faced with falling living standards, inflationary pressures, food insecurity and the threat (or reality) of social unrest, governments in developing countries have been resorting to measures that have exacerbated the upward pressure on world food commodities prices and weakened a rules-based international trading system. Nothing is bringing back the distrust of the market more forcefully than the current situation of high food and energy prices.
Soaring food commodities prices have pushed governments to intervene in markets in often inefficient and beggar-thy-neighbor ways. To cope with their repercussions, governments are using price controls, general (as opposed to targeted) price subsidies and export bans; and, net importers of food are debating whether they should re-instate agricultural support policies and trade barriers eliminated during the structural adjustment programs of the 1980s and 1990s in order to become more self-reliant in food production.
This reaction has significantly undermined a rules-based trading system. Even the recent collapse of the Doha Trade Round negotiations was due in part to the fall-out of high food prices. As food security returns to the political agenda, many developing countries want to protect their agricultural sector from surges in external competition through special safeguards, subsidies or trade barriers. As long as the multilateral system does not address how to eliminate the policy-induced sources of soaring food prices and contain their fluctuations, it should come as no surprise that developing countries will choose to protect their own interests even if it is at the expense of others.
Although rising food prices were previously noticed (and noted), it was not until the second half of 2007 — and, in particular, in the first quarter of 2008 — that soaring food prices took center stage among the world's most pressing issues. There is, however, reason for this lagged response. Although food prices have risen since 2002, the rate at which they increased accelerated from the second half of 2007. Between July 2007 and June 2008 prices rose by 42 percent; this is equivalent to a third of the increase observed from January 2002 onwards in only 15 percent of the time. Since July 2008, food commodities prices began to fall. However, while this decline came as a relief, it should not be viewed with complacency. Food prices are likely to stay high — significantly higher than at the end of the last decade — in the foreseeable future.
What are the main causes of rising food prices? In particular, what is behind the acceleration in food price increases observed between mid-2007 and mid-2008? To what extent is the increase in world food commodities prices market-driven or policy induced? What are consequences of higher food commodities prices for developing countries? What is the appropriate policy response? Do governments have the policy instruments to cope with the effects of rising food prices?
My presentation is organized as follows. First, I analyze the causes of rising food commodities prices. Second, I look at the consequences of rising food prices on inflation and poverty in developing countries and examine the governments' response. Third, I discuss the policy options to mitigate the negative effects of rising food commodities prices. At the end, I summarize the main conclusions.
1. Why did food prices rise?
Supply-side Constraints
By and large, the performance of agriculture over the past twenty five years has been viewed as a success story. According to the World Development Report (2008), for example, "…[F]rom 1980 to 2004, the gross domestic product (GDP) of agriculture expanded globally by an average of 2.0 percent a year, more than the population growth of 1.6 percent a year. This growth, driven by increasing productivity, pushed down the real price of grains in world markets by about 1.8 percent a year over the same period." In addition, low prices were also the consequence of agricultural support policies in the European Union and the United States.
However, at the turn of the century, this success story was coming to an end. Standard forecasting models predicted that food prices would rise by 0.26 percent per year until 2030 and 0.82 percent per year from 2030 to 2050. What factors were behind this anticipated change? Contrary to the neo-Malthusian view that has characterized much of the public discussion, per capita consumption of cereals and meat was predicted to fall because of lower population growth and because in populous developing countries the attained per capita food consumption levels would be satisfactory. The International Food Policy Research Institute (IFPRI) projections for demand from 2025-30 and 2050, for example, predicted that growth in cereal consumption would slow from 1.9 percent a year during 1969-1999 to 1.3 percent a year during 2000-2030 and that growth in meat consumption would also slow from 2.9 percent to 1.7 percent a year for the same period.
The main sources behind the expected change in price trends stemmed from supply-side constraints arising from land and water scarcity and slow technical progress. First, the land frontier has been exhausted in the more densely populated regions — primarily Asia. In Latin America there is still room for land expansion, yet often at the expense of tropical and subtropical forests. While in Sub-Saharan Africa there is great potential for land expansion, this would require large investments in infrastructure, human capital and agricultural extension. Second, water is likely to become increasingly scarce and irrigated agriculture would have to compete with the demand from larger and larger industrial sectors and urban centers. Climate change is likely to worsen the availability of arable land and water for agricultural use. Third, slowed R&D spending cautions one to expect technological breakthroughs in the near future. The supply-side constraints had already started to manifest themselves as a decline in the growth rates of yields of major cereal crops in developing countries.
However, although models predicted prices to begin a rising trend, the orders of magnitude bear no resemblance with what actually happened to food prices in the past few years. As we saw above, from January 2002 to July 2008, the price index of internationally traded food commodities prices increased by 127 percent; about 20 percent per year or 100 times more than the predictions of the "business as usual" scenarios (!). The models are not meant to capture short-term fluctuations, but such a difference between predictions and actuality might be interpreted as a strong indicator that we are no longer living in the "business as usual" world. If future price increases were expected to be relatively moderate, what changed in such a fundamental way?
The Role of Biofuels
Let us start by analyzing more closely what happened to demand and supply in the markets for grains and oilseeds from 2000 onwards. Since around 2000, the stocks-to-use ratio for grains and vegetable oils began to fall and reached its lowest level in decades and in 2004 the ratio began to decline for oilseeds. (Figure 4) This is a clear sign that demand was outpacing supply. But was it due to a decline in harvested area, lower yields due to bad weather and disease, rising demand for food consumption or an increase in demand for industrial — that is, biofuels — use?
Evidence shows that there was a steady decline in harvested area (for corn and wheat in particular) at the beginning of the decade, a likely result of low prices in the past. Bad weather had a negative impact on yields and, in specific years, the yields fell below trend for wheat and rice in particular. However, the harvested area for corn, for example, rose sharply in response to higher prices and by mid-decade there were record global crops for corn and oilseeds. These trends seem to indicate that supply (harvested area) was gradually responding to incentives and bad weather was neither generalized nor persistent. Between 2000 and 2007, for all grains, harvested area grew at 0.4 percent and yield grew at 1.3 percent per year, which combined, as we shall see below, should have been enough to cover growth in demand for food consumption purposes.
On the demand side, consumption for food (including animal feed) of corn, wheat and rice was for the most part as expected. Contrary to what is often mentioned in the press, there were no surges in consumption on the part of China or India (or by developing countries in the aggregate) for corn, wheat or rice. The exception is oilseeds (soybeans in particular) for which the demand from China increased above trend. Demand for food consumption (including animal feed) for all grains grew at 1.7 percent per year from 2000 to 2007. Hence, excluding the demand for industrial use (biofuels), supply and demand grew at the same pace.
In contrast, after legislation on mandates, tariffs, and subsidies was passed in the EU and the US, the demand for corn and vegetable oils for industrial use (biofuels) rose above trend and at an increasing rate starting 2004/5. Feed use of maize, which accounts for 65 percent of global maize use, grew by only 1.5 percent per year from 2004 to 2007 while ethanol use grew by 36 percent per year and used 70 percent of the increase in global corn production. Industrial use of vegetable oils (which includes biodiesel) grew by 11 percent per annum from 2004 to 2007, compared with 3 percent per annum for food use. It is estimated that about one-third of this increase in consumption in vegetable oils from 2004 to 2007 was due to biodiesel. In Figure 5 we can observe how price increases of corn and soybeans accelerated after the demand for biofuels experienced its rapid increase.
In quantitative terms, the contribution of biofuels to the rise in food commodities prices has been estimated or calculated using different time periods and prices, different coverage of food products, and different methodologies. The general conclusion that emerges from these exercises is that the contribution of the expansion of biofuels to observed price increases is quantitatively significant. Collins (2008) estimated that around 60 percent of the increase in maize prices from 2006 to 2008 may have been due to the increase in maize used in ethanol." Mitchell (2008) concludes that "… the combination of higher energy prices and related increases in fertilizer prices and transport costs, and dollar weakness … explain 25-30 percent of the total price increase, and most of the remaining 70-75 percent increase in food commodities prices was due to biofuels and the related consequences of low grain stocks, large land use shifts, speculative activity and export bans." Using a general equilibrium model, Rosegrant, et al. (2008) estimated the impact of the acceleration in biofuel production on weighted cereal prices from 2000 to 2007 to be 30 percent in real terms.
How much of the increase in food commodities prices is caused by policy-induced increases in demand for biofuels as opposed to market forces such as higher gasoline prices (derived from higher oil prices)? According to McPhail and Babcock (2008) eliminating federal tax credits (for blending ethanol in gas) and tariffs — and, to a much lesser extent, mandates — in the United States would reduce ethanol production by 18.6 percent and the price of corn would decline by 14.5 percent. While significant, this leaves a large portion of the increase unexplained. What other factors made the production of biofuels profitable?
One obvious candidate is higher gasoline prices. If gasoline prices are sufficiently high, the production of biofuels may be profitable even without the mandates, tax credits and the like. There is a gas price for which the mandates and subsidies become unnecessary in order to make the production of biofuels financially profitable. According to McPhail and Babcock (2008), even if government support policies at the federal level are eliminated, if gas prices were to stay at 3 dollars per gallon or higher, ethanol production would rise from the current levels of 6.5 billion gallons to 14 billion gallons and corn price would stay at 4 dollars a bushel (until recently prices were around 7 dollars a bushel). In fact, as Elliott (2008) shows the mandated levels required by the Energy Policy Act of 2005 in the United States were apparently non-binding. (Figure 6)
In sum, markets were undoubtedly "stressed" before the expansion of biofuels production. However, in the absence of the rise in demand for biofuels, the price increases would have been more moderate, especially for corn. In particular, one would have expected the price increases to subside in 2004/05 when there were record global harvests in corn and oilseeds. Instead, price increases for corn accelerated. The global agricultural markets are highly interconnected. There are complex interactions between corn and oilseeds and other crops such as rice or wheat through substitution on the demand or supply side. If the price of the former goes up, through adjustments in behavior on the demand and supply side and arbitrage conditions, the other prices will follow suit.
The fact that food commodities have become a profitable alternative for the production of "non-human" energy has important implications. In contrast to food used for consumption purposes, whose income-elasticity is below unity (that is, the rate of increase in per capita food consumption falls as income per capita grows or Engel's Law), the income elasticity for food commodities used to produce nonhuman energy could equal unity or more. This turn of events significantly alters the forces at play in food commodities markets and — depending on what happens to oil prices, biofuels subsidies and mandates and research on the agricultural frontier — food could become permanently more expensive in a nontrivial way. In addition, the new link between the prices of food commodities and the prices of energy commodities makes the prices of the former much more sensitive to the economic cycle and macroeconomic policies. The impact of expansionary macroeconomic policies or of periods of aggregate global growth above capacity (overheating) on food commodities prices will be larger than before.
The biofuels-induced increase in the demand for food commodities (corn and oilseeds in particular), other things equal, will continue well into the future. Von Braun (2008) finds that with the current growth path of biofuel production, i.e. with the actual expansion plans for biofuels, oilseeds and corn prices would increase by 18 and 26 percent, respectively, by 2020. In contrast, the "business as usual" — that is, without biofuels — scenario mentioned above predicted an increase in food commodities prices of .26 percent per year or around 5 percent by 2020.
Macroeconomic Factors and Policy Reactions in the Developing World
The increase in prices of food commodities — along with other commodities — accelerated from mid-2007 up until mid-2008 when they began to fall. Between October 2007 and June 2008, for example, they rose by 31 percent: that is, almost a quarter of the increase since 2002 took place in about a tenth of the time. Were export restrictions and other defensive policies by developing countries a major driver? What role did macroeconomic factors — such as the depreciation of the dollar and lower interest rates in the US — play?
Export Restrictions
When stocks are low in markets with low demand and supply price elasticities, very small changes in demand or supply (or expected demand or supply) can have large effects on prices. Clearly during this period there were new incidents that could have had strong effects on expected demand and supply and consequently affected prices. In particular, administrative decisions to ban or restrict exports and put bids on purchases in some developing countries exacerbated the stress in what were already tight markets.
These undesirable dynamics seem to have particularly impacted the international price of rice. In Figure 7 one can observe how the acceleration in the price increases of rice coincided with the time in which some key countries introduced administrative measures that affected the supply or demand of the good.
Governments that introduced unilateral export restrictions or subsidized imports have been criticized because their actions drove already high international food prices even higher. However, these measures were taken in the context of extraordinary circumstances prevailing in the world food commodities markets. As we saw above, a significant portion of the rise in the prices of some commodities is due to the rapid increase in the production of corn- and oilseed-based biofuels and part of this increase is explained by subsidies for biofuels production in the European Union and the United States. Thus, the "moral imperative" cannot be invoked as a reason to persuade governments in developing countries to give up defensive policies if the rich countries are not willing to contribute with their share (i.e., by phasing out the policies in support to biofuels). Second, the threat to political and social stability derived from higher food prices is too real for governments to ignore for the sake of of a "global common good." (Figure 8) In the absence of a coordinated response such as international stocks that can be deployed to avoid shortages and price spikes, it is understandable that countries decide to concentrate on protecting their own citizens.
In addition, as we shall see below, in the last few months the uncertainty surrounding the short-term level of food commodities prices has been heightened by the fact that it is not entirely clear to what extent "transitory" macroeconomic factors — such as the depreciation of the dollar and lower interest rates — and speculation were affecting the relative prices of all commodities (including food commodities). For instance, to what extent commodities price increases were reflecting the relative scarcity of commodities in a very tight market? Or, instead, was part of a global inflationary process with commodities taking the lead?
This may be a good place to bring into the discussion the impact of macroeconomic factors in explaining the increase in food commodities prices: specifically the value of the dollar and interest rates in the US.
The Depreciation of the Dollar
There is evidence, which continued in this decade, that the cycle of the dollar is inversely related to the dollar price of commodities: as the dollar depreciated, commodity prices went up. (Figure 9) Mitchell (2008) argues that the contribution of dollar weakness to the increase in commodity prices between January 2000 and June 2008 could be of the order of 20 percent (.75 times 26 percent). And as shown in Figure 10, however, commodity prices rose in all major currencies. This is an indication that factors other than the depreciation of the dollar played a significant role.
The Sub-Prime Mortgage Crisis and the Commodity Price Rise Acceleration
Following the onset of the sub-prime crisis in mid-2007, there was a remarkable acceleration in commodity price increases. Could the two events be linked? Frankel (2008b) argues that the fact that commodity prices have risen across the board calls for some macroeconomic explanation. For some time, the most popular macro explanation was rapid growth in the world economy. However, since mid-2007 (and until mid-2008) price rises accelerated while the global economy has been slowing down. According to Frankel (2006, 2008), Calvo (2008) and others, one of the explanations may be the Federal Reserve's decision to lower interest rates since mid-2007. The mechanism at play is the following: when interest rates are low — such as in the present scenario — money flows out of interest-bearing instruments and into foreign currencies, emerging market stocks, other securities, and commodities — including food commodities. This portfolio shift drives the prices of these assets higher and higher until they reach a level where people perceive that they lie "sufficiently" above their future long-run equilibrium level. Monetary policy causes real commodity prices to rise initiallybecause other prices are "sticky" (or, in other words, they rise at a slower speed). Because of the different speeds of price adjustments and arbitrage conditions regarding price expectations and interest rates, commodity prices (and the prices of other assets) overshoot in real (and often in monetary) terms.
Frankel (2006) provides econometric evidence in support of the inverse relationship between commodity prices and real interest rates in the US dating back to the 1950s which is generally robust. Casual observation (Figures 11 and 12) shows that the decisions to lower interest rates by the Federal Reserve in mid-2007 were followed by an acceleration in the price increases. In Frankel's own words: "…events since August 2007 provide a further data point. As economic growth has slowed sharply, both in the US and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out. This is why commodity prices have resumed their upward march over the last six months, rather than reversing it." One could also add that the relatively rapid fall in all commodity prices between July and August 2008 contributes to yet another data point in the theory by giving more credibility to the notion that there was "overshooting" in the behavior of the prices of commodities.
Spot prices for food (and practically all) commodities fluctuated sharply since January 2008. In the case of food commodities, for example, the price of wheat went from $370 to $440 from January to March to then fall to $329 in May and the price of rice went from $394 in January to $1009 in May and dropped to $799 in July and $737 in August. Similarly, the price of corn started at a level of $207 in January, peaked in June at $287 (a 39% increase) and dropped 7 percent in July and even further in August back to March 2008 levels ($235).
The importance of expansionary monetary policy as a cause of the acceleration of the price increases has been dismissed by some analysts because if that were the case, one would observe an increase in stocks of commodities — including food commodities — and available evidence does not show this. However, in the case of certain commodities such as oil or metals, stocks can be accumulated in "invisible" ways: by drilling or mining less. In the case of agricultural commodities, this option does not really exist because one cannot accumulate a stock by simply not harvesting a crop. But, as Calvo (2008) has argued, in the face of highly inelastic demand, the desired level of stocks may increase, but given the short run inelastic nature of supply, this may express itself by rising prices rather than higher stocks. (Note that government interventions to restrict exports and expand subsidies have contributed to the inelasticity of supply and demand). Furthermore, it is naïve to think that stocks accumulated by sovereign governments are public knowledge in full. Finally, because of the recently created link between food commodities and fossil fuels through the biofuels nexus, part of the impact of lower interest rates on food commodities prices may be indirect (that is, there is no need to observe an accumulation of their inventories).
One important aspect to bear in mind is that the explanations of the acceleration in commodity price increases based on fundamentals versus monetary factors, though clearly distinct, are not mutually exclusive. The explanation which emphasizes the workings of physical demand and supply for commodities, considers inflation a consequence of these persistent relative price changes. In contrast, for the monetary explanation, the increase in the relative price of commodities is partly endogenous: a consequence of expansionary monetary policy. Both may be true and are likely to have been at play. This is an area that deserves further research.
In order to determine the appropriate policy response, it is important to know to what extent the price rise acceleration since mid-2007 is determined by fundamentals or is a result of monetary phenomenon. If price increases are a reflection of a "true" and "permanent" change in their relative price, governments should allow the increase to be reflected in domestic prices. To the extent that the price changes are the result of global inflationary pressures associated with lower US interest rates it might be sensible policy for governments to try to partially decouple domestic prices from the behavior of international prices. I shall discuss this in more detail below.
2. The Impact of Rising Food Prices on Inflation and Poverty
Rising Food Prices and Inflation
Rising food commodities prices pose significant macroeconomic challenges and policy dilemmas to developing countries. This is particularly so because it is not just food commodities that have been rising in price; all commodities have, including energy prices. Commodity exporters have been experiencing a boom and fiscal revenues have risen. However, the number of countries in this category is smaller than those hurt by higher commodity prices. As shown in Figure 13a and 13b, the change in terms of trade for food and fuel combined is positive for 29 countries and negative for 87. Moreover, the question remains whether countries that benefit from higher food and fuel prices have been able to transform the windfall into sustainable growth or continue to be vulnerable to the "natural resource curse." As for commodity importers, until mid-2007 they were partially insulated from the negative effect of rising world commodity prices because rapid global economic growth translated into higher exports, remittances and tourism. This changed with the onset of the subprime mortgage crisis in the United States. Since then, global economic growth has slowed down and commodity price increases accelerated. As a result commodity importers faced significant negative terms of trade shocks and pressure on their fiscal stance.
One thing that commodity exporters and commodity importers have in common is that both must grapple with inflationary pressures. (Figure 14) Inflation has been on the rise in developing countries. What is the most adequate response to cope with inflationary pressures stemming from higher world food and fuel prices? The answer depends on the extent to which the increase in world prices is a real (and permanent) or a "monetary" phenomenon. If the increase were a "pure" change in the real price of food commodities, central banks have two options: to accommodate the price increases as a spike in the rate of inflation or to suppress it through tight monetary policy. The former is preferable because it would avoid the negative impact that the latter has on economic activity. However, central banks that allow inflation to rise (in particular, if they allow it to exceed the set inflation targets) are putting their hard-won credibility at risk. This risk must be weighed against the costs of tight monetary policy in terms of foregone output. Also, in countries where wage and price indexation is widespread, it will be hard to prevent the initial increase in inflation from becoming entrenched.
Wage and price indexation, however, is much less frequent today than it was in the past. Given that fulfilling the inflation targets may mean that nonfood (with the exception of other commodities) prices must fall in nominal terms, some degree of accommodation might be desirable. Without a temporary accommodation of rising food commodities prices through a one off hike in inflation, significant losses in economic activity are likely and this, in turn, would exacerbate the impact on poverty that food price increases produce directly. In addition, the recessionary impact of tight monetary policy would reduce the fiscal resources available to compensate the poor through targeted safety nets.
Thus, a prudent accommodation of the price increase whenever feasible is a desirable course. One way to make the transitory nature of the accommodation credible might be for the central banks and ministries of finance to openly acknowledge that this will be the course of action and negotiate some form of "pact" with the business sector, labor unions and other groups' representatives to avoid inflationary dynamics from unraveling. An agreement with the IMF in which its task is to monitor whether monetary authorities and ministries of finance are treating the accommodation of the rise in inflation as temporary could be a way to strengthen the credibility of central banks and preclude inflationary expectations from becoming entrenched. But if the signals are that inflationary dynamics are taking hold (for example, if nominal wages are increased by similar amounts as the general price increases), central banks will have to tighten monetary policy to stop them.
For net importers of commodities, moreover, access to external resources from the IMF or other sources can allow them to adjust more gradually to the negative impact caused by higher food (and other) commodities prices on their balance of payments. External financing will help countries to adjust gradually to the new adverse circumstances but cannot be available to avoid them altogether. If this external financing is complemented with resources and policies to increase the levels of productivity and competitiveness, the adaptation of these countries to a negative environment could be turned into an opportunity.
A prudent accommodation of the food commodities price increase in the form of a transitory increase in inflation is the most desirable course of action if the latter represents a "permanent" change in the relative value of food (and other) commodities. To the extent that food commodities price increases are a monetary phenomenon, however, the appropriate policy response might be different. Insulating domestic prices from external inflationary pressures is correct. Even more so if the monetary commodity price cycle is likely to be subject to overshooting as happened in the period from mid-2007 to June 2008. One way to do this is to allow the local currency to appreciate. This would imply that food commodities prices (and, therefore, food prices) in the domestic currency would rise more slowly. As a result, real incomes would not suffer or not suffer as much as the increase in the international food commodities prices would imply.
In countries that are net exporters of commodities, a nominal (and real) appreciation of the domestic currency would be a natural by-product of the rise in revenues in foreign exchange resulting from the commodity boom unless central banks "sterilize" the inflows through open market operations. However, in countries that are net importers of commodities this may not be an option given the impact that higher commodity prices have on their current accounts. If the governments in these countries want to see an appreciation of their currency, they will need to raise interest rates and as a result face a slowdown in their economic activity. This effect can be mitigated if countries have access to external funds. One natural candidate to provide these funds is the IMF.
However, relying mainly on a macroeconomic price such as the exchange rate may not be the best course of action. An exchange rate appreciation has its costs because it affects all tradable goods. It creates disincentives to exporters and hurts import-competing sectors in the economy. An appreciation which is not driven by higher domestic productivity, moreover, can slowdown growth. And if economic growth falls, so do fiscal revenues thereby exacerbating macroeconomic imbalances. Thus, if the increase in world commodity prices is partially a monetary phenomenon, implementing policies that are targeted to contain domestic price increases in specific markets may be appropriate.
A sensible alternative would be to use a combination of an appreciation of the exchange rate with policies targeted to specific markets to contain the domestic price increases of, in particular, food commodities. Among the targeted policies there are those which make use of controls such as price controls and export bans and those which use fiscal policy to affect prices such as changes in general price subsidies, export taxes, indirect taxes and import tariffs. In general, on efficiency grounds, the latter are preferable to the direct controls. The choice of which specific targeted policies to use should be based on "common sense" criteria. For example, governments should choose price policy interventions which are more easily reversed (that is, they do not become hijacked by special interest groups), least distortionary, least regressive, most consistent with a rules-based trading system, most simply implemented from an administrative point of view and least likely to cause unsustainable fiscal imbalances.
How have countries been responding? The food price inflation data indicate that there has been some degree of accommodation. There is also evidence that currencies from many developing countries have appreciated vis-à-vis the dollar. But a large number of governments have been implementing targeted measures to contain prices for specific food commodities. More than 80 developing countries for which data is available have put in place at least one of the following: reduced import tariffs, reduced indirect taxes, relaxed import restrictions, price controls, general consumer subsidies, export bans, export restrictions and export taxes. (Figure 15)
With the exception of import-liberalizing policies, the rest of the measures has elicited quite a bit of criticism from multilateral institutions. Yet targeted policies may be an appropriate response if price increases in the world market are part of an inflationary process which originated in lower interest rates in the United States. As we saw in the previous section, there are reasons to believe that the recent acceleration in food commodities prices may be part of a global inflationary process. If this is true, part of the increase in food commodities prices is not a change in their "real" relative price (or opportunity cost) and governments from developing countries may be right in applying targeted measures to insulate domestic food prices from their behavior in international markets.
It is important to remember, however, that part of the increase in world food commodities prices is real and, thus, should be passed through to domestic prices. Policy interventions that attempt to retard the transmission of the change in international commodity prices to the domestic markets in full will be self-defeating because domestic producers and consumers will not adjust to the new price signals. Also, these measures can be very onerous from the fiscal point of view and inequitable in terms of the use of scarce government resources because, for instance, the benefits of many general subsidies largely accrue to the nonpoor. Hence, measures targeted to contain prices for specific food items should be applied in moderation and phased out when no longer necessary. The problem is that once implemented, new vested interests are born and the temporary nature of the interventions can diminish. The use of "pacts" or agreements with the business sector, labor unions and other representative groups such as those mentioned above might we a way to avoid this.
The use of policy interventions that put a wedge between domestic and international prices exacerbates the price pressures in world markets for the affected commodities. Many of these unilateral decisions restrict the flow of food commodities in the international markets and, therefore, weaken a rules-based trading system. Without a credible multilateral solution to large food price fluctuations, however, it is not surprising that countries pursue what is perceived as best for them even if the rest of the world is worse off as a result. A rules-based trading system should include safeguards and mechanisms that would make the protection of domestic consumers and producers from large — and recurrent — food commodities price fluctuations (in either direction) orderly and legitimate. One such mechanism is the creation of an international stock.
Rising Food Prices and Poverty
Until recently, analysts and policymakers used to be concerned that world food commodity prices were kept artificially low by agricultural support policies in advanced countries, thereby hurting millions of poor farmers in the developing world. Now, the concern is the opposite. With food prices sharply up, multilateral organizations and governments fear that the livelihoods of millions of poor consumers throughout the world have been put at risk.
How can higher food prices be good and harmful to the poor at the same time? The answer is simple: the poor include both net buyers and net sellers of food in significant proportions. Small poor farmers benefit from higher food prices. However, the poor in urban areas and those in rural areas with little or no access to land are negatively affected when food prices increase. This contradictory impact of food prices on the poor has been called the "food price dilemma." This dilemma has been the source of a futile debate regarding when the poor are better off: when food prices go up or when they go down. Rather than trying to measure and base the policy response on the net impact of higher (lower) food prices on poverty, policymakers should be prepared for the unavoidable fact that if food prices rise (fall) poor net buyers (net sellers) will need help and rejoice in the fact that poor net sellers (net buyers) will be better off. In either case, safety net programs will have to be expanded in coverage and size to compensate the group of poor who get hurt. In addition, when food commodities prices increase, there is an opportunity to help poor net sellers translate this windfall into a more long-term improvement in living standards.
As a general proposition, the impact on poverty generated by an increase in the price of food will depend on: i. the relative importance of different food commodities in the production set and consumption basket of different households and the difference between the two; ii. the magnitude of the relative price change; and, iii. the degree to which households are compensated for the price shocks by changes in their income (i.e., by the indirect effect on wages and employment caused by the price change). Evidence suggests that: the poor spend between 60 and 80 percent of their income on food on average; the increase in domestic food price has been significant, and the positive effects on wages take time.
What has been the impact of the recent increases in food prices on poverty? On average, the evidence finds that in the majority of countries, higher food commodities prices increase poverty. (Figure16) The orders of magnitude of the estimated short-term impact of higher food prices on poverty are significant. Ivanic and Martin (2008) show that about 105 million people in the least developed countries have been added to the world's poor since 2005 because of rising food prices. This is equivalent to about 10 percent of the people living with less than a dollar a day and, according to the authors, and "close to seven lost years of progress in poverty reduction" (p.17). Even middle-income Latin America has not remained impervious: Robles et al.( 2008) estimate that the increase in world food prices between January 2006 and March 2008 resulted in an increase of 4.3 percentage points in the headcount ratio or 21 million additional poor individuals. CEPAL (2008) — the UN Economic Commission for Latin America and the Caribbean — estimates that the ranks of the extremely poor and the moderately poor increased by 10 million each. The Asian Development Bank (2008) suggests that a 20% increase in food prices would raise the number of poor individuals by 5.65 and 14.67 million in the Philippines and Pakistan, respectively.
Throughout the developing world, poor net buyers will be adversely affected by higher food prices and net buyers living just above the poverty line are likely to become poor. Are developing countries ready to compensate these groups for their loss in purchasing power? In particular, do safety net programs exist and can they be easily expanded to incorporate the "new" poor? Do governments have the fiscal space to accommodate the additional resources needed to fund the safety net? Unfortunately, 19 (out of 49) low-income and 49 (out of 95) middle-income countries do not have safety net programs.
Figure 17 presents the safety net programs available in low and middle-income countries by category: cash transfers, food for work, food ration/stamp and school feeding programs. Given the characteristic of the adverse shock — i.e., an increase in the price of a good that takes up a substantial portion of the poor person's budget — the most adequate safety net is to compensate the affected population for their loss in purchasing power in cash. Although cash transfers programs (conditional and unconditional) are increasingly more common, they are still not pervasive. According to Figure 17 there are 16 (out of 49) low-income and 37 (out of 95) middle-income countries that have cash transfers programs. School feeding programs are a bit more common in low-income countries than cash transfers programs, but still only exist in 24 of low-income countries. While they will not compensate the poor for the loss of purchasing power associated with higher food prices, school feeding programs can insulate (at least in part) the children of poor households from suffering a cut in their food intake as a result of higher food prices.
In addition to the fact that there are many low- and middle-income countries that do not have safety net programs to help the poor hurt by higher food prices, those that do may have very limited coverage. In the case of Latin America and the Caribbean, for example, the coverage of cash transfer programs exceeds 25 percent of the population living in poverty in 8 out of 26 countries: Brazil, Colombia, Chile, Ecuador, Honduras, Jamaica, Mexico and Panama. The poorest countries in the region either do not have programs or have them in a very limited scale.
Furthermore, most of these programs do not have a mechanism to incorporate the "new" poor or increase the size of the benefit in the face of adverse shocks as part of their design. Some governments (Brazil and Mexico, for example) have increased the amount of the transfer to compensate for the loss in purchasing power. However, the programs have not incorporated as beneficiaries those who became poor as a result of the food price increase. Currently, it is unclear how many of the countries which have cash transfers programs increased the amount of the transfer and incorporated the "new" poor into the program (or implemented a complementary program).
In sum, the existing safety net system in developing countries leaves much to be desired. Safety net programs are inexistent or small in many countries; and, even in the countries in which cash transfers programs are large and effective in addressing chronic poverty, they are not designed to respond to shocks. This means that the majority of the poor who have been hurt or those who have become poor as a result of higher food prices are not being protected from the impact of higher food prices on their living standards. In the cases in which these programs have been expanded, this was done as an ad hoc measure implemented many months (or even years) after food price increases appeared in the scene.
Low-income countries for whom higher commodity prices represent a negative terms of trade shock may not have the fiscal space to finance an expansion let alone launch new safety net programs. There is no available data in the public domain as to how many countries may suffer from this problem. . These countries are candidates for receiving multilateral support in the form of grants or concessional loans whose destination should be to fund the safety net programs to cope with rising food prices. The World Bank, for example, has already approved more than 120 million dollars of grants primarily (from its Food Price Crisis Response Trust Fund funded from Bank surplus) to bolster the safety net system in 14 low-income countries and an additional 400 million dollars is in the pipeline.
Should the overriding policy recommendation be to implement cash transfer programs as quickly and as in many countries as possible? The answer is yes. These programs are crucial to help "pure" and net buyers of food cope with rising food prices, but as long as they have an "insurance" component; that is, as long as cash transfer programs are able to incorporate the "new" poor and adjust their transfers fast enough. As mentioned these programs where they exist have not been designed with an "insurance" component in mind. It will be necessary to analyze whether cash transfer programs can be adapted to incorporate an "insurance" component and what does this imply in terms of their institutional design and implementation.
Are there other measures that can be implemented to help poor consumers cope with rising food prices? De Janvry and Sadoulet (2008) suggest that measures geared to increase access to land and improve the productivity of subsistence and below-subsistence farmers can be a more appropriate intervention particularly in the case of poor countries. In low-income countries between 80 and 90 percent of the poor live in rural areas and between two-thirds and three-fourths of them have access to a plot of land. However, even if they home-produce some of the food they consume, most of them are net buyers of food and are hurt by higher food prices. If this group could have more access to land and/or increase the productivity of the land they already have, two goals could be achieved simultaneously. First, one could reduce the impact of higher food prices on the rural poor by lowering the amount that must be purchased by them in the market and converting those with sufficient assets into self-sufficient farmers or even marginal net sellers. Second, one could begin to address the supply-side constraints on food commodity production mentioned in Section 1 at the lower end of the spectrum. De Janvry and Sadoulet recommend that policy measures should increase the access to: improved seeds and fertilizers for crops, and to small animals; credit to purchase inputs; more land; and, technical assistance.
We have seen that higher food prices make large numbers of the already poor poorer and some of the nonpoor poor. But could this impact on poverty translate into lower long-run economic growth? In low-income countries with little or no agricultural potential if food becomes "permanently" more expensive, we could start to witness the process described by Nobel Prize Laureate Robert Fogel in reverse. Fogel demonstrated that — by increasing the amount of energy available for work and the human efficiency in transforming the dietary energy due, for example, to a lower incidence of disease — improvements in the UK's diet could account for as much as 30 percent of the growth between 1790 and 1980. By the same token, if higher food prices lead increasing numbers of people in poor countries to downgrade their diet (in quantity and quality) for a sustainable period, long-run economic growth in those countries would fall. This, in turn, would cause progress on the poverty front to diminish even further.
The opposite could happen in low-income countries with large numbers of marginal net sellers of food commodities for whom higher food prices would translate into better living standards. As these groups become better nourished and more productive, long-term economic growth could be higher than before. What policy interventions could help lock in the windfall of higher food prices into sustained higher standards of living? Clearly one course of action would be to combine the policies proposed by de Janvry and Sadoulet to improve the productive potential of marginal net sellers and subsistence farmers with programs designed to improve the human capital of children in these households through interventions that would focus on nutrition, education and health.
3. Concluding Remarks
World food commodities prices increased 130 percent from January 2002 to July 2008. Individual agricultural commodities show even more pronounced increases: corn, wheat, rice and soybeans rose by 190, 162, 318 and 246 percent, respectively. Although food prices have risen since 2002, the rate at which food prices increased accelerated in the past year. Between July 2007 and June 2008 prices rose by 42 percent; this is equivalent to a third of the increase observed from January 2002 onwards in 15 percent of the time. Since July 2008, food commodities prices began to fall. While this decline comes as a relief, prices are likely to stay high in the foreseeable future.
As we saw, there are three main drivers of rising food prices: long-term supply-side weaknesses, a change in demand due to the surge in the production of biofuels starting in 2004, and the combination of macroeconomic factors such as the depreciation of the dollar and lower interest rates in the United States with export-restricting policies on the part of developing countries since mid-2007.
For developing countries, the consequences of soaring food prices can be very large and the policy challenges complex. First, higher world food commodities prices cause significant inflationary pressures in developing countries. One key policy dilemma is to what extent governments should allow the changes in world food commodities prices to be passed through to domestic prices. If the increase is a reflection of a global inflationary process, partially insulating domestic food prices may be the most adequate response. Many developing countries have chosen this path. The use of policy interventions that put a wedge between domestic and international prices exacerbates the price pressures in world markets for the affected commodities. Without a credible multilateral solution to large food price fluctuations, however, it is not surprising that countries pursue what is perceived as best for them even if the rest of the world is worse off as a result. A rules-based trading system should include safeguards and mechanisms which would make the protection of domestic consumers and producers from large — and recurrent — food commodities price fluctuations (in either direction) orderly and legitimate.
Second, available evidence suggests that the decline in living standards of poor consumers caused by higher food prices outweighs the benefits accruing to poor agricultural producers in the majority of countries that have been analyzed so far. Implementing measures to help the poor consumers cope with higher food prices are of the essence. However, too many developing countries lack the instruments, administrative capacity and fiscal space to implement safety nets such as cash transfers fast enough and in the required scale. This is one of the most pressing policy challenges that we face.
Since many of the extreme poor in low-income countries live in rural areas and between two thirds and three fourth of them have access to small plots of land, policy interventions that would further expand their access to land and increase the productivity of their plots could kill two birds with one stone. Greater access to improved seeds, fertilizers and small animals, credit to purchase inputs and land, and technical assistance could reduce the impact of higher food prices on the rural poor. These policies would lower the amount that must be purchased by them in the market and convert those with sufficient assets into self-sufficient farmers or even marginal net sellers. These measures would also help address the supply-side constraints on food commodity production for the extreme poor living in rural areas in low-income countries.
Multilateral financial institutions can play a key role in providing financial resources to countries facing negative terms of trade shocks, technical assistance in the design of safety nets and resources to add fiscal space to countries to fund safety net programs. International organizations can also help countries design the appropriate macroeconomic policy response. This will call for greater flexibility in the menu of policy options traditionally deployed by the Bretton Woods institutions, including temporary measures to contain price increases of specific goods. Finally, multilateral organizations can help countries design, implement and fund programs whose main objective is to enhance the productive capacity, and thereby improve the food security, of millions of poor farmers throughout the developing world.
Food prices are unique since food is unlike any other good. Food is not simply a source of pleasure. Food is essential for survival; it is the most basic of basic needs. Access to basic nutrition permits humans to live, work, reproduce and fend off disease. It should come as no surprise that the poor themselves list hunger and food insecurity as their core concerns. Food is special from the production point of view as well. It is the key ingredient in generating human energy, and human energy is essential to any, and all, economic activity. If food becomes permanently and significantly more expensive, long-term economic growth in the poorest countries could slow down. These are the reasons why we need actions now.
Thank you.
Nora Lustig is the J. B. and Maurice C. Shapiro Visiting Professor of International Affairs at the Elliott School of International Affairs, George Washington University. This lecture is based on Nora Lustig's paper Thought for Food: the Challenges of Coping with Soaring Food Prices (September 2008), prepared for the Center for Global Development. The author is grateful to Maria Davalos for her excellent research assistance, and to Mark Eisinger and Amanda Lintelman for very useful editorial suggestions.
