It May Not Work Perfectly, But It’s a Damn Sight Better than Sarkozy’s “Popular Terrors”

The World Bank has midwifed a deal to facilitate hedging of agricultural prices in developing nations.  The bank has committed to sleeve the credit risk for “simple” hedging trades that JP Morgan does with private businesses like farm coops and ag processors in developing countries.

In theory this is a great idea–though beware, it will necessarily require more evil speculators to enter the market to bear the risk!  But I have my doubts about how things are going to work out in practice.

My doubts arise from the fact that although hedges should be evaluated ex ante, they are all too often criticized ex post.  That is, whether a hedge makes sense should be determined before you see how prices move: after all, the point of a hedge is to reduce exposure to price risk, protecting against the downside by giving up the upside.  But it is all to common, and perhaps all to human, to evaluate hedges after one has seen how prices moved in fact.

Roughly speaking, 50 percent of the time you will be happy with the results of a hedge, but 50 percent of the time you will have hedger’s remorse: you will find that you would have made more money if you hadn’t hedged.  For instance, if you are an airline and you buy fuel forward as a hedge, you are quite happy with your decision if fuel prices indeed rise, for you have locked in a lower price.  But if fuel prices fall, you will have committed to buy at a price than is currently available in the marketplace.  D’OH!

But if you had perfect foresight, you wouldn’t need to hedge: you’d be a very rich speculator.  If uncertainty about future prices is costly to bear, you should be happy to reduce your exposure to that risk, and shouldn’t look back and say shoulda, coulda, woulda.

However, in the real world, managers, investors and others second guess when hedges end up losing money.  If you want a great example–or terrible example, depending on your perspective–look at all those municipalities in Europe and the US who entered into derivatives trades that protected them against higher interest rates.  They have squealed loudly in the aftermath of dramatic falls in interest rates that put those hedging contracts underwater.  They claim they were duped, and have attempted to escape their contractual obligations: indeed, they have sometimes succeeded.

The same thing is likely to happen with the World Bank facilitated ag hedges.  Sometime in the future, the hedgers are going to lose money on their hedges.  Retrospectively, they will regret their decision to hedge.  Being human, they will attempt to escape their obligations.  Given the political sensitivities associated with a large financial institution–JP Morgan–and an international organization domiciled in DC and funded and strongly influenced by western governments and institutions, it doesn’t take much imagination to write in your head the advertising spots bewailing the victimization of unsophisticated DM tillers of the soil by nefarious Wall Street and City sharpies.

Thus, the $200 million the World Bank is committing may really be an option premium, as the protection could well be one-sided, with the hedgers collecting when their trades are in the money, and finding ways to avoid payment when they are out.

Even if the WB is effectively underwriting free options (or, at least, subsidized ones), that may be a good idea nonetheless.  Especially given the financial fragility of many companies in developing nations (and remember that financial imperfections is the reason that hedging makes sense), and the political ramifications (which can include violence) of sharp changes in the price of food products in such areas, a subsidized risk transfer is likely welfare improving.  But have no illusions as to how this program might play out in practice.

The World Bank initiative is certainly a damn sight better than Sarkozy’s plans to “rebalance the structure of capitalism” (I s*** you not–that’s what he said) by clamping down on food price volatility by limiting speculation.   Which brings to mind what Adam Smith said about the subject 235 years ago:

The laws concerning corn [i.e., grain] may every-where be compared to the laws concerning religion. The people feel themselves so much interested in what relates either of their subsistence in this life, or to their happiness in a life to come, that government must yield to their prejudices, and, in order to preserve the public tranquillity, establish that system which they approve of. It is upon this account, perhaps, that we so seldom find a reasonable system established with regard to either of those two capital objects.

. . . .

The popular fear of engrossing and forestalling [commodity speculation] may be compared to the popular terrors and suspicions of witchcraft. The unfortunate wretches accused of this latter crime were not more innocent of the misfortunes imputed to them, than those who have been accused of the former. The law which put an end to all prosecutions against witchcraft, which put it out of any man’s power to gratify his own malice by accusing his neighbour of that imaginary crime, seems effectually to have put an end to those fears and suspicions, by taking away the great cause which encouraged and supported them.

But then Smith was just another Anglo-Saxon, rather than a dirigiste Frenchman.  (Not really, and any Scot would take extreme umbrage at the suggestion!  And as many of Sarkozy’s opponents in France never tire of pointing out–he’s not French!)

Note the fundamental contrast in approaches.  The World Bank is attempting to facilitate the efficient transfer of risk–transfers that are impeded by contracting frictions and lack of knowledge in developing markets.  Sarkozy is attempting to impede the voluntary transfer of risk.  The World Bank is attempting to palliate some of the consequences of the underdevelopment of capitalism in poor countries–consequences which include the inability to enforce efficient risk sharing contracts.  Sarkozy is engaged in some grandiose scheme to remake capitalism.

Yeah, that always works out so well, Nick.

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