The crisis in agriculture has moved to the forefront of
national attention. Scarcely a day passes without a story on the evening
news about farm foreclosures or farmers pleading for financial relief.
Occasionally the tale is even more dramatic and invokes a public
response. One Colorado farmer, for instance, recently crashed his
tractor through the front window of the bank which holds the mortgage on
his farm. When the story appeared on television, sympathetic viewers
began sending contributions to a fund established to provide for his
legal defense. Clearly not all is well down on the farm.
Why are so many American farmers in financial trouble?
Individuals who confine discussion to nonrecourse loans, marketing
orders, or target pricing will uncover only part of the answer. Evidence
indicates that government intervention in the money supply, popularly
called monetary policy, is responsible for many of the financial woes of
agriculture.
Farmers have long recognized the importance of monetary
policy. Even in post-revolutionary America a large number of the debates
in state legislatures concerned the proper role of government in
monetary affairs. 1 Farming interests consistently supported
"easy money - inflation. Later, agrarian support for inflation
manifested itself in several political movements. For instance, the
Greenback party was largely supported by agrarian interests to promote
the issue of paper currency. 2 The Greenbackers claimed that
"easy money" would cure the farmer's problems. Although their assertions
have proved false, agriculture's advocacy for inflation can be explained
when one understands the business of farming.
Agriculture requires a large capital investment. Even a
small farm needs a substantial investment in land and the machinery.
Quality farm land can cost several thousand dollars an acre, and an
average farm may run several hundred acres. A tractor alone can cost a
farmer upwards of a hundred thousand dollars, and this doesn't include
the implements for it to pull.
Individual farmers, however, rarely have the savings to
finance even a small operation. Farmers typically obtain credit from
commercial banks, savings and loans, and the U.S. government. Without
credit, farmers are unable to purchase new land and machinery. In short,
credit is an integral factor in agriculture.
As with any other factor of production, the terms and
conditions under which credit is assumed and maintained play a major
role in business decisions. The farmer is concerned not only with the
terms of a loan, but the terms viewed against the current state of the
economy and projected economic conditions. How the economy is expected
to perform over the life of the loan may be even more important than the
actual terms.
Agriculture's interest in monetary policy can now be
explained. Since the farmer's livelihood is directly linked to the
long-term performance of the economy, the factors which affect the
economy, such as monetary policy, are of paramount importance. At the
very least, the farmer would like to insure that long-term economic
performance does not harm his position. Even more desirable is a
situation in which monetary policy favors agricultural interests.
The Power of the Fed
Agriculture is not the only special interest group with
a stake in monetary policy. Heavy industry, labor, and a bevy of other
groups all would like a voice in monetary policy. The question then
arises about how monetary policy is formed. Who wields this enormous
power over the American economy? In the United States, responsibility
for monetary policy falls chiefly on the Federal Reserve Board, commonly
called the Fed. Through regulation of the quantity of money in
circulation, the Fed hopes to achieve an optimal level of monetary
growth and credit expansion.
There is little doubt about the Fed's ability to change
the rate of monetary growth. Through various instruments, the Fed
influences interest rates and other credit market conditions. What is
open to question, however, is the Fed's ability to prescribe an optimal
rate of monetary expansion-if such an optimal rate even exists.
Can the Fed know what the proper rate of expansion
should be? The simple answer is no. The Fed would need total knowledge
of all the factors that might affect the economy, which clearly no group
of individuals can possess. Consequently, opinions on the optimal growth
rate vary widely, depending on whose interest is at stake. What one
group considers optimal growth another group may find detrimental. For
example, farming interests generally favor rapid growth of the money
supply. Labor, on the other hand, tends to find inflation undesirable.
Thus, various special interest groups try to influence monetary policy
to their benefit.
In practice monetary policy is determined by the Board
of Governors of the Federal Reserve Board. Each of the seven governors
is appointed by the President to a nonrenewable 14 year term. Often
special interest groups try to influence monetary policy by exercising
their leverage over appointments. Agriculture, for example, has used
this tactic in the past. In 1922 agricultural interests persuaded
President Warren G. Harding to appoint an "agriculturist" to the Board
of Govemors. 3
Each member of the board is subject to political
pressure from a variety of sources. In an election year, the
administration may encourage the Fed to cause a mild inflation, thereby
stimulating the economy and aiding incumbents. Congress and the
administration may also influence the Fed to monetize the Federal debt,
thus causing inflation in order to finance large government
expenditures. If the inflation becomes a political burden, however,
Congress or the President may call upon the Federal Reserve Board to
slow monetary growth.
The effect of all these political influences is an
unpredictable, myopic monetary policy. A change in any one of the
factors which influence the Fed may cause a major shift in monetary
policy. Each policy shift causes significant fluctuations in the
economy. Thus, every time the Fed alters its policy, individuals in the
economy must also alter their economic activity and long-range
forecasts. They must adjust to each policy shift. It is the policy
shifts and consequent readjustments that have caused many of the severe
problems in American agriculture.
Throughout the late 1970s, the Fed pursued a policy of
rapid money and credit expansion. The resulting inflation, which lasted
several years, caused farmers to believe that inflation would continue.
They made their investment decisions accordingly. Federal price
supports, Federally subsidized credit, 4low interest rates,
coupled with the seemingly favorable investment climate caused by the
inflation, prompted many farmers to bury themselves in a mountain of
debt.
The inflation caused economic distortions. Since most
nominal prices rose, nominal income also increased. Rising incomes and
low real interest rates convinced farmers that they were in a better
financial situation than they actually were. If, as many farmers
expected, the inflation continued and their nominal incomes rose, their
debt payments would become less of a burden. Thus, the expectation of a
continuing inflation induced farmers into investments which they never
would have undertaken in a period of stable money.
But no one can predict the political future. The
farmers couldn't anticipate the appointment of Paul Volcker as Chairman
of the Federal Reserve Board in 1979, and the mounting political
pressure to slow inflation. Following Volcker's appointment, the Fed
began an erratic shift in policy that was designed to reduce inflation .
5 While actual monetary growth varied from month to month,
the overall result of the Fed's policy was to slow the growth in the
money supply. As a consequence, inflation subsided. The economy began a
painful period of adjustment which led to a recession.
Trapped
Farmers became victims of the recession. With monetary
expansion slowing, money incomes stopped rising. Without rising incomes,
many farmers faced severe cash flow problems. Their incomes became
insufficient to service the massive debts they had accumulated during
the inflation. The result, which we see reported on the evening news, is
the foreclosures and bankruptcies of many small farmers. It should be
emphasized that the readjustment problems are not restricted to
agriculture, but affect every sector of the economy to some degree. The
U.S. government essentially lured these farmers into a financial trap
that was sprung by the Fed.
Eventually, many of these farmers will recover.
Nothing, however, prevents the same cycle from repeating itself. As long
as the Fed is allowed to cause long periods of inflation followed by
radical and sudden policy shifts, farmers will be subjected to painful
readjustments. Thus, any long-term solution to the agricultural problem
must put a stop to the Fed's erratic monetary policy.
Several solutions have been proposed. Although they
have one, element in common eliminating the arbitrary factors and
political influences in the Fed's decisions-they differ radically in
approach.
One solution, advocated by Milton Friedman and the
monetarists, proposes greater government control of the money supply in
the form of a Constitutional amendment which would require the Fed to
limit monetary growth to a certain level. 6 While this
solution might enhance predictability of the Fed's actions, it faces the
same knowledge problem that currently plagues the Fed. There is simply
no way to know how much monetary growth will insure a given economic
expansion at a given point in time. And, if the Constitutional amendment
left loopholes for the monetary authorities to try to determine what the
monetary growth should be, monetary policy probably would become just as
chaotic as it is today.
Another proposed solution to the problems of erratic
monetary policy is the institution of a completely free banking system.
This would remove the money supply from government control. Such a
system has an excellent historical precedent. During the first half of
the nineteenth century, a successful free banking system existed in
Scotland. 7 Competing private banks issued banknotes which
were redeemable in specie and individuals had the right to use the
currency of their choice.
The system possessed several natural checks on
inflation. Since each banknote was imprinted with a statement insuring
its redeemability, banks were required to keep substantial specie
reserves. When a bank wanted to expand its note issue, it needed first
to acquire more specie. If a bank inflated its currency without
enlarging its reserves, the market ensured that it would suffer severe
consequences. An increase in note issue caused more notes to be
presented for redemption. If the bank had failed to expand its specie
reserves, its existing reserves would be quickly depleted. If the bank
continued the inflation for any length of time, bankruptcy would result.
However, long before the bank went bankrupt, the depletion of reserves
would force the officers of the bank to halt the inflation.
Perhaps an even more important virtue of free banking
is that it depoliticizes the money supply. Political influences would be
replaced with market forces. The supply of money would be regulated by
the same market forces which currently regulate the supply of shoes and
other commodities. Monetary stability would be achieved through freely
acting individuals, as opposed to the Fed's attempt at monetary
stability through central control. Thus, it would appear that free
banking offers the best hope of an economy free from recessions and
economic shocks.
The establishment of a free banking system faces many
legislative barriers.8 It requires the elimination of the Fed
and the abolition of legal tender laws which require individuals to use
a specific currency. Indeed, any law which specifies the currency of
payment must be repeal ed. The largest barrier, however, may be the U.S.
government itself. The government benefits substantially from the status
quo. Inflation increases its revenues and lowers the real value of its
debt.
Uncertainty introduced by the Fed's almost random
policy causes severe financial distress in the farm community, and
indeed the entire economy. According to Milton Friedman, the last few
years have been "a striking example of the harm that monetary
instability can pro duce. " It is clear that a comprehensive solution to
the problems of agriculture must include a curtailment of the Fed's
ability to produce eco-nomic chaos.
At the time of the original publication, Jay Habegger
was a sophomore at the University of Colorado at Boulder. He was an
intern at FEE during the summer of 1986.
1. Jackson Turner Main, The Anti-Federalists, Critics
of the Constitution 1781-1788 (New York: W, W. Norton & Company,
1961).
2. Milton Friedman and Anna Jacobson Schwartz, A
Monetary History of the United States 1867-1960 (Princeton, N.J.:
Princeton University Press, 1963), p. 44.
3. Benjamin Haggott Beckhart, Federal Reserve System
(American Institute of Banking, The American Bankers Association, 1972),
p. 33. 4. E. C. Pasour, Jr., U.S. Agricultural Policies: A Market
Process Approach (Irvington, N.Y.: The Foundation for Economic
Education, 1986), chapter 16.
5. Michael G. Hadjimichalakis, The Federal Reserve,
Money, And Interest Rates: The Volcker Years and Beyond (New York:
Praeger Publishers, 1984). p. 38.
6. Lawrence H. White, "Inflation and the Federal
Reserve: The Consequences of Political Money Supply" (Cato Institute
Policy Analysis, The Cato Institute, Washington, D.C., 1982).
7. For more information on the history and theory of
free banking see: Lawrence H. White, Free Banking in Britain: Theory,
Experience, and Debate 1800-1845 (New York: Cambridge University Press,
1984) and Donald R. Wells and L. S. Scruggs, "Toward Free Banking," The
Freeman, July 1986.
8. White, "Inflation and the Federal Reserve."
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
May 1987, Vol. 37, No. 5.
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