Ethanol Revisited

I recently read an excellent article in the May/June 2007 issue of Foreign Affairs, which is published by the Council on Foreign Relations. Professors C. Ford Runge and Benjamin Senauer argue in "How Biofuels Could Starve the Poor" that the push for corn-based ethanol is driving up global food prices.

High oil prices have prompted governments to subsidize the development of alternative fuels. Brazil uses sugar to produce ethanol. The U.S. has focused on corn-based ethanol. Although corn production is near record levels, an increasing portion is being dedicated to refine ethanol. This has depleted corn inventories. Furthermore, as farmers plant more and more corn, yields of other food crops are falling, pushing up their prices as well.

Ethanol is expensive to produce. Ironically, high crude oil prices are necessary for ethanol production to be profitable. The authors argue that if oil prices fell back to $30 per barrel (admittedly, not a very likely outcome), corn prices would have to fall to less than $2 per bushel for ethanol production to remain a profitable business. However, at $80 per barrel for oil, ethanol refiners could afford to pay more than $5 per bushel for corn and still make a good return. The tradeoff, of course, is more expensive food.

I commented on much of this back in April when I wrote Ethanol is Not the Solution. I argued that the most promising technology to address our transportation needs in the short term is the plug-in hybrid car. Since then several automobile manufacturers have announced plans to invest more money to research and develop this technology. The farm lobby may oppose these efforts, but success would not only significantly reduce our dependence on foreign oil, it would also bring food inflation under control.

Starbucks Raises Prices and Analysts Cheer

There seems to be little skepticism on Wall Street about Starbucks' recently announced price increase. The company admitted again that higher costs are pinching profits. It is struggling with higher dairy prices, higher fuel prices, and higher energy prices.

But consumers are also dealing with higher prices, leaving them with less and less income to spend on discretionary items like Starbucks coffee. So is the nine cents per cup price increase sufficient to preserve profit margins without depressing volumes? Or is it too much of an increase that will turn away some customers and make them wonder why they are paying so much for coffee? These are the questions Starbucks and analysts are grappling with.

Customers are getting squeezed by higher prices for all kinds of things. Food and energy prices in particular are taking a bite out of their incomes. I doubt even Starbucks believes that customers will finance their coffee purchases with stock market gains or home equity loans. The bottom line is that things don't look promising for Starbucks right now. We'll learn more about the company's financials on August 1. In the meantime, I'm sticking with my recommendation to short the stock.

The Real Cost of Living

Wednesday night I argued on Kudlow & Co. on CNBC that inflation is problematic. I mentioned soaring gasoline and food prices. Larry Kudlow took me to task saying those volatile components are rightly excluded when measuring core inflation. He said the prices of other things like televisions and cell phones have been falling. He didn't care for my argument that consumers buy gasoline and food every week, but that they might buy a cell phone only once every two or three years. He said I was being silly.

After thinking about it for a while, I realized that even the costs of watching television or making a phone call have risen. Take television. Granted, quality has improved dramatically, but the cost of watching television has gone up tremendously. I purchased a color television set in 1987 for $299 and paid an additional $200 to have a rotational antenna installed on my house. That allowed me to capture stations from Baltimore to Philadelphia. There were no additional costs involved. I received all my programming for free.

These days you would have to buy a high-definition television set. I know prices for HDTVs are falling, but they still cost about $1,000 or more. You also have to subscribe to premium cable or satellite services that cost at least $60 per month. And even though you can now get hundreds of stations, it is still difficult to find much that is worth watching. So, economists may argue that the cost of a television has fallen if you factor in the vastly improved quality. Yet the fact is that the cost of watching television today is much higher than it was in the 1980s.

As for cell phones, they were certainly a rarity back in 1987. Those who wanted one installed in their car had to pay a fortune. These days cell phones are ubiquitous. Yet I can't say that I have noticed a decrease in the price of making a call. Even cell phone prices don't seem to have fallen much in recent years. Yes, the phones are getting cooler and cooler. They do offer lots of features I never thought I needed. But when you consider all those hidden fees and taxes, the cost of making a call just seems to go higher and higher.

There are many such examples. Technology has brought us lots of products we couldn't even have imagined just a couple of decades ago. And if these products come with added features with only a marginal increase in price, economists actually consider that a price decrease. Yet the cost of daily life keeps rising. Think of all the things you do on a regular basis. You spend money on housing and clothing. You have to eat and drive to work. You might watch television and listen to satellite radio. You might go out to dinner and a movie. You might take a vacation. Perhaps the quality of the things you buy on a regular basis has improved, but the costs of daily life are certainly not falling.

Life is Good Without a Car or Food

Is there or is there not an inflation problem in the U.S. economy? Anyone who buys gasoline knows inflation is rampant. Filling up the average sized gas tank costs about $50 these days. Just a few years ago you would have needed only about $30. Food prices are also way up. Even Starbucks is complaining that high dairy prices are pinching profit margins.

Yet Fed officials and most economists say inflation is not so bad because they prefer to focus on core inflation. In other words, they want to know how much prices are rising if we exclude gasoline and food. They believe gasoline and food prices are just too volatile to provide a meaningful measure of inflation, so they simply ignore them.

But investors are waking up to the fact that gasoline and food really matter. Consumers know these items are taking a bigger and bigger bite out of their paychecks. The effects are starting to show as consumer spending becomes strained. For example, Wal-Mart has been complaining for some time about higher gasoline prices weakening their customers' purchasing power. It turns out some of those customers are making up for this by resorting to the 5-finger discount. Wal-Mart is getting fed up with the increased levels of shoplifting activity it is seeing, so it announced plans to be more aggressive about prosecuting violators.

In the meantime the housing market continues to implode and foreclosures keep rising. Even S&P and Moody's have finally figured out that sub-prime mortgages are indeed risky. Housing prices are falling nationwide. Of course, the high-end of the market will probably fare well. But average prices are likely to fall enough to put some homeowners in a negative equity position.

As for jobs, so far so good. The economy is still creating jobs and the unemployment rate remains low. Nonetheless, incomes are not doing so hot. According to the Commerce Department, inflation-adjusted incomes actually fell in May. Of course, that's using overall inflation, which includes those volatile gasoline and food prices. Those of you who are lucky enough not to have to drive or eat, well it turns out you're doing pretty well!