Resolved: That the United States should substantially change its federal agricultural policy.

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Source: Challenge, Jan-Feb 1997 v40 n1 p72(15).

Title: What drives agricultural cycles?
Author: James Herendeen and Milton6 Hallberg

Full Text COPYRIGHT 1997 M.E. Sharpe Inc.

In April, President Bill Clinton signed into law the Federal Agricultural Improvement and Reform Act (the FAIR Act). A major feature of this act is the removal of price supports and production controls for most of the agricultural commodities now receiving such support, including wheat, feed grains, oilseeds, rice, and cotton. Dairy price supports will be phased out by 1999. Farmers will receive $36 billion in direct payments at a declining rate over the next seven years. These payments will be unrelated to current prices or production and will be based entirely on past payments. If at the end of seven years Congress fails to enact new legislation, permanent legislation calling for high price supports and production controls will be reactivated.

Congress has chosen a fortuitous time to remove price supports and production controls for the major farm commodities. For the past several years the dollar has been relatively undervalued against the other major currencies. Export demand for farm commodities has been strong, and farmers producing export commodities have been doing well. But whether this experiment succeeds will depend on what happens to world demand for U.S. agricultural exports, on what happens to the value of the dollar, and on how Europe, Japan, and other producers respond to what they will perceive as a flooding of the world market by the United States. To understand why this is the case, this article examines the boom and bust in the agricultural economy during the 1970s and 1980s. Prosperity (or lack of it) in agriculture during this period was at least in part the unintended consequence of macroeconomic policies pursued for other reasons.

Agricultural price supports and production controls have dealt primarily with the symptoms of agricultural distress, not the causes. They have also had the undesirable side effect of restricting output by low-cost U.S. producers while higher-cost European and Japanese producers faced few or no output restraints.

The situation in agriculture at present is similar to the situation in 1972, when the excess capacity of the 1960s ended and a combination of high world demand and a falling dollar led to an export boom and seven years of prosperity for agriculture. However, this was followed by a major agricultural collapse in the 1980s. Are we setting ourselves up for a repeat performance a few years down the road? There seems little doubt that farmers will respond to increased prices and reduced production controls by again increasing production of the major crops - wheat, cotton, soybeans, rice, and feed grains. The cash payments to farmers under the new law, which are unrelated to price or production, will help encourage this result.

The governments of European countries and Japan will choose among several responses to the increased production. First, they could decide to follow the United States and eliminate their price supports. This would cause massive distress for their high-cost producers and would have to be accompanied by subsidies to help inefficient producers to leave agriculture. With the rate of unemployment in Europe double that in the United States, this seems unlikely. Second, they could impose high tariffs against U.S. imports to protect their domestic producers. The United States would probably retaliate by restricting its imports from them. Third, they could impose import quotas on U.S. products, which would also likely lead to retaliation. Fourth, they could try to negotiate an international agreement with the United States, which in turn might force the U.S. Congress to reconsider the removal of price support and production controls. In all likelihood, Australia and Canada will follow the lead of the United States, since they are also low-cost producers. This would exacerbate the problems of Europe and Japan.

What will be the effect of the new farm bill on food prices? Over the next year or two, retail food prices will increase for reasons that have nothing to do with the new farm program; rather, the cause will be the current increase in grain prices attributable to shortages and high world demand, which will lead to higher prices for livestock products, cereals, and baked goods. However, the increase would have been even greater if output were still being restricted by the old farm programs.

While we can expect lower prices for retail food as output expands and farm prices decline, the reduction will be small. A major portion of retail food prices represents processing, packaging, and distribution. These costs will be relatively unaffected by the new farm programs.

What about costs to taxpayers? As direct payments to farmers decline, budget costs for farm programs will be reduced. However, this may be partially offset by rising costs of export subsidy programs continued under the FAIR Act. Thus, we can expect some reductions in expenditures for agriculture. However, as important as agricultural reform is to farmers and the rural community, it is only a small share of the total federal budget.

Thus, it seems quite possible that within a few years agriculture will return to a situation of excess capacity and depressed prices. It is highly unlikely that the central banks of the major countries will allow a sustained expansion that would keep world demand high. Unlike in 1972, the dollar has been rising since May 1995. This will put a damper on rising U.S. exports. It is unlikely, however, that we will get a sustained rise in the dollar as occurred in the 1980s. If we get a return of excess capacity and depressed prices, Congress and the president will be under pressure from farm interest groups to reimpose price supports and production controls. This is what happened in the 1980s after farm programs had been essentially deactivated in the 1970s.

Conceptual Issues

For any individual industry, such as agriculture, exchange rates can be treated as externally determined. However, changes in exchange rates lead to changes in relative prices and greatly influence agricultural output. When the dollar rises, the dollar price of U.S. goods to other countries goes up. This means that foreign consumers will find U.S. goods more expensive. When the dollar falls, the dollar price of U.S. goods to consumers in other countries will fall and U.S. exports will rise.

Purchasing-power parity requires that the dollar price of U.S. goods roughly equals the dollar price of comparable foreign goods. The dollar price of foreign goods is the foreign currency price divided by the exchange rate, where the exchange rate is the foreign currency price of dollars. If the dollar falls, then either U.S. prices of traded goods must rise or foreign prices, in their currency, must fall in order to move toward purchasing-power parity. If the dollar rises, then either the prices of U.S. traded goods must fall or the prices of foreign traded goods must rise to move back toward purchasing-power parity.

When the U.S. dollar is undervalued it acts as a subsidy to export industries, such as agriculture, and as a tax on import industries. When the dollar is overvalued it acts as a tax on export industries, such as agriculture, and as a subsidy on import industries. Over time, the tax or subsidy is eroded away as prices adjust back toward purchasing-power parity. We do not argue that purchasing-power parity always holds but rather that prices adjust in the direction predicted by purchasing-power parity when exchange rates are free to change. In addition to affecting relative prices, exchange rate changes also affect incomes in export and import industries. A falling dollar leads to rising incomes in export industries.

The Role of Monetary and Fiscal Policy

Macroeconomic policies affect agriculture primarily through changes in exchange rates, real interest rates, and aggregate demand of both the United States and the rest of the world. This is because agriculture is a major export industry - especially the major feed and food grains and oil crops grown in the Midwest and Great Plains, cotton grown in the South and Southwest, and tobacco grown in the South. Agriculture is also a very capital-intensive industry with a large part of that capital being land. In 1990 total assets (excluding operator household) per self-employed worker was about $424,000. For commercial farms it would be much higher. In agriculture, residual incomes are capitalized into land values in a manner very similar to the way corporate incomes are capitalized into stock prices. The two major factors in this capitalization process are profit expectations and real interest rates (the interest rate minus the inflation rate).

With flexible exchange rates, monetary policy may be reinforced through the foreign sector. When the Federal Reserve pushes down interest rates (or increases growth of bank reserves), the dollar is likely to fall. When the dollar falls, net exports rise, giving aggregate demand an additional stimulus. When the Fed turns restrictive, the dollar is likely to rise. This will reduce net exports and make a given monetary policy more restrictive than it would have been if the dollar had not changed. When the dollar was devalued in 1971 and then allowed to float in 1973 at the same time that monetary policy was highly expansive, it led to a quick fall in the value of the dollar and a quick acceleration of inflation rates. Low real interest rates contributed to an undervalued dollar throughout the 1970s. When real interest rates increased in the 1980s because of very restrictive monetary policy, the dollar rose and the process was reversed. Falling commodity prices contributed to a quick deceleration of inflation rates. Expansive fiscal policy and easier monetary policy allowed the economy to expand after 1982. However, partly because of high real interest rates, the dollar remained overvalued until 1986 and the raw material - producing sectors remained depressed. Only when the dollar fell, starting in late 1985, did these sectors finally recover.

Monetary policy is not neutral in the short run, partly because changes in demand lead to short-run changes in relative prices, which in turn affect output. These changes in relative prices reflect differences in elasticities of supply and demand, which depend in part on the stages in the production process and are not primarily dependent on the monopoly power of firms or unions.

The U.S. Economy and the Agricultural Economy

Figure 1 shows the index of real GDP in agriculture and the index of real GDP for the aggregate economy.(1) The agricultural economy shows surges in income in 1973 and 1979 and a big drop in the 1980s. The dashed line shows agricultural GDP peaking in 1973 and hitting a trough in 1986. For the U.S. economy we see the recession of 1974 - 75, the double-dip recession of 1979 - 82, and the recession of 1990 - 91. In addition, there were two short expansions in the 1970s and a long expansion in the 1980s. Also shown is trend GDP for the aggregate economy. All real values used in this and subsequent figures were found by dividing nominal values by the GDP deflator. Thus, our farm income figures represent real income for agriculture, not real output.

Realized real short-term interest rates are the difference between the short-term interest rate and the inflation rate. [ILLUSTRATION FOR FIGURE 2 OMITTED] When inflation increased in the 1970s, the Fed was unwilling to push short-term interest rates high enough to keep real rates positive. For the period 1973-80, average realized real short-term rates were -1 percent. In the 1980s the Fed prevented interest rates from declining as fast as inflation rates and kept real rates abnormally high. For the period 1981-86, average real short-term rates in the United States were almost 6 percent. Also shown in Figure 2 is the index of the real value of the dollar. Note that the real value of the dollar moved relatively closely with the real interest rate over the twenty-year period. The Fed, intentionally or not, was influencing the value of the dollar by influencing real interest rates.

Figure 3 shows the annual percent change in the index of industrial prices, all farm prices, and crop prices. Crop prices are more volatile than are farm prices, which in turn are more volatile than industrial prices. Also shown in Figure 3 is the change in the inverse of the real value of the dollar lagged one year. The inverse of the dollar index measures the dollar price of foreign exchange. When the dollar falls, the price of foreign exchange rises. The relation is lagged one year because changes in the price of foreign exchange show up as price changes a year or so later. Note that the price of foreign exchange and agricultural and industrial prices moved together over the period. However, in the early 1970s these prices increased faster than did the price of foreign exchange. With high world demand this is what we would expect. In the late 1980s the price of foreign exchange increased faster than did the prices of these commodities. With world demand depressed, part of the effect of the falling dollar showed up as falling prices in other countries. A major point revealed by Figure 3 is that all basic commodity prices moved together over this period. Food and oil are not the special cases they are often portrayed to be. Further, basic commodity prices moved in the same direction as did the inverse of the value of the dollar.

Figure 4 shows the index of real agricultural exports and the inverse of the real value of the dollar (the real value of the dollar before 1973 was assumed to be equal to the nominal value). Note that real agricultural exports increased by about 50 percent between 1971 and 1974, when the dollar fell, and by about 30 percent more, when the dollar fell again in the late 1970s. Real agricultural exports fell by more than 50 percent between 1980 and 1986, when the dollar rose. In the late 1980s, when the dollar fell again, real agricultural exports increased by about 20 percent.

Implications and Interpretations

What can we conclude from all this? First, agricultural output and prices are much more volatile than aggregate output and aggregate prices. This is primarily a function of the stage of production and the fact that farmers are price-takers not price-makers. For crops it is also a function of weather. As we move from retail to original producer level, elasticities of both supply and demand get much smaller on average. Also, since farmers are price-takers (whether from the market or from government programs), there is no short-run relationship between price and cost of production as there is for many finished goods.

Second, the agricultural business cycle, at least in the 1970s and 1980s, was only very loosely related to the aggregate business cycle. Instead it was closely related to the business cycle for raw material producers. The 1970s was a period of prosperity for agriculture and other raw material producers. It was a period of relatively high unemployment and high inflation for much of the rest of the economy. For the 1973-82 period, the rate of average real growth was 1.86 percent, average unemployment was 7 percent, and average inflation was 8.7 percent. In the 1980s the whole process was reversed. Raw material prices fell with the rising dollar and falling world demand. Raw material industries remained in recession until 1987, but the rest of the economy experienced high growth and declining inflation after the Fed switched policy in 1982. The rapid decline in inflation would not have been possible without the fall in basic commodity prices. Likewise, the long expansion of the 1980s was made possible by the fact that there were no raw material bottlenecks to slow the economy (as there were in the 1970s). Average real growth for the 1983-92 period was 2.86 percent, average unemployment was 6.5 percent, and average inflation was 3.8 percent.

Third, the major driving forces of the agricultural business cycle of the 1970s and 1980s would appear to have been changes in real interest rates, changes in the value of the dollar, and changes in world demand for basic commodities. These were not unrelated; they were the joint product of monetary and fiscal policy of the United States and other major countries - policies that were pursued for macroeconomic objectives unrelated to agriculture. This cycle was monetary in nature but not in the simple monetarist views so popular in the 1960s and 1970s.

Fourth, the combination of falling real interest rates and rising farm incomes led to rising land values in agriculture and to the expansion of farm debt, setting the stage for the credit crisis that followed in the 1980s. Rising real interest rates and falling farm incomes caused a collapse of farmland values in the first half of the 1980s.

Fifth, real agricultural exports are highly correlated with the inverse of the value of the dollar. Because feed grains, food grains, and oil crops - our largest agricultural exports - are highly homogeneous products, their domestic prices had to increase or decrease as the dollar fell or rose. Changes in prices for feed grains and oil crops are reflected in prices for livestock products, cereals, and baked goods. Thus, export prices have an effect far beyond that portion of the crop actually exported.

Why did the agricultural boom last seven years, and why did the bust also last seven years? In other words, why did production and profit margins not adjust quickly to the new level of prices after the initial shocks? There are several possible reasons. First, it took several years of higher prices to convince farmers and agricultural lenders that higher prices were here to stay. (By then, unfortunately, they were not.) This was also true of government, which had to adjust farm programs and crop set-aside provisions to the new realities. U.S. output is only part of the story because markets for feed grains and food grains are worldwide. Likewise, in the 1980s it took several years to convince farmers and policy-makers that a world of excess capacity had indeed returned. And it took government several years to reimpose farm programs that had been more or less deactivated in the 1970s.

When prices rise, why don't farmers just produce more? In the short run, farmers increase output with given capacity. In the long run, they can expand capacity by buying additional land, equipment, and livestock. When prices fall farmers will adjust output somewhat, but the problem is that they produce under conditions of very high fixed costs. Only when price no longer covers the variable cost of fertilizer, fuel, seed, and hired labor does it pay to cut output. Farmers who are not highly in debt can, and do, continue to operate for several years even when price is substantially below average total cost. They have little choice. It is difficult to sell land when land prices are extremely depressed. The opportunity cost of the farmer's labor is extremely low, especially in rural areas. In the short run, it pays farmers to operate at more or less full capacity; in the long run, adjusting capacity is a slow and often painful process.

Whether the FAIR Act successfully eliminates government intervention in agriculture will depend on world demand for agricultural commodities, the value of the dollar, real interest rates, and how other major producers (especially Europe and Japan) respond to the new U.S. policies.

If the United States and other major countries could succeed in stabilizing the world economy by stabilizing real interest rates, exchange rates, and the growth of aggregate demand, the chances that government could avoid future intervention in agricultural markets would greatly improve. Unfortunately, this seems highly unlikely. Unexpected changes in world demand, exchange rates, and real interest rates have serious consequences for export industries like agriculture. Perhaps the Fed, in cooperation with its counterparts in other major countries, should pay more attention to the international value of the dollar and should attempt to maintain approximate purchasing-power parity between the dollar and other major currencies.

If, over time, output expands and farm prices fall, we are likely to see a return of a situation of excess capacity in U.S. agriculture. If this happens, Congress and the president will be under pressure from agricultural interest groups for a return of farm programs. This is what happened in the 1980s after the period of prosperity in the 1970s. Only time will tell whether Congress and the president will be able to withstand the pressure.


1. This section examines some descriptive statistics regarding the U.S. economy and the agricultural economy. Data are from Economic Report of the President, Federal Reserve Bulletin, Agricultural Statistics, and Statistical Abstract.

For Further Reading

Edwards, Clark. "The Exchange Rate and U.S. Agricultural Exports." Agricultural Economics Research (winter 1987): 1-12.

Hallberg, Milton C. Policy for American Agriculture. Ames: Iowa State University Press, 1992.

-----. "1996 Food and Agriculture Legislation: New Wine in New Bottles?" Farm Economics. Agricultural Experiment Station, Pennsylvania State University (May-June 1996).

Harl, Neil E. The Farm Debt Crisis of the 1980s. Ames: Iowa State University Press, 1990.

Herendeen, James B. "Inflation and Recession 1973-75: What Went Wrong? Where Do We Go from Here?" Farm Economics. Agricultural Experiment Station, Pennsylvania State University (May 1975).

-----. "Agriculture in an Unstable Economy." Farm Economics. Agricultural Experiment Station, Pennsylvania State University (September-October 1987).

Herendeen, James B., and William Grisley. "A Dynamic 'Q' Model of Investing, Financing and Asset Pricing: An Empirical Test for the Agricultural Sector." Southern Economic Journal (October 1988): 360-73.

McKinnon, Ronald. "Monetary and Exchange Rate Policies for International Financial Stability: A Proposal." Journal of Economic Perspectives (winter 1988): 83-103.

Pasour, E.C., Jr. Agriculture and the State. Oakland, CA: Independent Institute, 1990.

Schuh, Edward. "The Exchange Rate and U.S. Agriculture." American Journal of Agricultural Economics (February 1974): 1-13.

Williams, Robert McFetridge. The Politics of Boom and Bust in Twentieth-Century America: A Macroeconomic History. St. Paul, MN: West, 1994.

JAMES HERENDEEN is professor of economics and finance at the University of Texas at El Paso. MILTON HALLBERG is professor of agricultural economics and rural sociology at Pennsylvania State University.

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