How Goldman Sachs Created the Food Crisis
Don't blame American appetites, rising oil prices, or genetically modified crops for rising food prices. Wall Street's at fault for the spiraling cost of food.
BY FREDERICK KAUFMAN | APRIL 27, 2011
Demand and supply certainly matter. But there's another reason why food across the world has become so expensive: Wall Street greed.
It took the brilliant minds of Goldman Sachs to realize the simple truth that nothing is more valuable than our daily bread. And where there's value, there's money to be made. In 1991, Goldman bankers, led by their prescient president Gary Cohn, came up with a new kind of investment product, a derivative that tracked 24 raw materials, from precious metals and energy to coffee, cocoa, cattle, corn, hogs, soy, and wheat. They weighted the investment value of each element, blended and commingled the parts into sums, then reduced what had been a complicated collection of real things into a mathematical formula that could be expressed as a single manifestation, to be known henceforth as the Goldman Sachs Commodity Index (GSCI).
For just under a decade, the GSCI remained a relatively static investment vehicle, as bankers remained more interested in risk and collateralized debt than in anything that could be literally sowed or reaped. Then, in 1999, the Commodities Futures Trading Commission deregulated futures markets. All of a sudden, bankers could take as large a position in grains as they liked, an opportunity that had, since the Great Depression, only been available to those who actually had something to do with the production of our food.
Change was coming to the great grain exchanges of Chicago, Minneapolis, and Kansas City -- which for 150 years had helped to moderate the peaks and valleys of global food prices. Farming may seem bucolic, but it is an inherently volatile industry, subject to the vicissitudes of weather, disease, and disaster. The grain futures trading system pioneered after the American Civil War by the founders of Archer Daniels Midland, General Mills, and Pillsbury helped to establish America as a financial juggernaut to rival and eventually surpass Europe. The grain markets also insulated American farmers and millers from the inherent risks of their profession. The basic idea was the "forward contract," an agreement between sellers and buyers of wheat for a reasonable bushel price -- even before that bushel had been grown. Not only did a grain "future" help to keep the price of a loaf of bread at the bakery -- or later, the supermarket -- stable, but the market allowed farmers to hedge against lean times, and to invest in their farms and businesses. The result: Over the course of the 20th century, the real price of wheat decreased (despite a hiccup or two, particularly during the 1970s inflationary spiral), spurring the development of American agribusiness. After World War II, the United States was routinely producing a grain surplus, which became an essential element of its Cold War political, economic, and humanitarian strategies -- not to mention the fact that American grain fed millions of hungry people across the world.
Futures markets traditionally included two kinds of players. On one side were the farmers, the millers, and the warehousemen, market players who have a real, physical stake in wheat. This group not only includes corn growers in Iowa or wheat farmers in Nebraska, but major multinational corporations like Pizza Hut, Kraft, Nestlé, Sara Lee, Tyson Foods, and McDonald's -- whose New York Stock Exchange shares rise and fall on their ability to bring food to peoples' car windows, doorsteps, and supermarket shelves at competitive prices. These market participants are called "bona fide" hedgers, because they actually need to buy and sell cereals.
On the other side is the speculator. The speculator neither produces nor consumes corn or soy or wheat, and wouldn't have a place to put the 20 tons of cereal he might buy at any given moment if ever it were delivered. Speculators make money through traditional market behavior, the arbitrage of buying low and selling high. And the physical stakeholders in grain futures have as a general rule welcomed traditional speculators to their market, for their endless stream of buy and sell orders gives the market its liquidity and provides bona fide hedgers a way to manage risk by allowing them to sell and buy just as they pleased.
But Goldman's index perverted the symmetry of this system. The structure of the GSCI paid no heed to the centuries-old buy-sell/sell-buy patterns. This newfangled derivative product was "long only," which meant the product was constructed to buy commodities, and only buy. At the bottom of this "long-only" strategy lay an intent to transform an investment in commodities (previously the purview of specialists) into something that looked a great deal like an investment in a stock -- the kind of asset class wherein anyone could park their money and let it accrue for decades (along the lines of General Electric or Apple). Once the commodity market had been made to look more like the stock market, bankers could expect new influxes of ready cash. But the long-only strategy possessed a flaw, at least for those of us who eat. The GSCI did not include a mechanism to sell or "short" a commodity.
This imbalance undermined the innate structure of the commodities markets, requiring bankers to buy and keep buying -- no matter what the price. Every time the due date of a long-only commodity index futures contract neared, bankers were required to "roll" their multi-billion dollar backlog of buy orders over into the next futures contract, two or three months down the line. And since the deflationary impact of shorting a position simply wasn't part of the GSCI, professional grain traders could make a killing by anticipating the market fluctuations these "rolls" would inevitably cause. "I make a living off the dumb money," commodity trader Emil van Essen told Businessweek last year. Commodity traders employed by the banks that had created the commodity index funds in the first place rode the tides of profit.
Bankers recognized a good system when they saw it, and dozens of speculative non-physical hedgers followed Goldman's lead and joined the commodities index game, including Barclays, Deutsche Bank, Pimco, JP Morgan Chase, AIG, Bear Stearns, and Lehman Brothers, to name but a few purveyors of commodity index funds. The scene had been set for food inflation that would eventually catch unawares some of the largest milling, processing, and retailing corporations in the United States, and send shockwaves throughout the world.
The money tells the story. Since the bursting of the tech bubble in 2000, there has been a 50-fold increase in dollars invested in commodity index funds. To put the phenomenon in real terms: In 2003, the commodities futures market still totaled a sleepy $13 billion. But when the global financial crisis sent investors running scared in early 2008, and as dollars, pounds, and euros evaded investor confidence, commodities -- including food -- seemed like the last, best place for hedge, pension, and sovereign wealth funds to park their cash. "You had people who had no clue what commodities were all about suddenly buying commodities," an analyst from the United States Department of Agriculture told me. In the first 55 days of 2008, speculators poured $55 billion into commodity markets, and by July, $318 billion was roiling the markets. Food inflation has remained steady since.
The money flowed, and the bankers were ready with a sparkling new casino of food derivatives. Spearheaded by oil and gas prices (the dominant commodities of the index funds) the new investment products ignited the markets of all the other indexed commodities, which led to a problem familiar to those versed in the history of tulips, dot-coms, and cheap real estate: a food bubble. Hard red spring wheat, which usually trades in the $4 to $6 dollar range per 60-pound bushel, broke all previous records as the futures contract climbed into the teens and kept on going until it topped $25. And so, from 2005 to 2008, the worldwide price of food rose 80 percent -- and has kept rising. "It's unprecedented how much investment capital we've seen in commodity markets," Kendell Keith, president of the National Grain and Feed Association, told me. "There's no question there's been speculation." In a recently published briefing note, Olivier De Schutter, the U.N. Special Rapporteur on the Right to Food, concluded that in 2008 "a significant portion of the price spike was due to the emergence of a speculative bubble."
What was happening to the grain markets was not the result of "speculation" in the traditional sense of buying low and selling high. Today, along with the cumulative index, the Standard & Poors GSCI provides 219 distinct index "tickers," so investors can boot up their Bloomberg system and bet on everything from palladium to soybean oil, biofuels to feeder cattle. But the boom in new speculative opportunities in global grain, edible oil, and livestock markets has created a vicious cycle. The more the price of food commodities increases, the more money pours into the sector, and the higher prices rise. Indeed, from 2003 to 2008, the volume of index fund speculation increased by 1,900 percent. "What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets," hedge fund Michael Masters testified before Congress in the midst of the 2008 food crisis.
The result of Wall Street's venture into grain and feed and livestock has been a shock to the global food production and delivery system. Not only does the world's food supply have to contend with constricted supply and increased demand for real grain, but investment bankers have engineered an artificial upward pull on the price of grain futures. The result: Imaginary wheat dominates the price of real wheat, as speculators (traditionally one-fifth of the market) now outnumber bona-fide hedgers four-to-one.
Today, bankers and traders sit at the top of the food chain -- the carnivores of the system, devouring everyone and everything below. Near the bottom toils the farmer. For him, the rising price of grain should have been a windfall, but speculation has also created spikes in everything the farmer must buy to grow his grain -- from seed to fertilizer to diesel fuel. At the very bottom lies the consumer. The average American, who spends roughly 8 to 12 percent of her weekly paycheck on food, did not immediately feel the crunch of rising costs. But for the roughly 2-billion people across the world who spend more than 50 percent of their income on food, the effects have been staggering: 250 million people joined the ranks of the hungry in 2008, bringing the total of the world's "food insecure" to a peak of 1 billion -- a number never seen before.
What's the solution? The last time I visited the Minneapolis Grain Exchange, I asked a handful of wheat brokers what would happen if the U.S. government simply outlawed long-only trading in food commodities for investment banks. Their reaction: laughter. One phone call to a bona-fide hedger like Cargill or Archer Daniels Midland and one secret swap of assets, and a bank's stake in the futures market is indistinguishable from that of an international wheat buyer. What if the government outlawed all long-only derivative products, I asked? Once again, laughter. Problem solved with another phone call, this time to a trading office in London or Hong Kong; the new food derivative markets have reached supranational proportions, beyond the reach of sovereign law.
Volatility in the food markets has also trashed what might have been a great opportunity for global cooperation. The higher the cost of corn, soy, rice, and wheat, the more the grain producing-nations of the world should cooperate in order to ensure that panicked (and generally poorer) grain-importing nations do not spark ever more dramatic contagions of food inflation and political upheaval. Instead, nervous countries have responded instead with me-first policies, from export bans to grain hoarding to neo-mercantilist land grabs in Africa. And efforts by concerned activists or international agencies to curb grain speculation have gone nowhere. All the while, the index funds continue to prosper, the bankers pocket the profits, and the world's poor teeter on the brink of starvation.
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