For Tokyo Agro-Forum

By Dr. Robert N. Wisner, University Professor and Mr. Keita Fukunaga, Graduate Research Assistant, Department of Economics, Iowa State University

Highlights: The U.S. government safety net is extremely important to U.S. grain, cotton and oilseed farmers but traditionally has excluded producers of livestock, fruits, and vegetables. In the last few years, this safety net has accounted for 22 to 29 percent of gross receipts for growing corn, along with 22 to 36 percent for wheat, 19 to 26 percent for soybeans, and 33 to 59 percent for rice producers. These percentages do not include farmer benefits from subsidized crop insurance, disaster payments, and low-interest government loans. The safety net also has important private-sector components that are explained here.

U.S. agriculture for many decades has operated with various government safety nets that are designed to partially protect against price and weather risks. These programs originated in the 1930s, a period of major stress for farmers and farm families because of a world-wide economic depression, several years of extreme drought, low farm prices, and numerous farms that were forced to be sold to pay debts to creditors. Early safety net programs included land-idling to reduce price-depressing excess production, government grain storage programs to help stabilize prices, and government loan programs.

One farm program concept originating in this period was the "Ever-normal Granary." A granary is a facility for storing grain. The Ever-normal concept was a program encouraging producers to store grain in years of good crops, and then to market the excess grain supply in years when adverse weather reduced production. This concept and the land-idling programs were major components of U.S. farm policy in most years from the mid-1930s until 1996. Much of the time over this period, the programs were able to keep U.S. crop prices within a relatively narrow range. A major period when this was not the case, however, was during the 1970s when rapid changes in world economic conditions temporarily brought sharply increased demand for grain and inability of U.S. production to meet all potential demand.

During the 1980s and early 1990s, GATT (General Agreement on Tariffs and Trade) negotiations led by the U.S. created a movement toward fewer restrictions on world trade in farm products. GATT negotiations led to modest lowering of the U.S. government safety net for farmers in the late 1980s and early 1990s. This movement toward less government distortion of international trade in farm products accelerated in the 1990s, with the result that GATT was replaced by the World Trade Organization ( WTO), a global trade governing body. These global changes in trade policy created an increased exposure to financial risk in U.S. agriculture, and a need for the recent major changes in the safety net used to protect farmers, the economy of rural communities, and the security of the U.S. food supply.

WTO brought additional pressure on the U.S. to adjust its agricultural safety net policies, especially to reduce or modify farmer subsidies that had trade-distorting effects. Several important U.S. agricultural subsidies were reduced, eliminated, or changed to a different form during this period. However, some trade-distorting subsidies remain, including concessional export credit sales programs with very low interest rates. Most other U.S. subsidies were shifted to forms that reduced or eliminated their trade-distorting impacts, but were retained to support farmers’ income. These changes mainly occurred through passage of the U.S. 1996 Farm Bill that established U.S. agricultural policies for the 1996 through 2002 crops. New legislation is now being developed to replace the soon-to-expire 1996 agricultural legislation.

Crops where significant trade-distorting subsidies remain include soybeans, sugar, peanuts, and tobacco. Except for soybeans, these crops are grown in relatively small geographic areas and represent a small share of total U.S. agricultural production. In addition, the U.S. has extensive subsidies and import restrictions for fuel ethanol, made mostly from corn, which help to support corn prices. Since the corn sweeteners market represents a major source of demand for corn, corn prices also receive indirect support from its restrictive import policy on sugar. The extensive subsidies for crop insurance also allow farmers to grow crops in risky areas of the U.S. where production otherwise would not occur.

At this writing, the U.S. farm safety net is largely defined by the 1996 agricultural legislation, although new legislation to modify the system is expected to be passed soon by the U.S. Congress. Major components of the safety net for farmers are as follows:

• Subsidized crop yield and revenue insurance
• Disaster payments and low-interest loans (Determined by Congress when major crop disasters occur over a large area, with the size of the payments depending on the size of the disaster)
• Government-subsidized interest rates on nine-month crop price support loans.
• Loan Deficiency Payments (LDPs, explained later) and Marketing Loan Gains (MLGs)
• Soybean and other oilseed Market Loss Access (MLA) payments
• Production Flexibility Contract (PFC) Payments, sometimes referred to as Agricultural Market Transition Adjustment (AMTA) Payments
• Market Loss Adjustment (MLA) Payments for grain and cotton producers, determined yearly by the Congress and based partly on the level of farm commodity prices
• Private-sector tools that protect against adverse price changes, including futures markets, options markets, and a large number of commercial contracts to manage price risks

Major risks that the safety net is designed to protect against originate from volatile commodity prices, and changes in shares of world trade in major agricultural commodities. Human capital risks such major illness or death of a key person in the farming operation also are important, and typically are protected through purchases of insurance offered by privately owned firms. Other risks stem from unfavorable weather and the chance that a farm’s crop yields will be well below normal. To illustrate how important weather risks are, Figure 1 shows the U.S. average corn yield since 1866. Except for the last the last six years, the U.S. average corn yield has been highly volatile over much of this time period. In some areas of the U.S., yields are much more variable than those shown in Figure 1. The percent deviation from the long-run trend in yields is shown in Figure 2. Deviations from the trend indicate the average yield has greater risk of being below normal than above normal. Crop yield insurance has been used for many years to protect farmers from low income caused by abnormally low crop yields. In the past five years, newer types of insurance that protect farmers against the combined risks of low yields and/or low prices have also become available.

Several different types of crop insurance are available to American farmers. Some kinds insure the yield per hectare and compensate farmers when their yields are below an insured percent of normal yields. Other types insure only for wind and hail damage. Hail is a type of severe ice storm that occurs during the growing season, and in extreme cases can cut the plant off at the soil surface. Other types of insurance pay farmers only when average yields for their county (the smallest U.S. governmental unit in the Midwest) are below a selected percent of normal yields. Crop revenue insurance has been available for about five years, and insures dollars of revenue per hectare. The insured level of revenue is a percentage of normal yields times the monthly average price of the harvest-time futures contract one to three months before planting time. With revenue insurance, either low yields or low prices or a combination of both can qualify the farmer to receive an insurance payment. The amount of government subsidy for the crop yield and revenue insurances is about 25% of the cost, although the amount of subsidy varies with the level of coverage the farmer purchases. Farmers can insure yields at levels ranging from 55 percent to 75 percent of their farm’s historical average yield. Insurance is available in five-percent increments, with the cost increasing for each increase in percentage of the normal yield that is insured. In some pilot areas, insurance at up to 85 percent of normal yields has been made available. Insuring at or below 65% of normal yields tends to result in a higher percent of the cost being paid by the government than insuring at higher percentages of normal yield.

These insurances are sold through the private insurance industry, generally by insurance agents who also sell liability insurance, policies for vehicles, farm buildings, health, life, and other areas of risk exposure. With the subsidized insurance, farmers can afford to farm marginal land in areas where frequent droughts or floods would otherwise keep the land from being used for crops. In that way, subsidized insurance affects global prices. Geographic areas where this marginal land has been brought into crop production in the last six years since the start of the 1996 Freedom To Farm Policy are especially concentrated in non-irrigated areas of the U.S. Great Plains, an area extending from Texas to North Dakota and Montana in the central part of the nation. Drought, wind, and hail risks in this region are much greater than in many other major cropping areas of the U.S.

An example of how revenue insurance works is shown below, using corn prices and yields from the year 2000 to illustrate the major principles. The average price of the December 2000 Chicago Board of Trade corn futures contract in February 2000 was $2.40 per bushel. In this example, the farmer who purchased a revenue insurance policy had an average proven yield history for his/her farm of 140 bushels per acre. The farmer chose to insure at 75% of the historical yield, so the insured yield was 105 bushels per acre. Multiplying 105 bushels per acre times $2.40 indicates this farmer insured the revenue from the crop at a minimum of $252 per acre. To determine whether the farmer received a payment from the insurance company for low revenue, the November average price of December corn ($1.96/bu.) was multiplied by the farmer’s actual corn yield for 2000. If this amount was less than 75% of the minimum insured value of the crop (pre-planting futures x actual yield), the farmer would receive an insurance payment for low income. Two types of revenue insurance provide increased insurance coverage if December corn or November soybean futures prices rise from February before harvest to harvest time. Another type of revenue insurance provides income protection only at the February (before harvest) price of November soybean futures or December corn futures.

The example shown above is summarized in the following calculations, for a farmer harvesting 90 bushels of corn per acre:

Before planting:

Historical average farm yield 140 bushels per acre

Percent of historical yield insured 75%

February average price, Dec. futures 2.40

Minimum insured income (140x 0.75x$2.40=$252) $252 per acre

Actual average farm yield 90 bushels per acre

Average Dec. futures price in November 1.96

Harvest revenue ($1.96x90bu./A.) $176.40

Insurance payment ($252-$176.40)=$75.60 per acre

The type of insurance that provides increased protection if futures prices rise at harvest time is a good companion tool for farmers to use if they sell part of their crop before it is harvested. If weather reduces the farmer’s yield to less than he or she has sold and prices rise, the insurance provides increased coverage to buy back over-sold market positions. Here is a hypothetical example of why this insurance feature is important to farmers who use the futures market or a forward contract to establish the price of their crop before harvest. . The farm’s variable cash costs of producing corn are $275 per acre. In this example, the same farmer in the earlier example decided to sell 105 bushels per acre of his expected production with a rise in the December futures price in May. The futures price at that time rose to $2.75 per bushel, and the local forward contract price for harvest delivery was $2.40 per bushel. That was $0.50 higher than average harvest-time prices in recent years.

In our example, the farmer’s crop suffered severe yield losses because of extreme summer drought that affected a large part of the U.S. Corn Belt. At harvest time, his actual yield was only 10 bushels per acre, but he had contracted to sell 105 bushels per acre to a local buyer. Further complicating his situation, the local price had risen to $3.40 per bushel and the December futures had risen to $3.75 per bushel. The grain buyer required him to either (1) buy back 95 bushels per acre of his contract at an extra cost of $1 per bushel (the amount price had increased) or (2) buy someone else’s corn to fill the contract. Either way, it would cost him $1.00 per bushel to buy back 95 bushels per acre of his contract. He would pay out $95 per acre and receive only $24 per acre from his crop (10 bushels per acre x the contract price of $2.40 per bushel). That would leave a negative gross income of $71 per acre. When costs of $275 per acre to produce the crop are considered, this producer would have a financial loss of $346 per acre on his crop, if he had no insurance.

With the type of revenue insurance that provides increased protection if prices rise, his insurance coverage rose to $393.75 per acre ($3.75 per bushel December futures at harvest times 105 bushels per acre insured yield). The insurance policy provided insurance coverage at the November average price of December futures, if the November price was higher than the February price before harvest.

If the farmer had purchased the type of revenue insurance that does not provide added benefits if prices rise, his insurance coverage would have been only $252 per acre ($2.40 February average price x 105 bushels per acre). Actual gross income for insurance purposes was 10 bushels times $3.75 (November average of December futures) or $37.50 per acre. Without the harvest-price coverage, the farmer’s insurance payment to cover the crop loss would have been $252-$37.50=$214.50 per acre. Subtracting the $95 cost to buy back the over-sold market position would leave only $119.50 plus the value of the 10 bushels per acre of corn actually produced to cover other costs of planting the crop. But since the farmer in this example had the harvest-price alternative for his revenue insurance, his insurance payment to cover the crop loss was $393.75 per acre ($3.75 futures x 105 bushels per acre insured yield) minus $37.50, or $356.25 per acre. Combined gross income (insurance payment and value of 10 bushels per acre of contracted grain) was $356.25+(10 bushels times $2.40 contract price=$24), or $380.25. Subtracting $95 to buy back the contracted corn left $285.25 per acre. This more than covered his variable production costs of $275 per acre. These comparisons of harvest-price and non-harvest-price revenue insurance are shown below:

Historical average farm yield 140 Bu./A. 140 Bu./A. 140 Bu/A.

Percent of historical yield insured 0% 75% 75%

February average price, Dec. futures 2.40 $2.40

Minimum insured income 0% $252 per acre $252/acre

(140x.75%x$2.40=$252)

At Planting time: Sold 105 bushels per acre on contract at $2.40/Bu.

December Futures price $3.75/Bu. $3.75/Bu. $3.75/Bu.

Insured crop value $0.00 $252/A. $393.75/A.

Actual average farm yield 10 Bu./A. 10 Bu./A. 10 Bu./A.

Harvest revenue (on 10 Bu./A. sold at $2.40) $24 $24 $24

($252-$37.50)=$214.50/A.

($393.75-$37.50)=$356.25/A.

Insurance premium (it was sold @ $2.40/bu.) $24.00 $238.50 $380.50

Less cost of buying back over-sold contracts -$95.00 -$95.00 -$95.00

Net price received for the corn -$71.00 $143.50 $285.50

Net return before govt. payment -346.00 -131.50 +10.50

Net return on 500 acres -$173,000 -$65,750 +$5,250

The summary of insurance results above are illustrated with a 500-acre corn enterprise. For many Iowa cash-grain (grain only) farms, this is a typical size of the corn cropping activity of their bushiness. These farms typically devote another 500 acres to soybeans, and the same insurance features are also available for soybeans.

Traditionally, insurance and government safety nets have only been available for U.S. producers of major grain crops, oilseeds, sugar, peanuts, tobacco, cotton, and milk. Recently, insurance has been expanded to include protection for producers of fruits, nuts, and vegetables. In 2001, work also was underway to develop revenue insurance programs that would include coverage for beef and pork producers. This type of insurance is being offered experimentally to farmers in a few pilot counties of some states who produce several crops and have no more than one-third of their income normally coming from livestock or livestock product sales. The pilot version of this

insurance allows farmers to insure their adjusted gross income at 65, 75, or 95 percent of their 5-year average income. Determination of income for insurance purposes comes from their federal income tax forms. One version of new U.S. farm legislation would require revenue insurance to also be made available to livestock producers as part of an expanded government agricultural safety net.

Yield insurance does not take into account futures market prices. Farmers who have this type of insurance, using the same percentage coverage and historical farm yield as the revenue insurance examples above, Figure 3. The beginning of flood damage to a soybean field.

would receive an insurance payment only if their farm average yield is lower than 105 bushels per acre. In some cases, at an extra cost, farmers can insure individual fields rather than having their insurance based on the farm’s average yield. For farmers who operate several farms, there also is an "enterprise" alternative at lower cost that bases insurance protection on the overall average yield for all farms the farmer operates. The probability of an insurance payment to the farmer for this type of insurance is lower than if individual farms or fields are insured. That is why there is a lower cost to purchase this type of insurance.

These loans are a modification of 9-month price support loans for major crops that have been available since the 1930s. Their original purpose was to provide farmers with immediate income at harvest and remove the pressure to sell the crops at harvest time, when prices usually are the lowest of the year. The 9-month loans are available for corn, wheat, soybeans, rice, cotton, grain sorghum, barley, and oats. With these loans, the grain or other crop becomes the collateral for the loan. At or before the end of the 9 months, the farmer may repay the loan plus interest and sell or feed the grain. However, if the loan has not been repaid and prices at the end of the 9 months are below the local loan rate (which varies from county to county), the farmer can simply deliver the grain to the Commodity Credit Corporation (CCC), which is an agency of the U.S. government. If that is done, he or she pays no interest and the loan is considered to be paid in full. CCC would then store the grain for an undetermined length of time, until it has a need for the grain for feed or food donation programs. Beginning in the late 1990s, changes in government programs encouraged farmers to receive a Marketing Loan Gain (MLG) rather than delivering the grain to CCC. The loan is paid off at the lower market price, and the farmer keeps the extra amount of the loan as his/her MLG. The net income for the farmer is very similar to the LDP that is explained below, except that the farmer has the use of low-cost government money from the loan for a few months.

The national average loan rates for major crops are established by the U.S. Congress and the Secretary of Agriculture for each year. U.S. average loan rates are well below the total cost of producing the crops, but offer partial protection from low prices. The county loan rates are based on the national average loan rate, with an adjustment that reflects transportation cost differentials and normal local price differences from the national average price. The state of Iowa has 99 counties. Normal price differences from the southeastern to northwestern corners of the state, for corn, are about $8 per metric ton because of location and transportation cost differentials to get the grain to ports. Northwest Iowa is over 300 miles further from the Gulf of Mexico ports than the southeastern corner of Iowa. For producers who use the 9-month loans, interest rates typically are subsidized by about three to four percentage points by the U.S. government.

The traditional 9-month loans were modified in the 1990s to create "Marketing Loans." With a marketing loan, farmers can still deliver the grain to the CCC to fulfill their loan obligations. However, that is strongly discouraged. Instead, most producers choose to receive what is called a Loan Deficiency Payment (LDP). As an example of how the LDP system works, soybean prices paid to central Iowa farmers as this is being are about $3.85 per bushel. The county loan rate is $5.20 per bushel. The LDP is approximately the difference between the local price and the loan rate, or in other words $1.35 per bushel in this example. A government office each day calculates an approximate local price for the LDP, although it may not exactly match the price being paid for the soybeans at a specific grain elevator or other grain buying point. Each county has several different companies that buy farmers’ grain, with some variation in price from one buyer to another. The price used for determining the LDP often changes daily. Instead of holding the grain until the end of the 9-month period and delivering it to CCC, the farmer may simply choose to receive the LDP before the 9-month period ends. In this case, it is called a MLG, and is calculated in the same way as the LDP. He or she is then free to sell the grain anywhere or at any time, or to feed it to livestock. Or the farmer may simply sell the grain at harvest time and receive the LDP without storing the grain. The LDP system is intended to guarantee that the farmer will not receive a lower price than the loan rate for grain, soybeans, or other major crops, even if prices are extremely low.

This system also is designed to avoid the need for the U.S. government to have the expense of owning and storing grain inventories. At this time, the U.S. government owns almost no corn or soybeans, and has only a small emergency reserve of wheat that is required by law. Since the U.S. is a major exporter of grain and oilseeds into world markets, this system allows U.S. and thus world prices to drop to very low levels, while protecting American farmers from the extreme low prices. For example, U.S. soybean prices at harvest time in 2001 were at the lowest levels since 1972. As an example of how this system distorts world trade, without the LDP system, it is almost certain that U.S. farmers would produce much smaller soybean crops than they are currently producing. That would allow soybean prices to be higher, and in turn would encourage farmers in other countries to produce more soybeans. The LDP at this writing accounts for 25% of the gross income U.S. farmers receive for their soybeans. Other direct government payments account for another 2.8% of U.S. soybean growers’ income.

The U.S. Congress originally limited the maximum LDP payments for each individual farmer to $75,000. On a farm owned by a married couple, and where both spouses are actively involved in the farm business, the maximum limit formerly was $150,000 for the couple. As payments per ton increased and became a more important part of farm income, the Congress increased these limits to $150,000 per individual farmer or $300,000 per farm couple. The original purpose of the payment limit was to restrict the competitive advantage that large U.S. farms have over small and medium size farms. The advantage the large payments gives them is most important in their ability to bid more aggressively than smaller farms in purchasing or renting cropland. Raising the payment limit has accelerated the increase in average size of U.S. farms.

U.S. loan rates for major crops and typical LDPs in major producing areas were as shown below in mid-October of 2001.

Table 1. U.S. Loan Rates and Loan Deficiency Payments for Major Crops in 2000 & 2001.

Cotton upland price Sept 2001:$0.343/lb.

Grain and oilseed producers in the last few years have received "Market Loss Adjustment" or MLA payments averaging about $0.14 per bushel ($5.15 per metric ton) for soybeans and approximately $0.34 per bushel for corn. Producers of sunflowers and other minor oilseeds also have received MLA payments. For soybeans and other oilseeds, these payments are made on actual current production. For corn, wheat, and other grains, they are made on historical average production. The logic for these payments seems to be that the U.S. government has failed to provide its grain and oilseed farmers with full access to foreign markets, because of its past prohibition of exports to Cuba and a few other nations. Additional logic also seems to focus on failure of the U.S. government to work aggressively to eliminate foreign government subsidies such as those in the EU and negotiate more favorable trade agreements. In summary, these payments are designed to help farmers receive income that theoretically might have been available to them if foreign trade policies were different.

These payments were established by Congress in the 1996 Agricultural Market Transition Adjustment legislation commonly known as "Freedom to Farm". They were designed to compensate farmers for elimination of higher income supports that were in the previous agricultural programs. Corn and wheat PFC and MLA payments were as shown in Tables 2 and 3 below for the last several years.

Table 2. U.S. average corn prices and government payments, 1996-2001 marketing years.

*Payments were made on 85% of historical yields and area. To adjust to payment rates for current production, payment rate was reduced to 75% of rate per historical bushels.

** Data for 2001 are estimates.

The size of MLA payments has been determined each year by Congress, with no specific formula for their determination. The determination has been on the basis of needs in the agricultural sector and availability of funds in the U.S. federal budget.

The actual gross return that an individual U.S. farmer receives will depend on a number of factors, including how and when he/she markets the crop and chooses to receive the LDP, their crop yields, and the crop area and yield history for the farm. The farm’s historical crop area and historical yield are used to determine the government PFC and MLA payments for all major crops except soybeans.

Table 3. U.S. average wheat prices and government payments, 1996-2001 marketing years.

*Payments were made on 85% of historical yields and area. To estimate payment rates for current production, payment rate was reduced to 75% of rate per historical bushels.

Source of Data: USDA, ERS Feed Outlook Yearbook 2001 (Washington, D.C.) and personal communication with the USDA, Farm Service Agency Office, Des Moines, Iowa, U.S.A.

**Data for 2001 are estimates.

Since 1998, U.S. government payments have accounted for 22 to 29 percent of the average U.S. farmer’s gross income from their corn enterprise, and 22 to 37 percent of their gross wheat income. Similar information is shown for soybeans in Table 4 below. The LDP is the average for the entire U.S. crop, with forecasts for the average price and LDP for the 2001 crop. Soybean MLA payments, unlike those for corn, are made on actual bushels produced in the current year. Actual LDPs will vary from state to state and farm to farm, depending on the time the farmer elected to receive them. National average payments since 1998 have ranged from about eight to 26 percent of the total gross receipts for the soybean crop.

Table 4. U.S. average soybean prices and government payments, 1996-2001 marketing years.

Source of Data: USDA, ERS Oil Crops Yearbook 2001 (Washington, D.C.) and personal communication with the USDA, Farm Service Agency Office, Des Moines, Iowa, U.S.A.

These combinations of prices and government payments in recent years have been well below the full cost of producing soybeans, but near the full cost of producing corn. Farmers are not required to plant corn to receive most of the payments we designated as corn payments. LDPs are an exception, since they are paid on the volume of the current crop. Thus, farmers can plant corn land to soybeans and still collect government corn payments on land that formerly raised corn. The decision of whether to raise corn or soybeans on the land in the last few years has been influenced strongly by the loan rates of the two crops and the variable costs of production (those costs that would not exist if the crop was not planted). These costs for Iowa farmers in 2001 are shown in Table 5, for medium quality land and average yields.. Because of low prices, farmers have viewed the loan rates as the likely gross income per bushel for the crops, with the other corn payments being a supplement to their income that is not based on what crop is planted on the land. With this structure for government corn payments, returns over variable cost for growing soybeans have been much larger than for corn and wheat, and U.S. soybean plantings have expanded by about 20 % since the last year before the "Freedom-to-Farm" policy was implemented. U.S. corn plantings over the same time period have increased slightly less than seven percent as land formerly idled under government programs was returned to production. Wheat plantings, in contrast, have declined by 14 %, while sorghum plantings increased 3 %.

Table 3. Estimated costs of crop production in Iowa for the 2001 crops*

*Drs. Mike Duffy and Darnell Smith, Costs of Crop Production, 2001, Iowa State University Fm -1712, Revised (Ames, Iowa, U.S.A.) December 2000.

Much of the increase in U.S. soybean production has occurred in the Great Plains states of Kansas, Nebraska, and North and South Dakota. These states historically were major producers of wheat and grain sorghum year after year. Continuous cropping of these grains was necessary to receive government payments under old farm programs. With Freedom-to-Farm programs, sorghum and wheat payments are based on historical area and yield, and planting of the two grains is not necessary to receive payments. Because farmers can plant soybeans and still receive sorghum and wheat payments, soybeans have become a profitable alternative crop in the region. In Iowa and other states where corn rather than wheat is the dominant crop, agronomic considerations such as serious soybean and corn disease and insect problems with continuous mono-crop farming encourage farmers to rotate the two crops. In a corn/soybean rotation, farmers plant corn one year and soybeans the next in the same field. The need for this rotation limits the amount of expansion in soybean area that has occurred in the major Corn Belt states.

WTO and the Colored Boxes** Based partly on Chad E. Hart and Bruce E. Babcock, "Implications of the WTO on the Redesign of U.S. Farm Policy", CARD Briefing Paper 01-BP 32, Center for Agricultural and Rural Development, Iowa State University (Ames, IA, USA) May 2001.

Agricultural subsidy and trade agreements negotiated through the World Trade Organization (WTO) have created a new set of terminologies that relate to government agricultural safety net systems. Participants in the WTO agreed to classify government subsidies as being in one of four "boxes": red, green, amber, or blue. These "boxes" limit the ways that the U.S. Congress will be able to alter the U.S. agricultural safety net in the years ahead.

There is no limit on the amount of money that can be spent on green box payments, since these are classified as non-trade-distorting. However, there are specific requirements that these types of payments must meet. They cannot be linked to current production and/or prices, or used to support prices. U.S. Production Flexibility Contract (PFC) payments are in this category. Total annual U.S. expenditures for the green box payments have been around $50 billion. They include meat inspection, research, extension, domestic food subsidies for low-income consumers, school lunch programs, environmental programs, and disaster relief. Domestic food subsidy programs are the largest expenditures in this category. Also included are the long-term U.S. cropland-idling program, lending programs for limited-resource farmers, and a number of other programs.

Amber box payments have the greatest potential for trade-distorting impacts. For the U.S., these payments last year were limited to a maximum of $19.1 billion annually. They include payments in the dairy, peanut, tobacco, and sugar support programs, the soybean LDPs, the Market Loss Assistance programs, and some crop insurance subsidies. To meet WTO criteria, disaster relief payments and crop insurance subsidies must not exceed 100% of a farmer’s actual loss in any given year. A "de minimis" rule allows countries to exclude minor programs from this total if expenditures for them do not exceed five percent of the value of the commodity they support. However, if total amber box payments exceed their allowed maximum, these de minimis payments are added back in when determining how much the country must reduce its expenditures for agricultural support programs.

Red box payments are those for which no payments are allowed because of direct trade-distorting impacts. Blue box payments are production-limiting payments which are based on fixed yields and production as outlined in the Uruguay Round of WTO negotiations. These payments must be limited to a maximum of 85 percent of the base level of production and do not have an annual restriction on the amount of expenditures permitted.

Since 1996, the U.S. Freedom-to-Farm Programs have met the expenditure limits established by WTO. These limits are based on aggregate expenditures for all commodities. Most U.S. government farm program payments are heavily concentrated in a small number of major commodities, namely corn, wheat, oats, rice, cotton, sorghum, barley, and soybeans. Higher valued commodities such as meat animals, fruits, and vegetables receive very few government payments or no payments at all. When total U.S. government payments are calculated as a percent of aggregate farm income, they are relatively small. However, payments to grains and soybeans represent a high percentage of gross income, and in recent years have been the entire source of profits for producing these crops. Soybeans represent the extreme situation. Unlike corn and wheat, soybean payments are based on current production. This causes them to be clearly market and trade distorting, not only for soybeans but also to some extent for competing crops. Hence, the U.S. government programs for soybeans violate the spirit, but not the legality of WTO. As this is being written, Brazil has begun procedures to bring U.S. soybean policies before WTO. It believes these policies are trade distorting and are the main factor accounting for extreme low world soybean prices.

Futures and options markets

Futures markets are widely used in the U.S. grain industry to protect against the risk of unfavorable price changes. Futures markets also are available to help farmers protect against rising prices for some inputs, including fuel, fertilizer, feed, and interest rates on borrowed funds. Almost every unit of corn, wheat, rice, cotton, and soybeans is priced through sales on the futures markets. The grain industry also uses these tools to offer to farmers various types of contracts for future delivery of crops. Some medium size and large crop farms make their sales directly in the futures markets rather than using the contracts offered by grain buyers. Recent surveys of U.S. farmers indicate that about two-thirds of them use either futures, options, or grain-buyer contracts to establish a price for part of their crops before they deliver the crops to markets. Grain-buyer contracts are derived from the futures and options markets. Various kinds of grain contracts and their areas of risk-exposure are shown in Table 4 below.

Futures markets are used to establish a specific price for the crop or other commodity before it is delivered to market. Options markets allow farmers to establish a minimum price for their products, while retaining the opportunity to benefit if prices rise after the option is purchased. Figure 4 shows a type of risk premium that has often been present in the December Chicago corn futures contract during the winter and spring before harvest. A premium of this type has been present in the price of this contract over 80% of the years since 1975. As more information about weather, planted area, and crop conditions becomes available to the market during the summer, this risk premium has a strong tendency to fade away. Years when it does not fade away typically are years of major drought or flooding in the U.S. Corn Belt.

Table 7. Areas where risk is present in commonly used U.S. grain farmer contracts.

In these years, the futures prices typically have increased in the summer, rather than following the more common tendency to decline into the fall harvest season. November soybean futures prices also have some tendency to follow this pattern, but the tendency is not as strong as for corn. The Corn Belt is an area extending from western Nebraska, Kansas, and the eastern Dakotas to Ohio, Michigan, and western Kentucky. These price patterns create opportunities for farmers to establish a price for part of their crops before harvest through the futures and options markets or grain buyer contracts. One newer contract designed to capture this risk premium goes by several different names. One version is called an +A contract. It provides farmers with a price equal to at least the average price of the December futures contract during the first six months of the calendar year, minus a location adjustment for their area. If the grain buyer is able to secure a higher price than this average, it will pay the farmer a price that is above the average.

Research by R. N. Wisner, D. E. Baldwin, and N. E. Blue indicates that for actual farms located in northwest Iowa, northwest Kansas, and northwest Ohio, taking advantage of this risk premium for corn and soybeans over the period from 1985 through 1998 would have increased average net returns for corn/soybean farmers with 1,000 crop acres in these locations by an average of nearly $20,000 per year (See reference *** at end of article). The results are based on extensive use of put options to set a floor price for corn, synthetic puts (hedge and call purchases) for soybeans, and a small percentage of the crop being priced with direct sales of futures contracts. Options and synthetic put positions were established in mid-May, while hedge sales without options were established in early July, and in late February in years following a weather-reduced short U.S. crop. A short crop was defined as one where production fell below the previous year’s total utilization. Further work by these authors indicates these strategies, would have increased the average net cash income for a moderately indebted farmer in the three state study area from about $2,000 average per year to slightly over $20,000 when combined with purchases of fall-price revenue insurance. Revenue insurance added less than $1,000 per year to average net income, but provided cash-flow protection to avoid severe financial problems in occasional drought or flood years. Table 8 below shows potential income gains from similar strategies for central Iowa corn and soybean farmers in the three years ending in 2000. As this is being written, harvest prices show potential gains from these strategies and the same size farm for the year 2001 of around $9,000 to $12,000. U.S. corn and soybean futures and options markets do not provide profitable marketing alternatives every year, and past market patterns do not guarantee future performance.

Establishing new agricultural legislation in the U.S. requires that the House of Representatives and the Senate in the U.S. Congress both pass a similar bill. Any differences between the House and Senate versions must be reconciled by a conference committee of the two branches of the federal legislature. The bill then must be signed by the President in order to become law. In October 2001, the U.S. House of Representatives passed new agricultural legislation that would establish the government farm safety net for the next 10 years, beginning in 2003. A 10-year farm bill is highly unusual since most farm bills have had only three or four years duration. The longer time period may reflect a desire to lock in agricultural funding support for many years, in the face of an uncertain economic future. Another motivation might be to protect against future cuts in agricultural supports that might be required by WTO negotiations. Marketing loan rates and target prices for major crops in the House version, and changes from current loan rates are as shown in Table 9 below.

Table 9. Loan Rates, Target Prices, and Fixed Payments for Major Commodities in the

2001 U.S. House Agricultural Bill, 10/05/01.

Maximum Marketing Loan Rate Target Price Fixed Payment

Corn $1.89/bu. N.C. $2.78/bu. $0.30

Wheat 2.58/bu. N.C. 4.04/bu. 0.53

Upland Cotton 0.5192/lb. N.C. 0.736/lb. 0.0667

Rice 6.50/cwt. N.C. 10.82/cwt. 2.35/cwt.

Soybeans 4.92/bu. (-$0.34)/bu. 5.86/bu. 0.42/bu.

N.C.= No change from 2001

Marketing loan rates in this bill are to be set by the Secretary of Agriculture at levels no higher than indicated here, and for most commodities no lower than the most recent 5-year olympic average of prices. Rice is an exception, and is a fixed rate with no adjustment. The Target Prices are to determine when counter cyclical payments will be made to farmers. If the market price is below the target price, a payment equaling the difference between the market price and the target price, up to a maximum of the difference between the target price and the loan rate will be made to farmers. The payment rate will be 85% of the farm’s historical planted area for the crop times its historical yield. The bill provides a mechanism farmers can use to update their historical area planted to the crop to reflect the most recent four years. With corn prices equal to the September 2000- August 2001 marketing year level, corn growers under this policy would receive a deficiency payment of $0.63 per bushel plus a fixed payment of $0.30 per bushel and a likely LDP of around $0.25 per bushel. Adjusting these safety nets to show payments per bushel of current production in 2000, the total including the price would be $2.80 per bushel. Thirty-four percent of the total income to corn growers would come from government payments. This total compares with $2.562 under the current farm program and 2000 payment rates. Soybean payments and prices with the market price continuing as in 2000-01 would be about $5.85 per bushel versus $5.806 in current farm programs, with government payments accounting for 22% of soybean farmers’ gross income. These changes would increase total income per bushel for corn and soybean growers by 9.3% and 0.7% respectively.

As this is being written, at least four very different Senate versions of new agricultural legislation are being developed. Details are limited, although one version would place strong emphasis on a return to government grain storage programs, higher support prices, and possible land-idling programs. Support prices would be increased annually to reflect inflation in crop production costs. This bill’s features would be similar to those of U.S. agricultural policies from the 1980s. The bill also would eliminate subsidized crop yield and revenue insurance, and would replace them with government disaster programs. This version will find strong opposition from several major farm organizations and agribusiness organizations that desire market orientation along with low farm commodity prices to enhance exports and discourage foreign production. The bill runs counter to the philosophy reflected in WTO.

Another nearly completed Senate farm bill would provide modest increases from current government income support payments. It also would provide substantial payments to farmers who follow good soil, water, and wildlife conservation practices, and would slightly increase the amount of cropland idled under long-term conservation reserve and wetland reserve programs. This farm bill would limit direct government payments per farmer to $100,000, down from the current maximum of $230,000. It would provide a counter-cyclical payment mechanism with payments made to farmers if the U.S. average income per acre falls below specified levels. Income would be determined by the current year’s U.S. production times the expected marketing year average price. Income levels guaranteed with this mechanism would be $120 per acre for wheat, $270 for corn, $215 for soybeans, and $475 for rice. These income levels would be substantially lower than the House version of counter-cyclical payments. Maximum quantities of crops that farmers could place in the marketing loan and price support loan programs would be limited to the production from about 1,475 hectares, although the actual amount of cropland might vary some from region to region.

A third version in early development stages at this writing would continue the PFC payments at current rates, and would raise U.S. average Marketing Loan Rates for major crops by five percent, except for soybeans. The soybean Marketing Loan Rate would be lowered to $5.15 per bushel, down from the current $5.25 per bushel. These adjustments would be made to reduce the tendency for government programs to increase U.S. soybean plantings at the expense of other crops. This version also would use weather conditions and the exchange rates of foreign currencies to the U.S. dollar to determine the size of government crop subsidies. WTO acceptance of weather and exchange rates as determinants of government subsidies is uncertain.

A fourth Senate version would eliminate the PFC and MLA payments beginning with the 2003 crop and would eliminate the LDPs in three years. In their place, it would provide risk management vouchers representing 80% of the 5-year olympic average income for the farm. The vouchers could be used to reduce the cost of purchasing any of several private-sector risk-management alternatives including crop yield or revenue insurance, futures, options, or forward contracts. This version also would provide substantial payments to farmers for good soil and water conservation programs, with these payments replacing some of the PFC and MLA payments. The U.S. President and Secretary of Agriculture have indicated they favor a program similar to this version. They also wish to see targeting of more payments to smaller and medium-size farms, with less support for large farms, and increased emphasis on economic development for rural communities.

Conclusions about the Future U.S. Government Safety Net

The wide range of alternatives being considered in the U.S. Senate indicates considerable time may be needed to reach a consensus. That, in turn, makes future U.S. farm safety net details uncertain. The House version appears to be the most likely of the various alternatives to set the direction for future U.S. government farm programs. This version would retain the marketing loans and loan deficiency payments. It would lower the soybean loan rate modestly, to discourage further shifts of cropland from wheat, grain sorghum, barley, corn, and cotton to soybeans. To compensate for the lower soybean loan rate, farmers would receive a fixed soybean payment that does not vary with prices. Another feature of this bill would be "Counter Cyclical Payments" to farmers which would increase in years when prices are unusually low. When prices are high, the payments would decrease. The counter-cyclical payments would be made on historical production of the farm, and in theory would not be trade-distorting. This farm bill, which has been approved by the House of Representatives, would significantly raise the income safety net for major crop farmers, but would be expected to have only minor effects on world prices. With U.S. efforts to deal with terrorism, the President has encouraged Congress to delay new agricultural legislation until 2002. However, Congress may be reluctant to do so for fear that available funding for agriculture will decline next year.

***Pre-harvest futures and options pricing studies:

• Wisner, R.N., "Harvest-Price Revenue Insurance and Pre-harvest Pricing: Companion Tools for Managing Grain Price and Yield Risk",Crop Insurance Today,Vol. 34, No.3, Aug.2001, pp. 5-7.
• Wisner, R.N., E.N. Blue, and E.D. Baldwin, "Pre-harvest Marketing Strategies Increase Net Returns for Corn and Soybean Growers," Review of Agricultural Economics, Vol. 20, No. 2, Fall/Winter 1998, pp. 288-307.