WHY THE FREE MARKET, NOT GOVERNMENT MANDATES, IS BETTER FOR FARMERS

Kevin McNew

For some 60 years, U.S. farm policy has attempted to provide income stability and support to U.S. farmers. Price supports and supply controls have been a mainstay of farm policies for the better part of this century. Although many justifications have been given for why U.S. agriculture deserves support while other industries do not, the most prominent reason probably is that farm incomes or other measures of farming returns are below what is being earned in non-farm industries. In essence, this argument is an accusation that the "market" does not provide adequate rewards to farmers.

In 1996, this sentiment seemed to change. Record-high commodity prices brought renewed optimism for agriculture. At the same time, Asia's robust economy led to a seemingly insatiable appetite for U.S. farm commodities and experts began to predict a food crisis in some parts of the world, most notably China. U.S. farmers and farm lobbyists seemed convinced: Farmers should be free to respond to market signals. The result was the Federal Agricultural Improvement and Reform (FAIR) Act of 1996, which did away with supply controls and reduced price supports in return for fixed payments over the next seven years. Some commodities, like tobacco, sugar, and peanuts, however, retained much of their old policies.

Farmers were happy because they were free to make production decisions without government interference. Policymakers were pleased because they were able to put an end to commodity market distortions and large program costs (albeit at a lofty price tag of $36 billion over seven years). And, finally, the market system seemed vindicated. At long last, the free market was deemed a fair and equitable gauge of commodity prices and, ultimately, farm incomes.

Now, three years into FAIR, we stand at an important crossroads. Most commodity prices are at or below the price support levels that just three years ago seemed unattainable; Asia's slumping economy has cut deeply into U.S. farm exports; China has been able to feed itself, indeed selling its surpluses on the world market; and agriculture is faced with conditions of oversupply. Once again, the market system comes under attack as opponents seek a return to pre-FAIR policies of higher price supports and renewed supply controls. Yet again we hear the accusations: The market system just doesn't work for agriculture.

I want to make two main points. First, agricultural commodity markets are extremely cyclical and volatile--probably more so than in other industries. This does not justify government farm policy, however. Like any other form of investment, the investment in farming should be judged on a long-term basis, and on this account there is ample evidence to suggest that farming is comparable with other industries. Second, not all farmers are equal when it comes to cost of production and therefore, profitability. Government policies have treated all farmers equally, however, by basing farm program payments in terms of prices. This has important implications for the distribution of farm program payments, as well as for the evolution of the farming sector.

The Farm Economy Is Extremely Cyclical

Commodity prices tend to cycle from times of high prices, which are profitable for most farmers, to periods of low prices, which are unprofitable. The fact that commodity prices are volatile and cycle from high to low prices over the course of several years is not a failure of the market system. Instead, such price tendencies are a consequence of the time it takes to produce commodities (usually six months or more), the importance of unpredictable weather on farm production, the inelastic demand of farm commodities, and the fact that most commodities can be stockpiled from one year to the next.

Farm policies in the past have done little to change the cyclical nature of prices. What can be said, however, is that farm policies of the past, while providing some relief from low prices, have created unnecessary surpluses, resulting in prolonged periods of low prices and fewer instances of high prices. To use an analogy, farm policy has been likened to a mother's slowly pulling off her child's Band-Aid, forcing the child to feel every hair ripped from its follicle, as opposed to giving it a sharp tear-off that leads to a once-and-for-all pain that ends quickly. In the long run, I believe farmers would be better served by the latter.

Why is it important to understand that commodity prices cycle? From a policy perspective, it is important to recognize that a free and competitive market will not always assure a profit. There will be years of "bad prices" that lead to a loss, but there also will be good years of higher prices that produce a profit. The role of the market is to assure that, over the long run, the profits and losses balance out, equaling the returns in other industries.

On this point, there is evidence that farmers fare quite well. Income per farm household equals or exceeds that of non-farm households in the United States. In addition, the average rate of return to assets on well-managed commercial farms is 10 percent or greater--comparable with what other resources earn in the economy. And, finally, the average net wealth of farmers is three times that of the average consumer. In total, it appears that the "market" has been generous to farmers.

To summarize this point, commodity prices are and will continue to be quite volatile. Today's farmers, as their fathers and grandfathers before them, all have had to face this fact. The market, however, provides adequate rewards for their efforts: not necessarily on a month-to-month basis or even on an annual basis, but over the course of several years. Like any investment, an investment in farming should be judged on the long-term result.

Not All Farmers Are Equal

Farming is indeed the paradigm of perfect competition--numerous suppliers producing a perfectly homogenous product at a market-determined price. What we sometimes forget about a perfectly competitive industry, however, is that the producers (in this case the farmers), must compete to survive. For the most part, that competition comes in the form of lowering production costs or competing for scarce resources, especially land. Advancements in technology and economies of scale are two of the driving forces that are influencing this trend toward lower production costs.

This means that not all farmers are equal when it comes to production costs. A 1996 University of Illinois study illustrates this fact. It finds that the average 1,500-acre Illinois grain farmer enjoys 15 percent lower production costs than a 500-acre Illinois farmer. In real terms, this means that a $2.30 corn price would result in a $7,000 loss for a 500-acre farm, but at that same price, the 1,500-acre farm would enjoy a $68,000 profit.

Government policy has failed to recognize this fact, however, when designing farm program payments. Farm program payments are made in terms of prices, not the measures of a farm's profitability. Thus, a farm program payment of 20 cents per bushel would mean a $15,000 payment for a 500-acre farm, thereby turning a marginally unprofitable farm into a marginally profitable one. In contrast, that same subsidy to a 1,500-acre farm would be a $45,000 payment, creating an extremely profitable situation. On the aggregate level, there is significant evidence that larger farmers enjoy most of the farm program benefits. For example, farms that have annual sales of $100,000 or more receive 70 percent of farm program payments, and their net-worth averages nearly $1 million per farm.

Unfortunately, the division of farm program payments between small and large farms does not end there. With more funds in hand, larger farmers tend to invest further in farm assets. Most notably, they tend to invest in land, which is the limiting input in agriculture. Doing so will make their farm more efficient by reducing average production costs, leading to better profit potential in the future. The small farmer, on the other hand, even with government payments, cannot afford the luxury of expanding. In fact, what the small farmer will find is higher land costs in the future as a result of larger farms' driving up the cost of land.

In the context of current farm policy debates, one option stands out in reference to the effects of farm size. That option is the $75,000 payment limit imposed by the current Loan Deficiency Payment program. Some policymakers are considering expanding that payment limitation. But even as low as grain prices have gotten, the likely size of a farm that would be limited by the $75,000 payment constraint would be in excess of 2,000 acres. Considering that these farms tend to be the most profitable and most wealthy, I suspect that U.S. taxpayers would consider subsidies to this group rather unpalatable.

Where to Go from Here

As mentioned previously, we stand at an important crossroads in U.S. farm policy. A return to the farm policies of the 1980s would lead to a return of the same problems that we had then: large government expenditures on farm programs, protracted periods of low prices, and the loss of America's competitive position in the world market. At the same time, we would do little to improve the outcome for small farmers. Their incomes would continue to be below that of large farmers and probably below that of non-farm workers. Farm policy payments, however, would continue to fuel the expansion of larger farmers.

If, instead, we choose a course of free-market agriculture, we accept that the market--not government--is the best judge of financial rewards. It will decide which farmers should stay in business and which farmers should choose other avenues. It will do so solely on the basis of efficiency and costs. Those that are efficient and produce at lower cost shall remain. Like any other freely competitive industry, competition is not always kind, but it is always fair.

--Kevin McNew is Assistant Professor in the Department of Agricultural and Resource Economics at the University of Maryland.

"EMERGENCY" RELIEF AND THE UNFINISHED REFORM AGENDA

By John E. Frydenlund

Although I am glad to be a part of this forum, I am disappointed that we must come together today to talk about whether Congress is retrenching or reneging on reforms it implemented in the Federal Agricultural Improvement and Reform Act of 1996. I would be much happier if we were discussing the unfinished reform agenda left by FAIR instead of the continuing threat of a return to the days of the federal government's agricultural command-and-control programs.

FAIR did provide a fundamental reform of the major commodity programs. Most significant, it shifted U.S. domestic agriculture policy away from the traditional price supports and supply controls. For 60 years, agriculture programs had been a hodge-podge of supply control programs, acreage reduction programs, and federally mandated requirements to plant specified crops on specific numbers of acres in order to qualify for federal support or payments.

FAIR eliminated most of these provisions, freeing farmers to plant for the world marketplace instead of for the U.S. government. It has been a very lucrative proposition for farmers. At the same time that they are free to plant whatever crop they want, they continue to receive guaranteed generous "market transition payments" through 2002. Over FAIR's seven-year life, which ends in 2002, the government will provide farmers over $35 billion--an average of $5 billion annually-- through these direct income payments. As it turns out, this $35.6 billion is just the tip of the iceberg.

But FAIR also left an unfinished agenda. One of the biggest failings in the legislation is that it does not include a provision to end all the traditional commodity programs at the end of its seven-year life. This is a very important victory for the opponents of reform because keeping that provision out of the legislation provides them with the upper hand when it comes to deciding what policies will follow the expiration of the present legislation.

At that time, if Congress did not either pass new legislation or at least eliminate permanent law dealing with the traditional commodity programs, U.S. agriculture policy would revert to the archaic mandatory supply-control programs that were a part of the original New Deal-era farm law. The old permanent law would also establish price support levels that would be even higher than the target prices and deficiency payments that expired in 1995. Because of this situation, I believe that those of us who seek greater reform the next time around will face a stiffer challenge in achieving our goals.

Two of the most antiquated programs--the peanut and sugar programs--virtually escaped any reform whatsoever in FAIR. These programs should be near the top of the "unfinished agenda" list. The peanut program is completely alien to any "freedom to farm" concept because it basically makes it illegal to grow and sell peanuts in the United States unless the farmer has a piece of paper from the government granting that right. The sugar program also is totally out of step with the real world. It supports U.S. sugar production at a level at least twice the world market price, and the supply of sugar is effectively controlled through the administration of restrictive import quotas.

The peanut and sugar programs increase the cost of government food purchase programs and force consumers in the United States to pay at least an extra $1 billion annually. The continuation of these programs also is detrimental to the export opportunities of the rest of U.S. agriculture because they undermine the credibility of U.S. negotiators to achieve greater market access for other agricultural commodities.

The dairy program also undergoes very little reform in FAIR, although the legislation does call for a phase-out of the dairy price support program and punted responsibility to the U.S. Department of Agriculture (USDA) to institute some vague reform of the antiquated federal milk marketing order system. It took almost three years to complete, but the Clinton Administration finally put forth a plan to provide reform--albeit minimal--of the milk marketing order program.

Under the new plan, federal milk marketing orders would continue to establish minimum prices that manufacturers must pay to producers based on whether the milk will be poured over cereal or used to make cheese or ice cream. In addition, the new orders would maintain the system of mandating price differentials among various regions, so premiums still would be charged to the processors of fluid milk based on how far the plants are from Eau Claire, Wisconsin. The only true reform would be to eliminate the federal government's dairy price-fixing system, which costs taxpayers and consumers at least $1 billion annually.

Creating Costly Cartels

Although the Clinton Administration's plan is a disappointment, it would take a small step toward reform by reducing the number of marketing order areas and reducing the disparity in mandated regional pricing differentials. Even these minimal reforms are under attack in Congress, however. In the House, there is legislation that would reverse the USDA's recent final rule on federal milk marketing order reform and mandate even higher milk prices.

FAIR also includes a provision to authorize the creation of the Northeast Interstate Dairy Compact, which allows a cartel of dairy producers in six New England states to set the price of milk artificially. The dairy compact was added to FAIR in the dead of night by one Senator who was holding the whole bill hostage, although the House had not included a compact provision in their version of the bill and the Senate actually had rejected a compact proposal. The compact was supposed to sunset when the milk marketing order reforms went in place. There now are efforts, however, in both the Senate and the House not only to reauthorize and expand the Northeast Interstate Dairy Compact, but also to grant authorization for the creation of a Southern Dairy Compact.

This preposterous idea, which would interfere with interstate commerce, would impose an unfair "milk tax" on consumers. If compacts were allowed to swallow up a vast percentage of the country, the cost to consumers would dwarf the $70 million that has been imposed on New England's consumers. Although the New England region produces less than 3 percent of the country's milk supply, adding additional states to the Northeast Compact and creating a Southern Compact would bring more than 40 percent of the country's milk supply and 60 percent of the country's consumers under the power of milk-pricing cartels.

The milk tax for this expanded compact region could amount to as much as $2 billion annually. Compacts also would directly affect government spending by increasing the cost of the food stamp and child and elderly nutrition programs. In the longer term, dairy compacts would cost taxpayers much more in declining sales of milk, surplus production, and government costs that quickly could grow into the billions of dollars. This is exactly what happened in the 1980s, when artificially high federal milk price supports put in place earlier cost taxpayers $17 billion. Congress should heed the lessons of the past and reject these efforts to undermine reform.

Annual "Emergency" Relief?

Getting back to the other commodity programs: In 1998, weather-related disasters and a retreat from relatively high commodity prices--caused largely by the global recession's impact on U.S. agricultural exports--led to calls for emergency relief. Although the actual economic loss due to weather-related disasters was less than $1.5 billion, Republicans responded to this so-called crisis by adding $4.2 billion in "emergency disaster relief" to the $56 billion fiscal year 1999 agriculture appropriations bill.

Democrats tried to use the "crisis" as an opportunity to reopen the farm law and take the first step toward dismantling FAIR by raising commodity loan rates. The long-term impact of that proposal would have been to lower farm prices further by increasing supplies, which would have led inevitably to calls for a return to acreage controls. This is exactly what happened all too often under the old supply-control policies.

In order to hold off this attempt to return to the old command-and-control policies that ended with FAIR, Republicans sweetened the pot so that, ultimately, the overall cost of the relief package was $6.6 billion. The bidding war got so out of hand that, in addition to actual weather-related losses, the bill paid for income losses stemming from lost foreign markets caused by the poor economic situation in Asia. It also included money for farmers who had suffered crop losses in previous years and livestock producers who had lost crops and had to buy feed. It even included money for dairy farmers, although they were receiving record high prices at the time.

Here we are, one year later, and everyone is crying "crisis" again. It seems that some in Congress must believe that last year's emergency relief package set a "baseline" for the annual "emergency" relief package. I understand that the Senate Republican package starts the bidding at $6.5 billion, while the Senate Democrats' emergency relief package totals $10 billion. Although Republicans have been more secretive about the details of their plan, the Democrats' package includes everything and the kitchen sink. The Republicans may have left the sink out of their package.

Looking at these emergency relief packages, I am convinced that the only real crisis is a crisis of the truth. This rush to dump wheelbarrows of money on farmers is based less on any real need and more on the continuing drive to buy votes.

The U.S. Agriculture Economy Is Strong

When compared with the first half of this decade, prior to the adoption of FAIR, all indications are that the agriculture economy in 1999 is actually quite strong. Total farm assets and land values, for example, are up dramatically from 1990-1994. In fact, even with the declines in 1998 and 1999, farm income during the past three years is higher than in the years prior to FAIR. Average income for the past five years exceeds that of the earlier half of the decade, with 1996 setting a record high.

In 1999, in addition to the $5 billion in market transition payments, farmers will receive $8.5 billion in loan deficiency payments and marketing loan payments due to the relatively low market prices at present--the largest sum of annual payments ever made under the commodity programs.

Furthermore, the current USDA projection is that net farm income for 1999 will be only $1.9 billion less than the eight-year official average in this decade and $2.9 billion less than the average of the past five years. Keep in mind that these projections are based on very low current prices and estimates of high yields around the world, so they probably represent a worst-case scenario.

Even under this worst-case projection, in the absence of any "emergency relief," 1999 farm income will exceed that of three of the previous nine years. You can put this whole farm "crisis" in perspective by looking at what the bottom line will be for farm income if either the Republican or Democrat emergency relief package is enacted: Under the Democrat plan, 1999 farm income would set a record high. Under the Republican plan, 1999 income would come in second only to 1996 income.

You have to wonder how much longer U.S. taxpayers are going to allow their pockets to be picked.

John E. Frydenlund is Director of the Center for International Food and Agriculture Policy at Citizens Against Government Waste.