Foundation for the Future: Can It Work?

June 5, 2011 10:14 PM
 

FFTF would tamp down volatility, wouldn’t enhance price

We asked three leading dairy economists what they thought the impact of Foundation for the Future would be. Our panel: 

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  • Scott Brown is associate director of the Food and Agricultural Policy Research Institute (FAPRI). He has done extensive analysis of FFTF and is currently analyzing the Federal Orders reforms.
  • Andy Novakovic is a professor of ag economics at Cornell University and recently chaired USDA’s Dairy Industry Advisory Committee.
  • Mark Stephenson is director of the Center for Dairy Profitability at the University of Wisconsin. He and Chuck Nicholson of Cal Poly have done extensive modeling of FFTF.

 

**Extended comments are highlighted in blue.

 

Would FFTF allow the U.S. industry to become more globally competitive?

Brown: On average, FFTF would have little effect on the competitive position of U.S. dairy producers, according to the FAPRI baseline. The Dairy Market Stabilization Program [DMSP] would reduce U.S. dairy exports in the short run in periods of low margins.

Novakovic: I think many of us are coming to realize, or perhaps long ago realized, that U.S. prices are probably more impacted by supply and demand on a global scale than just by U.S. supply and demand, even though trade represents only 5% to 15% of U.S. markets by volume. With this insight, many analysts and policymakers have naturally asked what will be the impact on trade if we do X, Y or Z, recognizing that the XYZ policy proposals typically involve doing something to manipulate U.S. markets for the purpose of impacting U.S. outcomes.

Critics or skeptics are concerned that it is at best problematic and at worst impossible to do something at the national level without risking either inviting imports or curtailing exports and thereby defeating the original purpose. This is a very valid concern. It is exactly this type of concern that led to the implementation of very strict import quotas in 1951 two years after we made parity pricing part of permanent law in 1949.

Growth management plans, in particular, draw this argument. In contrast, a cash subsidy to farmers will have some impact on supply and therefore market prices, but the direction of those effects are to allow market prices to stay low longer. To the extent that happens, imports are discouraged and exports are encouraged.

Most folks in the dairy industry would see that as a positive.
Growth management has the express purpose of keeping prices from failing and/or causing them to rise. To the extent it works, this tends to invite imports and undermine exports. Needless to say, the host of other factors that determine trade can work with or against the U.S. supply effects and can overwhelm those effects or barely dent them. It is difficult to categorically predict that a growth management plan will always cause one or another trade effect.

Proponents of growth management programs, particularly the version in DMSP, argue that the intervention is designed to be very short-term and very potent: get in there quick and hit ’em hard. This perspective does not dispute a possible trade effect so much as argue that such an effect won't have enough time to pick up steam because the growth intervention won't last long enough. Opponents fear this is wishful thinking.

Two issues have merit. One is that, the design and intention of the program notwithstanding, we can't know for sure how long a growth management program might stay in effect under different underlying conditions. It is certainly conceivable that some combination of circumstances would arise where the growth management impact included undesirable consequences for trade.

The second concern is that long-term planning can be impacted by short-term effects. If marketers decide that there are new risks imposed by a growth management plan, whether they are correct or not, they could devote their marketing energy to something other than developing export markets. Inasmuch as export market development is hard work, a strategic shift in attention would make an important difference.

It is possible that Federal Orders reform could have some trade implications. My instinct is that these would be smallish. The key issue is whether manufacturers of tradable products would find a new opportunity to sell abroad because they had more freedom in pricing raw milk at home. A couple of leading reform proposals call for 1) switching from product formula pricing to a competitive pay price and 2) eliminating minimum pay price regulations for some plants. Both of these elements are important.

Together, they suggest that a plant/firm would have more flexibility to establish a milk pay price that coordinates with its own marketing plan. To be sure, a plant can't entirely ignore the pay prices of its competitors, but a regulation that moved in the competitive direction would change the rules on the field enough to make this an interesting question.

Stephenson: Our modeling of FFTF indicates that exports will continue to be an important market for U.S. dairy products with or without FFTF. FFTF has a provision that would use some of the funds collected from the sale of penalty milk to enhance demand for dairy products.
We modeled this as purchases of cheese and some butter and nonfat dry milk that would be given away through noncommercial channels. This new demand from the giveaway program has the effect of slightly raising product prices, like cheese, which makes it slightly less competitive for export, but it was a relatively minor effect.

What impact would FFTF have on milk price levels?

Brown: FAPRI analysis shows little effect on milk prices on average over the range of market outcomes. DMSP would raise prices when margins fall below $6.

Novakovic: Growth management seeks to reduce margin variation by keeping the bottom of the milk price from going too low. As is true of any price stabilization program, one can’t raise the bottom without lowering the top; hence, fluctuations are reduced around an average.

Supply interventions can be designed to raise the average, e.g., Canada. The designers of DMSP (as well as other recent plans) have had the explicit purpose of not constraining milk production so much as to have a significant effect on the average milk price. My colleagues – Nicholson, Stephenson and Brown - have done projections that estimate that DMSP and similarly constructed growth management plans could have the desired effect on price stability and would not appreciably change the average milk price.

In fact, some model results suggest that milk prices might actually decline a bit on average when prices are stabilized.

Stephenson: FFTF would slightly elevate the U.S. All Milk price about 17¢ per cwt. It would raise the Class III price by about 70¢ and lower the Class IV by about 30¢.

What impact would FFTF have on milk price volatility?

Brown: DMSP would pull up prices when margins are low. That should cut the extreme lows out of milk prices that we have been experiencing. This should provide for modestly lower highs on the other side, as the supply adjustment under DMSP keeps supplies more consistent. These effects should reduce but won’t eliminate the milk price volatility that occurs today.

Stephenson: Volatility would be reduced significantly. However, the frequency of the price cycles would be increased as the program kicks in and out more often than the market variation in prices.

Would the margin protection program provide a better safety net for dairy producers?

Brown: The Milk Income Loss Contract (MILC) program begins direct payments sooner than base program payments would occur under FFTF. MILC covers only 45% of the price decline, while the base program is a hard price floor and covers the entire margin decline once triggered [on 90% of a producer’s base]. Important to this question will be the premium cost of supplemental margin coverage.

Novakovic: "Better" is one of those concepts that varies with the eye of the beholder. Current dairy price supports are close to meaningless and will become all the more so if the underlying purchase prices stay stuck around a $10 milk price equivalent and dairy markets stay at an average price plateau closer to $20.

The big question here is MILC versus margin insurance and the issue is obvious to everyone. Recognizing that government funding is highly limited, is it better to focus federal subsidies on bigger help for fewer and smaller farms or to spread the available help in smaller amounts across more farms regardless of size? One way this is expressed is: Should we help farms or milk?

Whether we should do one or the other, whether one is better, is not a question of economics. We might believe that a program that focuses assistance on smaller-scale farms will enable the more vulnerable farms to stay in or stay in longer. If this is true, it would tend to keep supplies long for more time.

While this might be a description we would generally have accepted in the past, I'm not so sure it applies today. It is no secret that the record prices of feeds have hit large-scale farms that purchase most or all of their feeds a lot harder than the more modestly sized farms that grow their own feeds.

We could probably find some broad economic consequences of using one plan or another, but I think at the end of the day this choice hinges on our collective judgment about what is right and fair.

There are two other aspects of this that are worth highlighting. Margin insurance is built around protecting milk margins. Dairy price supports and MILC focus on price. This is an important difference.

However, the trigger is not intrinsic to either approach. Insurance could be based on price and MILC could be based on a margin. In today's world, the margin approach makes sense, but that does not require us to go the insurance route at the same time.

The other aspect involves personal responsibility.
The Dairy Producer Margin Protection Program is designed to offer "catastrophic" protection at no cost to producers. The $4 margin level is what we saw in 2009, but it is well below the $6 level that characterized the last two downturns in 2006 and 2002–03.

Beyond that catastrophic level, higher levels of protection are available at increasing costs to the producer. Some will remember that we charged dairy farmers assessments in the 1980s to help pay for the cost of government programs. If we felt it made sense or we simply needed to do so, we could resurrect assessments to help pay for MILC.

Personal responsibility is also not a concept necessarily limited to one type of program. However, I think a lot of folks would agree that it makes sense to link personal responsibility with personal benefit. Paying a tax to support federal subsidies in general is not the same as making a choice to buy insurance for yourself.

Stephenson: If you are a large producer who caps out quickly on volume under MILC, there is the likelihood that you would receive much larger payments with the margin insurance. The margin insurance pays out dollar for dollar on protected milk when the trigger is met, and MILC pays only a percentage (currently 45%). It is important to realize that the no-cost base coverage for $4 margin insurance is truly a desperate level of milk and feed prices. Although producers can buy up to higher levels of margin coverage, the premiums are at decreasingly subsidized amounts and could be expensive.

Would FFTF have different regional impacts?

Brown: The margin protection program is a national program that makes the same payment across the country, so it should not have any regional effects. The DMSP program will curb excess milk supply growth in low margin outcomes. Those areas of the country that are growing most rapidly would face the largest constraint under DMSP.

Novakovic: I think there would be different impacts by region, but also by type of farm (size, production system), product sector (fluid, cheese, organic, artisanal, value-added), market structure (lots of buyers versus few buyers) and so on. Some of these factors are correlated with region, like big farms that rely on purchased feeds, but it may be the case that any farm that relies on purchased feed will experience a similar impact, regardless of what region they are in.

Growth management will be annoying to farms that experience unplanned or difficult-to-manage variation in milk marketings. Recent research indicates that there may be more of this than we thought. Growth management will be a cost of doing business for farms that plan growth. It may affect the timing of their investment decision, but it probably won't affect their decision to grow in general.

Margin insurance will be most appealing to farms that experience more margin volatility - in particular, volatility in milk returns over feed costs.

It is hard to say how the consequences of Federal Orders changes are distributed, but I suspect that the impact on the cheese business is rather different in Wisconsin than it is in Idaho, even though both have a similar share of total milk going into cheese. I also suspect that it could be harder to manage in the Northeast, which is very evenly divided across the major milk sectors [classes]. There is a lot to digest in the Federal Orders proposals and we haven't had much time to chew on them.

Stephenson: As modeled, we expect that Class III prices would be enhanced and Class IV prices somewhat diminished. To the extent that there are regional differences in utilization among milk uses, there would be some difference in regional impacts.

Would the supply management component be effective in reducing supplies in periods of low milk prices?

Brown: Getting paid zero for any milk a producer delivers over his allowable base should be a strong deterrent in reducing excess milk supplies. I think the DMSP component of FFTF would cause quick corrections in periods of low margins.

Stephenson: I believe so. If you aren’t going to be paid for some of your milk, and there is the additional significant cost of paying for hauling, I expect that most farms would reduce production to their base level. It is important to remember that the money a processor pays for penalty milk that is shipped will be used to purchase dairy products or otherwise enhance demand. So you are either pushing the milk supply down or pulling the demand for dairy products up - both of which will work toward increasing a milk price.

Conversely, will the supply management component restrict U.S. ability to participate in global markets?

Brown: DMSP will only operate when margins fall below $6. The FAPRI baseline would suggest that margins will not fall below $6 often in the future. I think these facts suggest DMSP will have small effects on our ability to participate in global markets. In addition, the DMSP base assigned to producers will be allowed to adjust upward as demand expands, allowing the U.S. to capture additional exports when global markets are strong.

Stephenson: The majority of the products that we are currently exporting are milk proteins in the form of whey and nonfat or skim milk powder. Somewhat less whey is exported under FFTF, but more nonfat dry milk is exported.


Will the proposed Federal Orders changes increase the U.S. industry’s ability to innovate and compete in both domestic and international markets?

Novakovic: Innovation, like most things, has a supply component and a demand component. However, I would suggest that opportunity [demand] tends to lead entrepreneurship [supply]. Entrepreneurs tend to look for opportunities regardless of a particular industry.

The question for dairy is not whether it contains entrepreneurs so much as whether it has opportunities to which entrepreneurs will be drawn. There is no shortage of technology or markets to enable that entrepreneurship. The bigger question is whether there is money to be made. Regulation, especially regulation that is heavily shaped by a desire to share the wealth or split the pie equitably, is pretty much antithetical to rewarding entrepreneurship. On the other hand, freewheeling entrepreneurship can lead to very uneven market outcomes, and for suppliers of what is a highly substitutable input (milk is milk) this can lead to farmers battling each other to the bottom while fighting for the privilege to sell to the high-value market.

Is it better to have decent returns shared by all, or a market that has a mix of steady, mature products with a smaller but vibrant and dynamic product line that results in great returns for some and mediocre returns for others?

Stephenson: This is difficult to comment on, as the Federal Orders changes under FFTF still seem to be in a state of flux. I personally don’t think that the change in method of price discovery will make much difference to the ultimate price received by dairy farmers, so I would expect no change in the course of milk production.

I do think that the current safety net of the Dairy Product Price Support Program has been influential in making our industry less in tune to the products the world wants. FFTF should encourage, or at least not impede, innovation in dairy product manufacturing.

Would the proposed price discovery mechanism for Class III prices provide more accurate pricing than the current product price formulas?

Novakovic: I'm not sure how we define "accuracy." The purpose of price is to coordinate supply and demand, to yield just as much production as buyers want to buy. We had price regulation based on a competitive pay price strategy for many years under the old M-W [Minnesota-Wisconsin] system. We have product formula pricing now.

I find it hard to argue that one system was definitely better than the other in the basic function of coordinating supply with demand.

I think that when we debate these systems we are actually concerned about two different issues. One is "I don't like the price that I'm getting." It may well be that we change the pricing system and discover that the monthly price of milk still bounces around like crazy and from time to time we can't cash flow. Different horse, same ride.

The second is "I don't understand where this price is coming from." This is the issue of transparency. Who sets the price of cheese? How do I know that this is really the value of butter? Even though USDA gets the formula prices from surveys with the idea of ensuring that farm prices are based on prices manufacturers actually get, there is some mystery to the origin of those prices.

There is a concern that because class prices are determined from product prices, manufacturers don't have much at stake when prices fluctuate. Competitive prices put more onus on plants to figure out the relationship between what they earn from sales and what they can afford to pay for milk inputs.

In the old days of the M-W, it was pretty clear that cheese and butter/powder plants in Minnesota and Wisconsin would smooth out their pay prices a bit relative to the changes in output prices for cheese, butter and nonfat dry milk. Their margins widened on the way up and got squeezed on the way down.

But, at the end of the day,
there is no reason to believe and no evidence to suggest that average margins over a year are much different in the product formula model versus the competitive pay price model. If we are hoping that, on average, prices would be higher with the competitive pay price approach, I suspect that is wishful thinking. There is some reason to believe that monthly competitive pay prices would fluctuate differently and in a slightly tighter range than is true with product formula prices.

I find the transparency argument interesting. Much has been said about the perfidy of the Chicago Mercantile Exchange in setting the price of cheese, which in turn shows up in the NASS survey price, which in turn is used in the Class III price formula. Who are these guys trading on the CME? Why would we think they will come up with an "accurate" price?


The competitive pay price proposal relies on noncooperatively owned, large cheese plants to set a competitive pay price. Is this a different group than the people who operate on the CME? Don't these plants primarily still price their commodity cheeses off of the CME price? Will the average dairy farmer know any more about where that competitive price came from than he does where the CME price came from? Is the proposed system really more transparent?

Stephenson: What does accurate mean? That implies that we already know what the "real" market price is and that our current method of price discovery is doing a poor job of revealing it. I am confident that under Federal Orders reform, plants will discover what they need to pay to get as much milk into their facility as they can profitably manufacture and sell. I also think that the current product price formulas, supplemented with over-order premiums, are getting the job done now.


Any final thoughts?

Novakovic: When I talk to industry members about policy choices, I always go back to basics. I ask two questions: What problem are you trying to fix? What does fixed look like?

When we talk about problems, we should be pretty clear and precise about what we mean. The price of milk is bad? Milk prices are too volatile? Every three years or so, the price of milk is so low that even better-than-average farm managers experience financial stress?

I don't know how to fix a milk price that is vaguely bad. but we can start getting some traction when we get more specific about what we mean. What problems are we fixing with current proposals? Is the problem that the designer of the proposal is trying to fix the same problem that you identify?

A proposal may do a swell job of fixing some problems, but that doesn't mean it is the solution to your problem. I wonder if sometimes we are attracted to doing something different not so much because we are convinced it is better but just because it is different and we don't like the outcomes we are getting under the current plan. Farmers ought to work hard on making sure, as best they can, that different is actually better, and, in particular, better for them.

Stephenson: There are always unintended consequences that will occur when implementing a policy as complex as FFTF. If it is implemented, we will need to be prepared to alter provisions to make it work in the way in which it was intended.

I think that producers are trying to evaluate whether the "cure" for volatile prices is worse than the volatility itself. For some, the answer is an easy yes or no -- many others are unsure. Technology and evolving markets have made dairy farming a much more complex occupation than it used to be. FFTF would increase the complexity of milk production decisions for individuals, but the need to use currently available risk management tools and actually market their milk has also increased the complexity.

 

 

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