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KC Fed Examines U.S. Ag's 'Wealth Effect'

Economists say the stage is set for another wealth effect and leveraging cycle in U.S. agriculture

Published on: May 7, 2013

Kansas City Federal Reserve Omaha Branch Executive Jason Henderson and economist Nathan Kauffman said this week that U.S. agriculture is set for a farm profit decline due to previous capital investments, larger commodity supplies and higher production costs.

Henderson and Kauffman explained the situation – what they call the 'wealth cycle' – in the latest Mainstreet Economist report.

Similar to nonfarm households, farm enterprises historically have used wealth to support consumption and investments when income fades, the report said. During years of low income, instead of allowing investments to fall with profits, farmers tap their existing wealth to finance and maintain their capital investments near previous levels.

Economists say the stage is set for another wealth effect and leveraging cycle in U.S. agriculture
Economists say the stage is set for another wealth effect and leveraging cycle in U.S. agriculture

Henderson and Kauffman point to the 1970s as the clearest example of the wealth effect in U.S. agriculture. A surge in U.S. exports in 1972 led to a doubling of U.S. crop prices and a spike in farm profits. Although farm profits quickly retreated, farmers accelerated their investments, and capital spending did not peak until 1979, they noted.

The authors point out similarities between then and now, noting that since 2009, wealth in the U.S. farm sector has increased due to rising farmland values. In 2013, farm incomes are projected to remain historically high, but longer-term projections don't reveal the same picture.

Henderson and Kauffman said in 2014, they expect a drastic decrease in farm profits due to rising supplies and higher production costs.

If agriculture's historical wealth effect holds true, they said, farm enterprises might use existing wealth to finance and smooth investment spending, sowing the seeds for another round of debt accumulation.

This can mean that generally, farmers may use existing wealth to purchase capital investments – structures, land improvements, vehicles, machinery and equipment – and lenders may be more willing to lend to farm enterprises with a greater amount of equity to use as collateral for loans.

Authors explain that the ascent into farm wealth began in 2006, when a doubling of U.S. agricultural exports and strong biofuels demand pushed annual real returns to farm operators above $45,000 per farm, the highest level since 1973.

Rising profits have spurred capital investments to the highest level since the 1970s with real capital expenditures per farm topping $12,000 per year in 2011. Even though the authors note that most famers have been conservative in capital spending, the wealth effect inevitably leads to accumulation of farm debt and leverage in U.S. agriculture.

"Today, an increase in farm debt may signal the beginning of another turning point in farm debt and leverage," the authors wrote. "After rising less than 1% annually since 2008, farm debt outstanding at commercial banks rose roughly 5% in the fourth quarter of 2012 for both real estate and non-real-estate debt. Similarly, Farm Credit System lending for real estate mortgages and production and intermediate-term loans rose 5.7% during 2012."

Risks associated with farm debt include low debt-to-asset ratios and potentially a sharp decline in farm asset value.

"If farm debt were to rise 40%, as it did during the 1970s, a 25% decline in farm assets would yield a debt-to-asset ratio of 20," the authors wrote. "Alternatively, if farm debt held steady, farm assets would need to fall by 50% to lift the debt-to- asset ratio above 20. The last time land values and farm assets fell this sharply was between 1980 and 1986, when farm assets fell 45%."

Report authors said though current farm debt ratios remain near historical lows, their projections of lower farm incomes, high wealth and low interest rates will be the recipe for another wealth effect in U.S. agriculture.

"Whether this farm boom simply fades or busts depends on the wealth effect and how farmers finance agriculture investments," Kauffman and Henderson concluded.

Read the entire report, The Wealth Effect in U.S. Agriculture.

Update: For a deeper look at the issue, check out the authors' additional publication, Farm Investment and Leverage Cycles: Will This Time Be Different?