The Bottom Line A A A You are here: ninemsn > The Bulletin > Columns & Opinion The pain in grain Monday, April 23, 2007 The US sees corn-based ethanol as the answer to its oil and greenhouse problems. The resulting agriculture revision could well fuel global recession. Remember the first oil shock back in 1974? Even if you were not around in those days, you probably know that this shock marked the end of the long boom that began at the end of World War II.
RELATED LINKS More from Max Walsh Have your say Quadrupling the price of crude oil from $US3 a barrel to $US12 a barrel ushered in a decade - even longer in the case of Australia - of high inflation and low growth. This was the era of stagflation.
What is often ignored about this episode is the critical role played by commodity prices - especially food prices - in driving OPEC's actions.
Wheat prices for example jumped by 22% in 1972, then by 157% in 1973 before OPEC flexed its new-found muscles in October 1973 and hiked the price of crude oil. Metal prices, according to the Reserve Bank's commodity index, were also up - by 59% - in 1973.
Then as now, OPEC was dominated by the Middle Eastern oil producers who imported most of their food requirements. With oil prices pegged in US dollars and with commodities soaring in price, the lid simply could not be held on oil prices.
Higher oil prices set off another round of inflationary pressures, which led to the second oil shock when the price of crude was doubled in 1979. Recession followed for most of the developed world - including Australia.
I recall these events because food prices have now joined the other commodity prices such as minerals and energy in shifting prices to new highs. Food prices are increasing across many countries at a double-digit rate compared with less than 3% in 2005.
This time it could be said that oil is dragging food prices along behind it, not vice versa.
Furthermore, political and economic factors are interacting in such a fashion that the rise in food prices could well extend over a number of years.
This is of particular importance to the developing countries of the global economy, a description which includes the oil-exporting region of the Middle East. In these countries, food accounts for a much higher proportion of the basket of goods that make up the consumer price index than is the case in developed countries.
In Australia, for example, food has a weighting of 15.8% in our CPI. In the Philippines, it is 50%; in Malaysia 35%.
Food prices are always volatile because they are dependent on climatic factors. Food has been the fastest climbing area of the Australian CPI - up 8.6% at an annual rate, according to the December quarter reading.
That was due largely to local factors, but when you have a major wheat exporter, such as Australia, that is suffering one of the worst droughts on record, it is not surprising that this is reflected in global grain prices.
The price index of Australian rural commodity prices has climbed by 10% over the last year and by 19% over the last two years. This is dwarfed by the rise in mineral prices but, point for point, food prices have much greater inflationary impact than mineral prices.
Compounding the climate factor in the global food market is the rapid industrialisation and urbanisation of large populous economies like China and India. This double-barrelled process alienates more and more land from rural production. Higher farming productivity does offset this to some extent but the real productivity gains come from the introduction of more efficient large-scale production techniques. Restructuring rural land usage raises the difficult issue of social and political stability among the large rural population.
The great ethanol bubble, still in its early stages but already having an impact, can now be added to the inflationary forces now impacting on food costs. The global food pool is being called on to satisfy demand from a totally new, rich and hungry market.
Last year, in the name of energy independence, President George W. Bush called on the US to produce 35 billion gallons of renewable fuel a year by 2017. His exhortation has been backed up with a subsidy program running into billions of dollars a year. (Direct corn subsidies cost the US taxpayer $US8.9bn last year.)
The impact of this multi-billion-dollar hand-out is already evident in the prospective plantings report released by the US Department of Agriculture earlier this month.
American farmers plan to increase the acreage sown to corn by 15.5% or some 12 million acres. To achieve this, they are proposing to reduce soy acreage by 11% and cotton by 20.5%.
The US is the major player in world grain production, accounting for more than 30% of global output. It is also the world's largest exporter of corn, soy and cotton and the third largest exporter of wheat.
The reshuffling of its agricultural output priorities cannot fail to have a serious impact on world food prices. Grains are a major cost factor, not only in direct human consumption but also in fattening beef, swine and chickens.
As two economists, C. Ford Runge and Benjamin Senauer, point out in an article in the latest issue of Foreign Affairs: "Filling the 25--gallon tank of an SUV with pure ethanol requires 250lb of [dried] corn - which contains enough calories to feed one person for a year."
Using the Runge and Benjamin figures, a calculator and the back of an envelope, I concluded that it would take 315 million tons of corn to produce Bush's 35 billion gallons of ethanol - assuming that this was the renewable fuel of choice, which it is at the moment.
Current US production of corn is 267 million tons. Consequently, the current total crop would still come up shy of the target. Current production would need to be expanded by some 20% if all the corn was diverted into the national fuel cycle, and by a lot more to satisfy traditional demand.
At the moment, only one-fifth of corn output is transformed into ethanol.
Corn syrup is the sweetening used in American soft drinks; corn is also used in the manufacture of products ranging from adhesives to crayons. It is estimated that of the 10,000 items in a typical grocery store, 2500 of them use corn in one form or another. At the butcher's shop, the proportion is much, much higher.
For the Bush target to be hit will require the dedication of many more hectares to corn production. Because all the prime agricultural land is in use, that means other rural production will have to be phased out. Exports would be cut back, not only of corn but soy, cotton and wheat as well.
Imagine what this would do to the household accounts in developing nations. Or look at what has already occurred in Mexico. It is estimated that about half of Mexico's 107m people rely on corn-based tortillas as their main source of calories. Late last year, the price of imported US corn doubled over a period of months. Public angst was exacerbated by a surge in speculation and hoarding.
Political unrest threatened to explode into violence and the new president, Felipe Calderón, imposed a cap on corn prices in January.
In China, the government has begun limiting the construction of corn-based ethanol plants to ensure that there is sufficient supply for humans and animals. TheWall Street Journal reported last week that Chinese officials have even banned new golf courses on farm land and begun unwinding subsidies they once paid to grain distributors to sell excess corn overseas.
To some extent the shortfall in supply could be filled by increasing output in producing countries such as Brazil.
But the USDA estimates that global corn consumption will increase to a record 730 million tons this year, exceeding supplies for the sixth time in seven years. Worldwide stockpiles will drop to 88 million tons, the lowest since the 1970s. So far this production shortfall, which has seen corn prices more than double, has not led to farmers elsewhere committing to increased output.
When we look back at the mid-'70s and the onset of stagflation, it is evident that the most powerful factors pushing the global economy in that direction were the economic policies pursued by the US under President Lyndon Baines Johnson.
Johnson believed he could conduct an expensive war in Vietnam while running large deficits to fund his "Great Society" welfare program domestically.
Arthur Oakum, chairman of the Council of Economic Advisers, reassured sceptics, saying: "When recessions were a regular feature of the economic environment, they were often regarded as inevitable ... Recessions are now generally considered fundamentally preventable, like airplane crashes not hurricanes."
Johnson exploited the reserve currency character of the dollar, printing greenbacks and flooding the global market with them. This surge in liquidity lifted global activity but set the fire underneath commodity prices leading to inflation, then stagflation. Among the first casualties was the fixed exchange rate system.
Johnson bequeathed the global economy a tainted economic legacy that took years to restore to health. Back then, however, the Federal Reserve was far less independent in spirit than it is today.
If food and oil enter in a push-me, pull-you inflationary spiral, which is a growing risk, then US Federal Reserve chairman "Gentle" Ben Bernanke will need to stop playing the nice guy.
It's not impossible to consider that, thanks to the ethanol bubble - a classic case of exploiting a genuine problem as an excuse to roll out the pork barrel - the global economy could be tipped into our first climate-change recession.
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