Governments purport to act for the benefit of their citizens. Their laws, regulations and policies are supposed to protect them. They also like to pretend that they can protect them from markets. Usually it is the other way around. Markets operate for the benefit of citizens and markets need protection from governments. Often government policies, implemented with the best intentions, backfire. The policies can create a bubble. Although these bubbles victimize the very citizens the government is trying to protect, they can be very profitable for investors. One of the most egregious recent examples has to do with rice.

Rice is the staple crop for half the world’s population. The world grows about 450 million tons annually, but the amount available for international trade is only about 7% of the total crop. This is tiny compared with 20% or so of the world’s wheat crop available for sale. So little reaches the market because it is considered a strategic food in many countries. Governments consider it so vital to their survival that they make sure that it under their control. Domestic markets are heavily regulated and protected in order to encourage self sufficiency. The world’s largest producer is China, but its 130 million ton crop is not for sale. The top exporters are Thailand and Vietnam, but together they export only about 17 million tons. India grew about 95 million tons in 2010-2011, but exported only slightly less than 4 million.

In 2007 the price of wheat started rising. For most of the decade it sold for about $200 a metric ton, but by September it was over $300. Countries started to panic. To maintain low prices for domestic supply, they restricted exports and lowered tariffs for imports. With the restricted supply the price rose further and hit an all time high of over $ 439 a metric ton in February of 2008. Since one bubble wasn’t enough, government thought they would create another.

When wheat became too expensive the Indian government decided to purchase more rice for its food programs. In October 2007, it banned the export of rice. At the time rice was plentiful. Farmers around the world were harvesting record crops, but because of the restrictions much of this crop was not available for global markets. So the price rose.

As the price rose, so did the panic and restrictive government policies. Egypt, Pakistan, and most importantly Vietnam joined India and restricted the export of rice. From a price of about $300 a metric ton in 2006, the price soared to over $1000. The panic then hit consumers. In Vietnam rice markets and supermarkets were cleaned out. Even in the US stores Walmart limited rice to 4 20 pound bags per customer. The insanity was due only to governments. There was still plenty of rice sometimes in the strangest places.

As a result of a trade dispute between Japan and the US, there were over a million tons of American rice sitting in Japanese warehouses. Like other Asian nations, Japan protects its rice farmers. They had no interest in using the rice domestically. They imported it only because the World Trade Organization told them to. Thanks to some lobbying by a US economist and a rice trader, the US and Japan agreed to release some of the rice onto the market in mid-May of 2008. The announcement of the release was sufficient to prick the bubble.

Fast forward to 2011. India and Pakistan are having a good year. Both countries have large surpluses, so good in fact that India in September agreed to lift the export ban. This was fortunate because droughts in the US and floods in Thailand have hit both countries exports, but these problems won’t help Indian farmers and traders. The traders were so afraid that the Indian ban would be reinstated that they sold their rice at rock bottom prices a month before the Thai floods drove the price up.

The implications of this story for investors are enormous. This isn’t just the story of the disastrous unintended consequences of a few well meaning, but incompetent Indian babus. Economists, financial analysts, and money managers all assume that prices and markets are driven by market forces like supply and demand. The reality is that these forces may be irrelevant in the short term. During the 2008 food crisis, the papers were filled with stories about shifts in global demand due to a wealthier Asia. The reality was something simpler and less profound.   

The good intentions of government bureaucrats are heavily implicated in the massive distortions and volatility of all market categories over the past five years. One policy creates a bubble and another attempts to ameliorate the effects, each one making the gyrations worse. For investors the profit comes from understanding these mistakes and not economic forecasts.