The Farm Credit Crisis
MARCH 01, 1988 by E.C. PASOUR
Dr. Pasour is a professor of economics at North Carolina State University at Raleigh.
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. 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.
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.” Indeed, the closure rate of agricultural banks has been significantly higher than that for nonagricultural banks.
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, Indeed, about half of the farm debt was held by the FCS and the FmHA in 1987. 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 de-ferral 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.
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 tojustify 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 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.” 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. By 1982, only about half of all FmHA loans and grants were for farm programs.
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 overexpansion of landholding or capital facilities in farming.
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 re placing marginal farmers with otherwise submarginal ones results in a gradual reduction in the overall efficiency level of lower income farm groups.
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 bor rowers 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 nonfarm occupations at the time the FmHA loans were made.” 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.
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. 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.
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.
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.
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.” At the end of 1984, there were 413 agricultural banks in Nebraska-19 have since closed. 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.
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.
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.
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 ap pear 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. 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.” From a nonfarmer 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.
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 adjustments 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 affecting farm credit and banking has had unforeseen and unintended consequences. In this respect government programs affecting agricultural credit markets are no different from government programs generally. 
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.
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.
23. Dale W. Adams, “Axe 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.