The “dot-corn” Bubble

The April 7th cover story of TIME, “The Clean Energy Scam,” claims that by pushing corn-derived ethanol in the US as an additive to oil, politicians and Big Business are making a bad situation worse. It is causing food prices to rise globally, contributing to global warming, and stealing money out of the public purse.

To some this is old hat. For a while people have been arguing against corn-based ethanol. Mother Jones magazine did a story on it in November 2007 (where I had come across the term “dot corn”). The graphic below from there succinctly makes the case against corn-based ethanol.

[Click on the image; you will get a new image which you can click once more to enlarge it.]

The story in the above image is simple. Due to mandated increase in the use of ethanol as fuel in the US, the increase in the derived demand for corn pushes up the price of corn, and consequently the price of food. Some estimates state that an additional half a billion people could suffer chronic hunger by 2025 as a side-effect.

In a post on this blog in August 2006, I had written about Vinod Khosla’s investments in corn-based ethanol. In that article I had reasoned from basic economics. (It is a fairly long post but I think it is well worth reading, even if I say so.) I concluded that article with the postscript:

I am postponing the “food versus fuel” issue for later. Basically it says that if resources are used in growing biomass for fuel, food production will suffer and adversely affect those who are already hungry and poor. Khosla rejects that trade-off and maintains that there is sufficient food but the ability to pay for it is lacking. In a future piece, I will explore why I agree with Khosla.

The TIME cover story gives some details about how the dotcom equivalent of corn is playing out. It is a mix of politics, economics, and public perception. There are powerful lobbies in the US that support ethanol. Last year, TIME reports, the subsidies for corn-based ethanol amounted to around $8 billion.

My position is the same as before. If prices at the pump are undistorted, then the market will figure out the socially optimal solution. But subsidies distort prices and therefore the market outcome cannot be trusted to be optimal. I should make clear that I am not against subsidies per se. There are economically valid justifications for subsidies, such as if they internalize some positive externalities or if there are high fixed costs that would prevent the market from reaching an optimal solution. If the subsidy of $8 billion were given to research and development of technologies that improve the process of extracting ethanol efficiently (corn based or cellulose based) so that ethanol becomes competitive relative to gas, there can be little argument against it. But the subsidy currently being given is not of that type. Therefore the outcome is most likely to be economically bad. It could be just a scam.

So what about the food versus fuel struggle? Let’s take the present case first which involves subsidies given to growers of corn and manufacturers of corn-based ethanol and their distributors. These subsidies increase corn production — which means that growers will substitute corn for other foodstuff. Since all of the increased corn production and more will go into fuel, it will reduce the supply of both corn and other foods in the marketplace and thus the price of food will go up.

How this shifts the supply of fuel depends on what the energy balance of the new mix of fuels is. If corn production itself uses a lot of oil, then the increase in the aggregate fuel supply will be lower than the additional ethanol supply. On the demand side, an increase in the price of fuel will certainly shift the demand lower no doubt. But there is a psychological element here which could perversely push up the demand. People may mistakenly believe that the consumption of ethanol based fuels is not as harmful to the environment as using gas, and thus be reluctant to economize on driving needlessly. Feeling virtuous, they may swallow the advertisers’ line about “the more you spend, the more you save.”

All this would have the predictable effect of shifting food from some mouths in the poor countries and into gas tanks in the rich countries. But wait, there is more to this story which we will go into in a bit.

Now let’s consider an alternative scenario: subsidies are not given to growers of corn, and manufacturers and distributors of corn-based ethanol — but instead public funding is given to R&D of alternative fuels, including ethanol. Suppose the R&D bears fruit and in a few years, bio-fuel technology is sufficiently advanced such that all sorts of substitutes for fossil fuels are able to compete honestly.

This alternate scenario does not guarantee that the food supply will not be adversely affected by the shift to biofuels. There are no free lunches in our universe. Unless the total productive capacity increases, the increase in the production of something necessarily means a decrease in the production of something else. You cannot stop using fossil fuel (either due to non-availability or due to policy) and start using biofuels without having to shift some stuff from the plate and into the gas tank.

There are a bunch of facts that frame the whole debate about food and fuel. First, food and fuel are substitutes in production. For any given productive capacity, more of one can be produced only at the expense of the other. So if more of both have to be produced, there is no alternative to increasing the productive capacity. Productive capacity can be increased in the case of fuel by two distinct ways. Either enormous new reserves of fossil fuels are found or the technology is developed for alternative fuels (or both.) Even if new fossil fuel reserves are found, their price will essentially track the prices of non-fossil fuel alternatives. If solar power is available at $20 a barrel oil equivalent, then a barrel of oil will be priced at $20; if solar power is available at $100 a barrel, then a barrel of oil can sell for $100 a barrel.

The lesson is that if you want cheap fuel in the future, you have to invest and discover cheap alternative fuels.

Second, the price of fuel will go up. Demand is definitely going to continue to rise because a couple of billion people are getting into cars and also because as the global economy is getting larger, the demand for manufactures and food is rising — which necessarily involves energy. Rising populations coupled with increasing standards of living cannot but mean more energy consumption. The same holds for food: more people eating higher up on the food chain means more demand for food. Increased demand means higher prices.

Sure higher prices also induces increase in the supply. How much the supply changes as a result of higher prices (that is what is called the “price elasticity of supply”) depends on factors such as the availability of land, water, energy, and food production technology (such as high yield seed varieties). Land and water are already in short supply. Therefore one can reasonably expect that the price of food will rise without inducing a great deal of increased supply (that is, the price elasticity is low). Higher food prices mean that poor people will have to make do with less.

Third, the availability of food for a population is a function of how productive the population is — which is another way of saying how much income the population has. Chronic hunger in a population is a consequence of low incomes. Expecting rich economies to continually provide food to poor people is not reasonable. So it does not matter whether the rich drive their SUVs using oil or ethanol; what matters is whether a certain population has enough income to buy food. If a billion people produce enough stuff (whatever it may be) that gives them an income, that itself will be sufficient motivation for farmers wherever to produce food if that is what the billion people want.

So what is in store for India? India’s over one billion people need a lot of food and a lot of fuel. Only if India’s income — the aggregate production of a billion+ people — is sufficiently large for it to be able to afford food and fuel, there will be sufficient food and fuel for it. Because India is a large economy, it has to be necessarily self-sufficient. No large economy can actually import all or even most of its food and fuel without being poor. As India is not naturally endowed with fossil fuel reserves, the only option is alternative fuels. That means, India has to invest in the R&D, which can only happen if the political will exists. Note that India does not have neither the land nor the water for doing what the US is doing — attempting to grow energy in the cornfields.

I should underline one fact which I have argued before: that the only real constraint in the world is energy. All things are readily available if there is sufficient energy. Given sufficient energy, you can have as much fresh water as you want, as much food as you want, as much of pretty much anything you want. So the biggest problem that India should aim at solving is the problem of energy. Conversely, if India is unable to achieve energy self-sufficiency, there is little hope for India.