food and energy financialization rough draft 2
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The Financialization of Foodand Energy Commodities
How the Financial Industry Forms A Bottleneck
On Human Development, State Security, and Full
Employment, and What To Do About It
Sharifi, Payam (UMKC-Student)
3/15/2012
This chapter seeks to relate food and energy prices today to the concept of full employment, which is
related to the concepts of human rights, human security (the combination of which forms human
development) and state security. The link between food and energy prices comes through theirfinancialization. In turn, financialization of food and energy commodities forms a bottleneck, which
prevents full employment and hence the evolution of human development from taking place. The
implications of the bottleneck cannot be understood unless one looks to the process of a countrys
development itself. All countries, whether primary commodity exporting or importing countries, have
their basic security threatened by the bottleneck. The existence of a manufacturing sector is vital for
the growth of human development and state security, and when and where the bottleneck threatens to
destroy it must be stopped. Some policy proposals are outlined to minimize the disruptions of the
bottleneck.
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Introduction
Commodity prices worldwide, more specifically prices of food and energy, have skyrocketed
over the past few years. What has arisen from this is a fierce debate as to the sources and causes of
these higher prices. Is it, as commonly suggested by many observants, because of rising demand in the
fast growing economies of China and India, among others? Or is it because of speculation and
manipulation by financial institutions and other speculative actors in the market? Putting aside the
issue of whatever the cause is, it must be understood that commodities markets today, compared to
even twenty years ago, are entirely opaque. Why this is so will be explained later, but it will suffice to
say that by living in a historically dependent world, that there are no narrow scope of answers of which
we can use like a toolset in understanding our social world. Yet this does not mean that our collective
hands should be thrown into the air, which is regrettably done all too often today. One reason for this
lays in the economics taught in universities and organizations worldwide. Modern orthodox economics
has pushed a neoliberal set of policy proposals for decades, essentially prescribing that developing
nations give up whatever policy space they may have. They do so by allowing deregulation and capital
market liberalization to guide the policy process. This chapter takes a more realistic approach to
understanding how food and energy prices are related, what effect they have on human rights, human
security, and state security, and what can be done about it. What will guide the understanding of this
issue is to understand what helps or hinders the process of development. More specifically, the
keyword that will constantly be referred back to in explaining this process is that of a bottleneck. The
bottleneck that exists is cumulative and circular in character, in that reactive policies that seek to tame it
do not work. Its roots are in financialization, a period in which financial markets have come to dominate
the world economy. The bottleneck in this case is a constraint on developing nations, whether primary
product exporting or importing countries, from expanding output and employment due to
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financialization, a process brought about by financial institutions. This constraint not only has a direct
impact on prices, but on the very structure of the economy. In turn, financialization must be understood
in terms of the consequences of the expectations of the financial sector on a (now) financial asset. This
section of this volume of Human Rights, Human Security and State Security seeks to understand how we
can alleviate the bottlenecks that prevent developing nations (given their specific historical
circumstances) from becoming nations that can provide for full employment and security for all, and
what can be done about it. To ensure that human rights and security are maintained, the path to
development relies exclusively on maintaining the level of aggregate demand sufficient to provide for
full employment and output. Yet there are a number of explanations, qualifications and pitfalls that
require elaboration and which will fully explained throughout this chapter. Therefore, this paper looks
to develop human rights and security through the broader, yet related, concept of human development.
Human development is defined as the process of broadening choices for people and strengthening
human capacity, while recognizing the value of working with the grain of the marketparticipation,
empowerment, equity, and international justice (are) key concerns (Emmerij, Jolly and Weiss 2001).
Hence the concept and policy of full employment is interwoven into the concept of human
development. Maximizing human development is done by breaking the bottleneck that constrains
economies worldwide from providing full employment, full capacity utilization, and price stability. The
key that should always be kept in mind here is that to do so will always require a strong manufacturing
industry. Maximizing employment and output, and hence human development and state security, relies
on the following policies: a competitive exchange rate, a strong state, a tax on primary commodity
producers, physical and virtual reserves of food and energy commodities, and increased domestic
production of essential food staples.
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The Problem of Expectations and Financialization
The global energy and food problem that grips our world today is commonly conceived as a
global supply and demand problem, particularly because of China and India. Yet this line of thought is
completely invalid, since both aggregate and per capita consumption of grain have actually fallen in
both countries (Ghosh 2010). Furthermore, this line of reasoning leaves out a very important
characteristic of the world having become more financialized. Stock prices, bond prices, and commodity
prices move at a pace so rapid that they have become indicators for the performance of the economy,
among other things. The most important question regarding commodity prices today is the following:
what mechanism or benchmark do producers use to price a food or energy commodity? Yet we bypass
this question for the moment and simply look at a related issue, which is to look at the role of
financialization through financial market expectations. Expectations matter in global price formation,
and no-one could state otherwise after the global financial crisis that has ravaged the globe.
Recognizing that the rise of food and energy prices are related to the inner workings of modern finance,
and that its coincidental rise just as the subprime housing boom was coming to an end is no accident, is
of particular importance here. Yet these expectations have been fueled along by the Federal Reserve.
In order to stop the blood stemming from the global financial crisis, the Federal Reserve drew upon the
comments of a long line of dead economists to support what is now referred to as the zero interest rate
policy, or ZIRP, and quantitative easing, or QE.
Economists Irving Fisher and John Maynard Keynes were among the first economists to call on
monetary policy to support asset prices. These were measures to be undertaken by the central bank, in
this case the Federal Reserve in the United States, to entice the general public (through the
manipulation of the prices of assets) to invest their cash or bond holdings back into the economy
(through either the stock market or direct investment into capital). Hyman Minsky made a similar claim
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for a Big Bank, or central bank in this case to come in and support the prices of capital assets in order
to help prevent a financial instability leading to recession (Kregel 1992). According to Irving Fisher (1933)
this would help stem the debt-deflation spiral not only in those assets but in the prices of commodity
and property values (Fisher 1933). Keynes essentially argued the same thing in his Treatise on Money
(Kregel 2011). Keynes argued that the determination of prices would occur through the central bank
instituting policies to increase investment and hence output and employment (Keynes 1930). So the
issue Keynes had to deal with, in his mind, was how to get people to stop saving and instead put that
money towards investment and output. So in fact policies by the central bank had everything to do with
what may be termed inducement effects. In short, what may be termed ZIRP and QE was simply the
policy of reaching a saturation point for short and longer dated securities such that the inducement to
save will instead become an inducement to invest. In other words, the central bank generates a position
in which excess liquidity will be moved out of financial debt instruments and into equities and industrial
circulation. Keynes argues that whatever increase in the price of equities or other assets that occurs will
be of no harm in a time of slump as a very excessive price for equities is not likely to occur at a time
of depression and business losses (Keynes 1930). Yet what Keynes realized as he worked towards his
General Theorywas that policies such as QE and ZIRP are just one side of the system; it had an impact on
the composition of financial assets in terms of their interest rate and the search for higher risk assets,
but not on real assets. Kregel notes:
Keynes requires the marginal efficiency explanation of capital goods prices for precisely the
same reason he employs the liquidity preference theory of interest rates, to break the equality
between the real return of capital and the rate of interest, which provides the possibility for
money to play an independent role as a real factor affecting the level of investment (Kregel1988)
Hence, the important point as outlined by Kregel is that today we live in a monetary production
economy. Money plays a central role in determining the level of effective demand, which is just a
function that says that spending and income are two sides of the same coin. In giving money a central
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role in his theory of effective demand, Keynes explanation was that expectations can determine the
level of employment and output. Hyman Minsky, who understood the implications of Keynes model,
later described it as having two separate prices. In Minskys two-price theory of financial instability
there is an assumption that there are two sets of anticipationsof the public over financial liabilities,
and of entrepreneurs over capital assets (Kregel 1992). In the words of Minsky, there are really two
systems of pricesone for current output and the other for capital assets (Kregel 1992). The
determination of capital asset prices are, in turn, determined by uncertainty and inducement effects.
The result is that the financial sector can have a real impact on financial and capital asset prices. If
energy and food have indeed become financialized, then the implication to be pondered is what effect
this may have on human development and state security.
Yet the topic of financialization needs a bit more context. Previous research by this author has
noted the financial markets role in commodities futures markets (or derivatives markets) (Sharifi 2011).
However, a transmission mechanism from the financial markets to the spot markets for food and energy
prices must first be established to make the claim that they have become financialized. Before we
examine that, it will be useful to see how food and energy prices have diverged from their historical
norm. The exhibit in Figure 1 shows the detachment many commodity prices have had from historical
price trend. As can be seen, many of these commodities, as of February 2011, were at least two to
nearly five standard deviations away from their historical average. A two standard deviation event
sustaining itself is seen as highly improbable, let alone a three, four, or five standard deviation event,
with the improbability of these events also illustrated. Whats to explain this paradigm shift that
simultaneously raised the prices of all of these different commodities? What stems from Hyman
Minskys analysis of capitalism is that periods of calm eventually develop into periods of crises (Minsky
2008). What he described is today referred to as bubbles. In the 1990s the USA had a bubble in
technology stocks, while in the 2000s there was a bubble in housing, the consequence of which we are
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now well aware. The two price model of Keynes and Minsky gives some hint to what may be driving this
phenomenon in commodities, which is financialization. Furthermore, the recent experiences weve had
with bubbles may confirm this hypothesis. The devil is in the details, and one piece of evidence
indicating how financial firms are completely dominating the derivatives market in oil was recently
leaked by Senator Bernard Sanders. It shows, for example, that Goldman Sachs had long positions for
nearly four hundred and fifty two million barrels of oil (Commission 2011). Yet again, however, this is
not evidence in itself that futures and other derivatives markets is the driver of oil. For that, a more
complete picture of how the economy and commodity markets operate must be presented.
Figure 1: Historic Rise in Commodity Prices
Source: Grantham 2011.
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Some (More) History
Where many economists and other professionals focus on the technical details and give no
mention of any particular institutional or historical circumstance, the ideas to be elaborated upon here
are fundamentally different. Where succinct solutions to specific problems are often made to try to sell
a particular idea, the ideas to be elaborated upon here only claim to sell aperspective. Indeed, one
must have a perspective and a model of the world if he or she is to act. The fact of the matter is that, no
matter how one may see the world, the method of analysis must be historically dependent.
Understanding food and energy commodity markets cannot simply follow a purely deductive approach
to understanding it, and particularly when referring to opaque markets like commodity markets today.
There are no laws of motions holding everything together to provide us with a harmonious world.
Furthermore, a purely descriptive analysis does injustice to the billions around the world starving from
malnutrition. If we are to do anything about the particular circumstance we live in today we must begin
with an ideal world we want to live in and work backwards. Hence we put aside two absurdities that are
quite commonly made in the world we live in today. The first is that the world is too complex and that
some natural order can magically fix it for us. No matter how absurd this seems, they are deeply
ingrained not only in neoliberal economic and development policies but also within multinational
institutions such as the World Trade Organization (WTO) (Kregel, Development 2012). The other
absurdity that stems from the first is the push-button policies commonly invoked to have a deterministic
outcome. That is to say, there is no uncertainty in the world that cannot have a number next to
itprices will always harmoniously adjust to meet supply and demand conditions. The only way to
dispense of these outmoded and irrelevant ideas and policy proposals is to adopt a realistic model that
takes into account the institutions and structures in the economy. The model used here has its roots in
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the ideas of New Developmentalism and Classical Political Economy. It is of the opinion here that it is up
to the economist
To define national objectives, to urge priorities, to show the inter-relation of apparently
unrelated problems, to devise consistent, non-contradictory programs to achieve specifiedobjectivesbecause, presumably, we are the only ones who know how the system
functionseconomists have the privilege and the obligation to advise (Curry 1967).
The difference between this and almost all of the standard material one reads on occasion is that the
orthodox economist has resigned himself to faith. To understand why this is so, its useful to go back to
the 18th century, when Voltaire wrote of a Professor Pangloss that believed that whatever arose as a
result of natural forces was a world that could simply have not been better (Reinert 2007). Hence such
belief systems came to be called Panglossian, which also characterizes neoliberal economists who
believe in a free market to not only provide for the best system of production, but of distribution. For
the sake of maximizing human development and state security, we should rid of the Panglossian belief
system that continues to hold us back. To understand the strategy of New Developmentalism, and
accept its conclusions, one must understand how it relates to food and energy prices today.
Understanding financialization is one important aspect of the world economy to note, but
understanding the process of development allows us to come up with the proper solutions to the
problem of rising food and energy prices.
With the creation of the United Nations came a few scholars who pushed certain ideas towards
national development. These set of ideas will be referred to as Old Developmentalism, with the name
Developmentalism arising from the goal of economic and political action towards development through
use of the state (Bresser-Pereira 2008). In other words human development and state security are
inherently intertwined within the framework. Among the scholars were Raul Prebisch and Hans Singer,
who developed a concept labeled the terms of trade, which quite simply calculates the price of exports
divided by the price of imports. The idea was that countries in the center, like the United States, that
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produced manufacturing goods were subject to increasing returns as the technology enhanced and
brought costs down. Periphery countries or developing countries on the other hand were nothing
more than primary commodity producing nations. Under the original idea of comparative advantage
that orthodox economics attached itself to, the idea that it was better for everyone if each country
specialized in something. Prebisch sought to dismantle this by showing that, where technology
decreased costs in center countries, the benefits accrued to the people of the nation through increased
employment and wages, while periphery countries were hurt by technological innovation as it enabled
them to produce more but with less labor. Hence, it made them more dependent on the center
countries to buy their goods to maintain the level of incomes necessary to maintain development. Yet
the catch-22 here was that rising productivity in the periphery meant ever-rising demand for imported
manufactured goods, while the same could not be said for primary product exports. The point is that it
didnt enable a periphery country to circulate any gains from trade within the country, as it provided no
opportunity for increasing the level of employment and output necessary to create new incomes. The
hypothesis was that the terms of trade and hence the external account would weaken in developing
nations over time
1
, as the quantity of primary product exports will deteriorate while the quantity of
manufactured imports increases (Toye and Toye 2004). In turn, this idea gave credence to the view of
protecting the infant industry within a nation from more efficient manufacturers in other countries, as
the importance of having a manufacturing sector was not lost for many developing nations. As one
developing nation representative stated, All our countries feel with perfect rightwhat we might call
the need for basic national industry (Toye and Toye 2004). To restate all of this, it was seen as a matter
of state security and human development to try to maintain a level of employment and output
necessary to provide for everyone.
1The terms of trade constraint, or external constraint, is one that develops through domestic exchange rate
appreciation. This in turn has implications on development that will be outlined in this paper.
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However, Old Developmentalism had a few issues that brought about its demise and the rise of
neoliberalism. One of the larger fundamental issues was that protecting industries eventually increased
the capital to labor ratio, and hence rather than behaving like manufacturing should have in passing
savings along to the population through employment, it was instead decreasing employment much like
the primary producing sector did (Bresser-Pereira 2008). The major consequence of this was an income
distribution that created haves and have-nots. As a consequence to income becoming concentrated
comes the shift to producing luxury goods, or in fact buying luxury goods from abroad rather than
reinvesting into productive capacity. In other words, the developing country becomes one that
increases per capita conspicuous consumption and pecuniary emulation. A further mistake that the
early school of developmentalists made was their acceptance of growth via foreign savings. The idea
has roots in the perverse acceptance that a country must have a stock of savings before it can grow, and
what better way to grow than to have all of these foreign savings being invested in a country without
large accumulated savings? Yet capital inflows automatically generate a claim by foreigners, while the
investments within the country dont generate anything one can use to meet those foreign claims. Old
Developmentalists like Prebisch may have known about import substitution carrying the seeds of its
downfall before they actually occurred, but to discuss the technical details in the face of a neoliberal
onslaught was wishful thinking (Emmerij, Jolly and Weiss 2001). Furthermore, the simultaneous rise in
inflation and unemployment was not satisfactorily answered by orthodox Keynesians at the time, and
hence the neoliberals could blame the state for all the ills within society. Yet what the neoliberals never
realized was that the issues that brought down Old Developmentalism were structural ones that
restricted fiscal policy measures from becoming effective.
Neoliberalism, on the other hand, has completely failed to raise the standards of living in
developing nations throughout the world a result of their Panglossian view of the world. It welcomed
capital account liberalization, as previously mentioned. Where policies and theory before neoliberalism
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ideology became prevalent had explicit acceptance of growth through external financing, the floodgates
to external financing were completely opened as neoliberalism became the dominant development and
growth strategy. This produced numerous crises that need not be fully detailed here, such as the East
Asian Crisis, Mexico and Argentina among others. As will be elaborated upon later when explaining the
specific policy proposals within New Developmentalism, external financing produces crises because the
developing country loses whatever policy space it may have had. Losing policy space is akin to losing
state security. Neoliberal policies encouraged foreign currency borrowing, and as far too many
countries now know, if productive capacity and hence domestic savings cannot keep up with the debt
service then there will eventually be a sharp currency devaluation as foreign investors flee. One part of
the problem had to do with profits actually going into the hands of foreign investors and not the general
public. The problems with neoliberalism wont be fully delved into here as they have been dealt with
elsewhere, but it will suffice to say that the experience of the past thirty or so years has been nothing
less than a sharp rebuke to policies it fostered. Yet one other issue of relevance must be raised as a
useful run-up to the next issue, which was the prevalent belief that everything good came from the
hands of the rich. The way to make savings go up, it was believed, was by giving people on the upper
end of the income brackets as much of the income and capital as they could. In turn they could reinvest
it and produce more employment and output, and hence inequitable distribution of income was
believed to be a good thing. This ended up not working out so well, as little investment was done and
instead conspicuous consumption in the form of buying a new Mercedes or mansion was an all too
common sight. This posed a problem for developing nations. If these individuals are buying new
Mercedes, the balance of payments will become negative. The question becomes: what to do? A
country can either reduce their imports, or redirect state expenditures into fixing the balance of
payments. Reducing the number of imported Mercedes simply isnt a policy option for the rich, so
instead a country opts for recession instead. So where the poor and middle classes in a developing
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country were hopefully trying to get a job, have now resigned to the fact that they may never get one,
and hence maintained and engrained their status as one of the many destitute members of society. Yet
it gets worse. The government, as a result, may have their budgets go into deficit to help the less
fortunate (due to the external constraint). To fix this, the policy of opting for recession was adopted by
the IMF itself, as they pushed the idea that the only way to fix a fiscal deficit is by pushing down the
level of public investment and employment, and hence incomes, with disastrous effects on human
development. Yet just like the crises that occurred in the early 1980s, the issue was one that was
internally generated and hence structural in nature. The key to understanding rising food and energy
prices lays in this understanding of structure and institutions.
Hence, New Developmentalism sprung from the ashes left behind by orthodox economists from
failing to incorporate structure and institutions into their models. New Developmentalism implies in its
name a nationalist perspective in the sense that economic policies and institutions must be formulated
and implemented with the national interest as their main criterion and with each countrys citizens as
actors (Bresser-Pereira 2008). Within this approach of New Developmentalism (as in Old
Developmentalism), human development and state security have once again become the focal point in
developmental economics. Yet the approach used here is not simply one focused on development. The
approach taken is one that seeks to explain the wealth of nations (and) capital accumulation, with an
implicit understanding that social structures and institutions are fundamental in its reasoning (Bresser-
Pereira 2008). On its face this may not seem at all radical to actually be looking at reality when
developing solutions, but this line of reasoning is in fact anathema to neoliberal ideology. Unlike
neoliberal economics, the approaches within New Developmentalism and of classical political economy
also understand that the state may not be able to alleviate the problems of production, distribution, and
stability due to structural constraints. The economics of a structural economist named Marcelo
Diamand could fully explain the issues of inflation and unemployment that mainstream Keynesian
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economics (the economics that neoliberals successfully tried to vanquish) could not, and that
transmission mechanism for prices and hence employment and output comes in the form of
bottlenecks.
Political Economy and Bottlenecks
So to finally present the model of the economy used to understand the bottlenecks vaguely
referred to at the beginning, the model depicted in Figure 2 (called the surplus approach) serves to
illustrate how a social surplus (profit) is created. This is a model that takes as its lineage a long line of
classical political economists from the 1700s and 1800s. Here the social product is the total amount of
commodities produced in a year, while the surplus is the share of the product going to the classes of
society other than the laborers, which can be determined by subtracting the (necessary consumption)
from the Social product, taken net of the means of production (Garegnani 1984). The key point here is
that this is a model ofreproduction, one that allows us to understand that the determination of the
social product and the real wage going forwardlies entirely in the hands of non-laborers. Ultimately this
is a model of not only production, but distribution. The owners who have access to the social surplus
ultimately determine how much they want to pay for labor and for further reinvestment into the social
product, and hence for reproduction of the system. Let us refer again to food and energy prices in
relation to both bubbles and investor expectations. Its entirely conceivable that these two factors (that
is, bubbles and investor expectations) are breaking the reproduction of the system, but at this point its
too early to tell. Yet this model is giving the hint as to what should guide us out of this mess: effective
demand.
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Figure 2: The Social Surplus Approach
Source: Garegnani 1984.
The early development economist Ragnar Nurkse probably said it best when he argued that all
capital is made at home (Nurkse 2009). His essential argument was that the capital needed towards
development is already available within the country, but that its not being used properly. Effective
demand is simply the acceptance of the fact that consumption creates an income for someone else.
Hence, the level of effective demand is best reproduced when those with access to the surplus
distribute it in such a way as to create enough income for laborers so that human development is
assured for all or most of the population. Traditional development theory a la Nurkse maintains that the
greatest potential for mobilizing all resources within an economy is through increasing employment.
Two theorems arise from his analysis. One is that most developing countries have abundant natural
resources. The other is that the real resources within a country are its people. Hence, an army of
unemployed and underemployed labor sits ready to work and better their lives. Yet even Nurkse
realized that this requires a policy that incomes stay within a country, and is hence saved, in order to
then increase capital and produce a surplus to then reproduce the system. One other developmental
economist who saw the importance of the concept of effective demand was Lauchlin Curry. His
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development experience started out in an underground experience in Colombia, having stayed there for
thirty years (Kregel, Development 2012). Initially blinded by the peculiar problems by particular
developing countries, he eventually discovered that the thing he didnt initially understand when doing
the Colombia project was the simple importance of increasing employment and thereby allowing
workers to earn income. If you give them a job and an income youve solved half of the development
problem. The problem with having underemployed workers, on the other hand, was also an issue but
stressed that it was not a resource/saving constraint but primarily an employment constraint. It cannot
be stressed enough that the concept of full employment and a sufficient level of effective demand to
provide for it is directly intertwined with human development and state security, as one cannot possibly
have one without the other. By this point the discussion has seemingly veered away a bit from the
discussion of food and energy prices, but one cannot possibly see the problem and create a solution that
portends to care about human development and state security without this essential concept of full
employment at hand. The surplus approach is central to the analysis of food and oil prices.
The discussion now turns back to Marcelo Diamand and his concept of a bottleneck(Diamand
1977). A bottleneck as defined here takes a slightly different approach than the one Diamand uses.
Here a bottleneck is defined as a constraint in an economy that prevents production and employment
from increasing. Measures to increase incomes (with subsidies or direct transfers) by governments
further exacerbate the situation of either high prices and/or resource constraints, as the constraint
continues to push the price ever higher in response. This in turn introduces stockpiling by consumers
and countries, while the process of ever higher prices continues in perpetuity. Thus the issue with a
bottleneck is that it structurally disables a country from increasing effective demand. The significance of
this concept, and its application towards food and energy prices, cannot be fully appreciated without
understanding Diamands approach of the bottleneck. His approach to understanding the economy was
of a fundamentally different perspective than that of traditional Keynesian or Monetarist approaches.
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Diamands conception of a bottleneck was the insufficiency of an item not very significant in terms of
its own value but essential for the carrying out of an activity of much greater value (Diamand 1977).
The main bottleneck arose through some natural resource constraint used as an input to goods or
services. The idea is that if the price mechanism operates efficiently in increasing the price of some
natural resource thats scarce for whatever reason, that on the first instance it will have a distributive
impact, as incomes get distributed from the rest of the population to the owners of that resource. This
then generates two responses: the first is that, as a consequence of wage earners being hit the hardest,
those wage earners or even the government may do something to offset the distributive impact.
However, no adjustment was made in terms of the bottleneck. The second response is the natural
tendency for a decline in overall demandwith the tendency being that demand will fall until the
resource in short supply is no longer in short supply. So what has been done is adjust demand back
upwards relative to available supply, but with no change in supply you get ever increasing inflation. This
may also cause many actors in the market to attain larger stocks of the natural resource as a sort of
hedge against future price increases. Yet this reinforces the bottleneck rather than alleviating it. What
this has done on the one hand is increase budget deficits, while on the other increasing inflationary
pressures and decrease real wages. Of course what arises out of all this is the focus on government as
the problem, with either monetary expansion or fiscal imbalances having caused all of the problems. So
an agency like the IMF comes to a developing country and tells them to reduce their deficits and run
tighter monetary policy. In other words, their solution is to let the developing economy contract until
the fiscal constraint and inflation has lessened. Yet the fundamental problem, which was that of the
bottleneck and not of government policies per say, had not been resolved. So an additional round in
which the price of the scarce factor goes up may in fact ensue once more.
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Diamand explains the bottleneck by looking at the behavior of producers after they find
themselves with an increase in their respective incomes. With more of the incomes being allocated and
hence distributed to the owners of the natural resource commodity, the owners of that resource would
then have to find some way to spend that additional income to eventually recirculate it back into the
economy. So the commodity producer in this instance has two options. Either it can directly invest or
spend their incomes back into the economy, or simply give it to the banking system. Yet the bottleneck
in this case was that rather than investing in productive capacity or spending, commodity producers
were putting their proceeds into the banking system, with the assumption then being that banks would
lend those funds to others. Yet, individual banks dont know whether an individual investor is going to
be paying him back, so what ends up happening on net is that the money ends up staying in the bank
and, hence, a generalized decline in purchasing power results. The cycle that existed of a decline in
effective demand, a decline in investment, and a response in most countries of increasing nominal
wages hence reinforces the bottleneck. It is from this conception of the bottleneck that oil and food
prices today can be understood. The issue with a bottleneck, at all times, is that it constrains money
from being recirculated from one part of the economy to the other. In particular, this would naturally
prevent employment, output, and hence effective demand from rising and would in fact cause it to fall.
If we relate this to the surplus approach as shown above, we can infer that in fact less of the surplus is
going to wages and the social product.
It is from this understanding of the bottleneck that the conclusion can be drawn from, which is
that the financial industry today represents a bottleneck and hence a threat to human development and
state security worldwide. Understanding why this is so requires understanding that the financial
industry has increasingly dipped their toes into commodity markets. As was shown in Figure 1, many
commodities have in recent years gone far beyond their historical price. Furthermore, prices have been
fluctuating very rapidly, especially in 2008 when prices spiked all the way to $147/barrel and then back
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down to under $40/barrel within a couple of months (Ghosh 2010). Whatever has been causing the
price increase in one commodity is likely to have caused the price to increase in another. This certainly
makes sense with regards to oil prices as it relates to other commodities: oil is a direct input into the
production of other inputs through transport and irrigation costs. Yet the issue is that commodities
markets are made up of two separate markets today: the derivatives market and the spot market. The
derivatives market, or specifically the futures market in commodities, is completely dominated by
financial firms such as investment banks and hedge funds as shown by the leaked internal CFTC
document. Yet this makes no mention of a transmission mechanism: how would the futures market
affect the spot market, where actual transactions between a buyer and a seller take place? The
emergence of futures markets brought with it promises that sellers and buyers could meet to exchange
a commodity at an agreed upon price. Hence, not only would their risk be hedged, but prices in
general would also not be subject to as many rapid fluctuations in price. The traditional argument is
that speculation provides liquidity to the futures market, where speculation requires that if such
activities are to be profitable, they must be stabilizing rather than destabilizing. The vital function of
speculators is to predict future market patterns and thereby reduce the intensity and volatility of
change (Ghosh 2010). From this one would conclude that in fact speculators have smoothed out the
prices of commodities, and hence prices would have been fluctuating even worse than what was seen
over the past six plus years. Yet this point fails to acknowledge that futures markets work completely
differently than they once used to. Indeed, without acknowledging these changes one could not
understand how financial markets form a bottleneck around growth and development.
How Commodities became Financialized
The first change that must be understood is that participants in futures markets rarely, if ever,
take delivery of a commodity in question. The contracts are merely rolled over from one period to
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another before expiration occurs, protecting themselves from having to take delivery (Sharifi 2011). The
fundamental point to take away from this is that there is no longer a one-to-one relationship between
the futures price in oil to the spot price. Traditionally as a contract nears expiration the futures price
would necessarily have to converge to the spot price, as the futures price is merely a side bet to the real
market where the commodity is exchanged. However, when someone now predicts the future and
makes a bet, they no longer have to worry about the real market, but simply worry about the average
persons expectation of what the average price of the futures price of that commodity will be. The
second change is that investment banks and financial institutions have created commodity index funds
that institutional investors can allocate their money into. In other words, as a result of delivery no
longer taking place, investors and others can play in the derivatives market for commodities much like
they can with stocks. The implications are given by Ghosh (2010), where index funds
Focus on returns from changes in the index of a commodity aggravated the treatment of these
markets as vehicles for a diversified portfolio of commodities (including not only food but
alsoenergy) as an asset class, rather than as mechanisms for managing the risk of actual
producers and consumers (Ghosh 2010).
One name commonly given to many of the investors allocating money to commodity funds like the
Goldman Sachs Commodity Index Fund, or GSCI, is that of inflation hedgers(Cook 2009). As pointed
out earlier, one result of policies like QE and ZIRP are that expectations of inflation, justified or not, are
increased, while on the other hand investors are simply looking for yield in a zero interest rate
environment. Hence as a result of successful advertising, commodities became the asset of class of
choice, particularly as fears of supply shortfalls due to a rapidly growing China and India became more
prominent. GSCI in turn has motivation to have people in their funds, as they can charge a fee for every
new individual brought in. Where financial innovation allowed a speculative euphoria to occur through
the selling of more and more homes to unqualified borrowers, innovation in this case allows the fears of
investors to be priced into commodities futures markets. In fact, when one looks to the period 2001-
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2003, bank earnings were depressed, and hence needed alternative sources of revenue. Making
subprime loans was one of them. Commodity index funds are now the other source. If one looks at the
increase in financial flows to these funds they are more or less coincident in timing with the end of the
subprime boom, with leverage of course being just as important here as it was with subprime.
Yet it gets worse. It is agreed that, no matter how the futures price gets affected due to the
actions of these inflation hedgers and traditional speculators, that at some point real supply and
demand factors will kick in and bring prices back to reality. Yet it hasnt been taken into account
whether these commodity funds and others have been speculating in the real market. One argument
advanced is that oil producers are being enticed to keep it in the ground (Cook 2009). It notes that in
2005 Shell Oil had entered into a partnership with ETF Securities to allow investors in ETF Securities to
invest in the idle oil Shell had provided they, Shell, were given a loan. In essence, Shell leased the oil
over to ETF Securities. Eventually firms like ETF decided to do this with some of the major oil producers.
GSCI and British Petroleum have also engaged in such transactions (Cook 2012). Cook (2009) argues
that
Oil producers motivation to do this redoubled after the financial crisis commenced and
interest rates went essentially to zerothe zero bound. Why produce oil and
exchange it for financial assets yielding 0%? Producers preferred to lease or lend their
oil instead(Cook 2009).
It would be further argued here, due to Minskys two price theory, that ZIRP had a similar effect on
conventional investors and speculators. Yet why stop in futures markets? Indeed, it has been argued by
some that these commodity funds and hedge funds among other financial firms have been buying up
entire farms or oil tankers and thereby restricting output and/or making the real supply figures harder
to access (Kregel, Development 2012). In fact, the supply figures for most commodities are purely
fictitious, particularly when financial actors have a motivation to see to it that they are lower than either
expected or perceived (Kregel 2012). The manipulation of price benchmarks published by price reporting
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agencies of spot oil transactions, which are supposedly used by a wide variety of actors, is treated as a
well-documented possibility (TECHNICAL COMMITTEE 2012). What this in fact does is maintain the
futures price on an upwards trajectory, magnifying the gains made by leveraged traders and speculators
and hence magnifying the impact of these funds going forward. All of this brings us to the important
question of the transmission mechanism of futures prices on spot prices. It has long been argued that
futures necessarily converge to spot, but this argument only holds if the futures are held to the date of
delivery. Absent that, there is no functioning economic argument remaining as to what point the
futures market decides to price a commodity at. It then comes down to the question of the motivations
of the major actors in commodities futures markets today. If it is their motivation to either hedge
against expected inflation and/or speculate in the belief that commodities only price trajectory is
upwards, then futures do not necessarily have anything to do with the spot price. With speculation that
financial actors have increasingly moved into the spot market, there really is no question that prices do
not reflect supply and demandand as mentioned, some of the existing benchmarks that are used for at
least some futures or spot transactions are unreliable. The fact is that interviews havent been
undertaken with the individual commodity producers questioning what benchmark they use to price
their respective commodity. Yet at least one paper has noted that spot prices in food commodities have
been following the futures price, rather than vice-versa (Hernandez and Torero 2010). A fundamental
question arises out of all of this: In an era of rising commodity prices without dwindling supplies or rising
demand, why would a commodity producer sell at a price lower than the globally available futures
price? As UNCTAD notes, Excessive price fluctuations foster uncertainty about the validity of the price
signals emanating from international commodity markets and add to the lack of transparency of those
markets (UNCTAD 2011) Yet the financial sectors impact is not so clear cut, and that will be described
more below.
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The Constraint of the Bottleneck
It follows from this that any attempt to alleviate the impact of high food and energy prices
simply magnifies this impact, and hence creates a bottleneck for developing countries. The bottleneck
in this case is a constraint on developing nations, whether primary product exporting or importing
countries, from expanding output and employment due to the financial sectors impact on commodity
prices. Understanding why this is so (that is, why rising commodity prices will have a constraining affect
no matter how a country decides to grow) is to understand why it is a bottleneck. That it should affect
non-primary producing nations is at least more intuitive. One basic proposition in the New
Developmentalist literature is that, in the absence of a state providing for full employment and/or
output, a country with a strong manufacturing sector will not necessarily lead to increasing wages in the
presence of unemployment (Kregel, Development 2012). This is because the excess labor constrains
wage growth. In a developing nation, rising commodity prices can worsen this impact. At some level
consumers will be spending an inordinate amount of their incomes or wealth merely to survive. As if
such an intuitive notion needed evidence, many Americans cannot afford to buy food in what is
supposed to be a part of developed world (Cooper and Burke 2012). Yet where this is having a
noticeable impact in the United States, the loss of purchasing power in developing nations is deadly
(USDA 2011). On another level, the effect of a global recession and rising commodity prices has led to
unemployment and decreased production around the globe. With respect to developing nations this
also leads to government policies to provide for either a buffer stock of food or energy, increasing
domestic production of food and energy, or income transfers and/or other social welfare policies to
diminish the impact. However, increasing buffer stocks sends a lower supply figure to the market and
thereby increases the price of the respective commodity. Government deficits in turn have a negative
impact on the balance of payments. In the face of an increasingly negative balance of payments,
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decreased production, and the presence of rising commodity prices the currency may see a depreciation
that the nation may not be able to deal with, especially if they have a pegged exchange rate. This is
because a depreciating currency means rising primary product prices, thereby perhaps negating any
government policies that tried to alleviate it. The situation becomes worse if the country was primarily
financed by external savings, as a country will find it more difficult to find the external currency
necessary to make the debt payments. In turn, investors will flee the country and put added pressure
on the currency much like what happened a decade ago in Argentina and elsewhere. The overall impact
here is increased inequality, output and employment, not to mention malnutrition or death. The
negative impact on both human development and state security cannot be overstated.
As bad as the impact of rising food and energy prices are on countries where manufacturing
accounts for the majority of exports, the impact on primary commodity producing nations is even
worse. At first blush it may appear that they would be the primary beneficiaries of higher commodity
prices, but in fact they too are deteriorating. The financial system can be an accelerator to the increase
in primary commodity prices, but they can also accelerate the decline of primary commodity prices
when they fear their positions are dangerous, as they did in 2008. The inherent volatility in commodity
prices characterized by this rather large outlier throughout the period of commodity speculation brings
Farmers toover (sow) in some phases and under (cultivate) in others. Many farmers in the
developing world have foundfinancial viability of cultivation has actually decreased in this
period, because input prices have risen and output prices have been so volatile that the benefit
has not accrued to direct producers (Ghosh 2010).
Hence, increases in primary product prices are akin to fools gold. As was mentioned in the earlier
discussion on the terms of trade (or the external constraint), manufacturing is historically and
theoretically important in providing for full employment and output. Yet what occurs in these nations
with high commodity prices is deindustrialization, which is an additional impediment to the decline in
the terms of trade. Increased agricultural exports have diminishing returns, which translates into higher
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prices and an appreciation of the exchange rate. If a countrys primary product exports are setting the
exchange rate (as they would naturally do when they are the primary export), then it must necessarily
be too high relative to the needs of the infant industrial sector that has to date been trying to grow and
develop. This is because, as an infant industry, it naturally has higher costs and lower efficiency
compared to primary products. As noted elsewhere there lays an obstacle on the demand side with
serious effects on supply, the phenomenon of which is known as the Dutch disease (Bresser-Pereira
2008). The Dutch disease is typically caused by an abundance of cheap natural and human resources,
but in this case rising commodity prices means more impetus to develop those natural resources
whether they are food or energy (Bresser-Pereira 2008). Deindustrialization also occurs because,
increasingly, imported goods become cheaper than the domestic ones due to the appreciated exchange
rate. The bottleneck here is hence much more severe, particularly as it applies to those with fixed
exchange rates. The benefits of those primary product exports accrue only to the owners and workers,
as the rest of the country is mired in abject poverty. This is because one needs industrialization if they
are to provide for full employment and output. Indeed, such a country is reminiscent of the type that
has a few citizens with two or more Mercedes, while the rest cannot afford to buy a bundle of food. Any
measures taken outside of an exchange rate adjustment are bound for failure, as industrialization
cannot maintain itself in the presence of an appreciated exchange rate. Yet an exchange rate
adjustment is itself not such an easy task to deal with. On the one hand there is political opposition
from primary product producers who before accrued all of the benefits, while on the other there must
be some method of financing the exchange rate adjustments. In addition, the appreciating currency
attracts foreign investors who then cause further appreciation, particularly when they are able to
engage in carry trade maneuvers whereby they borrow from a country with a low interest rate and
invest in a country where they believe they will see gains. The very presence of a commodity price
boom means that it would take that much longer for a country to reverse course. Yet even when it
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eventually gets to that point, it must start again from scratch and wait, historically, decades to get to a
state of industrialization necessary to provide for human development and state security.
A model serves to illustrate the effects outlined above, the totality of which involves diminishing
effective demand. Figure 3 below shows how the bottleneck is taking away from both real wages and
reinvestment into the social product. More unemployed labor means lower real wages, as does higher
commodity prices. On the other hand, deindustrialization means less money going into the social
product, thereby restricting the ability of full employment and output to take hold. Higher commodity
prices also implies a distribution affect through increased consumption on energy and food, and hence
towards commodity producers and the financial industry. Finally, more of the surplus going to the
bottleneck means by implication less of it going to the social product. That bottleneck represents an
institution, and hence that increased consumption goes back to the surplus. Yet nothing directs that
surplus from going towards more socially useful activities, and hence comes the loss of any chance of
human development, and by implication, state security. It must be noted that what is being said here is
not new. Thorstein Veblen and the entire strand of institutionalist thought in economics has long
recognized deliberate industrial sabotage by those controlling the means to production in order to
maintain their control on prices and power (Veblen 1982). Yet, if the rise of modern finance is any
indicator, sabotage is now taking place on a scale larger than ever.
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Figure 3: The Social Surplus with a Bottleneck
Source: Adopted from Garegnani 1984.
Policy Proposals
The bottleneck that increasingly threatens human development and the security of the
developing state must be tackled directly. It is not a constraint that cannot be handled. If the
commentary above was sufficient in understanding that manipulation and speculation determines
prices, then by implication that means that a developing nation can do it as well. In an ideal world the
United States and Europe would act to end speculation on futures exchanges as well as on spot price
benchmarks. Yet this is obviously far from an ideal world, and to the extent that these actions should be
undertaken this paper has little more to add to what has been written elsewhere [See (UNCTAD 2011)].
The developing world has little time to continue waiting on the developed world to do the right thing,
and hence an outline for development in an era of rising commodity prices must be established. As
noted, a developing nation can have either primary commodities or manufacturing as their export base.
Both are sensitive to rapid fluctuations in, and increases in, food and energy prices.
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As should have been apparent above, the state plays the strategic role in maintaining a structure
of the economy that promotes human development, as the market clearly cannot and will not do it. Yet,
how can a country get around the bottleneck? A general policy that all developing countries should
institute is a competitive exchange rate through a strong state. This is the exchange rate which
corresponds to manufacturing within a country becoming competitive to that of the world market
(Bresser-Pereira 2009). To summarize the importance of everything noted above, Pereira (2009) states
that
Economic development is a process of increasing productivity that takes place within industries
and, principally, through the transfer of labor from low value-added industries to high value-
added industriesindustries that use sophisticated technology and pay high average wages andsalaries (Bresser-Pereira 2009).
One may have a floating or fixed exchange rate currency, but to ensure that the rate corresponds to
trade rather than financial inflows and outflows, capital controls must be initiated. Inflows and outflows
refer not just to portfolio investment, but to external debt financing. Capital controls may come in the
form of a strict control, or through a tax on financial flows, otherwise known as a Tobin Tax. The motto
that must be kept in mind is that all capital is made at home (Nurkse 2009). External financing is
neither necessary nor warranted, as increasing unemployed resources at home presents the greatest
opportunity for increasing output and human development. This is the very definition of a strong state:
when external claims do not constrain policy space. In the surplus approach mentioned earlier, the level
and determination of the surplus depends on the capitalist, and its remuneration into the social product
and real wage is in their hands. The state can and must intervene such that the level of effective
demand is kept high, and that can only be done through use of a competitive exchange rate. The ability
to build up the manufacturing base (by having a competitive exchange rate) increases employment,
wages, and domestic consumption as has been noted here from the beginning (Bresser-Pereira 2009).
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Developing nations mired in the Dutch Disease face the toughest constraints against a strong
manufacturing base, and hence policy must be more specific. Keeping the exchange rate competitive is
tough, particularly when foreign investors have flocked to the currency in droves (assuming absent
capital controls). The implication is that the state must run a large budget deficit. Without having any
negative impact on foreign capital flows that budget deficits presume (that is, to prevent foreign
investors from fleeing), and to best ensure the growth of manufacturing, the best policy a nation could
use is to tax primary commodity producers to make the corrective policy budget neutral. The tax can be
either an export tariff or perhaps a land tax. The basic idea is to claw back the earnings made by the
agricultural or energy sector and then to subsidize the manufacturing sector to make them more
competitive. There are two options available in subsidizing: on the one hand it may be given directly to
manufacturers in supporting their endeavors, or it may be used to impact the currency and make it
competitive, which supports the general policy proposal above. An important point to make here is that
this policy should be imposed until the manufacturing base becomes stronger. Yet, as was noted above,
in this particular food and energy crisis food producers may themselves not be making much of a surplus
due to over sowing or under-cultivating. They may in fact be victims of the bottleneck as much as
anyone else.
So an even more important policy to ensure the security of the population and the state,
particularly in those countries without a strong agricultural sector, is to ensure that a physical reserve of
the essential food commodities exist to prevent the malnutrition and death surrounding the uncertainty
in food production and prices. A reserve may also be instituted, as others have noted, on the
international level (Braun and Torero 2009). The idea here is that a physical reserve may not be enough
to address the fluctuations seen today. Braun and Torero (2009) have the idea that the World Food
Programme manages this international, decentralized reserve that would better ensure developing
nations be able to meet the emergency needs for food and prevent extreme price spikes (Braun and
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Torero 2009). The same concept can be applied with reserves for oil or other energy commodities. The
problem with this idea, however, is that it may signal to speculators that demand is going higher while
supply is dwindling, and raise prices for the short to medium term. A related idea here is that domestic
production be increased for those essential food staples used in a particular country. Some have noted
that China has been buying up farms throughout the world in order to ensure food security for the
Chinese people. For many developing nations this is simply not a feasible optionand where food
shortages occur future disaster may strike, and hence the importance of domestic consumption cannot
be overstated.
A final idea first proposed by Braun and Torero (2009) is that of a virtual reserve for food and
energy (Braun and Torero only advocated for a food reserve). This takes the battle straight to the
speculators. The idea as espoused here is that a group of nations pull together a fund managed by an
expert in commodities futures trading to flood it with sell orders and thereby decrease the price. This is
not at all a desperate measure to take. The futures market and now the spot market has clearly become
a market of ramp speculation and manipulation. It is in the best interest of both primary commodity
producing countries (due to Dutch disease), as well as commodity importing countries, to get prices
closer to their true supply and demand valuation. The design by Braun and Torero (2009) initially
proposed that this fund signal to the market when they will threaten to intervene if the price goes too
high. However, part of the reason why financial firms have been able to get away with speculating in
commodity markets is that they are completely opaque. The Commodities Futures Modernization Act
deregulated commodities markets and made them opaque, and hence it is proposed here that
developing nations take advantage of this feature and manipulate prices as they wish. The point is to
prevent developed nations from taking action against developing nations if commodity market
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interference becomes well known2. The size of the fund, how its directed, and what an appropriate
price for a commodity is, must be determined by the countries in question. The likelihood of success
must be determined by the expert or group of experts, as the risks of losing money are always likely.
However, the success of such a program would mean less income transfers and other governmental
programs that would worsen fiscal deficits and the balance of payments, not to mention reduce the
likelihood of Dutch disease.
Conclusion
The financialization of food and energy commodities by financial institutions is the major link
between energy and food prices, and has created and become the bottleneck that constrains human
development and threatens state security worldwide. Developing nations are particularly vulnerable, as
human development relies on full employment policies. Where and when the bottleneck prevents full
employment via industrialization to take place, human development is potentially held back by decades.
This can take place through the Dutch disease, an increasingly negative balance of payments, and other
potential factors. The potential solutions are a competitive exchange rate, a strong state, a tax on
primary commodity producers (to somehow subsidize the manufacturing sector), physical and virtual
reserves of food and energy commodities, and increased domestic production of essential food staples.
All of these policies should be developed in unison, as they become stronger when acted upon together.
Most importantly, a strong state requires that no external claims be allowed to entrench on domestic
policy space. This will allow the other policies to be enacted, and hence for human rights, human
security, and state security to be maximized.
2The irony that the United States might take action to prevent speculation by developing nations, while
allowing speculation by investment banks and others, should not be lost here.
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