Gary North Strikes Again With Rising Food Prices.

While taking complex subjects and simplifying them to easily understandable statements is usually a tricky task, Gary North has mastered the technique.  While many are placing the blame for rising food prices squarely on the Federal Reserve and Ben Bernanke, North points out why this conclusion is short-sighted:

Why are food prices rising? Simple: because urban people in formerly Third World nations are getting richer. India and China are the obvious examples. As these economies are freed from the regulations that once burdened them, the growing urban middle class bids up the price of food. People with money in their pockets like to eat more and better food. In the bidding war between rural people with little capital and therefore low incomes vs. urban residents with more capital and higher incomes, rural people lose.

There is an ancient error, stretching back to Adam Smith, which says that retail prices rise because of cost-plus inflation. Prices for raw materials rise, forcing up retail prices. This was refuted by Carl Menger, the original Austrian School economist, in 1871. He showed that production costs rise in response to bids by entrepreneurs, who in turn expect rising demand for the output of their enterprises. The prices of economic inputs rise in response to expectations.

When, in the second half of 2008, entrepreneurs and speculators finally recognized the extent of the recession, they stopped bidding for as many raw materials. So, the prices of these production goods fell.

It is true that monetary policy affects the business cycle. It is true that QE2 is inflationary. But let us not mistake cause and effect. The increase in commodity prices all over the world ever since early 2009 is the result of simultaneous central bank policies. The Federal Reserve System and other large central banks began inflating in late 2008 to reverse the banking panic by large depositors, not small depositors, who were covered by FDIC rules.

That commodity prices could continue to rise in expectation of a QE2-generated recovery later this year is quite possible. It depends on what entrepreneurs expect commercial bankers to do. Will bankers lend? If so, the M1 supply will rise, and so will the M1 multiplier. That will force up prices. But QE2 may fail to persuade commercial bankers to lend. Then the FED will be pushing on a string.
My point is this: you should pay no attention to anyone who tells you that the rise in food prices has been the result of recent Federal Reserve policies. Commodity prices rose in 2010 despite a policy of monetary deflation by the FED. This is rarely discussed by financial commentators.

 Much of what the Federal Reserve does when implementing such measures of QEII is to influence the market with a kind-of false sense of prosperity.  Hence the stock market rise when QEII was announced and before it was actually implemented.  Entrepreneurs and investors are expecting higher profits on consumer goods due to what they see as coming inflation and increased demand.  In North's words, they begin to bid-up their final price when they make their initial investment in capital goods.  Consumers as a whole will eventually get their hands on the bank's enormous amount of excess reserves and will begin to spend it.  This happens at different levels because money reaches people at different times.  The banks that receive the newly-printed dollars (in modern day terms it is just an electronic adjustment to their balance sheet) are the first to profit while those who don't have easy access to credit and get the money last are given a raw deal because inflation has already happened.  Henry Hazlitt explained this cycle over 50 years ago in Economics in One Lesson.

When it comes to rising food prices, the Fed is not directly responsible but rather it is the China Central Bank and its money-printing induced boom.  Like North said, people are moving out of poverty in China at an extraordinary rate and speculators are bidding up the price of food as more Chinese are able to afford higher quantities of it.  At the same time, China's easy-credit policies are leading to a huge bust, especially in real estate, if the Central Bank does not start clamping down on it.  It has already started to do so by increasing banking reserve requirements a few times in the past month or so, but time will tell if China's government and Central Bank are really in control of it's booming economy.  The official inflation rate in the country was 5% last year, but "official" in terms of what the Chinese government lets on is usually a red flag.  Other reports have said it was at least 10%.  Inflation of 10% sounds likes one of Krugman's wet dreams to me.