In Frank Norris's bestselling novel The Pit, published posthumously in 1903, the hero, Curtis Jadwin, turns from a likeable man-about-town into a monomaniacal money-grubber in the space of a few short chapters. The cause? He begins to speculate on wheat futures at the Chicago Board of Trade. Jadwin attempts to "corner" the market by buying up all outstanding futures contracts until he controls the price of wheat. Only when his wife demonstrates the damaging effects that his speculation is having on people does he allow competition to re-enter the market. By this point, he is already bankrupt.
Norris's novel was based on the life of Joseph Leiter, a speculator whom the New York Times called "the king of the wheat pit". Leiter was the largest holder of wheat in history when he attempted his "corner" in 1897-98. His speculation, like Jadwin's, ended in ruin. The Pit was a huge success on publication, largely because it rides a deep-seated public mistrust of speculation in commodity derivatives, particularly the agricultural commodities whose price fluctuations have a noticeable effect on the cost of the goods in our shopping baskets. With recent hikes in the price of wheat, cocoa and pork, suspicion has once again fallen on the speculators.
Futures are almost as old as agriculture itself. They are now traded in a broad range of commodities, from wheat to water to orange juice, although their original aim was to enable farmers to hedge against poor harvests. A wheat farmer would buy futures at the beginning of the harvest year. In the event of a bad crop, the futures would rise in value, compensating him for his lost earnings. In the event of a good harvest, he would lose some money on his futures, but would make it back on his crops. Similarly, futures allow bakers and other consumers of commodities to lock in prices at a pre-known level, avoiding the risk that a spike in the "spot" price (the price at which you can buy, say, a bushel of wheat today) renders their end product uneconomical.
Speculators have been involved in the futures market since the late 19th century. The food crisis of 2008, in which surging prices led to riots on the streets of cities around the world, was just one in a long list of occasions when speculators have been blamed for volatility in food prices. Hedge funds are the modern successors to Leiter, taking advantage of the ability to trade commodity futures on a "margin" (putting down a fraction of the cash value of the trade) to make huge bets on price movements. The financial markets are no longer just stocks and bonds. But the image in the popular press of slick-suited devils stealing food from the mouths of the world's poor is off the mark.
Volatility in commodity prices is a natural reflection of supply and demand. At the end of The Pit Jadwin is ruined, not by other traders, but by a bumper wheat harvest. This has been the case throughout the history of commodity speculation. Speculators magnify price movements that are already inherent in the market, but the effect of their bets is usually transitory and almost always overstated by the press.
The current wheat crisis has been caused by the drought sweeping across the Russian steppes, ruining the harvest for the world's third-largest exporter. Ukraine, Kazakhstan and Germany have also suffered substantial falls in yield. But, unlike in 2008, harvests have been good elsewhere. Global wheat inventories are in decent shape. Russia imposed an export ban on its wheat on 5 August that will stay in place until the end of the year. While this has sent prices up another few per cent, we are far from the peaks of two years ago. Cooler weather is forecast and this crisis will pass. Speculators may cause prices to remain steep for slightly longer, or to reach higher levels than they would have risen to naturally, but no hedge fund has the resources to change the path of the global commodity markets.
The bare necessities
Agricultural commodity speculation raises tricky moral issues even if its financial impact is limited. I was a trader at ABN Amro in March 2007 when the bank launched the first product that allowed retail investors to speculate on rice prices. In 2008, at the height of the food crisis, a marketing email went out from ABN pointing out that rice inventories were at an all-time low. Now, we were told, was the moment to invest in one of the world's most important food crops, before prices rose further. This at a time when street children in Haiti were eating cakes made of mud and hundreds of millions of people across the globe were threatened with starvation.
Groups such as the World Food Programme and the American Bakers Association call upon the Commodity Futures Trading Commission (which regulates futures in this sector) to crack down on funds that bet on food prices. The calls have risen in pitch recently despite several studies demonstrating that, over time, speculators have in fact dampened volatility in prices.
Regardless of the financial impact of speculation, greater regulation of these hedge funds might not be a bad thing. Speculation in agricultural commodity derivatives may not have a significant impact on prices, but it does point to a mindset among traders that belongs to a time before the great crash of 2008. During the boom, many bankers seemed to forget that the mortgages they packaged into exotic financial instruments were linked to real houses inhabited by real people. In a world where everything is an asset class fit for speculation, we risk making the same mistake as Jadwin, forgetting that water, rice and wheat are more than just commodities: they are necessities.
Alex Preston's column appears fortnightly.
His novel "This Bleeding City" is published by Faber & Faber