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CARD: Center for Agricultural and Rural Development

Spring 2009, Vol. 15 No. 2

In this issue...

Should Government Subsidize Farmers' Risk Management?

Intricacies of Meeting the Renewable Fuels Standard

ACRE: Price Support or Crop Insurance?

Crop Outlook for 2009

pdf for printing

Should Government Subsidize Farmers' Risk Management?

Bruce A. Babcock
babcock@iastate.edu
515-294-5764

One look at the long list of abbreviations used for U.S. farm programs indicates the pervasive role that government plays in providing subsidized risk management to the U.S. crop sector. To take full advantage of these subsidies, farmers and those who serve them need to be able to decipher not only what ACRE, GRP, SURE, GRIP, RA, CRC, APH, LDP, DP, CCP, and HRO stand for but also how the programs work and how they either substitute for or complement one another as well as other private risk management efforts.

These programs guarantee crop prices; yields at the field, farm, and county levels; and revenue at the field, farm, county, and state levels (see the table). The price guarantees can increase if farm prices rise after planting. Some guarantees are based on historic acreage; others are based on the current year's planted acreage. Some guarantees are based on past prices and yields; others are based on projected prices and yields. One program (DP) pays out every year, even if yields and prices are at all-time record levels. Another program (SURE) requires that farmers buy crop insurance.

The programs are also complex in their administration. Some of the guarantees are administered by USDA's Farm Service Agency (FSA). Others are administered by the USDA's Risk Management Agency (RMA). The RMA programs are delivered to farmers by private crop insurance agents who are paid commissions fully funded by taxpayers. FSA programs are delivered to farmers by government employees fully funded by taxpayers. Payments from RMA programs come from a fund that farmers contribute to but that is mostly funded by taxpayers. A portion of the risk from the fund is borne by private insurance companies, but most of the RMA program risk is borne by taxpayers. All of the FSA program risk is paid for by taxpayers.

Fundamental questions that never seem to be addressed by those who support taxpayer subsidies for risk management are whether the public receives any benefits from these subsidies, and if it does, whether the benefits outweigh the costs. If there is no broad public purpose served by subsidizing farmers' risk management decisions, then we need to look at parochial regional benefits and the profits of private businesses to understand why the programs are proliferating at such a rapid rate.

The Cost of Agricultural Risk

Farmers are not unlike other investors: they invest in annual operating inputs (land rent, seed, fertilizer, fuel, and chemicals), machinery, and land in the hope that they will earn enough from the sale of their crops to cover their operating costs and payments on their machinery and land. If they do, then they earn a profit. If not, then they must call on their own assets to cover the loss or ask forbearance from their lenders.

Economists measure the cost of risk as the difference between the amount of money that an investor expects to make on average from a risky investment and the smallest amount of money that the same investor would accept to sell the risky investment. If the investment has low risk, then this difference will be small. Very risky investments lead to a high cost of risk because of a large probability that the investment will be lost. Most investors will not take on high-risk investments unless the payback when the investment is not lost is substantial. This gives rise to the risk/return trade-off. To induce investment in risky assets, the returns when the investment pays out must be large enough to compensate investors for the high probability that the investment will be lost.

The cost of risk is a real production cost. And because the cost of risk is greater for riskier crops and in riskier regions, farmers who grow these crops or who farm in these regions have higher costs of production than farmers who do not.

Private or Public Provision of Risk Management?

Farmers should treat risk just as they treat any other production input, such as fertilizer, seed, and machinery, by balancing the returns from its use with the associated increased cost. For example, in years in which the returns to corn are expected to be higher than the returns to soybeans, farmers can increase expected profits by planting more corn and less soybeans. But the increase in expected profits only comes about by taking on more risk, because growing more corn typically reduces diversification. Farmers that have a high tolerance for risk (which means that risk imposes a low cost on them) will tend to plant more corn than will farmers with a lower tolerance of risk.

Farmers should also invest in activities that reduce the cost of risk by more than the cost of the activity. The value of the risk reduction from diversification of family labor and management efforts into both on- and off-farm activities often is greater than the cost associated with that diversification. Most farmers find that the value of associated risk reduction is greater than the cost of hail, fire, disability, health, and life insurance. Many farmers find that the value of reducing price risk is greater than the cost of buying put options on commodity exchanges. And a few farmers find that the value of hedging against poor weather during the growing season by buying put or call options on future weather is greater than the cost of the options.

If farmers fully understand the risks they face and private markets exist to allow them to pay for desired levels of risk reductions, then the efficiency with which agriculture operates cannot be increased through subsidized risk management. The reason we have so many subsidized risk management programs is either that the private sector is incapable of providing the kind of tools that farmers desire or that Congress uses the subsidies to meet some other objective.

Private Price and Yield Insurance

On April 10, 2009, the 2009 new-crop corn futures price closed at $4.22 per bushel. New-crop soybeans closed at $9.22 per bushel. Farmers can protect against drops in their harvest-time selling prices by selling a futures contract at these prices. There is no cost to selling a futures contract, but farmers must deposit funds on each contract they sell and they must have access to sufficient credit to make margin calls if prices rise. Put options are an alternative means of price protection whereby a farmer pays an amount up front (the option premium) for the right to sell a futures contract at a specified price. The existence of commodity exchanges with highly liquid markets implies that the private sector is quite capable of providing price protection for farmers.

Commodity exchanges work to provide price protection for farmers when there are sufficient numbers of natural buyers who will take the opposite position of the natural selling interests of farmers. Agricultural processors who are harmed when prices rise are those natural buyers in price contracts. Futures markets for state average yields failed because there were no interests that desired protection against high yields. This meant that no one was interested in buying farmers' attempts to sell yield futures. However, in the Corn Belt, the conditions that favor high corn and soybean yields harm sellers of electricity used to run air conditioners in the summer. Cool summers tend to lead to low profits for generators and high yields. Hot summers lead to high demand for electricity and large profits for power generators. Hot summers can also lead to low yields. Thus, a private market for weather contracts (which are actively traded on the Chicago Mercantile Exchange) could be used by farmers as yield insurance.

Crowding Out the Private Sector

So why don't more farmers trade weather contracts to protect against the financial losses caused by low yields? Because taxpayers fund a crop insurance program that offers insurance agents a large commission to get farmers to sign up for an insurance policy that pays out, on average, twice what a farmer is asked to pay as a premium. Private insurance companies are willing to insure a farmer's yield because a large portion of the risk of this insurance is borne by taxpayers. Why should a farmer care about weather contracts when taxpayers provide more reliable coverage against low farm yields at a small fraction of the true cost of insurance?

Farmers who sign up for ACRE are protected against corn prices below $3.75/bu, soybean prices below $8.75/bu, and wheat prices below $6.00/bu. Farmers who buy subsidized revenue insurance receive revenue guarantees based on $4.04 for corn, $8.80 soybeans, and $6.20 spring wheat. Farmers who sign up for both ACRE and crop insurance will receive double compensation if harvest prices fall dramatically. Why should farmers use the private sector and hedge against low prices when taxpayers are providing heavily subsidized price protection?

The private sector simply cannot compete with the heavily subsidized risk management programs offered by the government. The question then becomes whether taxpayers are getting anything in return for their investment or whether the subsidies are really just a hidden means of transferring money to farmers and the crop insurance industry.

Do Taxpayers Benefit from Risk Management Subsidies?

Left on their own to manage risk, farmers would choose to buy products and to use strategies that reduce the probability of financial ruin to levels that reflect the cost of the risk reduction. Given that many farmers in the United States and other countries survive and thrive without large risk management subsidies, it is apparent that farmers' actions combined with products provided by the private sector would be sufficient to keep U.S. agriculture viable and producing abundant supplies of food for U.S. and world consumers. It is difficult to find the extraordinary circumstances that make the production and marketing of corn, soybeans, wheat, rice, and cotton so different from that of other crops around the world that U.S. producers require heavily subsidized risk management to grow these crops. But this does not mean that elimination of all the risk management subsidies would have no impact.

Because the cost of risk is a real production cost, risk management subsidies are essentially a cost-of-production subsidy. It follows that the main effect of the subsidies is to increase the production of the crops that receive the subsidized risk management. The crops and regions that have the largest reduction in risk will have the largest increase in production. High-risk crops and regions include dryland cotton in Texas, wheat in arid regions of the Great Plains, and corn and soybeans in parts of the Dakotas and the Southeast. The production of low-risk crops in low-risk regions would be largely unaffected by elimination of risk management subsidies because the percentage of reduction in production costs would be small.

Why might taxpayers benefit from expanded production of select crops in high-risk, largely low-productive regions? If expanded production in high-risk regions is large enough to significantly affect U.S. and world aggregate production, then risk management subsidies will lower market prices for the subsidized commodities. Any such decrease in commodity prices will benefit consumers somewhat.

But the prospect of slightly lower commodity prices cannot justify the billions of annual risk management subsidies. Furthermore, a large proportion of the subsidies do not even flow to farmers but rather go to the crop insurance industry. Instead of looking at taxpayer benefits of expanded production in high-risk areas, it is more instructive to look at the political benefits of this expanded production, and at the lobbies that guard against changes in risk management policy.

Political Benefits of Subsidizing Farmers' Management of Risk

Members of Congress who represent high-risk, low-productive agricultural areas of the United States are among the biggest supporters of traditional farm subsidies, crop insurance, and disaster payments. This support is entirely consistent with a desire to serve their constituents' interests in maintaining agricultural production and the associated support infrastructure. Given the prominent role that agriculture plays in many Great Plains states, it is not surprising that sufficient support for continuing subsidies is so easily obtained.

What is not so easy to understand is why we choose to fund a vast network of insurance agents to induce farmers to buy heavily subsidized crop insurance, and why we need to pay private insurance companies large amounts of money to service the insurance contracts. Regional political interest in supporting agriculture in high-risk areas could be accomplished at much lower expense by eliminating program duplication through program consolidation, and by administering all programs through the FSA (as we are doing with SURE, ACRE, LDP, CCP, and DP). This would save on aggregate program expenditures, and it would save the large fees currently paid to crop insurance agents and companies.

One straightforward explanation for why attempts at such a consolidation were not successful in the 2008 farm bill is that crop insurance agents and companies have their own supporters in Congress. Together, supporters of crop insurance agents, crop insurance companies, and of agriculture in higher-risk regions make a formidable barrier to agricultural reform.

Different lobbying groups often need to support each other's priorities in order to keep the political coalition together. Thus, we see that the new FSA-administered SURE disaster program, which was a priority of senators from Montana and North Dakota, requires that farmers buy crop insurance, which automatically increases compensation to that industry.

It is possible that reform will come about simply through public awareness of the excesses of the risk management subsidies. But if history is any guide, it will take something more. Perhaps the need to finance trillion-dollar deficits as well as federal programs that provide benefits like clean air and water, transportation infrastructure, and nutrition will eventually force Congress to economize by increasing the efficiency of risk management programs in agriculture.