26 May 2008

Buying large-scale insurance

I made a shocking admission in a comment at Samizdata - that there was something important that I thought might be difficult for the market to provide.

The issue was agriculture. Globally, agriculture is heavily state-dominated, and in the short term (at least until recently), the most profitable way to run agriculture was not to have any, but to buy in food from abroad, subsidised by foreign taxpayers.

If Britain had followed that policy for the last couple of decades, we would now be in even more trouble responding to the sudden increases in global food prices. (Assuming that land which has not been farmed recently can't quickly be brought into production - which is a question I am not able to answer).

Now in theory there would be a market opportunity, insuring against food shortages by maintaining - even at a loss - the capability to ramp up food production quickly, so as to be able to profit from shortages.

What I said was that this kind of large-scale investment, which is likely to show negative return but has a compensating possibility of a large profit, would have to be handled through the financial markets. As they have been functioning relatively poorly recently, the investments might not have happened.

(This is still in my fantasy Britain where the EU was not already subsidising farming to survive).

Thinking about it some more, there are various ways in which this kind of investment could be made.

The most obvious is to fund the losses by selling out-of-the-money commodity call options. If food prices do not rise, the options expire unexercised; if the prices do rise, you're in.

If that can't be made profitable, it means that the options are too cheap.
I would have thought there were plenty of buyers of such options - people who wanted insurance against expensive food. Supermarkets would be a prime potential buyer.

But here we see the real problem. Farmers are politically popular (how else would they get all that help?). Supermarkets are politically unpopular - there is always political activity seeking to restrict them. They are simultaneously accused of driving down wholesale prices, driving up retail prices, and squeezing out competition.

Insuring against food shortages costs money in normal years. If these costs are transferred from politically popular farmers to politically unpopular supermarkets, the chance of getting government help correspondingly declines. Therefore the mere tendency of government to involve itself in the industry acts to rule out the most effective market solutions before they even start.

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