Farm credit problems are front page news. In early
1987, 104,000 commercial farm operators (17 per cent of the total) with
$28.4 billion of debt were considered to be "under financial stress" so
that lenders could lose $6.3 billion on these loans. 1
However, the amount of financial stress in agriculture varied
considerably from region to region, being greatest in the Northern
Plains, Lake States, and Corn Belt.
The regional variation in problems of farm borrowers is
important to farm lending agencies, also under financial stress. The
government-sponsored Farm Credit System (FCS) has lost some $4.8 billion
since 1985 through mortgage and loan defaults - more than any other
financial institution in U.S. history. Congress responded and in late
1987 a multi-billion dollar package of Federal assistance to help bail
out the FCS was passed.
The Farmers Home Administration (FmHA) is the primary
farm lending agency of the U.S. Department of Agriculture (USDA) with a
historical mission of providing credit to high-risk farmers. Thus, the
high degree of financial stress by FmHA borrowers in the mid-1980s
should not be surprising. A 1986 GAO study found that more than half the
FmHA borrowers were either technically insolvent or had extreme
financial problems.2
It is not only farmers and government credit agencies
that are encountering financial problems in farm credit markets. Many of
the commercial banks that have failed in the 1980s have been
"agricultural banks." 3 Indeed, the closure rate of
agricultural banks has been significantly higher than that for
nonagricultural banks.4
The purpose of this paper is to show how government
intervention has resulted in two kinds of problems related to
agricultural credit. First, it is shown how subsidized credit has
contributed to the current plight of farmers. Second, the relationship
of government banking regulations to farm bank lending problems is
stressed. The conclusions reached are that farm credit woes are inherent
in "easy credit" policies by governmental credit agencies and in the
current system of banking restrictions that reduce portfolio
diversification and increase risk.
Easy Credit in Agriculture
Federally subsidized farm credit programs have
increased from a marginal source of farm financing for a few hardship
cases to a major source of farm credit during the past fifty
years.5 Indeed, about half of the farm debt was held by the
FCS and the FmHA in 1987.6 This figure actually understates
the governmental influence on farm credit because the taxpayer-financed
FmHA supports agricultural loans by private lenders. For example, a 1984
debt deferral and adjustment program permitted the FmHA to guarantee
problem farm loans held by a commercial bank, provided the lender
reduced the principal or the interest rate charged by specified amounts.
Easy credit policies in agriculture lead to information
problems, incentive problems, and a number of indirect and unintended
effects.
Information Problems
In a market system, interest rates and the amount of
credit used are determined by market forces. In the absence of a market
test, there is no reliable method to determine how low interest rates
should be or how credit should be allocated. Subsidized credit, in
effect, is an income redistribution program. The problem of determining
a "fair" interest rate is the same as determining "just prices"
generally and is one with which philosophers have struggled for
centuries. Economic theory cannot be used to justify credit programs
that benefit some farmers at the expense of other farmers and taxpayers
- any more than it can be used to justify other income redistribution
programs. The conclusion is that any governmentally imposed reduction in
interest rates or increase of credit to agriculture is purely arbitrary.
Implementation Problems
Implementation problems arise in subsidized credit
programs as they do in all situations in which resources are allocated
through the political process. The FmHA, for example, was designed to be
"lender of last resort," lending to borrowers unable to obtain credit
from private credit agencies. In the case of FmHA's so-called limited
resource loans, credit is extended when farmers "need a lower interest
rate to have a reasonable chance of success." 7 However, when
credit is arbitrarily increased to high-risk farmers, too many resources
remain in agriculture.
There is also a moral hazard problem in all cases where
the FmHA acts as a "lender of last resort." That is, an individual's
behavior is affected when he is protected from the consequences of his
actions. If subsidized credit is available to a farmer who either cannot
obtain credit elsewhere or who needs a lower interest rate to succeed,
the farmer is less likely to change his behavior so as to qualify for
credit from commercial sources and more likely to continue to need lower
rates.
Public choice theory - the application of economic
principles to the political process - holds that goods and services are
likely to be over-produced when provided through the political process.
As the original purpose for a government program is achieved,
politicians and decision makers in a government agency have incentives
to broaden the scope of the agency's activities to prevent funding
decreases.
The theory of bureaucratic productivity appears to be
consistent with actions of the FmHA. The mandate of the FmHA has been
broadened considerably over time to include loans for rural housing,
community facilities, and business and industry programs, so today FmHA
credit is available in rural areas for almost any conceivable purpose
.8 By 1982, only about half of all FmHA loans and grants were
for farm programs. 9
The FmHA provides a good example of how subsidized
credit is influenced by political considerations. A tightening in FmHA
rules, especially foreclosure, is politically sensitive. Both Secretary
Bergland in the Carter Administration and Secretary Block in the Reagan
Administration imposed a moratorium on farm foreclosures. Yet, without a
firm foreclosure policy, government lending agencies are likely to get
dragged into economic ventures that are progressively more hopeless. In
contrast, when credit is available only from private lenders, who expect
to profit from lending, there is much less likelihood of over-expansion
of landholding or capital facilities in farming.
Indirect Effects
Subsidized credit affects the profitability of
production and influences which producers remain in production. When
allocated on the basis of its opportunity cost, credit generally is used
by those producers meeting the profit test - those who best accommodate
consumer demand. On the other hand, some less productive producers are
kept in production when credit is subsidized, resulting in higher prices
for land and other specialized resources, increased output, and lower
product prices. Thus, farmers not receiving subsidized credit are
harmed, since this results in higher costs and lower product prices.
The market process by which competition weeds out less
productive producers and rewards the more productive is altered when
subsidized credit is extended to those who are failing and cannot obtain
credit elsewhere. Subsidized credit hampers resource adjustments and
perpetuates low income problems in agriculture. One economist explains
this paradox in which government assistance to agriculture benefits the
less productive at the expense of the more productive, thereby reducing
overall productivity, as follows:
Financial assistance provided through the subsidies to
the least efficient farmers leads to lower farm commodity prices and
higher cost of farm resources, especially land, and reduced farm
incomes. This tends to place the next group of farmers on the efficiency
scale in the failure class. This process of replacing marginal farmers
with otherwise submarginal ones results in a gradual reduction in the
overall efficiency level of lower income farm groups.10
Easy credit also has affected production methods and
the structure of farming. It has led to the substitution of machinery
and other capital inputs for labor in agriculture, resulting in more
highly mechanized farms. Lower interest rates also have encouraged
farmers to buy more land. In view of widespread public concerns about
farm size and capital requirements in commercial agriculture, it is
ironic that government credit programs have contributed to the trends
toward larger and more highly mechanized farms. It is also ironic that
government has subsidized credit, thereby increasing output of farm
products while, at the same time, attempting to reduce farm output
through various other agricultural programs.
The effect of easy credit policies during the
agricultural boom of the late 1970s on farm woes of the 1980s warrants a
special note. Cheap credit creates an incentive to expand the size of
farm operations through borrowing. And "too much" credit is more likely
to be extended when lenders do not bear the full consequences of their
actions. In the late 1970s, a period of inflation and favorable product
prices, farmers borrowed heavily to invest in land, machinery, and other
capital facilities. In retrospect, many highly--leveraged farmers
borrowed too much. And they would not have borrowed so much if they had
had to pay credit rates that were not subsidized, implicitly or
explicitly, by the FCS and the FmHA.
As long as farm land prices were rising rapidly, as
during most of the period from World War II to 1981, farms generally
could be sold for enough to liquidate the debt when high-risk and other
farm borrowers went out of business. With the decline in farm real
estate values since 1981, however, losses by FmHA and FCS borrowers have
been at a high rate. Hence, the evidence suggests that easy credit
programs, especially those of the FmHA have "prolonged the agony of many
farmers who should have transferred to non-farm occupations at the time
the FmHA loans were made." 11 Thus, there can be little doubt
that the easy government credit policies of the 1970s contributed to the
financial distress and farm bankruptcies of the 1980s.12
Finally, the cost of subsidized credit in agriculture
ultimately is borne by the public. The federal government can finance
its programs by raising taxes, deficit spending, or through new money
creation. In reality, all these financing methods are likely to be used,
resulting in higher interest rates, higher taxes, and
inflation.13 To maintain political support for subsidized
credit, it is important that the costs be widely dispersed and not
easily determined, while the benefits be easily seen and heavily
concentrated - a phenomenon characteristic of many governmental programs
that redistribute income.
Government-Assisted versus Private Credit in Agriculture
The objective of Federal credit agencies is quite
different from that of profit-seeking private credit institutions. The
purpose of the former, as stressed above, is to offer terms and
conditions to selected borrowers that are more favorable than those
available from private lenders. When compared with fully private loans,
government--assisted credit may include lower interest rates or loan
guarantees, less stringent credit risk thresholds in making credit
available, or more generous repayment schedules.
Federally sponsored and financed agricultural credit
programs have been under a great deal of financial pressure because
their loans are specifically for agriculture, which is experiencing the
greatest amount of financial turmoil since the 1930s. As suggested
above, many commercial banks with high percentages of agricultural loans
in their portfolios have also been in trouble during the 1980s. There is
no way to diversify risks under current institutional arrangements when
credit institutions deal heavily with one sector of the economy, whether
the credit institutions be public or private. This is explained in the
following section.
A problem is likely to arise when a credit institution
in a predominantly agricultural location is not able to diversify its
risks outside its geographic area and outside of agriculture. This
inability to diversify risks is inherent in the FCS and FmHA. It is also
a problem for commercial banks located in predominantly agricultural
areas, such as those in parts of the Corn Belt, which cannot diversify
their risks because of government restrictions on branch banking.
Branching within states is governed by state laws, and only about half
the states allow unlimited branching within their borders.14
A recent study of agricultural bank lending practices
by the Federal Reserve Bank of Dallas found that branch-banking
regulations have increased the probability of bank closure. One of the
advantages of branching is increased diversification. Greater
diversification means less risk and, consequently, a lower probability
of banks' closing. In states with a broad mixture of industrial,
commercial, and agricultural businesses, but with geographical
concentration of agriculture, statewide branching can reduce
significantly the risk of bank loan portfolios. 15
The significance of portfolio diversification through
branch banking in states with a great deal of diversity is illustrated
by the banking situation in California (which allows statewide
branching). Although California is the most important agricultural
state, the state is so diverse that less than 5 per cent of all bank
loans are to farmers and ranchers. Consequently, agricultural lenders
there have fared much better than agricultural banks generally. Despite
the importance of agriculture, California accounted for only one of the
68 agricultural bank failures in 1985.16
Statewide branch banking would have much less effect on
portfolio diversification in states heavily concentrated in agriculture
(or in any other line of commerce). In Nebraska, for example, a
restricted branching state, loan portfolios are heavily loaded with
agricultural loans. In 1984, 38 per cent of the loans were to farmers
"and probably half again as much was to farm-related businesses."
17 At the end of 1984, there were 413 agricultural banks in
Nebraska - 19 have since closed. 18 In situations in which
agriculture is the dominant activity and there is little opportunity for
diversification, statewide branching would have relatively little effect
in reducing lending risk.
Interstate Banking
Restrictions on banking make farm lending more risky.
Partly as a result of geographical restrictions on banking, two-thirds
of all bank failures in 1986 occurred in the Kansas City and Dallas
Federal Reserve Districts, home to many poorly diversified farm and
energy banks. 19
In states in which there is a heavy concentration in
agricultural production, or more generally in a few lines of commerce,
geographical restrictions on banking significantly reduce portfolio
diversification. Consequently, banks operating across state lines are
able to diversify their risks much more effectively than banks
restricted to a given geographic area. Although bank holding companies
have engaged in a modest amount of interstate banking in recent years,
Federal laws such as the McFadden Act and the Bank Holding Company Act
limit full realization of the benefits of interstate
banking.20
A bank that makes loans in different regions does not
have its fate tied to the economy of one region. Specifically, under a
system of interstate banks, a bank in a farming region would not have
all its loans dependent upon the farm economy. Thus, it is not
surprising that Federal and state restrictions on branching appear to
have played an important role in recent woes of agricultural banks.
Restrictions on banking, as they affect agricultural
credit, illustrate the point made by Ludwig von Mises that government
intervention creates pressures for further intervention. Government
restrictions on bank branching within and between states make it much
more difficult for banks in agricultural regions to diversify their
portfolios - hence, the government--created "need" for
government-operated and government-sponsored credit institutions.
Restrictions on competition in banking are similar in
one respect to governmental restrictions on competition in agriculture.
In each case, the restrictions represent successful attempts by
politically powerful groups to achieve wealth transfers through the
political process. Many banks oppose nationwide banking, just as many
farmers oppose free markets, because it would subject them to increased
competition.21 In neither farming nor banking, however, is
there any persuasive evidence that current restrictions are beneficial
to the public at large.
Conclusion and Implications
Government intervention in credit markets has been
harmful in a number of ways. Easy credit has increased the amount of
credit used in agriculture - especially by high-risk borrowers. Hence,
it contributed to the increased prices of farm real estate and the
increased numbers of highly leveraged farmers of the 1970s-and,
consequently, to the financial and farm bankruptcies of the 1980s.
Subsidized credit has enabled many farmers who
otherwise would have shifted out of agriculture to continue farming. And
the resulting higher cost of land and other farm resources, increase in
output, and decrease in commodity prices have reduced incomes of farmers
not receiving the benefit. Economic logic supports the conclusion of
Clifton Luttrell, former agricultural economist with the Federal Reserve
Bank of St. Louis: "Instead of alleviating the problem of poverty in
agriculture, as often alleged, such credit perpetuates the problem"
22 From a non-farmer and taxpayer point of view, the increased
flow of credit to agriculture means some combination of higher interest
rates, higher taxes, and inflation.
Subsidized credit as a public policy poses the same
problems as other kinds of intervention affecting market prices. The
market process allocates credit on the basis of expected productivity
and profits. In the absence of the profit and loss benchmark, there is
no objective basis for determining how much credit should be used in
agriculture. Thus, it is impossible to determine how effectively credit
is being used in government credit programs. Moreover, the moral hazard
problem is endemic in easy credit programs where borrowers must
demonstrate that they lack other sources of credit.
A number of arguments have been used to justify cheap
credit in agriculture. A recent analysis of the most widely used
arguments concluded that the arguments were either unsound, counter to
economic logic, or not supported by the evidence.23
Government intervention affecting the abilities of
agricultural credit institutions to diversify portfolios also is
harmful. Problems arise when lending institutions deal only with one
sector of the economy - whether the credit agencies are public or
private. Government restrictions on nationwide banking reduce
diversification in bank loan portfolios, thereby increasing risk and the
likelihood of bank failure.
Branch banking regulations, by making lending in
agriculture more risky, also increase pressures for easy credit programs
through government credit institutions.
The analysis suggests three main points. First, cheap
credit has hampered resource ad-justments and contributed to current
financial stress in U.S. agriculture. Second, government restrictions
that prevent nationwide banking have increased risks of banks
specializing in farm loans. Third, government intervention af-fecting
farm credit and banking has had unfore-seen and unintended consequences.
In this respect government programs affecting agricul-tural credit
markets are no different from government programs generally.
At the time of the original publication, Dr. Pasour
was a professor of economics at North Carolina State University at
Raleigh.
1. Steven R. Guebert, Agricultural Situation Report
(McLean, Virginia: Farm Credit Administration, September 18, 1987).
2. General Accounting Office, Farmers Home
Administration: Financial and General Characteristics of Farmer Loan
Program Borrowers (Washington, D.C.: U.S. Government Printing Office,
1986), p. 2.
3. Agricultural banks are defined in different ways,
but most definitions are based on the percentage of agricultural loans
in a bank portfolio. Hilary H. Smith, "Agricultural Lending: Bank
Closures and Branch Banking," Economic Review (Dallas, Texas: Federal
Reserve Bank of Dallas, September 1987), p. 27.
4. Ibid p. 27.
5. Clifton B. Luttrell, "High Costs of Farm Welfare via
Federal Programs: An Analysis of Their Origin, Growth and Effects,"
unpublished manuscript, 1987.
6. Emanuel Melichar, Agricultural Finance Data Book
(Washington, D.C.: Board of Governors of the Federal Reserve System,
June 1987), p. 19.
7. U.S. Department of Agriculture, A Brief History of
Farmers Home Administration (Washington, D.C.: U.S. Government Printing
Office, 1983), p. 15.
8. Clifton B. Luttrell, op cit., p. 114.
9. U.S. Department of Agriculture, op cit., p. 19.
10. Clifton B. Luttrell, op cit., p. 133.
11. Ibid., p. 12 1.
12. Michael T. Belongia, Agriculture: An Eighth
District Perspective (St. Louis, Mo.: The Federal Reserve Bank of St.
Louis, Spring 1984).
13. Clifton B. Luttrell, op cit., pp. 124-126.
14. Hilary H. Smith op cit., p. 32.
15. Ibid.
16. Lindley H. Clark, Jr., "Interstate Banks Could Ease
Farm Credit Woes," The Wall Street Journal, January 20, 1987, p. 35.
17. Hilary H. Smith, op cit., p. 32.
18. Ibid.
19. Michael Becker, Steve Horwitz, and Robert O'Quinn,
"Interstate Banking: Toward a Competitive Financial System," Issue Alert
No, 18 (Washington, D.C.: Citizens for a Sound Economy Foundation,
1987), p. 9.
20. Ibid., p. 13.
21. Ibid.
22. Clifton B. Luttrell, op cit., p. 133.
23. Dale W. Adams, "Are Arguments for Cheap
Agricultural Credit Sound?" Ch. 6 in Undermining Rural Development with
Cheap Credit, Dale W. Adams, Douglas H. Graham, and J. D. Von Pische
(eds.) (Boulder, Col.: Westview Press 1984), p. 75
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
March 1988, Vol. 38, No. 3.
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