The US FTA issue highlights policy failures in Australian agriculture

The political rhetoric surrounding the signing of the Australian US bilateral trade agreement brings to mind Joan Robinson’s view of neoclassical economics. Writing in Economic Philosophy back in 1962, she said:

 For the neo-classicals a belief in Free Trade became the very hallmark of an economist: protectionists belonged to the lesser breeds.

Today’s market economics is a neo-classical synthesis and anyone who argues with it is certainly regarded as belonging to “the lesser breeds”.

General equilibrium theory underwrites neoclassical philosophy. Since the 1970s general equilibrium modelling has become the accepted tool for rural policy analysis and for finding solutions to industry dislocation. Efficiency and productivity gains necessary for industry to meet competitive international pricing have become its central tenets.

The ascendancy of theory over reality has now become the major problem for Australian rural policy; and an exploration of the concept of  “competitive efficiency” draws the conclusion that  “lesser mortals” might better understand reality than neoclassical theorists.

“Competitive efficiency” is a theoretical concept accepted professionally as a textbook teaching benchmark for first year economics.  It cannot exist in the real world because of its very restrictive underlying assumptions, the most restrictive assumption being that of pure competition. It assumes a market structure with these characteristics:

• A large number of buyers and sellers none of whom can influence price or output
• Free entry and exit of firms
• Profit maximization
• No government regulation
• Perfect mobility of production factors
• Perfect knowledge

The real world agricultural markets consist of substantial government intervention; unequal distribution of market power; intense government regulation; immobile factors of production and very imperfect knowledge. Competitive efficiency cannot exist in the real world.

Moreover, competitive efficiency has been misunderstood by Australian politicians, academic advisors, bureaucrats, and media commentators and has become a populist concept involving the ability of an agricultural industry to meet some international or border price of a particular commodity.  Border price comparisons, incidentally, show Australian farmers to be very competitive.

Examination of the 2003 OECD Report on Agricultural Policies demonstrates Australia is second only to New Zealand in terms of %PSE which measures total farm support as a percentage of total farm revenue at farm gate value. Furthermore, using the common farmer efficiency measure( NPCp), it can be shown that average farm gate prices for Australian commodities equal the international or border price benchmark. Finally, the ratio of average price paid by consumers at farm gate to farm gate border price ( NPCc) for Australian agriculture suggests that Australian consumers have the cheapest food inputs across the OECD.

Australian farmers, therefore, are border price competitive - but not competitively efficient. They are two different concepts. This confused understanding of competitive efficiency carries important implications for rural policy and sectoral stability

Extended time series data demonstrates the consequences of inappropriate policy.

Sources: ABARE Australian Commodity Statistics 2003, p17
RBA Statistical Bulletin Financial Supplement March 1981 p115
RBA Statistical Bulletin Dec. 2003, pS40

Annualized Growth

Annualised time-series analysis demonstrate costs rise faster than farm production. In 1961, costs represented 62.5 per cent of GVFP; but by 2001 were 79.6 per cent. NVFP increasing at 4.9% annually suggests that nominal farm income fell proportional to production. With farm input prices rising in sympathy with the CPI, Real NVFP declined – 0.9% annually, inferring real value of farm income also declined

With farm costs outstripping GVFP, farm production expansion had to be funded by credit. Debt statistics and correlation analysis support an assertion that costs drive production, which in turn drives debt.

Over the long term input prices rise more rapidly than output prices and this explains the decline in terms of trade. This reflects a mal-distribution of market power across input suppliers, producers, and output markets; and persistent and protracted oversupply in commodity markets. It also suggests protracted oversupply in commodity markets. In terms of competitive efficiency this would indicate a number of issues:

• Les than optimal allocation of resources with respect to the wider economy
• Rigidities of factor markets across land, labor and capital
• Imperfect information flows
• Monopoly power exercised in both input and output markets

Agricultural policy inherently believes that increased efficiency and rising productivity will maintain profit margins under long term real price decline. This is not substantiated in the real world. Australian farming has become financially fragile over a long period. Consequences have been:

• Long-term falling real farm incomes
• Declining rural and regional business fortunes
• Narrowing of the industrial bases of regions
• Population redistribution to urban and sponge city destinations
• Contraction of services
• Rising levels of poverty
• Inability to hold the young and talented in rural communities
• Suicides levels of national significance in older males
• Overall damage to the social fabric of rural communities

If these perverse policy outcomes are to be remedied, the policy measures necessary  will be costly to public sector budgets at all levels. The wider community will pay the price in reduced services across education, health, transport, infrastructure expenditure, and law and order.

Because of these perverse policy outcomes, rural sector living standards have declined in contrast to rising urban living standards. Urban attention has begun to focus upon lifestyle issues such as conservation and the environment. Conflict between urban and rural Australian over lifestyle issues is now emerging.

The underlying cause of conflict between rural and environmental policy lies in the theoretical pricing system underpinning rural policy. Third party impacts such as pollution, resource depletion, and environmental degradation are not included as input costs in economic models used for rural policy analysis. Modelled input costs are confined to actual physical inputs used in the production process.

The compensation solution espoused by participants in the environmental debate breaks down in reality. The principles of compensation theory require only that compensation is theoretically possible. In the real world losers lose and winners win. Consequently, if government intervenes to correct third party impacts from production processes, then any mal-distribution of income and declining living standards become evidence of policy failure. It also reflects a misallocation of resources and economic inefficiency.

Australian farm policy is the product a complex debate from the third quartile of last century over industry and tariff reform. Of particular note were:

• The Green Paper on Agriculture 1974
• Establishment of the IAC 1974
• Development of a neoclassical synthesis computerized model of the Australian economy
• Emerging low farm income problem
• Agricultural economists favoring rural adjustment over rural reconstruction
• Worldwide move to right wing economic philosophies across Europe, USA, NZ, Australia.

In 1977 the Rural Adjustment Scheme (RAS) replaced Rural Reconstruction. Rural Reconstruction had been about assisting the farm sector to adjust to changes in overseas market conditions. The Rural Adjustment Scheme (RAS) seeks to adjust industry to structural change. RAS includes drought assistance, farm household support and farm build-up finance. Assistance is restricted to the long term viable; long-term “non-viables” are expected to exit the industry. It is a very contentions policy instrument domestically, and is described overseas as a policy of rural depopulation.

Since National Competition Policy legislation was introduced in 1995, RAS has been used to assist industries through the deregulation process. Pork, dairy and sugar are “deregulated” industries that are seriously questioning the relevance of RAS. It is becoming increasingly consistent with social engineering principles

International agricultural trade changed dramatically in 1995 with the ratification of the WTO Agreement on Agriculture (AoA). A rules-based system became the international legal framework for agricultural trade. Australia steadfastly refuses to accept this and maintains support for the 1980s Cairns Group agenda.

WTO provides for bilateral and regional trading agreements between member nations.  Hence WTO AoA Rules become significant for agriculture in bilateral and regional trading arrangements. NAFTA is a good example. The Australian / US bilateral agreement is another.

Times series analysis suggests that the Australian /US bilateral agreement will force a re-think of Australia’s agricultural policy. Consider the following table - and Mexican behavior

Selected % PSE Comparisons

Source: Agricultural Policy in OECD Countries Monitoring and Evaluation 2003; Annex Table 2p.p.44-45.

NAFTA appears to have prompted Mexico to provide support to its agricultural sector in line with the US. On the other hand, Canadian support to agriculture fell during the same time frame. Canadian farmers are clearly disadvantaged within NAFTA in terms of farm support levels.

Australian % PSE at 4% suggests that once the US Bilateral Agreement is signed, all three NAFTA members will provide support to their farm sectors well above that of Australia. The US FTA will offer indirect access to Australia for NAFTA member countries. Agricultural and environmental leaders in Australia would do well to ponder the implications of support differentials between Australia and NAFTA member countries

Industries of particular interest are compared below:

Support Comparison US Australia 2000-02
%PSE by Selected Industry

Source; Agricultural Policies in OECD Countries Monitoring and Evaluation 2003 Tables III.15 & III.45

The WTO AoA provides for a two-tiered system of domestic support. First, a bound Aggregate Measure of Support (AMS) defines a nation’s total level of support to agriculture under price and production distorting instruments. Second, a system of exempt payments allows support additional to the AMS under clearly defined policy instruments that are neither price nor production distorting. Exempt payments instruments offer a wide range of support including decoupled income; environment; conservation; structural adjustment and income insurance.

Decoupled income support is an important instrument and underwrites Covered Crops Programs to US grains industries. The EU announced a move to this type of support last year.  Payments are usually based upon a defined historic production base such as cropping areas or headage payments (number of animals). A target price is set independently of the industry and used as a basis to provide a deficiency or counter-cyclical payment to meet the difference between actual market price and the target price.

Rural policy is about income redistribution back to the farm sector to offset long-term erosion of real farm income. Income effects of sectoral realignment in mature growing economies cannot be reversed by confused economics pursuing increasing efficiency and rising productivity.  This policy direction simply compounds oversupply in international markets.

Lifestyle, environmental and conservation concerns in an increasingly urbanized society also lie beyond confused economics. These lifestyle issues are now in open conflict with rural policy.

Australia needs to consider the following questions
· How best to rebuild rural industries and the damaged social fabric of regional communities
· How to deliver a just price for rural output                         
· How the rural sector can deliver lifestyle, conservation and environmental services to urban Australia
· How to alleviate environmental degradation in overcrowded urban communities by rural reindustrialization

These questions are now being addressed in other mature economies with varying degrees of success. Australia needs to observe and learn form these experiences.