How the Fed Fooled Farmers; J. Habegger

164 How the Fed Fooled Fartners by Jay Habegger T he crisis in agriculture has moved to the forefront of national attention. Scarcely a day passes without a story on the eve ning 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 televi sion, sympathetic viewers began sending con tributiQns 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 finan cial trouble? Individuals who confine discus sion to nonrecourse loans, marketing orders, or target pricing will uncover only part of the an swer. Evidence indicates that government in tervention in the money supply, popularly called monetary policy, is responsible for many of the financial woes of agriculture.

Farmers have long recognized the impor tance of monetary policy. Even in post-revolu tionary 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 Jay Habegger is a sophomore at the University of eolorado at Boulder. He was an internat FEE during the summerof 1986. 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 invest ment. Even a small farm needs a substantial in vestment in land and ~he 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 commer cial 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 as sumed 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 liveli hood is directly linked to the long-term perfor mance of the economy, the factors which affect the economy, such as monetary policy, are of 165 paramount importance. At the very least, the farmer would like to insure that long-term eco nomic 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, com monly 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 166 THE FREEMAN. MAY 1987 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 undesir able. 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 ap pointed 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 "agricul turist" to the Board of Govemors. 3 Each member of the board is subject to polit ical pressure from a variety of sources. In an election year, the administration may en courage the Fed to cause a mild inflation, thereby stimulating the economy and aiding in cumbents . 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 anyone of the factors which influ ence the Fed may cause a major shift in mone tary 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 con sequent 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,4 low interest rates, coupled with the seemingly favorable invest ment 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 in come also increased. Rising incomes and low real interest rates convinced farmers that they were in a better financial situation than they ac tually 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 appoint ment of Paul Volcker as Chairman of the Fed eral Reserve Board in 1979, and the mounting political pressure to slow inflation. Following Volcker's appointment, the Fed began an er ratic 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 in comes 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 in to a financial trap that was sprung by the Fed. Eventually, many of these farmers will re cover. 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 readjust ments. 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. Al though 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 govern ment 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 en hance predictability of the Fed's actions, it faces the same knowledge problem that cur rently plagues the Fed. There is simply no way to know how much monetary growth will in sure a given economic expansion at a given point in time. And, if the Constitutional amendment left loopholes for the monetary au thorities 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 histor ical precedent. During the first half of the nine teenth 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 im printed with a statement insuring its redeema bility, 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 in crease in note issue caused more notes to be presented for redemption. If the bank had failed to expand its specie reserves, its existing re serves 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 re serves would force the officers of the bank to halt the inflation.

HOW THE FED FOOLED FARMERS 167 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 indi viduals, 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 reces sions 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 speci fies the currency of payment must be repealed. The largest barrier, however, may be the U.S.

government itself. The government benefits substantially from the status quo. Inflation in creases 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. 0 1. Jackson Turner Main, The Anti-Federalists, Critics of the Con stitution 1781-1788 (New York: W. W. Norton & Company, 1961). 2. Milton Friedman and Anna Jacobson Schwartz, A Monetary His tory 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 Educa tion, 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, Experi ence, 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."