The Farm Credit Crisis; E.C. Pasour, Jr.

The regional variation in problems of farm borrowers is important to farm lending agencies, also under financial stress. The gov ernment-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. Con gress 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 his torical 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 ex treme 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 Dr. Pasour is a professor of economics at North Carolina State University at Raleigh.

closure rate of agricultural banks has been sig nificantly 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 in fluence on farm credit because the taxpayer-fi nanced 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 re duced the principal or the interest rate charged by specified amounts.

Easy credit policies in agriculture lead to in formation problems, incentive problems, and a number of indirect and unintended effects.

109 Infornlation 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 in terest rates should be or how credit should be allocated. Subsidized credit, in effect, is an in come 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 tax payers-any more than it can be used to justify other income redistribution programs. The con clusion is that any governmentally imposed re duction 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 polit110 THE FREEMAN. MARCH 1988 ical process. The FmHA, for example, was de signed 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 How ever, 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 af fected when he is protected from the conse quences 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 overproduced when provided through the po litical· 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 de creases.

The theory of bureaucratic productivity ap pears 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 al most 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 con siderations. A tightening in FmHA rules, espe cially foreclosure, is politically sensitive. Both Secretary Bergland in the Carter Administra tion and Secretary Block in the Reagan Admin istration imposed a moratorium on farm fore closures. Yet, without a firm foreclosure policy, goverment 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 land holding or capital facilities in farming.

Indirect Effects Subsidized credit affects the profitability of production and influences which producers re main 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 de mand. 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 re wards the more productive is altered when sub sidized credit is extended to those who are failing and cannot obtain credit elsewhere. Subsidized credit hampers resource adjustments and perpetuates low income problems in agri culture. Oneeconomist 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 reduc tion 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 cap ital 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 govern ment credit programs have contributed to the trends toward larger and more highly mecha nized farms. It is also ironic that government has subsidized credit, thereby increasing output of farm products while, at the same time, at tempting 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 con sequences 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 bor rowed too much. And they would not have bor rowed so much if they had had to pay credit rates that were not subsidized, implicitly or ex plicitly, by the FCS and the FmHA. As long as farm land prices were rising rap idly, as during most of the period from WorId 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 evi dence suggests that easy credit programs, espe cially those of the FmHA have "prolonged the agony of many farmers who should have trans ferred to nonfarm occupations at the time the FmHA loans were made."l1 Thus, there can be little doubt that the easy government credit pol icies of the 1970s contributed to the financial distress and farm bankruptcies of the 1980s.12 Finally, the cost of subsidized credit in agri culture 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 infla tion. 13 To maintain political support for subsiTHE FARM CREDIT CRISIS 111 dized 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 pri vate 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. Federall y sponsored and financed agricul tural credit programs have been under a great deal of financial pressure because their loans are specifically for agriculture, which is experi encing the greatest amount of financial turmoil since the 1930s. As suggested above, many commercial banks with high percentages of ag ricultural loans in their portfolios have also been in trouble during the 1980s. There is no way to diversify risks under current institu tional arrangements when credit institutions deal heavily with one sector of the economy, whether the credit institutions be public or pri vate. This is explained in the following section.

A problem is likely to arise when a credit institution in a predominantly agriculturalloca tion 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 com mercial banks located in predominantly agricul tural 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 un limited branching within their borders. 14 A recent study of agricultural bank lending practices by the Federal Reserve Bank of 112 THE FREEMAN. MARCH 1988 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 mix ture 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 di verse that less than 5 per cent of all bank loans are to farmers and ranchers. Consequently, ag ricultural 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 ex ample, a restricted branching state, loan port folios are heavilx 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 Ne braska~ 19 have since closed. 18 In situations in which agriculture is the dominant activity and there is little opportunity for diversifica tion, 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 concentra tion in agricultural production, or more gener ally 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 re stricted 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 in terstate 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 agri cultural credit, illustrate the point made by Ludwig von Mises that government interven tion 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 di versify their portfolios-hence, the govern ment-created "need" for government-operated and government-sponsored credit institutions. Restrictions on competition in banking are similar in one respect to governmental restric tions on competition in agriculture. In each case, the restrictions represent successful at tempts 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 in creased competition.21 In neither farming nor banking, however, is there any persuasive evi dence 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 bor rowers. 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 agri culture 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 re ceiving the benefit. Economic logic supports the conclusion of Clifton Luttrell, former agri cultural economist with the Federal Reserve Bank of St. Louis: "Instead of alleviating the problem of poverty in agriculture, as often al leged, such credit perpetuates the problem. ''22 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 al locates credit on the basis of expected produc tivity 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 un sound, counter to economic logic, or not sup ported by the evidence. 23 Government intervention affecting the abili ties of agricultural credit institutions to diver sify 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 re strictions on nationwide banking reduce diver sification in bank loan portfolios, thereby in creasing risk and the likelihood of bank failure.

THE FARM CREDIT CRISIS 113 Branch banking regulations, by making lending in agriculture more risky, also increase pres sures for easy credit programs through govern ment 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 re spect government programs affecting agricul tural credit markets are no different from government programs generally. D 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 def initions 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," un published manuscript, 1987. 6. Emanuel Melichar, Agricultural Finance Data Book (Wash ington, 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. 121. 12. Michael T. Belongia, Agriculture: An Eighth District Per spective (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, Jf., "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, "In terstate 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.