TigerHawk

The just-published October 11th issue of The Economist has a timely survey on the world economy, and I recommend it as a great way to get your arms around what is going on. Drop by your local bookstore and read the whole thing.

One of the articles deals with this year's spike in commodities prices, and it includes an excellent passage on the culpability of governments. Fair use excerpt for your Sunday morning reading pleasure:

Rising prosperity, however, is not the whole story behind stronger demand. Government-induced distortions have also blunted price signals. In many emerging economies governments control the prices of important fuels, such as diesel, and keep them below world-market levels. Oil-exporting countries are the worst offenders. Whereas the American price is close to a dollar per litre, for instance, Saudi Arabia sells petrol at 13 cents and Venezuela at 16 cents (see chart 7). Tellingly, the Middle Eastern oil exporters have seen a big increase in oil consumption. In 2007 they accounted for a quarter of the rise in global oil demand even though they represent a far smaller share of the world economy.

As oil prices rose, some countries decided to start unwinding these distortions. Oil-importing countries such as Malaysia, Taiwan, Indonesia, China and India have pushed up fuel prices in recent months. China has raised prices twice, in November 2007 and again in June this year. Its petrol prices are now not far off America’s (though other energy prices in China are still artificially low). But many other countries kept prices fixed and increased the size of their subsidies. This has hurt their government finances and, more importantly, has made price volatility worse by obstructing the route from higher prices to weaker demand.

The distortions that governments introduce are even more evident in foodstuffs, and this time the culprits are rich countries, particularly America and Europe. Ostensibly to reduce carbon emissions, governments in both places have introduced policies to encourage biofuels (corn-based ethanol in America and biodiesel in Europe). Thanks to these subsidies and regulations, demand for maize and vegetable oils (on which biodiesel is based) has exploded and these crops have displaced others, such as wheat.

Analysts from the OECD to the World Bank argue that biofuel demand is the biggest single reason why food prices have soared in the past couple of years, accounting for as much as 70% of the rise in maize prices and 40% of the rise in soyabean prices. Higher energy prices have also made a difference as fertiliser and other input costs have risen.

Rather than recognise their own role in creating the food-price spike, many Western politicians (notably President George Bush) have pointed to rising affluence in emerging economies. Richer Indian and Chinese consumers are indeed eating more meat than they did—though a lot less than people do in the West—but that shift has not been sudden enough to explain the price surges since 2006. It is biofuels that have made the difference.

Demand shocks and misguided government policies go a long way towards explaining the behaviour of commodity prices in recent years. But supply surprises have also played a role, particularly in oil, where the supply response to higher prices has been sluggish even by its standards.

After years of low oil prices in the 1990s the OPEC group of producers began the recent boom with plenty of spare capacity. That spare capacity has all but disappeared, largely because production outside OPEC has been disappointing. Again, government policy played a part. The vast majority of the world’s oil reserves are in the hands of government-owned oil companies. Too often these firms use their revenues for political purposes rather than invest it to raise output.

In agriculture emerging governments restricted supply, aggravating the problems caused by demand in the rich world. Panicked by rising food prices in 2007, more than 30 governments, from Ukraine to China, introduced export restrictions for farm produce. This cut the supply of food on world markets, sending prices even higher. Rice was worst hit because only 4% of its global crop is traded across borders, compared with 13% for maize and 19% for wheat. On news of bans in China, Vietnam, Cambodia, India and Egypt (which between them grew 40% of world rice exports in 2007), the price tripled within a few weeks.

In this panicked environment, futures prices for all food commodities shot up. At times investment funds may have exacerbated fears about scarcity. But for food, as for fuel, the main reason for the price rises of recent years has been unexpected demand growth, often compounded by government distortions.

Contrary to what the critics of speculation suppose, the main task of futures markets has been to signal these fundamentals to firms and households, speeding up their adjustment to the changing balance of supply and demand for physical commodities. In the absence of such signals, it would have taken even bigger and more extended swings in the prices of physical commodities to bring supply and demand into balance.

The same mix of fundamentals and government action, but in reverse, helps explain the easing of prices in recent months. The drop in commodity prices in dollar terms partly reflected a strengthening of the greenback. Oil prices in euros, for instance, have fallen by 25% less from their peak than oil prices in dollars. A series of sensible moves by governments, such as the decision by some big exporters to lift export controls, helped ease the panic in food markets. The prospect of bumper cereal crops has boosted confidence about short-term supply. The Economist’s food-price index at end-September was down 23% from its peak. Yet nobody is denouncing speculators for driving prices down.

The oil market is also adjusting. A new Saudi field has come on stream, improving the prospect of a supply boost. On the demand side, consumers have started to respond. Faced with petrol at $4 a gallon, American drivers changed their habits faster than expected, switching to smaller cars, driving less and using public transport more.

Most important, the world economy has suddenly slowed, and its prospects have darkened dramatically....

The Economist does not say it, but there is also this: The American decision to forego drilling in much of our own remaining unexplored territory is also a government policy that has delayed the natural increase in production that would follow from higher oil prices. It may be a wise decision nonetheless -- your results may vary -- but there is no denying that it is a government intervention that affects supply.