An update on the farm economy.

The latter part of the 1980s was a time of strong recovery in the farm economy. Farm exports rebounded from their lows of the mid-1980s, farm prices rose more than prices in general, farm income strengthened, and the farm balance sheet stabilized. In 1990, however, prices fell sharply in some parts of the farm economy, and in 1991, price weakness has become more widespread. Agricultural exports have been sluggish this year, farm income has fallen, and the value of farm land appears to be edging down in real terms.

A softening of the farm economy may rekindle memories of the early and middle 1980s, when the sector suffered a major decline and a wave of farm failures. But as we will discuss below, the current situation in farming differs in several ways from the considitions that existed then. Inventory overhangs, which were sizable in the first half of the 1980s, are virtually absent now; stocks of some key crops are in fact rather tight at the moment. Moreover, farmers have not been in a mood to boost output aggressively. Partly in response to government incentives, many acres are being held out of production, and farm capital investment has been restrained. On the financial side, farmers have been cautious in bidding up land values, and they have cut back heavily on the use of debt since the early 1980s. Overall, imbalances in the sector are far less pronounced than those of the early 1980s, and financial vulnerability has been reduced.

THE RECENT BEHAVIOR OF FARM PRICES

Three fairly distinct periods can be identified in the farm price data of the past decade (table 1). In the first, about 1981 to 1986, the farm economy was under severe pressure as the prices received by farmers for farm products fell 11 1/2 percent overall. Price declines extended to almost all livestock products and crops; they were especially large for grains and oilseeds. Although farmers offset part of that pressure by cutting costs and improving productivity, their nominal income was well short of the levels of the late 1970s. With prices in general having risen considerably over the period, farmers suffered a sizable loss of real purchasing power. (1)

In the second period, 1986 to 1990, the index of prices received by farmers rose 22 percent. Increases extended to virtually all commodity groups. The climb in the prices of meat animals was especially large, amount to more than 30 percent over the four-year period, with relatively steady gains throughout. The annual price changes for crops were much more volatile. In 1988, when severe drought cut deeply into production, the prices of feed grains, oilseeds, and food grains all surged. Later on, as concerns about a persistence of drought diminished and exports flagged, the prices of these crops fell, retracing part of the 1988 gains. The overall rise in prices received by farmers from 1986 to 1990 was more than double the increase in prices of production inputs purchased by farmers from the nonfarm sector; it also exceeded, by about 6 percentage points, the cumulative rise in the implicit price deflator for GNP over the period.

This year, overall farm prices likely will be down for the first time since 1986. Through the first ten months of 1991, the prices received by

[TABULAR DATA OMITTED]

farmers were, on average, about 1 3/4 percent below the level of a year earlier. Over this ten-month period, the average prices of livestock products and of feed grans and food grains were all below the levels of a year earlier. A big rise this year in the prices received by growers of fruit largely reflects a surge in the prices of oranges and other citrus products since last winter's freeze in California. Prices of the inputs purchased by farmers from the nonfarm sector have continued to rise this year, once again adding to the pressures on farmers' terms of trade.

Very recently, some farm prices have firmed. Wheat prices have moved up considerably since late summer amid signs that the export market might be improving. In addition, cattle prices have reversed a portion of their sharp decline of mid-summer. Dairy prices also have increased of late, aided by a small decline in the output of milk. Overall, however, farm prices in October were about 3 1/2 percent below the level of a year earlier.

THE DETERMINANTS OF FARM PRICES

The firmness of farm prices through the latter part of the 1980s appears to have been largely the result of a rebound in farm exports, continued growth of domestic demand, widespread production restraint in the farm sector, and the effects of the 1988 drought. Similarly, the weakness of prices this year seems to have been caused by weak exports, soft domestic demand, and a pickup in the rate of expansion of livestock production. Excess supplies of farm crops do not appear to have played a major role in the recent price declines: Although crop production rebounded after 1988, it no longer is on the strong upward trajectory that was apparent before the 1980s, and inventories of crops are relatively lean by the standards of the past decade.

Farm Exports

Just as the boom-bust cycle that took hold in farming two decades ago was heavily influenced by trends in the farm export markets, the more recent swing in farm prices also has ties to the changing patterns of farm exports. From 1986 to 1989, real farm exports rose sharply, retracing the previous decline (chart 1). The rise in grain exports was especially large over this period: he volume of corn exports surged, and wheat export were strong for a couple of years.

Economic growth in foreign economies was relatively brisk over the 1986-89 period. In addition, changes in U.S. farm policy in the mid-1980s permitted prices to move lower for a number of crops and enhanced their competitiveness in world markets. Competitiveness also was boosted by the effects of a sustained depreciation of the exchange value of the dollar, which extended from early 1985 to the end of 1987. Export subsides for some commodities, notably wheat, also helped to lift export volume over this period.

After the start of 1990, farm exports flattned out in real terms. Harvests in foreign countries have been relatively good in recent years, and exporters have continued to compete aggressively. In addition, the impetus to U.S. exports from the big decline in exchange rates has long since faded. After its plunge ended in late 1987, the exchange value of the dollar took on more of a sideways trend, changing relatively little on net from 1987 on. A slowing of economic growth abroad has been still another depressant of export growth. Under these influences, the uptrend in total U.S. farm exports petered out after 1989, and the exports of some farm products fell considerably. In the grain markets, the volume of wheat exports dropped most of the way back to its low levels of the mid-1980s, and corn exports also declined sharply.

The very recent news on farm export developments has been a little more favorable, however. In the third quarter of 1991, real exports of agricultural products rebounded to a level slightly above that of a year earlier. In addition, the market for wheat has been buoyed since mid-August by the prospect of increased food aid or subsidized sales to the Soviet Union. Thus, events currently do not seem to be moving in the direction of a severe, protracted decline in farm export such as that seen in the first half of the 1980s, and a moderate advance in exports from the pace of recent quarters is not inconceivable.

Domestic Demand for Farm Products

Farm prices also appear to have been influenced by the domestic business cycle in recent years. More than three-fourths of the nation's output of farm products is used in the domestic economy, most of it as food but some also as leather goods, tobacco products, textiles, house furnishings, and apparel. The quantity of food purchased by households is not as sensitive to the business cycle as are purchases of household durables such as automobiles. Still, the potential for adjustment of food outlays may be greater than is commonly thought. When consumers see their real incomes growing less rapidly or even declining, they may eat away from home less often, shift to a cheaper mix of foods for home consumption, stretch out leftovers further than they normally would, or adjust their food budgets in still other ways. Whatever the actual adjustments, the growth of food purchases does tend to vary positively with the growth of real disposable income, often accelerating during expansion phases of the business cycle and, more often than not, slowing or perhaps even turning negative in periods of slow growth or recession.

That cyclical relationship seems to have held in at least a rough way over the past decade (chart 2). Real purchases of food and beverages were weak from 1980 to 1982, when the U.S. economy was going through two recessions in quick succession. Growth of food purhcases then picked up as the economy moved into expansion and as the growth of real disposable income strengthened; the average rate of growth in these purchases over the four-year period starting in 1983 was more than 3 percent per year. Growth of real food purchases slowed in 1987 and 1988 but still averaged close to 1 3/4 percent per year. In 1989, however, real consumer expenditures for food flattened out; growth of real income had slowed by that time, and food price increases had accelerated to a rate faster than inflation in general. In 1990, income growth was very sluggish--less than 1 percent in terms of annual averages--and food prices again rose faster than prices in general; accordingly, real purchases of food fell a bit. This year, the rate of increase in food prices has slowed; but income through the first three quarters of the year was below the average for 1990, and the real purchases of food have remained sluggish, according to the preliminary data currently available.

The Supply of Livestock Products

The aggregate output of livestock products rose about 6.5 percent from 1986 to 1990, but the increases were uneven from year to year, and the overall gains masked some big differences across the various products (table 2 and chart 3). During 1991, production gains have become more widespread,

2. Changes in output of livestock products, 1987-91 (1) Percent

                   Item                1987 1988 1989 1990 1991
Index of livestock production           2.72.7    0    .9  1.7
Selected products
  Beef                                 -3.3   .1 -1.9 -1.5  1.0
  Pork                                  2.2  9.2   .9 -2.9  4.0
  Poultry                              10.2  4.1  7.0  7.2  5.5
  Milk                                  -.3  1.7  -.6  2.8   .2
MEMO
Animals on farms, beginning inventory
Cattle, January 1                      -3.1 -2.4 -1.6   .1  1.3
Hogs and pigs, 10 states, March 1        .7  7.7   .4 -3.5  4.5

(1) For index and products, changes from averages of previous year to those for year indicated; values for 1991 are based on projections fo the Department of Agriculture. For inventories, changes to date indicated from same date of previous year.

SOURCE. Based on data from Department of Agriculture. and with demand weak, prices of livestock products have fallen.

The output of poultry has risen sharply again this year, to a level about two-thirds above that of ten years ago. This strong secular advance has been spurred by changes in dietary habits that have favored chicken and turkey.

In contrast, the output of beef fell fairly steadily over most of the period from 1986 to 1990. Cattle producers, who had suffered large financial losses in the mid-1970s, have been reluctant ever since to undertake major expansion. They did boost herds moderately in the first part of the 1980s, but that increase was more than reversed in the latter part of the decade; at the start of 1989, the total number of cattle and calves on farms and ranches was at its lowest level in three decades. A little rebuilding of the herd has come about in the early 1990s in response to the high cattle prices of recent years, and output of beef appears to be headed for a small advance this year.

Output of the other major livestock products has exhibited a more variable pattern from year to year. From 1986 to 1990, pork production traced out another of the three- or four-year cycles that has long been its hallmark: Output expanded rapidly in 1987 and 1988, but then leveled off in 1989 and turned down in 1990, contributing, along with lowered beef output, to the tightness in meat supplies in that year. This year, pork production has rebounded. Output for 1991 as a whole likely will be at the high end of the range of the past decade but will fall short of the peak, which came in 1980.

Dairy production also has exhibited an uneven pattern of expansion in recent years. Like crop producers, dairy farmers entered the second half of the 1980s burdened by surpluses, and a period of production restraint was needed to work off the excess stocks; a government buyout of a portion of the dairy herd helped to facilitate the needed adjustment. By the fourth quarter of 1986, the output of milk was nearly 5 percent below the level of a year earlier. Before long, however, output started to turn up again, as rapid productivity gains quickly made up for reductions in the size of the herd. Then, repercussions of the 1988 drought cut into milk production, but by 1990, still another upswing in output was in train. Stocks began to accumulate once more, and prices, which had shot up temporarily, came crashing back to government support levels. This year, producers have moved to curb production gains, and in recent months, prices have increased a little from their lows.

Even with a firming of the demand for livestock products, the outlook for livestock producers over the near term may be less favorable than the situation of the past few years. The cattle business now seems to be edging back into the expansion phase of its production cycle. At the same time, pork and poultry producers also are boosting output. Given the inertia that biological constraints typically impart to livestock production, gains in output may extend well into 1992. However, producers are not likely to keep pushing their production ever higher in the face of declining prices and profits, and sooner or later, renewed production restraint is sure to emerge in one segment or another of the livestock industry, although neither its timing nor its magnitude can be predicted with much precision.

Crop Production and Inventories

The aggregate output of farm crops has been on a sideways trend since 1980 (chart 4). From 1980 to 1986, plantings were cut back drastically, and real investment in new equipment and structures was curtailed. During this period, however, productive potential in farming continued to exceed the level of demand, leading to sizable inventory accumulation, especially for some of the major field crops. The stockpile of corn at the end of the 1986 marketing year amounted to about an eight-month supply, roughly triple the average carryover during the two previous decades. The stockpile of wheat was the equivalent of a ten-month supply; and the carryover of cotton amounted to more than a full year's supply, given the depressed rates of usage seen at that time. In 1986 and 1987, many observers thought that these large stockpiles would continue to be a depressant of prices for some time to come, even as current production and consumption were being brought back into closer alignment.

The production restraint that emerged in the first half of the 1980s persisted over the balance of the decade and on into the 1990s. On average, almost 30 million fewer acres were planted in the second half of the 1980s than in the first half (table 3); incentives provided by the government's farm programs have helped keep acreage low. Farmers' purchases of tractors and other new machinery perked up a little as the farm recovery progressed, but not enough to offset depreciation, so that the real stock of farm capital remained on a downward course. Labor input also continued to fall after 1986, albeit not quite as rapidly as in the first half of the 1980s. Although productivity in farming continued to advance at a brisk pace, the reductions in farm inputs were large enough to bring to a halt the previous uptrend in the aggregate output of farm crops. The annual production of corn, which had exceeded 8 billion bushels four times from 1981 to 1986, has not reached that mark even once since 1986. Wheat production in the past six years has been, on average, about 18 percent below the harvests from 1981 to 1985. To be sure, the production of some other crops has been increasing in recent years (cotton output this year will apparently be the highest since 1937), but the gains for these other crops have not been large enough to keep aggregate crop output on its former uptrend.

The efforts of farmers and the government to restore a more favorable supply-demand balance for crops was aided greatly by the severe drought of 1988, which helped to eliminate the overhang of farm inventories more quickly. The carryover of corn after the drought amounted to 3.2 months of usage, less than half of what it had been two years before, and a much tigher supply-demand balance emerged for other crops as well. With production and usage remaining in reasonably close balance, the supply overhangs have not reappeared. Indeed, the nation's stockpile of grain appears likely to be lean at the end of the current marketing year. Thus, in sharp contrast to the situation that prevailed earlier in the 1980s, farm inventories are not themselves a major impediment to increases in the prices of farm crops.

FARM INCOME AND

THE FARM BALANCE SHEET

Farm income was strong from 1986 to 1990. But in another display of their caution of recent years, and in contrast to their behavior during the 1970s boom, farmers did not start bidding up the value of land and investing heavily in other farm

[TABULAR DATA OMITTED]

assets. Instead, they kept the value of farm assets fairly steady in real terms.

The relationship of farm income to farm asset values reflects, of course, the interplay between actual and expected farm earnings. In a given year, actual income may be high or low, depending on production, the state of domestic demand, the parameters of government farm programs, and economic conditions abroad. The value of farm assets, on the other hand, can be read as an indicator of farmers' expectations of income over the longer run. Farmers presumably are willing to invest in land and other assets only if they are convinced that future earnigns from those assets will be sufficient to justify the purchase price and will be greater than if the investments had been directed elsewhere. Lenders presumably are willing to extend credit only if the prospects for repayment from future earnings look favorable.

The 1970s surge in real farm income, while dramatic, had largely dissipated by 1976; yet the value of asts and debt continued to spiral upward for a number of years. Farmers and lenders, it seemed, were wagering on a prosperity of major proportions that seemed to recede before them even as the size of the wager kept growing. The divergence between current earnings and apparent expectations of future earnings became even more pronounced when energy prices and interest rates began to soar in the late 1970s. Eventually, however, the expectations embodied in the balance sheet had to come into better alignment with actual earningers reported each year on the income statement. That realignment was accomplished in the 1980s through a steep markdown in the value of farm assets and, in the latter part of the decade, a strengthening of farm earnings.

Farm Income and Expenses

The average level of net farm income, adjusted for inflation, was about $36 billion for the 1987-90 period (table 4); although this level of income was moderately below the average for the 1970s, the decade of the boom, it was roughly 50 percent higher than the 1981-86 average. Farm income data for 1991 still are subject to some uncertainty. As of mid-October, the Department

4. Real farm income and expenses, annual averages for selected periods, 1971-91 (1)

Billions of 1982 dollars

           Item         1971-80   1981-86   1987-90   1991
Net farm income             39        24        36      32
Gross farm income          171       155       146     139
Production expenses        132       131       110     108

(1) Inflation adjustment made by dividing nominal income and expenses of farmers by implicit price deflator for gross national product. Calculations for 1991 assume that nominal income and expenses will be at midpoints of ranges forecasted by Department of Agriculture as of October 1991 and that the annual rise in the implicit price deflator will be 3.9 percent, the same as its year-to-year change over first three quarters of 1991. Components may not sum to totals because of rounding.

SOURCE. Based on data from Department of Agriculture and Department of Commerce.

of Agriculture is forcasting that nominal net farm income will be in the range of $41 billion to $46 billion. If the midpoint of this range is realized, and an adjustment is made for inflation, the resuling level of real net income would be about 10 percent below the average for the 1987-90 period; it would remain far above the 1981-86 average, however.

To understand why real farm income was strong after 1986, one must look back once again to the period before 1986, when farmers were cutting production costs with a vengeance (table 5). total farm production expenses, in real terms, peaked around the start of the 1980s, at about $155 billion. By 1986, they had plunged

5. Real farm income and expenses, total changes over selected periods, 1981-90 (1)

Billions of 1982 dollars

           Item                 1981-86   1986-90
Net farm income                    -1.0      10.4
Gross farm income                 -39.5      10.3
Cash marketings                   -31.9       9.8
Government payments                 8.3      -3.3
Other cash income                   1.7        .7
Noncash income                    -17.6       3.0
  Value of inventory change        -9.0       4.4
  Imputed rent and home
     consumption                   -8.6      -1.4
Production expenses               -38.5       -.1
Intermediate inputs               -19.5       3.3
  Inputs of farm origin            -8.7       3.0
  Manufactured inputs              -9.4       -.2
  Other                            -1.4        .6
Interest                           -6.6      -3.5
Taxes and rents                    -1.7       1.1
Labor expenses                     -1.2       1.3
Capital consumption                -9.5      -2.3

(1) See note to table 4.

nearly 30 percent, to $110 billion. The cuts, which showed up in virtually all categories of expense, stemmed in part from a reduction in actual physical input; but they also reflected a rate of rise in farm input prices that lagged behind inflation in general (which thus caused inflation-adjusted farm costs to fall). With regard to the farm inputs purchased from the industrial sector, real outlays for petroleum products were halved from 1981 to 1986, and those for fertilizer fell 40 percent. Farmers' interest expenses dropped steeply from 1981 to 1986, as interest rates declined and as the volume of debt contracted. Charges for farm capital consumption dropped nearly $10 billion in inflation-adjusted terms from 1981 to 1986. Charges for hired labor also came down a little in real terms.

After 1986, farm production expenses essentially stabilized in real terms. But with costs so much lower, farmers were well-positioned to profit once farm prices began to improve. After plummeting in the period from 1980 to 1986, real cash receipts from marketings turned up in 1987 and made further small gains in each of the next three years. The accumulated gain in these receipts from 1986 to 1990 was about $10 billion. At the same time, government assistance to farmers jumped to more than $14 billion in real terms in 1987, roughly twice the average over the previous five years and equal to about 40 percent of total net farm income. After 1987, real payments trended lower, but as of 1990 they still amounted to about $7 billion and were equal to about 18 percent of net farm income.

Although net farm income probably has declined this year, farmers' well-being ultimately will be affected more by the trend in income over time. In that regard, a pickup in economic growth here and abroad obviously would work to support the demand for farm products. But it also is essential that farmers maintain a focus on cost control and productivity gain, the factors that have been so important in raising the level of profitability in the sector in recent years.

The Farm Balance Sheet

Reversing the 1970s surge, the real value of farm assets fell more than $500 billion from the end of 1980 to the end of 1986, as the earlier expectations of agricultural prosperity gave way to a more sober and probably more realistic view of farming's future (table 6). Most of the drop was reflected in the value of farmland, the price of which plunged in the first half of the 1980s. Land prices turned up in nominal terms after 1886, at first a bit faster than inflation in general, and then a bit slower. In real terms, however, the total change in land prices from 1986 to 1990 was relatively small, as was the change in the real value of farm assets. The real value of assets over this period was only moderately below that which had prevailed for a number of years before the boom of the 1970s; the effect of the boom thus appears to have been fully reversed by the contraction of the 1980s. No major change in the balance sheet seems to have occurred in 1991; land prices appear to be up slightly from the levels of a year ago but not as much as prices in general.

The rate of return earned by investors in farm assets (most of the investors being farmers themselves) improved considerably in the latter part of the 1980s. The ratio of current earnings to the value of assets averaged about 5 percent over the four-year period starting in 1987. this rate of return was about twice that seen in the seven-year period from 1980 to 1986 and was well above the average rate of return during the 1970s. Of course, farmers in the 1970s also benefitted, at least on paper, from real capital

6. Real farm assets, liabilities, and equity, total changes over selected periods, 1970-91 (1)

Billions of 1982 dollars

       Item        1970-80   1980-86   1986-90   1990-91
Assets                484      -511        -2       -13
  Real estate         432      -437        -9        -8
  Other assets         52       -74         7        -5
Liabilities            79       -57       -34        -3
Equity                405      -454        32       -10

(1) Excludes farm dwellings and the debt related to those dwellings. Inflation adjustment made by dividing nominal assets and liabilities of farmers by implicit price deflator for gross national product. Calculations for 1991 assume that nominal assets and liabilities will be at midpoints of ranges forecasted by Department of Agriculture as of September 1991 and that the annual rise in the implicit price deflactor will be 3.9 percent, the same as its year-to-year change over first three quarters of 1991. Components may not sum to totals because of rounding.

SOURCE. Department of Agriculture and Department of Commerce. gains on the value of their land; in fact, the size of those capital gains dwarfed the current income generated by farm assets. By contrast, cumulative real capital gains on farm assets have been slightly negative since 1986 and have offset a portion of the rise in current earnings.

Underlying the balance-sheet data are some major changes in the attitudes of farmrs since the 1970s. In that decade, the rate of current return to farm assets fell back after a surge in 1973 and 1974, but this reduced rate of return did not deter farmers from continuing to bid up land prices at a rapid clip, thereby driving the rate of current return on assets still lower. In contrast, in the period since 1986, a much-improved rate of current return (on average, as high as that of the first half of the 1970s) has not touched off another boom in land prices.

Restraint also has been evident on the other side of the balance sheet. After soaring in the 1970s, real farm debt turned won in 1981 and had declined nearly 30 percent by the end of 1986. It then went right on declining over the remainder of the decade, even as the farm sector recovered; by the end of 1991, farm debt in real terms was little more than half the level of a decade earlier. The ongoing reduction of debt stemmed, in part, from a low level of farm investment in both fixed capital and inventories. In addition, the much reduced level of land prices cut into financing needs, and farmers tended, more than before, to finance land acquisitions with internal funds rather than credit. The volume of farm debt outstanding also continued to be reduced by charge-offs of loans that had gone bad earlier in the 1980s; some of these loans still were being written off in the 1990s. With total farm debt thus falling rapidly and farm asset values fairly stable in real terms, real farm equity--the wealth that farmers have invested in their operations--increased about $30 billion from the end of 1986 to the end of 1990. Only part of that gain seems to have been reversed in 1991.

THE RECENT EXPERIENCE

OF FARM LENDERS

The financial problems of farmers during the mid-1980s caused a total many farm lenders to fail or be restructed, and those that survived saw the size of their market shrink drastically as the volume of farm debt declined. In addition, like farmers, lenders shifted to more cautious business strategies in reaction to the period of financial stress. The financial structure of agricultural lenders changed, as did the terms of lending that they offered. Bank lending to agriculture became more profitable toward the end of the 180s; and the farm loan volume of banks began to expand, slowly at first and then a bit more briskly. The operations of the Farm Credit System also have been profitable of late, after big losses in the mid-1980s, and the farm loan volume of the system appears to be edging up. In contrast, the loan volume of the Farmers Home Administration, the government farm lender of last resort, has been declining rapidly in the early 1990s as the agency has been cleaning up problem loans left from the 1980s.

Commercial Banks

The repercussions of the farm financial problems reverberated among commercial banks even as farm incomes were beginning to improve late in 1986. Failures of farm banks continued at a rapid rate--peaking at almost seventy failures each year from 1985 through 1987. (1) This rate of failure of agricultural banks was stunning given that only a few agricultural banks had failed between World War II and the start of the 1980s. Yet, the vast majority of agricultural banks survived and remained active in farm lending; in 1990, as in 1985, farm banks constituted about 35 percent of all commercial banks (table 7). Furthermore, the distribution of agricultural loans across degrees of specialization in agricultural lending was about unchanged in 1990 from that in 1985 despite the rapid change and consolidation seen in the commercial banking sector.

Agricultural lending by commercial banks declined for a couple of years in the 1980s but has

[TABULAR DATA OMITTED]

since rebounded. At the end of 1990 the volume of outstanding farm loans held by banks amounted to about $50 billion, about 7 percent higher than at the end of 1985 (table 7); the share of all farm loans that were held by banks grew substantially, from 25 percent in 1985 to 35 percent in 1990 (not shown). Much of the share gained by banks came at the expense of the Farm Credit System (FCS). From 1982 to 1990, the FCS lost almost one-half of its farm loan volume as rates on its loans rose relative to other sources of farm debt and as its financial problems grew. The volume of bank loans secured by farm real estate rose by about half from 1985 through 1990, and the share of banks in that market roughly doubled, to nearly 22 percent. In contrast, the volume of outstanding debt that was not secured by farm real estate was about 7 percent lower at the end of 1990 than at the end of 1985, although the volume of such debt has been growing since 1987.

The volume of non-real-estate loans made by commercial banks for the purchase of farm machinery and equipment fell considerably during the 1980s--from about $6 billion in 1983 to about $2 billion by 1988--and has not recovered a great deal since. Much of this shrinkage likely reflects the general reduction in capital spending in agriculture in the past decade. In addition, the volume of loans for current operating expenses excluding those for livestock has only recently picked up to the levels that were seen in the early 1980s. In contrast, loans for the purchase of feeder livestock have picked up appreciably, a development that likely reflects the strong returns for that enterprise in recent years.

Average interest rates for new agricultural loans have been trending downward since early 1989, generally following the direction of interest rates in the economy as a whole. Rates on farm loans at commercial banks now are a their lowest level since the 1970s. Interest rates have been lower, on average, for larger loans than for smaller loans since interest rates peaked in the early 1980s because the rates on the larger loans have tended to adjust more quickly to the declines in money market rates over that period. In general, a growing proportion of new loans have been made with an interest rate that floats; an estimated 75 percent of the volume of bank loans had adjustable rates in August 1991, in contrast to about 17 percent in 1979.

Despite the rebound in overall bank lending to farmers since 1987, the ratio of loans to deposits at agricultural banks has remained fairly low. Agricultural banks in the Kansas City and Dallas Federal Reserve Districts have had particularly low ratios, with loans equal to only about onehalf of deposits in both of these areas. Given the low reading on this commonly used indicator of the availability of funds, banks appeared to be positioned to expand lending more rapidly than they actually did. And in fact, quarterly surveys by several Federal Reserve Banks show that agricultural bankers wished to make more farm loans in the period from the late 1980s on; however, bankers may have been more selective in their lending choices, and farmers were demanding less credit than they were before the crash in farm finances.

Agricultural banks consistently had a higher return on assets than did other small banks during the 1970s, but as the volume of problem agricultural loans mounted through 1987, the profitability of agricultural banks suffered (chart 5). Then, as the recovery in the farm sector picked up steam, agricultural banks again started to earn profits at a higher rate than other small banks.

Perhaps the higher rate of return earned by banks that specialize in agricultural lending reflects a premium for the greater riskiness of agricultural lending. This rationale is consistent with the broad theme of much of the academic literature on finance, in which investors must be compensated for taking greater risks by earning a higher average return. The riskier environment in which agricultural banks seem to operate also might lead them to maintain a greater proportion of their asets as capital to cushion some of the swings in returns that they might encounter. Indeed, generally the greater the proportion of farm loans in the portfolio of a bank, the greater that bank's ratio of capital to assets (chart 6). Of course, the relatively high earnings for agricultural banks might arise from sources other than high risk, such as market power or special expertise, but neither of these explanations would lead to the greater amount of capital that farm banks hold.

The Farm Credit System

As the 1980s began, the Farm Credit System was fast consolidating its position as the dominant farm lender. The agency, a lending cooperative that was created early in the twentieth century to lower the cost of farm debt, acquires money in national capital markets at rates of interest that are slightly above the rates on Treasury securities and below the rates paid by its commercial competitors. The access of the FCS to inexpensive capital has been rationalized by policymakers as compensation for legal measures that prevent it from building a broader portfolio outside the agricultural sector. In the 1970s and early 1980s, when interest rates were rising, the cost advantage of the FCS over its commercial competitors was magnified by its policy of pricing new loans according to its average cost of funds rather than its marginal cost. The agency's volume of lending grew rapidly over this period.

Two things happened early in the 1980s that greatly reduced the profitability of the FCS. First, the farm sector fell on extraordinarily bad times, and the quality of the FCS loan portfolio, restricted by law to the agricultural sector, deteriorated rapidly. Second, after a very sharp runup in 1981, interest rates began to fall, leaving the average cost of FCS funds higher than new capital from the national money markets. In addition, the FCS inadvertently boosted its cost of funds by issuing, near the time that interest rates peaked, a large amount of longer-term bonds (most with a maturity of ten to fifteen years) that had no call provisions--with hindsight, a mistake that put them at a competitive disadvantage for years to come. By 1985, as loan losses mounted and its most creditworthy customers refinanced their FCS loans with commercial lenders that were increasingly competitive, the Farm Credit System was in financial crisis.

To address its financial problems, the FCS set aside large amounts of its shrinking income in a reserve for loan losses; in 1985 the $3 billion that it reserved for loan losses amounted to about 228 percent of its net interest income for that year. At roughly the same time as the FCS was reporting the steep decline in income to fund the loan loss reserves, it was petitioning the Congress for financial assistance. After a great deal of debate, the Congress in 1987 gave the FCS a $4 billion line of credit. The Congress allowed the FCS to repay funds borrowed from this line over fifteen years at subsidized rates, but it also required the system to revise its organizational structure and submit to greater governmental oversight. As of the end of 1990, the FCS had tapped only about one-third of the $4 billion line of credit.

Ironically, the completion of the assistance bill, the Farm Credit Assistance Act of 1987, coincided with an upturn in farm income that soon would help the Farm Credit System and other farm lenders to return to profitability. The rejuvenation of the agricultural sector allowed the FCS to reduce it reserve for loan losses in each year from 1987 to 1990, thereby adding to its current income in those years. Since 1988, the FCS has earned a return on assets of about 1 percent per year, a rate roughly comparable to those at agricultural banks.

Through the first half of 1991, the profitability of the Farm Credit System continued to improve. Net interest income during this period amounted to 0.7 percent of total assets (not at an annual rate), compared with 0.6 percent during the first half of 1990. According to the FCS, almost all of this improvement came from a larger interest margin rather than an increased volume of lending. The FCS has been retaining its profit either as surplus or as a restricted fund for capital that was mandated by the 1987 assistance bill. Total capital stock and surplus amounted to 200 percent of nonperforming loans at midyear, compared with 156 percent in mid-1990.

Farmers Home Administration

By legislative design, the Farmers Home Administration (FmHA) is the agricultural sector's lender of last resort. Created in the 1930s, the agency grants loans to farmers only when they have been refused credit at other lenders. The FmHA is a conduit for subsidized loans to disadvantaged groups, to rural communities for development purposes, and to farmers who have experienced a natural or economic disaster that the government has deemed extraordinary. As the lender of last resort, the FmHA in the mid-1980s picked up some problem loans when other farm lenders refused to extend additional credit to borrowers whose financial condition had become shaky.

Thus, with loans generally made to less creditworthy farm customers, the FmHA suffers a rate of delinquency by its borrowers that is much higher than that among other lenders. Moreover, a variety of court injunctions and congressional directives have hindered the agency from foreclosing on delinquent loans or attempting to collect late payments. The volume of farm loans outstanding at the FmHA peaked at $27.8 billion in the fiscal year that ended in 1986, and roughly $12 billion of these were delinquent. By the end of fiscal 1990 the agency had pared its volume to about $20 billion, but still roughly $8 billion was delinquent, most of it for a number of years.

The delinquent loans at the FmHA are the last major holdover from the farm financial problems of the 1980s; loan portfolios at other lenders have regained more normal levels of quality and profitability. In recent years, the FmHA has gained some ability to deal with its delinquent loans, although still with many legal restrictions and at a high cost to taxpayers. The restructuring or foreclosure of these delinquent loans will finally bring the farm financial crisis of the 1980s to a close.

SUMMARY

The softness of the farm economy this year follows several years in which income was relatively strong. Farmers took advantage of the high returns in those years to pay off debt and to consolidate their operations, leaving themselves in a good position to weather transitory periods of falling income. Similarly, farm lenders have strengthened their financial positions. This year's downturn in the farm economy may cause financial hardship among some farmers and lenders, especially those in areas hurt by drought or other natural disasters. But a recurrence of the widespread problems of the mid-1980s probably would require an extended period of weak income; the risk of such a period transpiring is being moderated by the present leanness of inventories, the cautious production strategies in the farm sector, and the continued efforts of farmers to keep tight control over their production costs.