The Financialization of Food and Energy Commodities

How the Financial Industry Forms A Bottleneck On Human Development, State Security, and Full Employment, and What To Do About It
Sharifi, Payam (UMKC-Student) 3/15/2012

This chapter seeks to relate food and energy prices today to the concept of full employment, which is related to the concepts of human rights, human security (the combination of which forms human development) and state security. The link between food and energy prices comes through their financialization. In turn, financialization of food and energy commodities forms a bottleneck, which prevents full employment and hence the evolution of human development from taking place. The implications of the bottleneck cannot be understood unless one looks to the process of a countrys development itself. All countries, whether primary commodity exporting or importing countries, have their basic security threatened by the bottleneck. The existence of a manufacturing sector is vital for the growth of human development and state security, and when and where the bottleneck threatens to destroy it must be stopped. Some policy proposals are outlined to minimize the disruptions of the bottleneck.

Introduction
Commodity prices worldwide, more specifically prices of food and energy, have skyrocketed over the past few years. What has arisen from this is a fierce debate as to the sources and causes of these higher prices. Is it, as commonly suggested by many observants, because of rising demand in the fast growing economies of China and India, among others? Or is it because of speculation and manipulation by financial institutions and other speculative actors in the market? Putting aside the issue of whatever the cause is, it must be understood that commodities markets today, compared to even twenty years ago, are entirely opaque. Why this is so will be explained later, but it will suffice to say that by living in a historically dependent world, that there are no narrow scope of answers of which we can use like a toolset in understanding our social world. Yet this does not mean that our collective hands should be thrown into the air, which is regrettably done all too often today. One reason for this lays in the economics taught in universities and organizations worldwide. Modern orthodox economics has pushed a neoliberal set of policy proposals for decades, essentially prescribing that developing nations give up whatever policy space they may have. They do so by allowing deregulation and capital market liberalization to guide the policy process. This chapter takes a more realistic approach to understanding how food and energy prices are related, what effect they have on human rights, human security, and state security, and what can be done about it. What will guide the understanding of this issue is to understand what helps or hinders the process of development. More specifically, the keyword that will constantly be referred back to in explaining this process is that of a bottleneck. The bottleneck that exists is cumulative and circular in character, in that reactive policies that seek to tame it do not work. Its roots are in financialization, a period in which financial markets have come to dominate the world economy. The bottleneck in this case is a constraint on developing nations, whether primary product exporting or importing countries, from expanding output and employment due to

3 financialization, a process brought about by financial institutions. This constraint not only has a direct impact on prices, but on the very structure of the economy. In turn, financialization must be understood in terms of the consequences of the expectations of the financial sector on a (now) financial asset. This section of this volume of Human Rights, Human Security and State Security seeks to understand how we can alleviate the bottlenecks that prevent developing nations (given their specific historical circumstances) from becoming nations that can provide for full employment and security for all, and what can be done about it. To ensure that human rights and security are maintained, the path to development relies exclusively on maintaining the level of aggregate demand sufficient to provide for full employment and output. Yet there are a number of explanations, qualifications and pitfalls that require elaboration and which will fully explained throughout this chapter. Therefore, this paper looks to develop human rights and security through the broader, yet related, concept of human development. Human development is defined as the process of broadening choices for people and strengthening human capacity, while recognizing the value of working with the grain of the marketparticipation, empowerment, equity, and international justice (are) key concerns (Emmerij, Jolly and Weiss 2001). Hence the concept and policy of full employment is interwoven into the concept of human development. Maximizing human development is done by breaking the bottleneck that constrains economies worldwide from providing full employment, full capacity utilization, and price stability. The key that should always be kept in mind here is that to do so will always require a strong manufacturing industry. Maximizing employment and output, and hence human development and state security, relies on the following policies: a competitive exchange rate, a strong state, a tax on primary commodity producers, physical and virtual reserves of food and energy commodities, and increased domestic production of essential food staples.

The Problem of Expectations and Financialization

The global energy and food problem that grips our world today is commonly conceived as a global supply and demand problem, particularly because of China and India. Yet this line of thought is completely invalid, since both aggregate and per capita consumption of grain have actually fallen in both countries (Ghosh 2010). Furthermore, this line of reasoning leaves out a very important characteristic of the world having become more financialized. Stock prices, bond prices, and commodity prices move at a pace so rapid that they have become indicators for the performance of the economy, among other things. The most important question regarding commodity prices today is the following: what mechanism or benchmark do producers use to price a food or energy commodity? Yet we bypass this question for the moment and simply look at a related issue, which is to look at the role of financialization through financial market expectations. Expectations matter in global price formation, and no-one could state otherwise after the global financial crisis that has ravaged the globe. Recognizing that the rise of food and energy prices are related to the inner workings of modern finance, and that its coincidental rise just as the subprime housing boom was coming to an end is no accident, is of particular importance here. Yet these expectations have been fueled along by the Federal Reserve. In order to stop the blood stemming from the global financial crisis, the Federal Reserve drew upon the comments of a long line of dead economists to support what is now referred to as the zero interest rate policy, or ZIRP, and quantitative easing, or QE. Economists Irving Fisher and John Maynard Keynes were among the first economists to call on monetary policy to support asset prices. These were measures to be undertaken by the central bank, in this case the Federal Reserve in the United States, to entice the general public (through the manipulation of the prices of assets) to invest their cash or bond holdings back into the economy (through either the stock market or direct investment into capital). Hyman Minsky made a similar claim

5 for a Big Bank, or central bank in this case to come in and support the prices of capital assets in order to help prevent a financial instability leading to recession (Kregel 1992). According to Irving Fisher (1933) this would help stem the debt-deflation spiral not only in those assets but in the prices of commodity and property values (Fisher 1933). Keynes essentially argued the same thing in his Treatise on Money (Kregel 2011). Keynes argued that the determination of prices would occur through the central bank instituting policies to increase investment and hence output and employment (Keynes 1930). So the issue Keynes had to deal with, in his mind, was how to get people to stop saving and instead put that money towards investment and output. So in fact policies by the central bank had everything to do with what may be termed inducement effects. In short, what may be termed ZIRP and QE was simply the policy of reaching a saturation point for short and longer dated securities such that the inducement to save will instead become an inducement to invest. In other words, the central bank generates a position in which excess liquidity will be moved out of financial debt instruments and into equities and industrial circulation. Keynes argues that whatever increase in the price of equities or other assets that occurs will be of no harm in a time of slump as a very excessive price for equities is not likely to occur at a time of depression and business losses (Keynes 1930). Yet what Keynes realized as he worked towards his General Theory was that policies such as QE and ZIRP are just one side of the system; it had an impact on the composition of financial assets in terms of their interest rate and the search for higher risk assets, but not on real assets. Kregel notes: Keynes requires the marginal efficiency explanation of capital goods prices for precisely the same reason he employs the liquidity preference theory of interest rates, to break the equality between the real return of capital and the rate of interest, which provides the possibility for money to play an independent role as a real factor affecting the level of investment (Kregel 1988) Hence, the important point as outlined by Kregel is that today we live in a monetary production economy. Money plays a central role in determining the level of effective demand, which is just a function that says that spending and income are two sides of the same coin. In giving money a central

6 role in his theory of effective demand, Keynes explanation was that expectations can determine the level of employment and output. Hyman Minsky, who understood the implications of Keynes model, later described it as having two separate prices. In Minskys two-price theory of financial instability there is an assumption that there are two sets of anticipationsof the public over financial liabilities, and of entrepreneurs over capital assets (Kregel 1992). In the words of Minsky, there are really two systems of pricesone for current output and the other for capital assets (Kregel 1992). The determination of capital asset prices are, in turn, determined by uncertainty and inducement effects. The result is that the financial sector can have a real impact on financial and capital asset prices. If energy and food have indeed become financialized, then the implication to be pondered is what effect this may have on human development and state security. Yet the topic of financialization needs a bit more context. Previous research by this author has noted the financial markets role in commodities futures markets (or derivatives markets) (Sharifi 2011). However, a transmission mechanism from the financial markets to the spot markets for food and energy prices must first be established to make the claim that they have become financialized. Before we examine that, it will be useful to see how food and energy prices have diverged from their historical norm. The exhibit in Figure 1 shows the detachment many commodity prices have had from historical price trend. As can be seen, many of these commodities, as of February 2011, were at least two to nearly five standard deviations away from their historical average. A two standard deviation event sustaining itself is seen as highly improbable, let alone a three, four, or five standard deviation event, with the improbability of these events also illustrated. Whats to explain this paradigm shift that simultaneously raised the prices of all of these different commodities? What stems from Hyman Minskys analysis of capitalism is that periods of calm eventually develop into periods of crises (Minsky 2008). What he described is today referred to as bubbles. In the 1990s the USA had a bubble in technology stocks, while in the 2000s there was a bubble in housing, the consequence of which we are

7 now well aware. The two price model of Keynes and Minsky gives some hint to what may be driving this phenomenon in commodities, which is financialization. Furthermore, the recent experiences weve had with bubbles may confirm this hypothesis. The devil is in the details, and one piece of evidence indicating how financial firms are completely dominating the derivatives market in oil was recently leaked by Senator Bernard Sanders. It shows, for example, that Goldman Sachs had long positions for nearly four hundred and fifty two million barrels of oil (Commission 2011). Yet again, however, this is not evidence in itself that futures and other derivatives markets is the driver of oil. For that, a more complete picture of how the economy and commodity markets operate must be presented.

Figure 1: Historic Rise in Commodity Prices

Source: Grantham 2011.

Some (More) History

Where many economists and other professionals focus on the technical details and give no mention of any particular institutional or historical circumstance, the ideas to be elaborated upon here are fundamentally different. Where succinct solutions to specific problems are often made to try to sell a particular idea, the ideas to be elaborated upon here only claim to sell a perspective. Indeed, one must have a perspective and a model of the world if he or she is to act. The fact of the matter is that, no matter how one may see the world, the method of analysis must be historically dependent. Understanding food and energy commodity markets cannot simply follow a purely deductive approach to understanding it, and particularly when referring to opaque markets like commodity markets today. There are no laws of motions holding everything together to provide us with a harmonious world. Furthermore, a purely descriptive analysis does injustice to the billions around the world starving from malnutrition. If we are to do anything about the particular circumstance we live in today we must begin with an ideal world we want to live in and work backwards. Hence we put aside two absurdities that are quite commonly made in the world we live in today. The first is that the world is too complex and that some natural order can magically fix it for us. No matter how absurd this seems, they are deeply ingrained not only in neoliberal economic and development policies but also within multinational institutions such as the World Trade Organization (WTO) (Kregel, Development 2012). The other absurdity that stems from the first is the push-button policies commonly invoked to have a deterministic outcome. That is to say, there is no uncertainty in the world that cannot have a number next to itprices will always harmoniously adjust to meet supply and demand conditions. The only way to dispense of these outmoded and irrelevant ideas and policy proposals is to adopt a realistic model that takes into account the institutions and structures in the economy. The model used here has its roots in

9 the ideas of New Developmentalism and Classical Political Economy. It is of the opinion here that it is up to the economist To define national objectives, to urge priorities, to show the inter-relation of apparently unrelated problems, to devise consistent, non-contradictory programs to achieve specified objectivesbecause, presumably, we are the only ones who know how the system functionseconomists have the privilege and the obligation to advise (Curry 1967). The difference between this and almost all of the standard material one reads on occasion is that the orthodox economist has resigned himself to faith. To understand why this is so, its useful to go back to the 18th century, when Voltaire wrote of a Professor Pangloss that believed that whatever arose as a result of natural forces was a world that could simply have not been better (Reinert 2007). Hence such belief systems came to be called Panglossian, which also characterizes neoliberal economists who believe in a free market to not only provide for the best system of production, but of distribution. For the sake of maximizing human development and state security, we should rid of the Panglossian belief system that continues to hold us back. To understand the strategy of New Developmentalism, and accept its conclusions, one must understand how it relates to food and energy prices today. Understanding financialization is one important aspect of the world economy to note, but understanding the process of development allows us to come up with the proper solutions to the problem of rising food and energy prices. With the creation of the United Nations came a few scholars who pushed certain ideas towards national development. These set of ideas will be referred to as Old Developmentalism, with the name Developmentalism arising from the goal of economic and political action towards development through use of the state (Bresser-Pereira 2008). In other words human development and state security are inherently intertwined within the framework. Among the scholars were Raul Prebisch and Hans Singer, who developed a concept labeled the terms of trade, which quite simply calculates the price of exports divided by the price of imports. The idea was that countries in the center, like the United States, that

10 produced manufacturing goods were subject to increasing returns as the technology enhanced and brought costs down. Periphery countries or developing countries on the other hand were nothing more than primary commodity producing nations. Under the original idea of comparative advantage that orthodox economics attached itself to, the idea that it was better for everyone if each country specialized in something. Prebisch sought to dismantle this by showing that, where technology decreased costs in center countries, the benefits accrued to the people of the nation through increased employment and wages, while periphery countries were hurt by technological innovation as it enabled them to produce more but with less labor. Hence, it made them more dependent on the center countries to buy their goods to maintain the level of incomes necessary to maintain development. Yet the catch-22 here was that rising productivity in the periphery meant ever-rising demand for imported manufactured goods, while the same could not be said for primary product exports. The point is that it didnt enable a periphery country to circulate any gains from trade within the country, as it provided no opportunity for increasing the level of employment and output necessary to create new incomes. The hypothesis was that the terms of trade and hence the external account would weaken in developing nations over time1, as the quantity of primary product exports will deteriorate while the quantity of manufactured imports increases (Toye and Toye 2004). In turn, this idea gave credence to the view of protecting the infant industry within a nation from more efficient manufacturers in other countries, as the importance of having a manufacturing sector was not lost for many developing nations. As one developing nation representative stated, All our countries feel with perfect rightwhat we might call the need for basic national industry (Toye and Toye 2004). To restate all of this, it was seen as a matter of state security and human development to try to maintain a level of employment and output necessary to provide for everyone.

The terms of trade constraint, or external constraint, is one that develops through domestic exchange rate appreciation. This in turn has implications on development that will be outlined in this paper.

11 However, Old Developmentalism had a few issues that brought about its demise and the rise of neoliberalism. One of the larger fundamental issues was that protecting industries eventually increased the capital to labor ratio, and hence rather than behaving like manufacturing should have in passing savings along to the population through employment, it was instead decreasing employment much like the primary producing sector did (Bresser-Pereira 2008). The major consequence of this was an income distribution that created haves and have-nots. As a consequence to income becoming concentrated comes the shift to producing luxury goods, or in fact buying luxury goods from abroad rather than reinvesting into productive capacity. In other words, the developing country becomes one that increases per capita conspicuous consumption and pecuniary emulation. A further mistake that the early school of developmentalists made was their acceptance of growth via foreign savings. The idea has roots in the perverse acceptance that a country must have a stock of savings before it can grow, and what better way to grow than to have all of these foreign savings being invested in a country without large accumulated savings? Yet capital inflows automatically generate a claim by foreigners, while the investments within the country dont generate anything one can use to meet those foreign claims. Old Developmentalists like Prebisch may have known about import substitution carrying the seeds of its downfall before they actually occurred, but to discuss the technical details in the face of a neoliberal onslaught was wishful thinking (Emmerij, Jolly and Weiss 2001). Furthermore, the simultaneous rise in inflation and unemployment was not satisfactorily answered by orthodox Keynesians at the time, and hence the neoliberals could blame the state for all the ills within society. Yet what the neoliberals never realized was that the issues that brought down Old Developmentalism were structural ones that restricted fiscal policy measures from becoming effective. Neoliberalism, on the other hand, has completely failed to raise the standards of living in developing nations throughout the world a result of their Panglossian view of the world. It welcomed capital account liberalization, as previously mentioned. Where policies and theory before neoliberalism

12 ideology became prevalent had explicit acceptance of growth through external financing, the floodgates to external financing were completely opened as neoliberalism became the dominant development and growth strategy. This produced numerous crises that need not be fully detailed here, such as the East Asian Crisis, Mexico and Argentina among others. As will be elaborated upon later when explaining the specific policy proposals within New Developmentalism, external financing produces crises because the developing country loses whatever policy space it may have had. Losing policy space is akin to losing state security. Neoliberal policies encouraged foreign currency borrowing, and as far too many countries now know, if productive capacity and hence domestic savings cannot keep up with the debt service then there will eventually be a sharp currency devaluation as foreign investors flee. One part of the problem had to do with profits actually going into the hands of foreign investors and not the general public. The problems with neoliberalism wont be fully delved into here as they have been dealt with elsewhere, but it will suffice to say that the experience of the past thirty or so years has been nothing less than a sharp rebuke to policies it fostered. Yet one other issue of relevance must be raised as a useful run-up to the next issue, which was the prevalent belief that everything good came from the hands of the rich. The way to make savings go up, it was believed, was by giving people on the upper end of the income brackets as much of the income and capital as they could. In turn they could reinvest it and produce more employment and output, and hence inequitable distribution of income was believed to be a good thing. This ended up not working out so well, as little investment was done and instead conspicuous consumption in the form of buying a new Mercedes or mansion was an all too common sight. This posed a problem for developing nations. If these individuals are buying new Mercedes, the balance of payments will become negative. The question becomes: what to do? A country can either reduce their imports, or redirect state expenditures into fixing the balance of payments. Reducing the number of imported Mercedes simply isnt a policy option for the rich, so instead a country opts for recession instead. So where the poor and middle classes in a developing

13 country were hopefully trying to get a job, have now resigned to the fact that they may never get one, and hence maintained and engrained their status as one of the many destitute members of society. Yet it gets worse. The government, as a result, may have their budgets go into deficit to help the less fortunate (due to the external constraint). To fix this, the policy of opting for recession was adopted by the IMF itself, as they pushed the idea that the only way to fix a fiscal deficit is by pushing down the level of public investment and employment, and hence incomes, with disastrous effects on human development. Yet just like the crises that occurred in the early 1980s, the issue was one that was internally generated and hence structural in nature. The key to understanding rising food and energy prices lays in this understanding of structure and institutions. Hence, New Developmentalism sprung from the ashes left behind by orthodox economists from failing to incorporate structure and institutions into their models. New Developmentalism implies in its name a nationalist perspective in the sense that economic policies and institutions must be formulated and implemented with the national interest as their main criterion and with each countrys citizens as actors (Bresser-Pereira 2008). Within this approach of New Developmentalism (as in Old Developmentalism), human development and state security have once again become the focal point in developmental economics. Yet the approach used here is not simply one focused on development. The approach taken is one that seeks to explain the wealth of nations (and) capital accumulation, with an implicit understanding that social structures and institutions are fundamental in its reasoning (BresserPereira 2008). On its face this may not seem at all radical to actually be looking at reality when developing solutions, but this line of reasoning is in fact anathema to neoliberal ideology. Unlike neoliberal economics, the approaches within New Developmentalism and of classical political economy also understand that the state may not be able to alleviate the problems of production, distribution, and stability due to structural constraints. The economics of a structural economist named Marcelo Diamand could fully explain the issues of inflation and unemployment that mainstream Keynesian

14 economics (the economics that neoliberals successfully tried to vanquish) could not, and that transmission mechanism for prices and hence employment and output comes in the form of bottlenecks.

Political Economy and Bottlenecks

So to finally present the model of the economy used to understand the bottlenecks vaguely referred to at the beginning, the model depicted in Figure 2 (called the surplus approach) serves to illustrate how a social surplus (profit) is created. This is a model that takes as its lineage a long line of classical political economists from the 1700s and 1800s. Here the social product is the total amount of commodities produced in a year, while the surplus is the share of the product going to the classes of society other than the laborers, which can be determined by subtracting the (necessary consumption) from the Social product, taken net of the means of production (Garegnani 1984). The key point here is that this is a model of reproduction, one that allows us to understand that the determination of the social product and the real wage going forward lies entirely in the hands of non-laborers. Ultimately this is a model of not only production, but distribution. The owners who have access to the social surplus ultimately determine how much they want to pay for labor and for further reinvestment into the social product, and hence for reproduction of the system. Let us refer again to food and energy prices in relation to both bubbles and investor expectations. Its entirely conceivable that these two factors (that is, bubbles and investor expectations) are breaking the reproduction of the system, but at this point its too early to tell. Yet this model is giving the hint as to what should guide us out of this mess: effective demand.

15

Figure 2: The Social Surplus Approach

Source: Garegnani 1984. The early development economist Ragnar Nurkse probably said it best when he argued that all capital is made at home (Nurkse 2009). His essential argument was that the capital needed towards development is already available within the country, but that its not being used properly. Effective demand is simply the acceptance of the fact that consumption creates an income for someone else. Hence, the level of effective demand is best reproduced when those with access to the surplus distribute it in such a way as to create enough income for laborers so that human development is assured for all or most of the population. Traditional development theory a la Nurkse maintains that the greatest potential for mobilizing all resources within an economy is through increasing employment. Two theorems arise from his analysis. One is that most developing countries have abundant natural resources. The other is that the real resources within a country are its people. Hence, an army of unemployed and underemployed labor sits ready to work and better their lives. Yet even Nurkse realized that this requires a policy that incomes stay within a country, and is hence saved, in order to then increase capital and produce a surplus to then reproduce the system. One other developmental economist who saw the importance of the concept of effective demand was Lauchlin Curry. His

16 development experience started out in an underground experience in Colombia, having stayed there for thirty years (Kregel, Development 2012). Initially blinded by the peculiar problems by particular developing countries, he eventually discovered that the thing he didnt initially understand when doing the Colombia project was the simple importance of increasing employment and thereby allowing workers to earn income. If you give them a job and an income youve solved half of the development problem. The problem with having underemployed workers, on the other hand, was also an issue but stressed that it was not a resource/saving constraint but primarily an employment constraint. It cannot be stressed enough that the concept of full employment and a sufficient level of effective demand to provide for it is directly intertwined with human development and state security, as one cannot possibly have one without the other. By this point the discussion has seemingly veered away a bit from the discussion of food and energy prices, but one cannot possibly see the problem and create a solution that portends to care about human development and state security without this essential concept of full employment at hand. The surplus approach is central to the analysis of food and oil prices. The discussion now turns back to Marcelo Diamand and his concept of a bottleneck (Diamand 1977). A bottleneck as defined here takes a slightly different approach than the one Diamand uses. Here a bottleneck is defined as a constraint in an economy that prevents production and employment from increasing. Measures to increase incomes (with subsidies or direct transfers) by governments further exacerbate the situation of either high prices and/or resource constraints, as the constraint continues to push the price ever higher in response. This in turn introduces stockpiling by consumers and countries, while the process of ever higher prices continues in perpetuity. Thus the issue with a bottleneck is that it structurally disables a country from increasing effective demand. The significance of this concept, and its application towards food and energy prices, cannot be fully appreciated without understanding Diamands approach of the bottleneck. His approach to understanding the economy was of a fundamentally different perspective than that of traditional Keynesian or Monetarist approaches.

17 Diamands conception of a bottleneck was the insufficiency of an item not very significant in terms of its own value but essential for the carrying out of an activity of much greater value (Diamand 1977). The main bottleneck arose through some natural resource constraint used as an input to goods or services. The idea is that if the price mechanism operates efficiently in increasing the price of some natural resource thats scarce for whatever reason, that on the first instance it will have a distributive impact, as incomes get distributed from the rest of the population to the owners of that resource. This then generates two responses: the first is that, as a consequence of wage earners being hit the hardest, those wage earners or even the government may do something to offset the distributive impact. However, no adjustment was made in terms of the bottleneck. The second response is the natural tendency for a decline in overall demandwith the tendency being that demand will fall until the resource in short supply is no longer in short supply. So what has been done is adjust demand back upwards relative to available supply, but with no change in supply you get ever increasing inflation. This may also cause many actors in the market to attain larger stocks of the natural resource as a sort of hedge against future price increases. Yet this reinforces the bottleneck rather than alleviating it. What this has done on the one hand is increase budget deficits, while on the other increasing inflationary pressures and decrease real wages. Of course what arises out of all this is the focus on government as the problem, with either monetary expansion or fiscal imbalances having caused all of the problems. So an agency like the IMF comes to a developing country and tells them to reduce their deficits and run tighter monetary policy. In other words, their solution is to let the developing economy contract until the fiscal constraint and inflation has lessened. Yet the fundamental problem, which was that of the bottleneck and not of government policies per say, had not been resolved. So an additional round in which the price of the scarce factor goes up may in fact ensue once more.

18 Diamand explains the bottleneck by looking at the behavior of producers after they find themselves with an increase in their respective incomes. With more of the incomes being allocated and hence distributed to the owners of the natural resource commodity, the owners of that resource would then have to find some way to spend that additional income to eventually recirculate it back into the economy. So the commodity producer in this instance has two options. Either it can directly invest or spend their incomes back into the economy, or simply give it to the banking system. Yet the bottleneck in this case was that rather than investing in productive capacity or spending, commodity producers were putting their proceeds into the banking system, with the assumption then being that banks would lend those funds to others. Yet, individual banks dont know whether an individual investor is going to be paying him back, so what ends up happening on net is that the money ends up staying in the bank and, hence, a generalized decline in purchasing power results. The cycle that existed of a decline in effective demand, a decline in investment, and a response in most countries of increasing nominal wages hence reinforces the bottleneck. It is from this conception of the bottleneck that oil and food prices today can be understood. The issue with a bottleneck, at all times, is that it constrains money from being recirculated from one part of the economy to the other. In particular, this would naturally prevent employment, output, and hence effective demand from rising and would in fact cause it to fall. If we relate this to the surplus approach as shown above, we can infer that in fact less of the surplus is going to wages and the social product. It is from this understanding of the bottleneck that the conclusion can be drawn from, which is that the financial industry today represents a bottleneck and hence a threat to human development and state security worldwide. Understanding why this is so requires understanding that the financial industry has increasingly dipped their toes into commodity markets. As was shown in Figure 1, many commodities have in recent years gone far beyond their historical price. Furthermore, prices have been fluctuating very rapidly, especially in 2008 when prices spiked all the way to $147/barrel and then back

19 down to under $40/barrel within a couple of months (Ghosh 2010). Whatever has been causing the price increase in one commodity is likely to have caused the price to increase in another. This certainly makes sense with regards to oil prices as it relates to other commodities: oil is a direct input into the production of other inputs through transport and irrigation costs. Yet the issue is that commodities markets are made up of two separate markets today: the derivatives market and the spot market. The derivatives market, or specifically the futures market in commodities, is completely dominated by financial firms such as investment banks and hedge funds as shown by the leaked internal CFTC document. Yet this makes no mention of a transmission mechanism: how would the futures market affect the spot market, where actual transactions between a buyer and a seller take place? The emergence of futures markets brought with it promises that sellers and buyers could meet to exchange a commodity at an agreed upon price. Hence, not only would their risk be hedged, but prices in general would also not be subject to as many rapid fluctuations in price. The traditional argument is that speculation provides liquidity to the futures market, where speculation requires that if such activities are to be profitable, they must be stabilizing rather than destabilizing. The vital function of speculators is to predict future market patterns and thereby reduce the intensity and volatility of change (Ghosh 2010). From this one would conclude that in fact speculators have smoothed out the prices of commodities, and hence prices would have been fluctuating even worse than what was seen over the past six plus years. Yet this point fails to acknowledge that futures markets work completely differently than they once used to. Indeed, without acknowledging these changes one could not understand how financial markets form a bottleneck around growth and development.

How Commodities became Financialized

The first change that must be understood is that participants in futures markets rarely, if ever, take delivery of a commodity in question. The contracts are merely rolled over from one period to

20 another before expiration occurs, protecting themselves from having to take delivery (Sharifi 2011). The fundamental point to take away from this is that there is no longer a one-to-one relationship between the futures price in oil to the spot price. Traditionally as a contract nears expiration the futures price would necessarily have to converge to the spot price, as the futures price is merely a side bet to the real market where the commodity is exchanged. However, when someone now predicts the future and makes a bet, they no longer have to worry about the real market, but simply worry about the average persons expectation of what the average price of the futures price of that commodity will be. The second change is that investment banks and financial institutions have created commodity index funds that institutional investors can allocate their money into. In other words, as a result of delivery no longer taking place, investors and others can play in the derivatives market for commodities much like they can with stocks. The implications are given by Ghosh (2010), where index funds Focus on returns from changes in the index of a commodity aggravated the treatment of these markets as vehicles for a diversified portfolio of commodities (including not only food but alsoenergy) as an asset class, rather than as mechanisms for managing the risk of actual producers and consumers (Ghosh 2010). One name commonly given to many of the investors allocating money to commodity funds like the Goldman Sachs Commodity Index Fund, or GSCI, is that of inflation hedgers (Cook 2009). As pointed out earlier, one result of policies like QE and ZIRP are that expectations of inflation, justified or not, are increased, while on the other hand investors are simply looking for yield in a zero interest rate environment. Hence as a result of successful advertising, commodities became the asset of class of choice, particularly as fears of supply shortfalls due to a rapidly growing China and India became more prominent. GSCI in turn has motivation to have people in their funds, as they can charge a fee for every new individual brought in. Where financial innovation allowed a speculative euphoria to occur through the selling of more and more homes to unqualified borrowers, innovation in this case allows the fears of investors to be priced into commodities futures markets. In fact, when one looks to the period 2001-

21 2003, bank earnings were depressed, and hence needed alternative sources of revenue. Making subprime loans was one of them. Commodity index funds are now the other source. If one looks at the increase in financial flows to these funds they are more or less coincident in timing with the end of the subprime boom, with leverage of course being just as important here as it was with subprime. Yet it gets worse. It is agreed that, no matter how the futures price gets affected due to the actions of these inflation hedgers and traditional speculators, that at some point real supply and demand factors will kick in and bring prices back to reality. Yet it hasnt been taken into account whether these commodity funds and others have been speculating in the real market. One argument advanced is that oil producers are being enticed to keep it in the ground (Cook 2009). It notes that in 2005 Shell Oil had entered into a partnership with ETF Securities to allow investors in ETF Securities to invest in the idle oil Shell had provided they, Shell, were given a loan. In essence, Shell leased the oil over to ETF Securities. Eventually firms like ETF decided to do this with some of the major oil producers. GSCI and British Petroleum have also engaged in such transactions (Cook 2012). Cook (2009) argues that Oil producers motivation to do this redoubled after the financial crisis commenced and interest rates went essentially to zero the zero bound. Why produce oil and exchange it for financial assets yielding 0%? Producers preferred to lease or lend their oil instead (Cook 2009). It would be further argued here, due to Minskys two price theory, that ZIRP had a similar effect on conventional investors and speculators. Yet why stop in futures markets? Indeed, it has been argued by some that these commodity funds and hedge funds among other financial firms have been buying up entire farms or oil tankers and thereby restricting output and/or making the real supply figures harder to access (Kregel, Development 2012). In fact, the supply figures for most commodities are purely fictitious, particularly when financial actors have a motivation to see to it that they are lower than either expected or perceived (Kregel 2012). The manipulation of price benchmarks published by price reporting

22 agencies of spot oil transactions, which are supposedly used by a wide variety of actors, is treated as a well-documented possibility (TECHNICAL COMMITTEE 2012). What this in fact does is maintain the futures price on an upwards trajectory, magnifying the gains made by leveraged traders and speculators and hence magnifying the impact of these funds going forward. All of this brings us to the important question of the transmission mechanism of futures prices on spot prices. It has long been argued that futures necessarily converge to spot, but this argument only holds if the futures are held to the date of delivery. Absent that, there is no functioning economic argument remaining as to what point the futures market decides to price a commodity at. It then comes down to the question of the motivations of the major actors in commodities futures markets today. If it is their motivation to either hedge against expected inflation and/or speculate in the belief that commodities only price trajectory is upwards, then futures do not necessarily have anything to do with the spot price. With speculation that financial actors have increasingly moved into the spot market, there really is no question that prices do not reflect supply and demandand as mentioned, some of the existing benchmarks that are used for at least some futures or spot transactions are unreliable. The fact is that interviews havent been undertaken with the individual commodity producers questioning what benchmark they use to price their respective commodity. Yet at least one paper has noted that spot prices in food commodities have been following the futures price, rather than vice-versa (Hernandez and Torero 2010). A fundamental question arises out of all of this: In an era of rising commodity prices without dwindling supplies or rising demand, why would a commodity producer sell at a price lower than the globally available futures price? As UNCTAD notes, Excessive price fluctuations foster uncertainty about the validity of the price signals emanating from international commodity markets and add to the lack of transparency of those markets (UNCTAD 2011) Yet the financial sectors impact is not so clear cut, and that will be described more below.

23

The Constraint of the Bottleneck

It follows from this that any attempt to alleviate the impact of high food and energy prices simply magnifies this impact, and hence creates a bottleneck for developing countries. The bottleneck in this case is a constraint on developing nations, whether primary product exporting or importing countries, from expanding output and employment due to the financial sectors impact on commodity prices. Understanding why this is so (that is, why rising commodity prices will have a constraining affect no matter how a country decides to grow) is to understand why it is a bottleneck. That it should affect non-primary producing nations is at least more intuitive. One basic proposition in the New Developmentalist literature is that, in the absence of a state providing for full employment and/or output, a country with a strong manufacturing sector will not necessarily lead to increasing wages in the presence of unemployment (Kregel, Development 2012). This is because the excess labor constrains wage growth. In a developing nation, rising commodity prices can worsen this impact. At some level consumers will be spending an inordinate amount of their incomes or wealth merely to survive. As if such an intuitive notion needed evidence, many Americans cannot afford to buy food in what is supposed to be a part of developed world (Cooper and Burke 2012). Yet where this is having a noticeable impact in the United States, the loss of purchasing power in developing nations is deadly (USDA 2011). On another level, the effect of a global recession and rising commodity prices has led to unemployment and decreased production around the globe. With respect to developing nations this also leads to government policies to provide for either a buffer stock of food or energy, increasing domestic production of food and energy, or income transfers and/or other social welfare policies to diminish the impact. However, increasing buffer stocks sends a lower supply figure to the market and thereby increases the price of the respective commodity. Government deficits in turn have a negative impact on the balance of payments. In the face of an increasingly negative balance of payments,

24 decreased production, and the presence of rising commodity prices the currency may see a depreciation that the nation may not be able to deal with, especially if they have a pegged exchange rate. This is because a depreciating currency means rising primary product prices, thereby perhaps negating any government policies that tried to alleviate it. The situation becomes worse if the country was primarily financed by external savings, as a country will find it more difficult to find the external currency necessary to make the debt payments. In turn, investors will flee the country and put added pressure on the currency much like what happened a decade ago in Argentina and elsewhere. The overall impact here is increased inequality, output and employment, not to mention malnutrition or death. The negative impact on both human development and state security cannot be overstated. As bad as the impact of rising food and energy prices are on countries where manufacturing accounts for the majority of exports, the impact on primary commodity producing nations is even worse. At first blush it may appear that they would be the primary beneficiaries of higher commodity prices, but in fact they too are deteriorating. The financial system can be an accelerator to the increase in primary commodity prices, but they can also accelerate the decline of primary commodity prices when they fear their positions are dangerous, as they did in 2008. The inherent volatility in commodity prices characterized by this rather large outlier throughout the period of commodity speculation brings Farmers toover (sow) in some phases and under (cultivate) in others. Many farmers in the developing world have foundfinancial viability of cultivation has actually decreased in this period, because input prices have risen and output prices have been so volatile that the benefit has not accrued to direct producers (Ghosh 2010). Hence, increases in primary product prices are akin to fools gold. As was mentioned in the earlier discussion on the terms of trade (or the external constraint), manufacturing is historically and theoretically important in providing for full employment and output. Yet what occurs in these nations with high commodity prices is deindustrialization, which is an additional impediment to the decline in the terms of trade. Increased agricultural exports have diminishing returns, which translates into higher

25 prices and an appreciation of the exchange rate. If a countrys primary product exports are setting the exchange rate (as they would naturally do when they are the primary export), then it must necessarily be too high relative to the needs of the infant industrial sector that has to date been trying to grow and develop. This is because, as an infant industry, it naturally has higher costs and lower efficiency compared to primary products. As noted elsewhere there lays an obstacle on the demand side with serious effects on supply, the phenomenon of which is known as the Dutch disease (Bresser-Pereira 2008). The Dutch disease is typically caused by an abundance of cheap natural and human resources, but in this case rising commodity prices means more impetus to develop those natural resources whether they are food or energy (Bresser-Pereira 2008). Deindustrialization also occurs because, increasingly, imported goods become cheaper than the domestic ones due to the appreciated exchange rate. The bottleneck here is hence much more severe, particularly as it applies to those with fixed exchange rates. The benefits of those primary product exports accrue only to the owners and workers, as the rest of the country is mired in abject poverty. This is because one needs industrialization if they are to provide for full employment and output. Indeed, such a country is reminiscent of the type that has a few citizens with two or more Mercedes, while the rest cannot afford to buy a bundle of food. Any measures taken outside of an exchange rate adjustment are bound for failure, as industrialization cannot maintain itself in the presence of an appreciated exchange rate. Yet an exchange rate adjustment is itself not such an easy task to deal with. On the one hand there is political opposition from primary product producers who before accrued all of the benefits, while on the other there must be some method of financing the exchange rate adjustments. In addition, the appreciating currency attracts foreign investors who then cause further appreciation, particularly when they are able to engage in carry trade maneuvers whereby they borrow from a country with a low interest rate and invest in a country where they believe they will see gains. The very presence of a commodity price boom means that it would take that much longer for a country to reverse course. Yet even when it

26 eventually gets to that point, it must start again from scratch and wait, historically, decades to get to a state of industrialization necessary to provide for human development and state security. A model serves to illustrate the effects outlined above, the totality of which involves diminishing effective demand. Figure 3 below shows how the bottleneck is taking away from both real wages and reinvestment into the social product. More unemployed labor means lower real wages, as does higher commodity prices. On the other hand, deindustrialization means less money going into the social product, thereby restricting the ability of full employment and output to take hold. Higher commodity prices also implies a distribution affect through increased consumption on energy and food, and hence towards commodity producers and the financial industry. Finally, more of the surplus going to the bottleneck means by implication less of it going to the social product. That bottleneck represents an institution, and hence that increased consumption goes back to the surplus. Yet nothing directs that surplus from going towards more socially useful activities, and hence comes the loss of any chance of human development, and by implication, state security. It must be noted that what is being said here is not new. Thorstein Veblen and the entire strand of institutionalist thought in economics has long recognized deliberate industrial sabotage by those controlling the means to production in order to maintain their control on prices and power (Veblen 1982). Yet, if the rise of modern finance is any indicator, sabotage is now taking place on a scale larger than ever.

27 Figure 3: The Social Surplus with a Bottleneck

Source: Adopted from Garegnani 1984.

Policy Proposals
The bottleneck that increasingly threatens human development and the security of the developing state must be tackled directly. It is not a constraint that cannot be handled. If the commentary above was sufficient in understanding that manipulation and speculation determines prices, then by implication that means that a developing nation can do it as well. In an ideal world the United States and Europe would act to end speculation on futures exchanges as well as on spot price benchmarks. Yet this is obviously far from an ideal world, and to the extent that these actions should be undertaken this paper has little more to add to what has been written elsewhere [See (UNCTAD 2011)]. The developing world has little time to continue waiting on the developed world to do the right thing, and hence an outline for development in an era of rising commodity prices must be established. As noted, a developing nation can have either primary commodities or manufacturing as their export base. Both are sensitive to rapid fluctuations in, and increases in, food and energy prices.

28 As should have been apparent above, the state plays the strategic role in maintaining a structure of the economy that promotes human development, as the market clearly cannot and will not do it. Yet, how can a country get around the bottleneck? A general policy that all developing countries should institute is a competitive exchange rate through a strong state. This is the exchange rate which corresponds to manufacturing within a country becoming competitive to that of the world market (Bresser-Pereira 2009). To summarize the importance of everything noted above, Pereira (2009) states that Economic development is a process of increasing productivity that takes place within industries and, principally, through the transfer of labor from low value-added industries to high valueadded industriesindustries that use sophisticated technology and pay high average wages and salaries (Bresser-Pereira 2009). One may have a floating or fixed exchange rate currency, but to ensure that the rate corresponds to trade rather than financial inflows and outflows, capital controls must be initiated. Inflows and outflows refer not just to portfolio investment, but to external debt financing. Capital controls may come in the form of a strict control, or through a tax on financial flows, otherwise known as a Tobin Tax. The motto that must be kept in mind is that all capital is made at home (Nurkse 2009). External financing is neither necessary nor warranted, as increasing unemployed resources at home presents the greatest opportunity for increasing output and human development. This is the very definition of a strong state: when external claims do not constrain policy space. In the surplus approach mentioned earlier, the level and determination of the surplus depends on the capitalist, and its remuneration into the social product and real wage is in their hands. The state can and must intervene such that the level of effective demand is kept high, and that can only be done through use of a competitive exchange rate. The ability to build up the manufacturing base (by having a competitive exchange rate) increases employment, wages, and domestic consumption as has been noted here from the beginning (Bresser-Pereira 2009).

29 Developing nations mired in the Dutch Disease face the toughest constraints against a strong manufacturing base, and hence policy must be more specific. Keeping the exchange rate competitive is tough, particularly when foreign investors have flocked to the currency in droves (assuming absent capital controls). The implication is that the state must run a large budget deficit. Without having any negative impact on foreign capital flows that budget deficits presume (that is, to prevent foreign investors from fleeing), and to best ensure the growth of manufacturing, the best policy a nation could use is to tax primary commodity producers to make the corrective policy budget neutral. The tax can be either an export tariff or perhaps a land tax. The basic idea is to claw back the earnings made by the agricultural or energy sector and then to subsidize the manufacturing sector to make them more competitive. There are two options available in subsidizing: on the one hand it may be given directly to manufacturers in supporting their endeavors, or it may be used to impact the currency and make it competitive, which supports the general policy proposal above. An important point to make here is that this policy should be imposed until the manufacturing base becomes stronger. Yet, as was noted above, in this particular food and energy crisis food producers may themselves not be making much of a surplus due to over sowing or under-cultivating. They may in fact be victims of the bottleneck as much as anyone else. So an even more important policy to ensure the security of the population and the state, particularly in those countries without a strong agricultural sector, is to ensure that a physical reserve of the essential food commodities exist to prevent the malnutrition and death surrounding the uncertainty in food production and prices. A reserve may also be instituted, as others have noted, on the international level (Braun and Torero 2009). The idea here is that a physical reserve may not be enough to address the fluctuations seen today. Braun and Torero (2009) have the idea that the World Food Programme manages this international, decentralized reserve that would better ensure developing nations be able to meet the emergency needs for food and prevent extreme price spikes (Braun and

30 Torero 2009). The same concept can be applied with reserves for oil or other energy commodities. The problem with this idea, however, is that it may signal to speculators that demand is going higher while supply is dwindling, and raise prices for the short to medium term. A related idea here is that domestic production be increased for those essential food staples used in a particular country. Some have noted that China has been buying up farms throughout the world in order to ensure food security for the Chinese people. For many developing nations this is simply not a feasible optionand where food shortages occur future disaster may strike, and hence the importance of domestic consumption cannot be overstated. A final idea first proposed by Braun and Torero (2009) is that of a virtual reserve for food and energy (Braun and Torero only advocated for a food reserve). This takes the battle straight to the speculators. The idea as espoused here is that a group of nations pull together a fund managed by an expert in commodities futures trading to flood it with sell orders and thereby decrease the price. This is not at all a desperate measure to take. The futures market and now the spot market has clearly become a market of ramp speculation and manipulation. It is in the best interest of both primary commodity producing countries (due to Dutch disease), as well as commodity importing countries, to get prices closer to their true supply and demand valuation. The design by Braun and Torero (2009) initially proposed that this fund signal to the market when they will threaten to intervene if the price goes too high. However, part of the reason why financial firms have been able to get away with speculating in commodity markets is that they are completely opaque. The Commodities Futures Modernization Act deregulated commodities markets and made them opaque, and hence it is proposed here that developing nations take advantage of this feature and manipulate prices as they wish. The point is to prevent developed nations from taking action against developing nations if commodity market

31 interference becomes well known2. The size of the fund, how its directed, and what an appropriate price for a commodity is, must be determined by the countries in question. The likelihood of success must be determined by the expert or group of experts, as the risks of losing money are always likely. However, the success of such a program would mean less income transfers and other governmental programs that would worsen fiscal deficits and the balance of payments, not to mention reduce the likelihood of Dutch disease.

Conclusion
The financialization of food and energy commodities by financial institutions is the major link between energy and food prices, and has created and become the bottleneck that constrains human development and threatens state security worldwide. Developing nations are particularly vulnerable, as human development relies on full employment policies. Where and when the bottleneck prevents full employment via industrialization to take place, human development is potentially held back by decades. This can take place through the Dutch disease, an increasingly negative balance of payments, and other potential factors. The potential solutions are a competitive exchange rate, a strong state, a tax on primary commodity producers (to somehow subsidize the manufacturing sector), physical and virtual reserves of food and energy commodities, and increased domestic production of essential food staples. All of these policies should be developed in unison, as they become stronger when acted upon together. Most importantly, a strong state requires that no external claims be allowed to entrench on domestic policy space. This will allow the other policies to be enacted, and hence for human rights, human security, and state security to be maximized.

The irony that the United States might take action to prevent speculation by developing nations, while allowing speculation by investment banks and others, should not be lost here.

32

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