Imagine a world in which Wall Street decided that vaccines were a good investment -- not pharmaceutical companies, but doses of medicine themselves. Speculators might start hoarding a mixed portfolio of polio, tetanus, and swine flu vaccines in a refrigerated warehouse. In the short term, desperate parents and governments would bid the price up; fervid Business Week articles would attract new hoarders to the market; investment houses would pocket increasing commissions. Eventually, possibly after one or more epidemics, drug companies would build more factories. The market would crash, normal vaccination would resume, manufacturers would be stuck with unneeded factories, and speculators who got out before the stampede would profit.
Sounds crazy -- but, for the past 10 years, the world has been doing something similar with wheat, corn, beef, and other food commodities (and with fossil fuels, a key input in our current food system). Unlike those fictional vaccine hoarders, most farm commodity speculators don't warehouse physical grain or meat. Instead they buy "futures," contracts by which farmers promise to deliver at a specific future date.
While speculators controlled less than 25 percent of wheat, rice, soy, and corn futures in 1998, by 2008, it was 70 percent. And -- according to grassroots advocates, an increasing number of economists, and the pope -- speculation was a key part of the 2008 food price crisis, in which, in less than two years, wheat prices more than doubled, more than 100 million people were plunged into poverty, and food riots erupted in countries around the world, before the rapid (but partial) price crash later in 2008.
From the New Deal in the 1930s through the 1980s, the futures market in food generally worked well, allowing farmers and commercial food buyers to plan ahead and protect themselves from price swings. Speculators who neither produced nor consumed commodities were allowed to buy a limited number of futures, providing "liquidity" (i.e. a wheat farmer could sell even if no granary or bakery was buying right then) -- but speculators weren't permitted to buy so much that it would create a bubble.
However, when regulators allowed those limits to erode over the past two decades, the futures market stopped helping farmers manage risk. Instead, it started injecting extra risk into farmers' lives, as food prices stopped reflecting the supply and demand of food and started reflecting the whims of Wall Street. Speculators fleeing the stock bubble in 2000 and the real estate bubble in 2006 poured money into commodities markets. A commodities-touting 2005 study sponsored by future bailout glutton AIG and promoted by Goldman Sachs increased the fad, as did real-life supply and demand stresses such as the increasing use of agrofuel.
Worse yet, much speculation in recent years has been in commodity index funds and commodity exchange-traded funds, relatively new kinds of instruments set up to buy and hold specific commodity futures, regardless of real-world commodity supply and demand. Although long-term speculators must regularly sell expiring futures contracts and buy newer ones, their gambling affects the real-life price for food, because commodity prices are based largely on the futures price.
Traditional commodities speculators use educated guesses about real-world conditions in order to know when to hold their futures contracts, when to fold them, and when to walk away. In contrast, index fund buyers aren't even looking at the cards. They drive prices ever upward -- until people notice the bubble, which then pops as those same speculators pull out. Both ways, brokers pocket commissions.
July's financial regulatory reform made real progress in closing some loopholes that had allowed excessive and behind-closed-doors commodity speculation (how much progress depends on the implementation rules government agencies write). But the reform mandated nothing to deter commodity index funds' buy-and-hold strategy -- which is a recipe for bubble disaster.
Fortunately, there is an elegantly simple measure against this destructive strategy: Stop giving it a tax break. Right now, farmers and food purchasers who use the futures market to hedge are paying up to 35 percent of their profits in tax, while index-fund speculators pay only around 24 percent; nonprofit foundations such as university endowments pay nothing. Sen. Ron Wyden (D-Ore.) plans to introduce a bill that would eliminate the index-fund tax break for food and oil commodities -- a common-sense measure that can help stop the next food crisis before it starts.