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CUT AND RUN?

While Congress feverishly debates tax cuts, tax extensions and earmarks en leu of actually tackling the national debt, Supply Doesn’t Care About Demand would like to tackle agricultural subsidies’ role in this fiscal hole.

Though this blog has devoted four months to U.S. agricultural subsidies and their harmful effects, the question still remains: Do current agricultural support policies cause more harm than good and if so, should the U.S. get rid of them?

Well, that’s a sticky question.  Overall, subsidies help increase farm revenue for large corporations, increase food production and keep market prices low.  Each of these positives is a loaded answer because they can be spun both ways.  More money for big business means small farms get less and less of the pie, contributing to their disappearance.  More food is actually overproduction in many cases, which leads to inefficient production models and market reactions.  Low prices help some U.S. consumers while hurting domestic and foreign producers pushed to the periphery of the subsidy trough.    Obviously these policies help a few while harming the many.

Even though these policies can harm more parties than they help, would getting rid of them be the solution?  Not surprisingly, The CATO Institute says yes.  In a completely twisted video full of cherry-picked facts, aptly titled, Downsizing the Federal Government, it argues the US Department of Agriculture should immediately cease all subsidy and price-support programs in an effort to trim the federal budget and reduce market distortion.  Now, it is true that reducing incredibly wasteful spending would help us tackle the national debt and help regain optimal market performance, however, the degree to which the CATO Institute claims is highly questionable for two basic reasons.

1.  The amount of money the federal government spends on wasteful and/or imperfect agricultural policies dwarfs in comparison to other areas.  Defense and social security gobble up 19 percent of federal spending each.  Medicare and Medicaid receive a combined 20 percent.  Interest on the debt alone takes up a whole 5 percent.  The entire USDA gets around $143 billion of the $3.7 trillion budget in 2011.  Fifty nine percent of that $143 billion goes to subsidies.  That’s .002 percent.  Technically speaking, it’s a drop in the bucket.

2. Immediate flight of the very capital propping up the industry would send crippling shock waves through the agricultural community.  Companies would crumble, production would come to a halt in some areas and prices would sky-rocket.  Libertarians and hardline free market advocates may call this a necessary herd culling to ensure the strongest survive, but Supply Doesn’t Care About Demand would call this a Malthusian Crash.  When populations reach their resource limits, they plummet.  This would be exactly the same.

America’s agribusiness is an addict and subsidies are its drug.  Like any hard addict, it has to be weaned off to survive.  Slow subsidy reductions are the methadone.  The CATO Institute’s proposed 92 percent reduction in one year is too drastic; too sharp.  Cutting food stamps and school lunch programs will not curb agribusiness imperfection and return world markets to equilibrium.

Reduce direct payments, price supports, export-credit guarantees and finally import tariffs–in that order–to let agriculture slip into a freer, more balanced market.

CHECK OUT THE FEDERAL BUDGET AND RELATED ANALYSIS

USDA 2011 BUDGET

CATO Institute proposed USDA cuts

CATO Institute: Downsize the Federal Government

FEDERAL BUDGET

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No, we’re not talking about a new king, but a new standard of measure for subsidies’ effects around the world.  Before we dive into the abstract details of today’s news, we need to talk a bit about what a standard of measure is and why it’s important.

A standard is a widely-accepted, established and respected level or principle.  So, a standard of measure is usually a respected common ground that places us all on the same page.  We can then compare different objects, ideas and processes using this standard.  Units of measure are a great example.

Just like a scale, economists weigh different things to put them in a universal context we can all understand (well, other economists, anyway).  More common, well-known measurements include Gross Domestic Product, Gross National Product and Consumer Price Index.  Forget the long names.  These are just ways to measure different things.  BUT nobody said these were perfect.  Many economists think GDP is too broad and unrepresentative of a country’s wealth, the CPI doesn’t represent crucial price fluctuations, yada yada and the debate rages on.  Rages right into subsidies.

Two World Bank economists have proposed a new scale to weigh the benefits and damages agricultural subsidies bring across the globe.  The two argue that past economic measures and indexes gloss over important details that really expose how subsidies affect markets.  The paper, so succinctly titled, “Changing Contributions of Different Agricultural Policy Instruments to Global Reductions in Trade and Welfare” says old indicators tended to take positive and negative outcomes at the same incremental value, which could result in an overall zero equilibrium.  As we all know, some positives are way more helpful and some negatives are way more damaging than others.  Essentially, the old indicators didn’t dissect the issue far enough and didn’t give proper weight to each outcome.

Jargon and math aside, the two economists argue their new way to measure agricultural subsidies and trade distortions–called Instrument Trade Reduction Index– proves export taxes to be the most damaging agricultural market distortion since the 1960s.  Yes, many forms of agricultural subsidies harm economies in many ways, but export taxes are the worst.  This delivers quite a blow to development theory.

Many development economists argue developed-world agricultural subsidies and market-flooding are the root of trade-distorting evils.  However, if this new assertion is true, it would be the developing and undeveloped countries penalizing themselves that hurts the most.

Typically, a developing country imposes an export tax (which is illegal in America) to keep products in the country or at least get a piece of the action that’s going overseas.  Many poor countries use it as a way to keep food within their borders.  One of the most perplexing modern trade phenomena is a chronically-hungry nation that is a net agricultural exporter.  In times of famine or global food availability shortages, like 2008, poorer countries hike up export taxes so it’s more profitable to sell food to hungry people at home than wealthier ones abroad.  This, the two economists argue, hits global trade the hardest and hurst poor countries the most.  All qualitative arguments aside, it keeps exporters from getting higher world prices, keeps the rest of the world from goods and ultimately decreasing capital inflows (reduces the amount of money comin’ in).

So, maybe agricultural subsidies aren’t the devil we thought.  Just kidding; they ranked #2 with the new measurements.

HAVE A LOOK WITH THESE HELPFUL LINKS

What is GDP?

What is CPI?

Economic indicators explained

National Public Radio’s Intelligence Squared recently ran a debate arguing the motion: “Organic food marketing is stuffed with hype.”   Spirited debaters from both sides of the motion quarreled over organic farming’s ability to feed the world, save the planet and increase overall human health.  One conventional farmer’s argument for conventional food production and consumption was grocery store prices.  The farmer claimed that “organic” is often used as a marketing ploy to charge more at the grocery store.  Supply and Demand won’t get into consumer behaviors, ethics,  environmental or health issues, but it will dive into the issue of cost vs. price.

So, this week’s question: Is organic food really more expensive than conventionally-produced food?

It is true that at a consumer level, the price of organic produce, meat and grains is higher than non-organic.  In fact, several consumer  price surveys have found organic options cost anywhere from 30-200 percent more.  This is quite a spread, but so are the options available at the store.  Produce came in closer to the 30 percent mark, while meats and specialty products (like cereals and packaged organic snack foods) hit closer to the 200 percent.  So, if you take a basket of goods…literally (econ joke, nevermind) and fill it with a normal shopping trip’s worth of conventional goods and fill another with organic goods, you will undoubtedly pay more for the organic basket.  How much more is wildly dependent on what you buy, when you buy it and where you are in the country.

Now that’s just just at the consumer level.  To find out how much something really costs, you have to look at the inputs of production, labor, transportation and financing.  Inputs of production is where our beloved subsidies come into play.

Conventional corn, wheat and soy products reap the benefits of production subsidization.  As previously mentioned in every post, conventional agriculture benefits from economies of scale (the cost of producing a single unit goes down the more units you produce, so if you produce a lot, you’re unit cost drops in sync.).  However, the scale of conventional agriculture in this country has passed the benefits of economies of scale and reached what’s called the point of diminishing returns.  What goes up must come down.  This means the advantage of economies of scale reaches a limit and if production continues at that size, it is no longer profitable.  Too much production actually starts to cost the entire process money, instead of making it money.  Instead of cycling production down like a manufacturing company, American agriculture has pushed forward into unsustainable profit loss.  The difference is then picked up by the tax payer.

Because large conventional agriculture is financially-imperfect and an unsustainable model that hemhorrages  massive amounts of money, the government steps in to prop it up.  The government subsidizes agricultural input costs like fuel for farm machinery, seed, pesticides and fertilizers, transportation costs, foreign import tariffs and even direct payments.  Since input costs are artificially lower, market price follows suit.

Though consumers pay less at what’s called “the point of sale,” (which is just a ridiculous way of saying checkout) for a conventionally-grown product, they  already paid quite a lot before bringing it up to the register.  This then begs the question of which product actually costs more.  Although we’ve just spent the last several paragraphs thinking about out of sight cost, we can’t arrive at an honest conclusion.  Any study that claims to do so is a blatant lie or just a foolish attempt.  We cannot dissect federal subsidies to a perfect per unit cost, nor can we even begin to quantify the qualitative claims of organic food proponents.

If organic food and its production is healthier, we cannot quantify potential healthcare and environmental savings.  It’s just not possible.  So, proponents and opponents may argue  their beliefs, but two things are clear:

1.)  That apple costs you more than the sign says

2.) If you go organic, you just paid twice

A recent podcast by NPR’s Planet Money discussing cotton recalled one of the most perplexing and agitating subsidies to date.  American taxpayers pay Brazilian cotton growers for the right  to subsidize American cotton growers.  Yes, you read that correctly.  American taxpayers pay domestic AND foreign subsidies.
Though America has subsidized its cotton growers in some form for two centuries, this peculiar arrangement sprouted from a World Trade Organization ruling earlier this year.  The United States formally agreed to pay Brazilian cotton growers $147.3 million a year in assistance to avoid over $800 million in tariff penalties on U.S. imports and end a 10-year WTO dispute.  This blog’s author covered the matter last April when the deal was announced. (Have a look here and here)
So, how we came to pay another country’s farmers:
As a fellow member of the WTO, Brazil alleged for years that the U.S. was breaking WTO trade rules through its cotton export credit guarantees within the GSM-102 Program.  All that jargon means that the U.S. government guarantees the transactions between its exporters’ and foreign importers so that U.S. businesses will always get their  money, even if the importer defaults on its end of the bargain.  If an exporter doesn’t get paid, the government picks up the tab.  This allows U.S. exporters to keep their prices artificially low compared to global prices.  This makes U.S. cotton more attractive and affordable, crowds smaller countries’ growers out of the market and leaves them to sit on the sidelines of large global trade.
Brazil had complained and complained, but were finally heard and brought the matter formally to the WTO in 2002.  After several rounds of decisions and appeals, the WTO finally sided with Brazil.  This was astonishing, but also didn’t really mean much.
You see, the World Trade Organization lacks any enforcement powers.  Since it’s a voluntary organization, members may come and go as they please and choose to obey the rules or not.  WTO judges issue decisions, but have no ability to follow through.  Once the decision is made, it is up to the disputing countries to come to an agreement.  So what’s the point of the whole thing, anyway?  We don’t have enough time for that.
However, the judges did rule that because the U.S. violated the rules, Brazil could retaliate with its own punishment (within certain parameters, of course).  Brazil decided to issue an import ban on some U.S. imports and high tariffs (import taxes) on others.  Brazil threatened about $830 million of damages to U.S. trade gains if the U.S. did not stop its export credit guarantees and conform to WTO rules.  Since the U.S. does pretty much whatever it wants, it struck a deal with Brazil instead.
Well, when Brazil announced its list of import tariffs on over 100 goods, U.S. industry lobby groups went nuts.  The tariffs hit everything from radios to ketchup to cars and boats.  Because it was such a wide array of goods, Washington got quite a wide array of phone calls.  So, the U.S. did what it does best, paid Brazil off.  If Brazil agreed to remove the tariffs, the U.S. would give its cotton growers $147.3 million a year in aid and “suspend” its cotton export credit guarantee program.  Suspend is in quotes because this is a 2012 Farm Bill issue and the program has to continue through the year with its current obligations.  Essentially, it’s business as usual.  Big business at that.  The GSM-102 program will continue to doll out its $5.5 billion marked for this year.
All in all, $147 million is a drop in the bucket compared to the $2.2 billion in subsidies the U.S. handed out to its cotton growers last year.  However, it’s the logistics that are more baffling than the numbers.  Paying somebody else so you can continue paying yourselves.  That’s U.S. subsidies for ya.
HELPFUL LINKS TO LEARN MORE

Usually Supply Doesn’t Care About Demand wouldn’t dive into monetary policy, but recent actions by Uncle Ben and the Fed are creating quite a reaction in agricultural commodity markets.

Two weeks ago, the Federal Reserve announced it would buy $600 Billion worth of US Treasury bonds in efforts to infuse liquidity into capital markets, thus spurring lending and borrowing, lowering the dollar’s relative market value, boosting exports and stimulating job orders and hiring.  Whew, still there?  Essentially, the Fed wants to put a whole lot more money in circulation to achieve its primary mandates:

1. keep inflation in check

2. keep unemployment low (but not too low)

Though economists, scholars and professionals have their own opinions on the plan’s effectiveness, Supply Doesn’t Care About Demand would like to point to commodity markets as an indicator of the plan’s mixed signals and unintended consequences.

When prices rise over a period of time, it’s called inflation.  It’s the term for what’s behind the griping, “In my day, gum was a nickle, a dime bag was a dime, etc.”  Inflation is good when its slow and steady.  Inflation is bad when prices rise too high too fast. Slow and steady wins the race.  Injecting such a large sum of money into an economy puts more money out there, causing prices to rise.  The true price of an item mostly stays the same compared to other items, it’s just the number that changes.  When more money is put in circulation, prices rise to compensate.  So, this inflation has hit commodity markets.

Agricultural commodities like soybeans, corn and sugar have jumped since the Fed’s announcement.  Some commodities are seeing two year highs (in nominal terms).  Prices jumped so quickly that the Chicago Mercantile Exchange–the largest commodities exchange–increased the amount of money traders need to keep on account to cover volatile price swings.  Essentially, prices are expected to continue to jump, so hedgers better have the money to cover their bets.

When things are looking so poor that the U.S. decides to pump money into its economy and intentionally weaken the dollar, it causes investors to shy away from currencies and head into more tangible items like gold, silver, bauxite and crude oil.  These drag other commodities along with them through a complex web of interdependence that is a lesson for another time.  This means agricultural products’ spot or cash prices rise along side.  The unintended consequence here is the volatile commodity price swing.

The Fed can’t direct the $600 billion to where it sees fit.  Ben Bernanke can’t say, “okay, housing you get $200 billion, energies you’ll get $2 billion.”  Money is out there and it will join the flow of dollars spinning around the globe.  Instead of pumping that cash into manufacturing, investors see it as a sign of weakness and look elsewhere for places to park their money.  Unintended consequences aside, the massive injection sends mixed signals to investors and capital markets.

But what do capital markets have to do with soybean futures?  Why, money of course.

Several weeks ago, the U.S. Treasury announced that the yield (rate of return on a unit of investment) on TIPS bonds(Treasury Inflation-Protected Securities) would be negative.  Negative bond yield means that you, the investor, pay someone else to loan them money.  A bond is a loan.  Money is made based on the idea that inflation will continue and thus the investor will make more money on interest and inflation return.  The only reason a bond is attractive is because of inflation.  A negative yield rate means that the U.S. Treasury is betting on deflation.  It expects prices to drop so low across the board that a less negative yield would be more attractive than a more negative yield.  It’s like saying, we’re all gonna lose money, but if you buy our bond, you won’t lose as much. This scares investors out of bond and currency markets and into more tangible markets like…commodities!  Here we are again, gold, silver, bauxite, etc.

The whole point of the $600 billion injection was to stimulate capital markets and increase lending.  When you tell investors that things are looking so bad that they should just take a minimal, known loss, they’re probably not going to stick around.  Don’t act too surprised when the $600 billion bomb you’ve dropped compounds the panicked flight and sends markets reeling.

Get your house in order, Uncle Sam.

Last time we saw an extremely simplified example of how futures markets influence commodity prices.  However, they’re just one of many umelements that determine prices.  This time we’ll take a look at price floors, just one form subsidies can take.

True to its name, a price floor sets a a minimum or “floor” for the price of a given commodity.  The larger programs are also called “price support schemes.”  This means that the government determines–through incredibly complex quantitative analysis by agronomists–what it believes the minimum return agricultural growers should get in order to keep those growers in business.  People won’t spend the time, energy and resources to produce a product that won’t give them a return when they could be doing something else.  Economists call this “opportunity cost,” but most people call it common sense.  Our example looks at dairy markets because it’s one of the most contested price floors in agricultural markets–especially with the recent roller coaster ride dairy prices have had in the past three years.  Though dairy is split into several categories (Class III, Class IV, nonfat dry, powder, etc.) we’ll look at block cheddar cheese.

In its infinite wisdom, the USDA decides on January 1st that dairy farmers should get at least $1.80 per pound of cheddar cheese for the rest of the year to at least help farmers break even on production costs.  This is great, but cheddar is trading at around $2.10 in January, so the USDA puts the policy on a shelf and waits until it needs to act.

Meanwhile, on the farm things are going great.  Herd numbers (dairy cow heards) are up and the milk is flowing.  However, around March it seems a little too much milk is flowing.  With all that supply, demand goes down.  (See, it always comes back to this simple relationship).  Those screaming orange and blue jackets on the CME floor stop screaming for cheese–theyr’e on to things in more demand–and the price starts to drop.  USDA numbers are in, milk production is strong and the price keeps dropping…$2.04, $1.91, $1.87…down, down, down.  Since farmers can’t store milk more than a day, the milk just keeps coming to market and keeps pushing supply up and up.  Then cheddar finally goes down to $1.82.

Alarm bells go off at the USDA.  Time to dust off that shelved price floor plan.  It looks like cheddar is going to dip below $1.80.  So, what does the USDA do?  The same thing the Fed does with currency.  The USDA starts buying cheddar cheese to increase demand and re-inflate the price for cheddar.  Those same quants that decided what the floor should be are now plugging numbers into their formulas to see just how many 40lbs. blocks of cheddar cheese they need to buy to keep prices at least at $1.80.  So, the government keeps buying and buying in massive quantities to unload cheese from the consumer market.  If traders and food processors won’t buy, then the government will.  If they don’t provide enough incentive to dairy farmers, people may think twice about starting their own herd.

Naturally, prices wanted to go lower and lower.  Supply was strong and herds were healthy, which paradoxically means prices won’t be.  Weird, yes.  So, cheddar cheese should cost less, but because of government intervention, dairy farmers will still get $1.80 spot price.  As we see, this distorts the natural balance of the market and costs taxpayers money.  Taxpayers pay to support dairy farmers’ wages.  Soo……what happens to all those 40lbs. blocks?  Well government cheese, of course!  No, seriously.

CHECK OUT SOME MORE INFO ON PRICE FLOORS AND DAIRY MARKETS:

CME Cheese prices

Great definition and graph for concept of “price floor”

News clip when price floors kicked in

Dairy Pricing arguments from Congressional Research Service


In earlier posts, we’ve seen that U.S. agricultural subsidies and trade distortions make prices rise and fall, which is a good start.  We’ve talked about tariffs and import quotas and trade agreements and how they distort prices.  But, where do all these prices come from?   Who decides corn will cost $5.60 a bushel?

Essentially, it’s supply and demand. Though there are many, many factors that go into commodity prices, we’ll look at a world free of subsidies, quotas and all other distortions to see the bare bones of agricultural commodity markets at work.  So, let’s follow that corn from field to table to see how we came to that $5.60:

Tilling the land for over 30 years, our corn farmer is no hayseed.  He knows he can’t predict exactly how much he’ll grow and what price he’ll get after harvest.  So, before his seed is in the ground, he puts his fall harvest up for sale.  He does this so he can at least guarantee himself a buyer and a price come harvest.  Sure, corn prices may go up and he could have made more money, but they could also go down and he won’t lose money.  Our corn grower puts his corn harvest up for sale in what’s called a futures contract.  He agrees to deliver 5,000 bushels for $4 a bushel by October 1st, bagging himself $20,000 no matter the price come October.  Our corn grower has guaranteed himself a salary if he fulfills his end of the bargain (5,000 bushels by Oct. 1). This agreement is a contract cited as “October delivery.”  Our farmer is called a “hedger” because he is hedging against October’s corn price.  Now that the business part is out of the way, our corn grower gets to planting.  We’ll check back with him later.

On the other end of that agreement  Heartland Foods.  Heartland makes Corn ‘o’ Copia cereal, so they obviously need our farmer’s corn.  They need 5,000 bushels of corn to make their tasty cereal.  However, they don’t know what the price will be in October for their much-needed corn.  So, locking themselves into a guaranteed price at $4 early is better than surprises later. Heartland is also a  “hedger” because they are hedging their bets against the future price.  Either party can gain or lose, but at least both know what they’re getting.

Our farmer didn’t sell his contract directly to a food processor.  He sold his contract through middlemen called brokers that work at a brokerage firm.  These middlemen buy and sell contracts on behalf of their clients (like our farmer) working through a clearing house and an open commodity exchange market.  Neither side of the agreement for 5,000 bushels will ever meet (in this capacity, anyway).

So, now we have our contract.  5,000 bushels of corn at $4 a bushel, for a total of $20,000.  This contract may then be placed on the open market by our farmer’s broker at what’s called an “exchange.”  Just like a stock exchange.  The U.S. has commodity exchanges in several cities like Minneapolis, Kansas City, New York and most notably, Chicago, which is the country’s largest.  The commodity exchange is a harried, frantic place filled with men and women in colored jackets screaming at one another in order to buy and sell these contracts.  These traders are called “speculators.”  They don’t know who is on either end of these contracts, nor do they really care.  They’re just playing hot potato with our farmer’s agreement to make some money when prices move up or down.  They won’t actually buy the contract and take delivery.  They’ll sell it before hand so 5,000 bushels of corn isn’t dumped on their Oak Park driveway.  However, these men and women that will never see the product help determine what the price of corn will be.  Now our prices take off.

Our farmer locked himself in at $4 a bushel.  That price takes all of his factors of production into consideration.  How much seed, water, machinery, fuel, labor, maintenance and potential damages will cost him to get that corn to market.  So corn is now $4 a bushel on the market.  However, it doesn’t rain for a whole month and the USDA lowers its corn crop forecast.  Uh oh.  There’s not going to be as much corn as expected.  So, traders go into a panic and are willing to pay more than $4 a bushel.  The more traders that feel this way, the higher the price goes.  The exchange floor is like an auction without an auctioneer.  Now those green and orange jackets are screaming $4.25, $4.27, $4.30!  The price of corn is on the rise.  Corn is hot.  After a few weeks of trading around $4.30,  Japan (the world’s largest importer) says its corn stores have rotted and they need to buy more.  Japan will be searching the globe for more corn.  Exports will definitely increase and demand is up again!  Now speculators think that corn is worth $4.60, $4.67, $4,70!    Corn is surging up with a frenzied pool of investors thinking Japan is going to buy so much corn that dwindling US crops won’t be enough.  U.S. food processors need that corn, so the price jumps again.  Consumers are buying more packaged goods at the stores, Japan needs more and the drought has destroyed some of that supply.

Now at this point Heartland has saved $3,500 since corn is now $4.70 a bushel (5000 x 4.7 = 23,500) and they only paid $4 a bushel.  Meanwhile, the jackets continue their frenzied buzz in the chaotic hive of the exchange floor, shooting prices higher and higher due to demand and speculation.  Corn prices hit the news, Japan’s shortage takes on serious worries and prices jump again.  Farmers and buyers are agreeing to new contracts every minute, trying to stay above…or below the price climb in an effort to make or save as much money as possible.  Prices climb all summer, with some pits along the way, and hit $5.60 on October 1st.

Due to the “fundamentals” of weather, supply, demand and global forces, corn is now worth $5.60 a bushel.  All those people that drove it up to $5.60 are still trading and driving prices for the open market, no matter that it’s time for our farmer to deliver.  They are on to other contracts and other market influences.  Unfortunately, our farmer lost $1.6o a bushel, or $8,000.  However, Heartland gained that $8,000.  There will always be a winner and loser in this zero sum game.  And it’s this game of risk that fuels commodity prices.  All those speculators look at what’s happening around corn and decide just how much they’re willing to pay and for how long.  Obviously this is an extremely simplified example, but it outlines the skeleton of where these commodity prices come from in a free market.  Next time, we take this example and throw in some corn subsidies to see where our price goes, showing just how much policy distorts price.

Please Have A Look at A Few Useful Tools for Understanding This Game

Chicago Mercantile Exchange (CME)

USDA Crop Predictions

Basic Commodity Trading Concepts

History of Commodities Trading