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Primary Commodity Prices: Economic Models and Policy.

The growing concern with commodity price volatility is observable both in the industrial countries, as well as in the less developed world. For the latter, primary products are an important source of export earnings and as LDC's typically dependent on the exports of just one or two commodities, fluctuations in the prices of these goods are seen as damaging to the development process. The industrial countries, on the other hand, produce primaries as well and seek to protect their domestic producers from fluctuations, especially in agriculture. The strongest impetus however to the industrial world in favor of commodity market stabilization stems from the experiences of high inflation rates and recession as a consequence of the runup of commodity prices in 1973-74. The 1980s have reinforced the interest in this topic because of the sharp increase of commodity price volatility during this period.

This book reports the proceedings of an international conference on primary commodity price determination which was held in London during March 1989. Despite the editors introduction, nine papers accompanied by discussants' comments illustrate the current state of the art in commodity economics both, on a theoretical as well as empirical level.

Part 1, which is devoted to econometric aspects as well as the practical importance of modelling forward-looking behaviour, starts with a paper by Maddala, who suggests methods to incorporate rational expectations into commodity models. In his paper, which is essentially a review of parts of Maddala's earlier work, the author stresses the importance of incorporating policy-induced market disequilibrium (due to price supports) for the estimation of supply elasticities.

Maddala's paper could also form the basis for criticizing the following empirical analysis by Gilbert and Palaskas who do not incorporate known institutional features into their applied work. The authors concentrate on the question of the extent to which there is evidence of forward looking behaviour as well as the significance of financial market influences (changes in the interest rates) on price determination. Forward looking behavior would imply a degree of automatic price stabilization. However, their empirical results only gives limited support for the first effect and in none of the six commodities analyzed did they find a significant interest rate effect. However, confronting these results with related empirical investigations in the area of industrial economics would suggest that a more detailed modelling of the lag structure would be likely to improve the empirical results for market prices.

In the final chapter of Part 1, Trivedi considers the implications of econometric modelling of speculative demand for inventories for research into price determination. In estimating a "semi-structural" price equation for tea, cocoa, and vegetable oils, the author finds mixed results. Especially in the case of tea the coefficient of the inventory variable in the price equation is unstable, indicating that speculative considerations are unimportant, except on rather special occasions. Although the estimation of "semi-structural" price equation seems preferable to modelling the complete structural model in case of an unfavorable data base the author loses all benefits of starting with a careful specified expectation structure. The price equation is therefore, according to the very critical comment of a discussant, indistinguishable from something that might have been estimated twenty years ago" [p. 1001.

Part 11 of the book contains chapters by Just, Bird and Radetzki on price determination for agricultural products, aluminium, and oil respectively. According to my subjective judgement, Richard Just's paper on agricultural prices deserves special attention as his arguments are relevant for other sector and commodity models as well. The author points out that frequent changes in policy regimes reduce the number of observations available under each regime, which makes econometric identification technically impossible. It is therefore necessary to impose substantial subjective and theoretical structure on the system, as well as to use more disaggregated data. Furthermore, Just stresses the role of the macroeconomy in understanding fluctuations in agricultural prices. Modelling agriculture as a partial equilibrium island was perhaps adequate prior to the significant events related to exchange rate determination in the 1970s. However, the sharp swings in interest and inflation rates in the late 1970s and early 1980s have allowed the importance of linkages between the macroeconomy and agriculture to be identified empirically.

Part Ill of the book addresses the problem of earnings stabilization. A comparison of future markets and price stabilization schemes as means of earnings stabilization is provided by Hallett and Ramanujam. Although the authors relax some of the restrictions usually imposed in theoretical models, they are able to derive applicable rules for choosing between these regimes. They conclude that no strategy will ever dominate in all circumstances, and it is therefore necessary to consider each case separately. According to their empirical results for copper, coffee, cocoa, and jute, it would be best to hedge in the first two markets, but to stabilize prices in both others.

Since most primary commodities are traded internationally, producers (merchants) are confronted with simultaneous uncertainty, in price and in the exchange rate. In a general equilibrium framework Kofmann, Viaene, and de Vries explore the relationship between the markets for foreign exchange (spot and forward) and the markets for commodities (spot and future). In their quite complex model, producers are also acting as merchants for the internationally traded commodity and are assumed to have access to a large enough forward market for the national currency. These assumptions, together with some others mentioned in the discussion by David Sapsford, unfortunately rule out most developing country producers for which earnings stabilization seems most important.

In the final paper Hermann, Burger, and Smit investigate empirically, whether existing commodity initiatives actually fulfill their primary objectives, which is to stabilize prices and export earnings. With respect to the two major compensatory financing schemes (the IMF'S Compensatory Financing Facility and the European Community STABEX system), the authors found only minor stabilization effects. It is furthermore argued that the International Coffee Agreement is rather a price-support than a price-stabilization scheme and only the International Rubber Agreement has succeeded in stabilizing to some degree. Nevertheless, the failure of three out of four of these schemes should not lead to the conclusion, that they should be scrapped at least for two reasons. The instability index applied, calculated on annual data, could be an inappropriate measure to capture all fluctuations. Furthermore, the existing commodity initiatives also contain redistributive elements. Although implicit income transfers are distributed independently of indicators of need, alternative forms of aid could not be expected, if one is to go by the evidence of history, to correlate much better with an index of poverty.

Despite the informative value of the particular contributions this volume deserves further attention at least for three reasons. Firstly, it encourages the interaction of two different types of commodity analysts, the market participants, whose approach is characterized by Bird as knowledge-intensive, and the market observers (academics), who adopt a logic-intensive approach. Both types of primary commodity modelling efforts are represented in this conference volume. Secondly, the contribution of Richard Just stands out especially for looking over the narrow fence of purely sector-specific modelling, in that it emphasizes the transmission of macroeconomic policy changes on the agricultural sector through exchange rates, interest rates, income, and inflation. These intersectoral effects have certainly gained in significance during the last two decades. And thirdly, most papers are characterized by serious theoretical modelling combined with up-to-date econometric testing. Because of the fairly high level of analytical and econometric skills required in some papers, the potential readership is however limited to researchers and advanced students.
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Author:Weiss, Christoph R.
Publication:Southern Economic Journal
Article Type:Book Review
Date:Jul 1, 1992
Words:1245
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