SEPTEMBER-OCTOBER 1999In This Issue:
Farm Income: The Return of the Safety Net by Randy Green
What is "Step 2"? by Randy Green
Farm Income:
The Return of the Safety Net
Three years after the "freedom to farm" law caused many to predict the end of government involvement in agriculture, direct federal farm payments will set a record at $22.5 billion. Though total farm-related spending was slightly more at the height of the 1980s farm crisis, never before has the government sent so much cash directly to farmers.
Because of these record payments, net farm income of $48.0 billion in 1999 will be $2.5 billion higher than the 1990-98 average, according to the U.S. Department of Agriculture. The 1999 net income level will exceed 1998 by $3.9 billion and will be close to 1997's $48.6 billion.
The importance of current federal payments is apparent from a comparison with 1997, when total federal payments were just $7.5 billion, one third the 1999 level. For the 1996/97 marketing year, corn prices averaged $2.71 at the farm level and soybean prices averaged $7.35, compared to cash prices on November 4, 1999, of $1.85 for corn and $4.56 for soybeans in central Illinois. Since farm income in the two years is forecast to be nearly the same, farmers must be deriving a large amount of income from somewhere other than the market. That "somewhere," of course, is the government.
Following passage of emergency assistance legislation in early October, USDA revised its farm income estimates to reflect the new payments. Although a substantial amount of the emergency assistance will not be paid out until 2000 (USDA keeps its income accounts on a calendar year basis), some $5.8 billion of the new aid will go to farmers by the end of this year, according to USDA.
What are the New Payments and When Will They Be Made?
The table below shows major components of the emergency assistance enacted by Congress, and an estimate of which calendar year the payments will be made, based on statements by Secretary of Agriculture Dan Glickman and other USDA officials.
Program Total Paid 1999
($ Billion)Paid 2000 or later Crop Lass Assistance
(disaster aid)$1.2 -0- $1.2 Market Loss Assistance
(based on AMTA payments)5.5 5.5 -0- Peanuts, Tobacco, Dairy, Sugar
(income aid, various forms)0.5 0.5 1/ Livestock Assitance
(disaster aid)0.2 -0- 0.2 Oilseeds (income aid) 0.5 -0- 0.5 1/ Less than $100 million
Other provisions of the emergency legislation, notably the restoration of "Step 2" cotton user payments, crop insurance assistance and a doubling of the limitation on loan deficiency payments, also have a cost but do not significantly increase direct payments to farmers. Step 2 payments may lead to a small increase in 2000 crop cash receipts if they increase cotton prices. Crop insurance assistance will reduce 2000 cash expenses, since farmers can purchase the same amount of insurance for less money. (Expenses might not fall by the full $400 million cost of the provision, however, since some farmers might buy insurance who otherwise would not have done so, increasing these farmers' expenses.) The higher payment limitation may increase loan deficiency payments, although USDA so far has not changed its estimate of these payments for 1999.
Government Payments: A Major Part of Income
Based on USDA's current estimates, direct federal payments in calendar year 1999 will account for -
For the second year in a row, Congress has reacted to criticisms that current farm policy lacks a safety net by injecting large amounts of cash into the farm economy. These emergency measures may be completely justified by the need to respond to a farm economy downturn that farmers could not have prevented and that had multiple causes.
- 9.9% of gross revenue for the farm sector, vs. 5.5% in 1998 and 3.3% in 1997;
- 38.9% of net cash income; and
- 46.9% of net farm income.
However, the emergency spending does raise important questions about the durability of the 1996 Federal Agriculture Improvement Act (FAIR Act or "freedom to farm" law). In particular, it seems likely that policy makers will ask themselves whether a policy of fixed, decoupled payments is sustainable. So far, at least, other major components of the FAIR Act's commodity policy -- planting flexibility and full production -- have not been seriously challenged. A final major component -- relatively low loan rates -- has been actively challenged but has so far withstood the assault.
With the last two years' payments, Congress has effectively restored a countercyclical element to farm income support. By pumping $22.5 billion in direct payments into the farm sector this year, the government has managed to raise farm revenues above their 1997 level and some $11 billion above the level of revenues in 1996.
Because total farm expenses have continued to rise (this year they will also be $11 billion higher than the corresponding 1996 level), the government payments will not cause farm income to set a record this year, but will push 1999 net farm income above the average level for the rest of the 1990s by $2.5 billion.
What If Congress Had Not Acted?
If the recent emergency assistance law had not been enacted, 1999 revenues would be $5.8 billion lower. That amount represents USDA's estimate of the portion of emergency assistance that will be paid out before the end of the year. (Of course, this means that next year's farm revenues will increase by the remainder of the direct payment portion of the $8.7 billion aid package.)
Without the $5.8 billion in new direct payments, 1999 revenues would have been $222.7 billion, basically unchanged from 1998. Higher cash expenses would have meant net cash income of $52.1 billion, the lowest since 1994 but only the third lowest of the 1990s in nominal terms. In this scenario, net farm income would have been $42.2 billion, the lowest since 1995 and also the third lowest level of the 1990s.
Emergency payments are by no means the only source of government assistance, of course. Loan deficiency payments in 1999 are projected to increase almost fourfold, to $6.6 billion from $1.8 billion in 1998 and virtually nothing in 1995-97. This figure actually understates the benefits of marketing loans, because when a farmer repays a loan at less than the loan rate and realizes a gain (rather than obtaining the same benefit through an LDP), this figure is included under "cash receipts" rather than "government payments" in USDA's income statements.
The marketing loan program - part of the FAIR Act - has become a substantial safety net in the last two years, although the judgment of Congress in both years was that the loan program alone was inadequate. However, if farmers had not had the benefit of the loan program this year and their only assistance from the government had been production flexibility payments, government payments would have been $6.6 billion less.
If the FAIR Act had not provided LDPs and Congress had not provided emergency payments, then direct government payments would be $12.4 billion less for 1999. Then gross revenues would have been just $216 billion, net cash income would have been $45.5 billion, and net farm income would have been $35.6 billion. Both of these net income figures would have been the lowest of the decade.
Thus, there is a disconnect between market fundamentals and projected farm income. The fundamentals, including oversupply, depressed prices and flat or rising expenses, have been quite gloomy. But large government payments are generally keeping aggregate incomes near or even above the levels of recent years.
Not Everyone is Above Average
It is important to point out that many individual producers are under severe stress, despite federal payments. Some producers have suffered from weather-related disasters. Others produce commodities - such as livestock and poultry - that receive few or no direct payments, but are equally susceptible to periods of low prices.
It is also conceivable that USDA's income series are not accurately capturing actual farm income experience. No doubt some producers would argue that even with government payments, they are under severe stress. If the numbers say that net income is the same as in 1997, they would continue, something is wrong with the numbers.
The USDA income series are imperfect; they are based on an economic model, not a census survey of every farmer in the country. Yet inasmuch as their chief components are price and output levels that are well-known and accurately measured, it seems likely that they are reasonably accurate. At any rate, there probably are no better nationwide income estimates.
On the other hand, the farm sector is so diverse that even if USDA measures aggregate income accurately, many individual farmers and even whole commodity sectors will have experience quite different from the aggregate. For example, we said that with the new emergency payments, 1999 net farm income will be close to the 1997 level. However, cash crop receipts for 1999 are forecast to be $15.4 billion less than in 1997, while livestock receipts are only $0.5 billion less.
How Will States Fare Under the 2000 Emergency Payments?
The emergency legislation requires market loss assistance (MLA) payments to be made during fiscal 2000. The law provides $5,544,453,000 for these MLA payments, and requires that they be "proportionate" to 1999 production flexibility contracts (PFCs), also known as "freedom to farm" payments or AMTA payments (after the Agricultural Market Transition Act, the portion of the FAIR Act that deals with commodity programs).
The total amount made available for MLA payments is about 1.01 times the amount of payments actually received under 1999 production flexibility contracts. This amount, in turn, differs slightly from the amount specified in the FAIR Act because some tenancy arrangements change from year to year, a few expiring Conservation Reserve Program contracts are converted to production flexibility contracts, and contract payments are sometimes reduced because of payment limitations. These same factors mean that the state-by-state estimates we provide below will probably differ from the payments actually made, though they should be reasonable approximations.
State 1999 PFC Actual 2000 MLA Estimate $Thousand AL 38,391 38,775 AK 143 144 AZ 41,249 41,661 AR 261,208 263,820 CA 194,572 196,518 CO 92,403 93,327 CT 899 908 DE 4,532 4,577 FL 7,939 8,018 GA 76,801 77,569 ID 68,049 67,375 IL 453,786 458,324 IN 223,748 225,985 IA 519,965 525,165 KS 386,394 390,258 KY 56,319 56,882 LA 137,003 138,373 ME 842 850 MD 15,363 15,517 MA 573 579 MI 94,661 95,608 MN 314,081 317,222 MS 130,768 132,076 MO 172,221 173,943 MT 123,519 124,754 NE 388,298 392,181 NV 893 902 NH 417 421 NJ 2,614 2,640 NM 19,263 19,456 NY 29,335 29,638 NC 61,453 62,068 ND 241,087 243,498 OH 152,050 153,571 OK 145,750 147,208 OR 35,452 35,807 PA 22,707 22,934 RI 32 32 SC 28,697 28,984 SD 157,965 159,545 TN 54,464 55,009 TX 471,675 476,392 UT 7,191 7,263 VT 1,436 1,450 VA 20,927 21,136 WA 89,011 89,901 WV 2,117 2,138 WI 120,841 122,049 WY 8,187 8,268 United States 5,477,290 5,544,453 1/ 1/ Total may not add due to rounding.
Looking Toward Next Year
House Agriculture Committee Chairman Larry Combest has already announced he will hold comprehensive hearings to review federal farm policies in early 2000. The Congressionally-chartered Commission on 21st Century Production Agriculture, a panel of farmers and other citizens, continues to prepare its own recommendations for future policies.
Though the odds of a major farm law overhaul next year remain less than 50%, it is clear that pressures on current policy are building. The experience of the last two years raises important questions about whether the FAIR Act can be sustained, and even more difficult questions about what kind of policy might succeed it after 2002.
More than three years after "freedom to farm" became law, most government controls over agriculture are gone, and few want them to return. The government payments, though, continue - and are getting larger.
Resources
To link to a table with USDA's most current farm income estimates, click here.
To link to a table with USDA's estimates of direct government payments, click here.
Reports on this year's emergency farm legislation have stressed the direct payments to farmers that will total some $5.5 billion. A less-noticed section of the same bill will have significant effects on cotton producers and users, and could interact with other parts of the legislation to influence the economics of federal payment limitations. This lower-profile section restores a price-competitiveness program called Step 2.
What is Step 2? How does it relate to the price support program for cotton? This article attempts to answer those questions. For simplicity's sake, the article assumes implementation of H.R. 1906, the 2000 agriculture appropriation bill which contains the farm emergency provisions, including changes to Step 2.
Marketing Loans
Under the Federal Agricultural Improvement and Reform Act of 1996 (the FAIR Act), cotton producers are eligible for marketing loans, which the statute calls "marketing assistance loans." The loan rate is set by formula, but cannot be higher than 51.92 cents per pound. For the 1999 cotton crop, the loan rate is the maximum 51.92 cents.
The theory behind marketing loans is relatively simple, but their administration is complex. Congress wants to guarantee farmers a certain minimum price for their commodities. Traditional price-support operations sought to establish a price floor: If prices fell below the loan rate, producers could repay their loans by turning over their commodities (the collateral for the loans) to government ownership. The result was, in theory, to remove surplus stocks from market channels and drive prices above the loan rate.
However, in a world market with competing suppliers, if the minimum price keeps a floor under actual market prices, U.S. price competitiveness is likely to suffer. Therefore, marketing loans are designed to achieve two goals simultaneously: to allow the producer to receive no less than the loan rate for his or her commodity, but let the price of that commodity fall below the loan rate if the market dictates.
In theory, these two goals are achieved by allowing producers to repay their loans at the market price if the market price is below the loan rate, and keep the difference. In that way, the government avoids assuming ownership of commodities, and stocks can flow freely into market channels. The result is income support without a price floor. Almost immediately, however, this relatively simple idea becomes complicated.
Repaying Loans
The FAIR Act says that cotton loans can be repaid at the lower of (1) the original loan rate plus accrued interest or (2) "the prevailing world market price for the commodity (adjusted to United States quality and location), as determined by the Secretary." This adjusted prevailing world market price is usually called the adjusted world price (AWP). The repayment requirement restates the basic marketing loan idea: If the market price is below the loan rate, the government should let the farmer repay his loan at that lower price and sell the commodity, rather than giving it up to the government. That way, markets can clear and surplus supplies will move through market channels more quickly.
However, the law also tries to deal with the circumstance in which the U.S. market price is below the loan rate but still above a world market-clearing price. Such a situation is not unusual, and could happen for several reasons: if U.S. production controls kept domestic supplies tighter than world supplies (less likely under the FAIR Act, of course); or if one or more major cotton suppliers was selling cotton at prices substantially below market-clearing levels. This part of the law is popularly called Step 1.
How Step 1 Works
The law essentially measures U.S. cotton price competitiveness by looking at prices of U.S. cotton versus the prices of cotton from competing suppliers. If the competitors' prices are consistently lower, Step 1 allows the Secretary of Agriculture to make a further cut in the price at which farmers may repay their loans.
Specifically, the law requires a comparison between the price of U.S. cotton delivered to Northern Europe, and "the 5 lowest-priced growths" of foreign cotton delivered to the same location. This average of five other countries' cotton prices is called the "Northern Europe price."
If the Northern Europe price averages less than the U.S. delivered price in Northern Europe in any given week, then USDA can cut the repayment rate for price support loans - in effect, to as low as the Northern Europe price. However, the law does not allow USDA to make this further cut if the AWP is more than 15% above the loan rate. The logic is that if prices are above the loan rate, demand is evidently healthy enough in relation to supply that no further adjustments are needed to keep U.S. cotton reasonably competitive.
Let's see how all of this worked during one week in October 1999. On October 14, USDA issued a press release that set the rate for repaying cotton loans through October 21. The Department's calculations begin with the "prevailing world market price," which is the Northern Europe price - this week, 47.41 cents per pound. Then USDA makes adjustments that are intended to equate this landed price in Europe to a corresponding price in an average U.S. spot market location. These adjustments allow the Department to "back off" transportation, quality and other factors, which this week totaled 14.14 cents. Subtracting this from 47.41 cents means that to meet the Northern Europe price, U.S. spot cotton would need to be priced at 33.27 cents per pound once all other costs are figured in. This price that would equate to the Northern Europe price is the AWP. (For some but not all cotton, there is a further subtraction called a "coarse count adjustment" which we will ignore here in order to keep a complex article from becoming more so.)
Now USDA moves to Step 1, deciding whether to make a further downward adjustment in the AWP. Under the law, the AWP must be less than 115% of the loan rate for any Step 1 adjustment to occur. That would be 59.71 cents (51.92 cents multiplied by 115%), and this week's AWP was only 33.27 cents, so the first test is met. The second test is whether the U.S. Northern Europe price exceeds the Northern Europe price - in plainer English, whether you can buy American cotton as cheaply in Northern Europe as you can buy cotton from our competitors.
This week, both tests were met. USDA did not say exactly how big the gap was between the U.S. Northern Europe price and the Northern Europe price, only that a gap did exist. Nevertheless, USDA decided, as it is entitled to under the law, not to make any Step 1 adjustment. (In order to live up to what people expect from government press releases, USDA expressed this decision by saying "it has been determined that this further adjustment to the AWP shall be 0.0 cents per pound.")
Enter Step 2
Step 1's purpose, to quote the National Cotton Council, is "to help make the cotton marketing loan program more effective in keeping U.S. prices at world levels." But what if this is not enough to make U.S. cotton competitive? Then Step 2 comes into play.
Step 2 requires USDA to issue "cotton user marketing certificates or cash payments" under certain circumstances. These certificates or payments are available to domestic users (e.g., textile mills) and exporters of cotton. To quote the National Cotton Council again, the Step 2 certificates "help bridge part of the gap between the price of U.S. and foreign growths." In effect, they buy down part of the difference between the U.S. price and the world price.
In the past, USDA has had the discretion to use certificates or cash for Step 2 payments. H.R. 1906 will place this option in the hands of the mill or exporter receiving the payments. Certificates will be redeemable for cotton placed under the loan program but not forfeited to the government. (They would also be redeemable for government-owned cotton if there was any.) One effect of this change may be to lessen the impact of payment limitations on cotton growers. This effect is discussed later.
USDA's October 14 press release, to which we referred earlier, does not mention Step 2, because funding expired earlier in the year. Under a provision designed to reduce spending, cumulative expenditures for Step 2 had been limited to $701 million, a level breached earlier this year. By repealing this provision, H.R. 1906 will re-activate the program. But on October 14, Step 2 was a dead letter.
Step 1 and Step 2 differ in several ways. Step 2 (when funded) is mandatory, while Step 1 is discretionary. The adjusted world price (AWP) to which Step 1 adjustments apply is set once a week. However, the law triggers Step 2 payments based on prices during a consecutive four-week period. Whereas Step 1 adjustments depend on the AWP being less than 115% of the loan rate, Step 2 is effective unless the AWP is more than 134% of the loan rate.
Remember the comparison the law required for Step 1: Does the U.S. Northern Europe price exceed the Northern Europe price? Are European buyers able to get U.S. cotton as cheaply as they can buy our competitors' cotton, on average? Remember, as well, that Step 1 averaged these price comparisons over a week.
Step 2 requires, in effect, that this weekly average relationship be assessed over consecutive four-week periods. If there is any period of four consecutive weeks in which, each week, the U.S. Northern Europe price exceeds the Northern Europe price by a specified amount, then the law assumes Step 2 is needed to bridge the implied competitiveness gap.
Note that it is not enough simply for the U.S. price to be greater than competitors' prices. The gap has to exceed a number specified in the statute: originally 1.25 cents per pound, later changed to 3.0 cents per pound in a budget-cutting move, and now again 1.25 cents with the President's signature on H.R. 1906, the 2000 agriculture spending bill.
The value of Step 2 certificates or payments is the gap between the U.S. Northern Europe price and the Northern Europe price, minus 1.25 cents per pound.
Suppose that Step 2 had been in effect on October 14, the date of the press release we examined earlier. Recall that the Northern Europe price - the point at which all USDA's calculations began - was 47.41 cents. We were not told the U.S. Northern Europe price, but suppose it had been 50.00 cents. The difference in these two numbers - 2.53 cents - is more than 1.25 cents. Let us also suppose that this was the fourth consecutive week in which the comparison of U.S. and competitor prices yielded a gap more than 1.25 cents. Then, under the law, Step 2 payments would be made for the following week. Their value would be the U.S.-competitor price gap (2.53 cents) minus 1.25 cents - or 1.28 cents. The law says they are to be paid on purchases by domestic users and sales by exporters during that following week.(1)
Step 2, in effect, allows a 1.25-cent gap to exist between U.S. and competitor prices, but requires that the government make up any difference after that. It places a limit on how uncompetitive, from a price standpoint, the United States is prepared to be.
Payment Limitations
Payment limitations may also play a role in the political economy of Step 2 payments. Marketing loan gains and loan deficiency payments are limited by law to $75,000 per person per year. Depending on how their operations are organized, producers may be able to effectively (and legally) double this amount. However, some larger cotton operations may still reach even the higher limitation.
In that event, the producer is in the unenviable position of either forfeiting his cotton to the government or selling it at a price less than the loan rate. As the gap between the loan rate and the AWP gets wider (i.e., as the world prices fall), producers reach the payment limitation at a lower level of production.
For example, the national average cotton yield per acre for 1999 is projected at 588 pounds. A producer who repays a 51.92-cent price support loan at the adjusted world price of 33.27 cents realizes a marketing loan gain of 18.65 cents per pound, or $109.66 per acre. If the producer has organized his or her operation to capture the full $150,000 payment limitation, then dividing $150,000 by $109.66 per acre means that the producer will hit the payment limit at 1,368 acres of cotton. If the producer operates 2,000 acres, then the cotton from approximately 632 acres will be eligible for the loan program but ineligible for a marketing loan gain or loan deficiency payment. If the market price is less than the loan rate, the producer can only realize the loan rate by forfeiting the cotton to the government.
H.R. 1906, however, will double the $75,000 payment limit to $150,000 for 1999 crops. Therefore, a producer who is organized (through up to 50% shares in two other farming operations) to capture double the nominal payment limit will be eligible this year for up to $300,000 in marketing loan gains. Using the same assumptions as before, the producer will not be affected by the payment limit until his or her plantings of cotton exceed 2,736 acres. (2)
Moreover, even if the producer is affected by the payment limit, another provision of H.R. 1906 may help. Under this provision, which we mentioned earlier, an exporter or domestic mill may elect to receive a Step 2 payment in certificates. These certificates, under the terms of H.R. 1906, are redeemable in loan-collateral cotton. Depending on Step 2 recipients' interest in obtaining certificates rather than cash, some cotton forfeitures may be averted through this mechanism, since certificate holders might buy cotton out of the loan program at the AWP.(3)
Step 2, in the view of many cotton industry spokesmen, tends to support U.S. cash cotton prices. If marketing loan gains were based on U.S. spot prices, then it could be argued that Step 2 would reduce the impact of the payment limit on producers by reducing the per-pound marketing loan gain.(4)
In fact, however, the marketing loan gain is measured using the world price, not the U.S. price. So the real question is what effect Step 2 has on world prices, and here the answer is unclear. If Step 2 causes New York cotton futures prices to trade higher than they otherwise would, and if competitor countries use New York futures to make their own pricing decisions, then Step 2 might raise world prices. On the other hand, to the extent that Step 2 allows U.S. exporters to offer cotton at more competitive prices and encourages other countries to respond in kind, it could reduce world prices. Therefore, it is not clear whether Step 2 has any real effect on how likely cotton producers are to become subject to payment limitations.
Step 3
In a reflection of both the complex nature of cotton programs and the differing priorities that normally have to be reconciled within the cotton industry, there is also a Step 3. Step 3 establishes special import quotas to temporarily increase imported cotton supplies in order to further encourage U.S. prices to reflect world-market values.
Whereas Step 2 is based on prices during a four-week period, Step 3 currently looks at 10 weeks' worth of data, but will be based on four weeks' worth under the new agriculture appropriation bill. As under Step 2, the relevant comparison is whether the U.S. Northern Europe price exceeds the Northern Europe price by more than 1.25 cents per pound. In this case, logically enough, the comparison adjusts the U.S. Northern Europe price to reflect any Step 2 payments that may be in effect (except during periods of tight supply, when this adjustment is not made).
Basically, the special import quota is equal to one week's domestic mill consumption of cotton, measured by the amount of cotton the mills have used in a recent three-month period. Other provisions of the law address tariff treatment of the special imports and how to deal with overlapping quota periods. To make matters still more complicated, the law also provides for an additional import quota (this one is referred to as a "limited" quota, distinguishing it from Step 3's "special" quota). It is triggered by U.S. market prices rising 30% above their average level for the preceding three years, and is set at 21 days' worth of domestic mill consumption, subject to some limitations.
Students of farm policy know that farm programs are seldom simple, and the cotton program may be more complex than most. The cotton industry, which has been influential in the design of federal cotton policy, has sought programs that would make U.S. cotton price-competitive to domestic mills and foreign buyers. At the same time, the industry has sought income and price support for cotton farms, which are often large in comparison to grain farms. Reconciling these policy goals has not always been easy, and certainly has not simplified program operations. Under H.R. 1906, the Step 2 program will again have the opportunity to contribute to both industry goals.
1. In actual practice, USDA makes payments on the basis of a bale of cotton being opened by the mill and upon proof of export by the exporter.
2. This example assumes the producer grows no commodities other than cotton that are subject to the payment limitation. In practice, many cotton farms will also produce soybeans, rice or another crop that will realize a marketing loan gain or loan deficiency payment this year. Benefits for all of these commodities are cumulated for purposes of applying the limits.
3. USDA is still discussing internally how it will implement the provisions of H.R. 1906. It is possible some administrative decisions could be made in a way that would change the effects of provisions in the bill.
4. In a typical cotton transaction, the producer has already placed his or her cotton under loan at 51.92 cents. The merchant purchases the right to redeem the cotton out of the loan - referred to as a "loan equity" transaction. The merchant redeems cotton at the AWP, while the grower effectively nets the original loan rate plus the equity payment. Of course, if the grower has already hit the payment limit for marketing loan gains, the merchant will not find this transaction attractive because the cotton would have to be redeemed at the original loan rate, not the AWP.