CARD: Center for Agricultural and Rural Development

For the fourth straight year, market prices for Midwest crops are low. Central Iowa soybean prices hover around $4.00 per bushel. Corn prices are around $1.80 per bushel, and wheat markets remain stuck at below $3.00 per bushel. What to do about these low prices has occupied a great deal of Congress's time as it attempts to craft new farm legislation. Nearly all farm bill proposals would continue to provide farmers levels of support much higher than those offered by the market.

Senator Lugar (R-Ind.), among others, argues that these subsidies are self-defeating in the sense that the subsidies induce farmers to produce, which lowers market prices, which then leads to increased demands for subsidies. Strong advocates of trade expansion criticize the subsidies because they weaken our trade negotiating position by making us vulnerable to the charge that the U.S. should practice what it preaches when it comes to subsidizing farmers. And other exporting countries criticize the subsidies because the resulting increase in U.S. supply hurts them by lowering world market prices.

The validity of the arguments against farm subsidies depends on how responsive supply is to government payments. If U.S. supply is largely unresponsive to government payments, then U.S. farm subsidies have little effect on agricultural markets, other exporting countries are not hurt by U.S. farm policies, and our trade negotiating position should not be affected at all. However, if subsidies induce greater U.S. supply, then they have a downside that should be recognized by U.S. agriculture as it prepares for a new round of World Trade Organization (WTO) negotiations.

The House and Senate have allocated an additional $73.5 billion in agricultural spending above existing baseline levels over the next 10 years. Recently the Administration agreed to this level of spending. What there is no agreement about is how to spend the money. And the primary policy difference between the House, the Senate, and the Administration is where to set loan rates.

Loan rates put a floor on prices farmers receive for their crops, but they no longer put a floor on market prices because of loan deficiency payments (LDPs). When market prices are below loan rates, farmers can sell their crops at market prices and receive an LDP—the difference between market prices and the loan rate—from the government. The U.S. Department of Agriculture (USDA) tries to make sure that LDP payment rates are attractive enough so that farmers do not forfeit their crops to the government.

Capitalism works because people and companies look to market prices and their own cost of production for guidance about what and how much to produce. When market prices are higher than production costs, it is a signal to expand production. Similarly, a drop in market price is a signal to contract production.

For crops covered by non-recourse loans, it is a different story. When market prices are below loan rates, farmers do not look at market prices for guidance about what to plant; instead, they look to loan rates for guidance, because they know that LDPs will make up the difference. Loan rates provide what some economists call a "hot incentive" to produce. This means that higher loan rates directly increase total production and decrease market prices, whereas a cut in loan rates should decrease production and increase market prices.

Congress has considered proposals that range from elimination of LDPs to dramatic increases in loan rates. For example, the National Corn Growers Association (NCGA) has proposed changing the marketing loan program to recourse loans (which would eliminate all price guarantees). And the National Farmers Union (NFU) has proposed increasing loan rates for corn, soybeans, and wheat to $2.49, $4.10, and $5.40 respectively from their current levels of $1.89, $2.59, and $5.26.

The large variation in loan rate levels among competing proposals does not translate into similarly large variations in projected payments to farmers. Nearly all proposed programs would spend at least $73.5 billion of the additional money allocated to agriculture. Proposals with lower loan rates would make up the difference with other types of payments. For example, the NCGA proposal would have continued Agricultural Market Transition Act (AMTA) payments and created a new countercyclical payment program. The NFU proposal would have eliminated AMTA payments and relied solely on loan rates.

The key difference in these policy proposals is whether they rely primarily on programs that create direct production incentives, such as marketing loans, or whether they rely on programs that make payments on a fixed base. When a farmer's planting decision or harvested production level has no affect on the amount of payment the farmer receives, then the program payments are said to be "decoupled." That is, payments and production levels are not related. AMTA payments are completely decoupled from a farmer's current production decision because they arrive even if a farmer's land is held idle.

Fixed, decoupled payments provide little incentive for a farmer to plant because the planting decision has no effect on the size of the payment. Some argue that increased decoupled payments may result in increased planted acreage because the payments infuse enough liquidity into farming operations that farmers choose to plant some kind of crop rather than idle land, but this effect likely is quite small.

Payments do not have to be fixed to be decoupled. For example, the NCGA countercyclical payment proposal would have made payments whenever national crop revenue fell below a target revenue level. The per-acre payments would have been paid to all farmers based on their average planted acres and yield levels during a historic base period. The payments would have been made regardless of a farmer's current planting decisions and current per-acre revenue levels. Adoption by Congress of the NCGA proposal would have meant that all program payments would have been decoupled from current production decisions. The only possible "coupling" would have been if farmers strategically planted acres of a particular crop in order to develop a new base in the hope that future farm bills would allow them to update that base.

So, the choice of loan rate levels is really a choice about how much Congress wants to maintain planting incentives when market prices are low. A high loan rate policy translates into a high degree of intervention. Low loan rates combined with large decoupled payments imply a low degree of intervention.

As shown in Table 1, the House agriculture committee farm bill (H.R. 2646) and the Senate agriculture committee farm bill (S. 1731) give farmers about the same level of total support, when expressed on a per-unit basis. The per-unit support levels include support from loan rates, countercyclical payments, and fixed, decoupled payments. Corn, wheat, and rice have a little higher level of total support in the House than in the Senate, and soybeans have a little higher level of total support in the Senate than in the House. But overall, the total amount of payments going to farmers is about the same.

A comparison of these support levels to average prices received by farmers over the last three years or to recent price levels indicates how unwilling Congress is to let farmers live by market prices.

The rough equivalence of payments masks significant differences in the degree of intervention of the two approaches. The House farm bill relies heavily on a countercyclical payment program that would pay farmers when prices are low. The House countercyclical payment programs would be decoupled because they are paid on a fixed acreage and yield basis and there are no planting requirements. In contrast, as shown in Table 2, the Senate bill relies much more heavily on marketing loans to subsidize farmers, which implies a much higher degree of intervention.

The higher loan rates in the Senate bill—and the associated increased planting incentives—perhaps reflect the desire of members of the committee to make sure that acreage in their states continues to be used for crop production. High-cost/low-yield production areas are those most at risk of losing planted acreage without the high loan rate incentives. And important members of the committee represent states that have high-cost/low-yield production areas.

Our current commitment under the WTO is not to exceed $19.1 billion in so-called amber-box support in any year. Payments that fall in the amber box are in some way related to current production or prices. Price support payments and crop insurance indemnities (net of the producer-paid premium) both fall in the amber box because they depend directly on a farmer's production level and/or market price. AMTA payments do not fall in the amber box because they are fixed payments paid on historical base acreage and yields. USDA decided that market loss assistance (MLA) payments belong in the amber box because low market prices induced Congress to pass them.

The decision to place MLA payments in the amber box is understandable when viewed in light of the legal definition that amber-box payments are any payments that depend on current prices or production. But the purpose of limiting amber-box payments is to place limits on government's ability to create incentives for farmers to produce more than they would produce if they responded solely to market prices. The rationale for these limits is that production in response to government incentives lowers world prices and hurts farmers in other producing countries. The limits are supposed to enhance market-based competition rather than competition in producer subsidies. Most economists would judge that MLA payments really did not create an extra incentive to produce crops, because a farmer did not have to produce anything to receive the payments.

Because MLA payments fall in the amber box, so too would the countercyclical payments proposed in the House and Senate agriculture committee farm bills, even though the payments are completely decoupled from a farmer's production decisions and therefore would not lower world prices. Under current WTO rules, payments that have little or no effect on world prices count against countries' limits on payments that distort world prices if they are related in some way to current prices or production.

The irony of current WTO rules is that the House farm bill is more likely to result in amber-box payments in excess of our $19.1 billion limit than the Senate bill, even though, as shown in Table 2, the Senate bill is much more likely to lower world prices because of the higher loan rates.

Late last year, WTO members met in Doha, Qatar, and agreed to work toward the elimination of agricultural subsidies. What this will mean in practice is that countries will work toward stricter limits on the types of subsidies that have an impact on other countries' producers. Given our unwillingness to let farmers' incomes be determined by market forces, the United States could take the position that countries should eliminate (or limit) all payments that directly entice farmers to produce more than what market prices dictate. If adopted, this position would allow Congress to subsidize farmers all it wanted, as long as it did so with decoupled payments. Countercyclical payments based on historical payment bases would be allowed without limit. Such an agreement would result in U.S. farmers, and farmers in other countries, growing the types and quantity of crops demanded by the market, while allowing Congress to subsidize the agricultural sector to the desired level. ♦