The Ethanol Hunger

America’s biofuels policies inevitably lead to larger price responses to supply shocks in the short run. In the long run, however, the higher prices that result could become an engine of economic development in the world’s poor rural regions.

WEST LAFAYETTE, INDIANA – Food prices have in many cases surpassed the peak levels reached in July 2008. At that time, food-price increases were attributed to growing global demand for food commodities, a major decline in the value of the US dollar, crop failures in some parts of the world, and biofuels. But what is driving the surge in prices today?

I believe that the key factors now are somewhat different from those that drove up food prices in 2008. Growth in global demand for food and feed commodities is still a major part of the story, as are biofuels. But the short- and long-term implications are quite different.

As developing countries become better off, one of the first things that happens is so-called “dietary transition.” With more income at their disposal, people begin to consume more of their food basket in the form of animal products. Producing these animal products requires significantly more agricultural resources than a predominantly plant-based diet. So, as incomes grow, demand for food products grows even faster. Both population growth and dietary transition contribute to faster demand growth and higher food prices.

Biofuels policies in the US and the European Union have led to the creation of biofuels industries with significant output capacity – mainly ethanol in the US and biodiesel in the EU. In the US, government policy mandates 48 billion liters of ethanol in 2011. Production capacity already exceeds that level.

Since this quantity is required by the government to be blended with gasoline, regardless of the price of ethanol, corn, or gasoline, the demand that it creates for corn is not at all responsive to the price of corn. In economic terms, such demand is highly “inelastic”: the mandate must be met at any price.

That is the situation in which we now find ourselves, at least in the short run. The added inflexibility (or inelasticity) amplifies the price response to a real or perceived crop shortfall either in the US or elsewhere. In addition, the fact that nearly 40% of the US corn crop is being used for ethanol, up from around 5% a few years ago, means that corn prices must be higher to meet the feed, export, and ethanol demands for corn.

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The bottom line is that the current version of US biofuels policy, with its fixed requirement for blending, leads to a greater price response in the event of a crop shortfall – in the short run. We saw this in 2008, and are now seeing it again.

But the 2011 surge appears to be rooted in broader commodity scarcity than before. In the first half of 2008, commodity prices moved up quickly – and plummeted just as fast in the second half of the year. There may well have been speculative behavior that contributed to the rapid swing.

Even with normal crop production around the world, we will end this year with stocks-to-use ratios near historic lows. Stocks-to-use ratios are a primary driver of commodity prices, because they give us an indication of the cushion that we have for shortfalls somewhere in the world. The ratio tells us essentially how many months of stocks we have, and today they are around 15% for some key commodities – meaning two months of stocks.

What about the long run? With several years to adjust, we would expect a powerful supply-side response to higher commodity prices now prevailing all over the world.

In many regions around the world, crop yields are only a fraction of US levels – even in agricultural zones with similar climate, soils, and other production conditions. In the US, it is common to see a gap of around 20% between test plots and actual yields in the same area. In many other regions, these gaps are 40-60%. The bottom line is that there is huge potential to increase production in many parts of Eastern Europe, Africa, and South America.

To the extent that higher commodity prices benefit farmers in these regions, they will respond by increasing their production, which will eventually reduce scarcity, increase stocks-to-use ratios, and attenuate the higher prices. In fact, to the extent that developing countries permit higher prices to go to their farmers, the result could be a significant stimulus to economic growth in rural regions of developing countries – where most of the world’s poor live.

One problem is that developing countries often attempt to isolate their domestic markets from world prices, particularly price increases, in order to protect their more politically powerful urban citizens. This policy can stymie rural development and diminish poverty alleviation.

The short- and long-term stories are simplifications, but they nonetheless convey the essence of some critical drivers of price changes. America’s biofuels policies inevitably lead to larger price responses to supply shocks in the short run. In the long run, the higher prices that result could become an engine of economic development in the world’s poor rural regions. That distinction could make a huge difference to millions of people.