European Affairs

Methods of Measuring Farm Support Must be Made Fairer     Print Email

Associate Professor, Department of Applied Economics and Management, Cornell University

With agricultural negotiations under way in Geneva, and more likely to follow in a new trade round, it is important to understand the extent to which current EU and U.S. farm policies do or do not distort trade.

Following is a comparison of U.S. and EU agricultural policies in the cereals sector, which is one of the most important both for domestic production and consumption and for world trade.

The current farm trade negotiations that are being conducted in the World Trade Organization (WTO) in Geneva concern the Agreement on Agriculture negotiated in the Uruguay Round. The purpose of the Agreement was to define, quantify and reduce the level of trade-distorting policy measures.

Commitments were made to reduce support to farmers in three major areas:

  • Import access. The aim is to lessen the impact of border protections by reducing tariffs and increasing minimum access.
  • Export subsidies. There are to be reductions both in the value of export subsidies and in the amount of trade to which they are applied.
  • Domestic support. Three categories have been established for domestic support measures: A so-called Green Box for "minimally trade-distorting" policies; a Blue Box for direct payments with supply controls such as acreage set-asides; and an Amber Box for trade-distorting support measures. Whereas Amber Box subsidies are to be reduced over time, Green and Blue Box subsidies are not subject to reduction.
There are many defects in the Agreement that unfairly penalize the European Union. The rules in the Agreement are defined in terms of policy instruments, rather than trade effects.

A key U.S. policy instrument currently in use is the loan rate, a guaranteed price to farmers.1 If the market price falls below the guaranteed price, farmers receive a subsidy known as a loan deficiency payment (LDP).

In addition, U.S. farmers receive various payments that are supposed to be "de-coupled" from the amount they produce, so as not to encourage excess production. Examples are production §exibility contract payments (PFCs), which are transitional payments provided for in the 1996 Farm Act (known as the FAIR Act) and emergency market loss assistance payments (MLAs), which were enacted by the U.S. Congress when market prices fell in 1997-2001. Crop disaster and crop insurance programs are also substantial and are shown by academic and U.S. government studies2 to have a potentially large impact on production and trade.

PFCs and MLAs in the United States are deemed non-distorting in the Agreement on Agriculture, while payments for hectares planted in the European Union are considered distorting, even though payments are conditional on set-asides and payment restrictions, and hence are less trade-distorting or perhaps do not even distort trade at all.

Furthermore, government payments to field crop farmers in the United States in the form of PFCs and MLAs stimulate higher production because fixed costs are covered. This induces farmers to stay on the land, reduces the risks of production and creates expectations for more support in the future.

The intervention price for cereals is the primary policy instrument in the European Union. This price has an indirect but important role in determining import tariffs, export subsidies and public stockholding activities, while providing a link to the setting of area payments3 and set-asides.

The EU intervention price system plays a major role in public stock-holding activities but there is no effect on the average market price in the long run, because stocks are inevitably released onto the market at some point in the future. Hence, stocks stabilize domestic prices and possibly stabilize world market prices.

On the other hand, increases in government payments to farmers in the United States after a market price decline always destabilizes world prices by pushing prices even further down.

The loan rate in the United States distorts production while the intervention price in the European Union as such does not.

A major challenge in the current negotiations is thus to address the imbalances in the definition and quantification of support to farmers in terms of trade barriers and production subsidies, so as to ensure a level playing field and reduce trade distortions.

The "aggregate measure of support" (AMS) is a measure of the assistance given by government4 to all commodities through policies that meet the "amber box" criteria of the Agreement on Agriculture. Twenty-eight countries agreed to reduce their AMS by 20 percent over six years. These reduction commitments were supposed to measure domestic support, independent of the support from import barriers and export subsidies.

In reality, however, the AMS is double counted with support derived from trade policies. For example, when market access commitments or the export subsidies are reduced, there is an automatic change in the AMS (and vice-versa - a reduction in the AMS requires a change in market access or export subsidies; otherwise the AMS reduction will have no effect on the market). For cereals, this con§ation occurs for the European Union and not for the United States. A major reform is needed in the way in which the AMS is defined and measured.

To illustrate the ridiculous nature of the problem, consider the fact that total support in the European Union as measured by the OECD's "producer subsidy equivalent"5 is less than total domestic support. Does this mean EU border support is negative, with no reductions required in import barriers and export subsidies? If the implied border support is negative, then credits should be transferred to the AMS.

Clearly, the European Union must insist that calculations for the farm support reduction commitments be rebalanced and separated from import access, export subsidy and domestic support measures before negotiations can begin on a level playing field.

The baseline AMS upon which domestic support reduction commitments are made is overestimated because it includes a substantial proportion of support already counted in market access and export subsidy measures. The calculation of the AMS ignores the fact that EU farm prices often diverge from the "administered price support" - the intervention price - upon which the measure of support is based. In the case of the European Union, farm prices are high because of export subsidies and import barriers, and so the AMS double counts the support to EU farmers. The intervention price upon which the AMS is calculated does not impact the market directly but is used to decide on the accumulation and disbursal of stocks.

This has implications for rebalancing the support reduction commitments between import access, export subsidies and domestic support measures. Indeed, a "§ashing amber box" is recommended that includes only domestic support that is trade distorting (with adjustments downwards for output reducing measures), and is not double counted with trade border measures (tariffs, export subsidies, etc.).

U.S. policy toward the cereals sector involves taxpayer-financed payments averaging $18.3 billion a year from 1998 to 2000. There are four major categories of aids.
  • Direct payments based on historical base acres in the form of PFCs (29 percent of the total)
  • Production subsidies through the fully coupled LDPs (26 percent)
  • "Emergency" assistance in the form of MLAs (26 percent) Other direct payments for conservation, crop insurance and disaster (19 percent)
The net cost of insurance programs to the U.S. government (net of premiums paid by producers) in fiscal years 1998 to 2000 was on average $1.5 billion per year, and is projected to be $3.5 billion in 2000.

U.S. farmers are guaranteed the loan rate, no matter what market prices are. But the system allows farmers to determine what market price during the year is used in calculating the subsidy and the loan rate itself. If farmers choose to declare the quantity of production that is receiving deficiency payments at times of the year when market prices are lower than the annual average, then the gross price received by farmers is even greater than the guaranteed loan rate.

This is because sales are not required at the time the quantity of production receiving payments is declared. In the 1998 crop year, farmers received an effective price well above the loan rate for three commodities of which the market price was below the loan rate. Other commodities qualified for LDPs even though the average market price exceeded the loan rate.

In addition to farmers being able to time their declarations in their favor, the reasons for these two phenomena may be that loan rates and the calculation of LDPs are differentiated by county so that the average market price for the United States is higher than the national loan rate, but in some counties the market price is below the county loan rate.

Furthermore, the loan rate may have been fixed too high in some counties compared to usual market prices, or the posted county price (a proxy for the average market county price that is used to determine the deficiency payment) may be too low. The U.S. Department of Agriculture computes the posted county price daily, based on price quotations on particular terminal markets.

This "over-compensation" by LDPs for market prices above or below the loan rate is an added incentive to overproduce, whether market prices are rising or falling. Such over-compensation does not exist in the EU intervention price system.

Even though area payments5 are made when market prices are above the intervention price, it is export subsidies, and not intervention support purchases or area payments, that determine the long run average market prices for EU cereal farmers.

Export subsidies are a key component of support to the EU cereals sector, while in the United States a similar role is played by direct production subsidies such as LDPs.

An export subsidy provides an incentive for exporters to increase their level of sales to the outside world. In the process of obtaining more supplies to export, the domestic price in the exporting country is bid up. As a result, domestic prices move higher than world prices, with domestic consumption declining and production increasing.

Producer subsidies, on the other hand, only result in an increase in domestic production, and domestic prices do not move above world prices, keeping domestic consumption stable. Hence, export subsidies in theory are more trade distorting than production subsidies.

In practice, however, the extent to which export subsidies are more trade distorting depends on the sensitivity in consumption to changes in price (the elasticity of demand). Because the demand for products such as wheat is very price insensitive at the farm level, the level of trade distortion is going to be largely determined by the increase in supply due to the subsidy. The supply response is the same for an export subsidy and a production subsidy (but the consumer price only changes in the case of export subsidies). Because consumption hardly changes anyway,6 the difference between a production and an export subsidy can become very small in terms of distorting trade.

In 1999, LDPs in the United States amounted to approximately $7.8 billion, of which cereals accounted for $5.3 billion, while EU export subsidies for cereals totaled approximately a850 million.

Suppose EU farmers receive the same price as before but instead of an export subsidy, it is in the form of a production subsidy similar to the LDP system in the United States. Calculations indicate that such a hypothetical production subsidy would distort trade only 10 percent less than the export subsidy that actually is used in the European Union. Hence, if the EU were to adopt a U.S.-style LDP subsidy scheme, the effect would be only marginally less trade distorting than the current EU export subsidy scheme.

It is instructive to look at what would happen if U.S. LDP subsidies were applied to the EU cereal market. The United States spent over six times more on the LDPs (for cereals only) than the European Union spent on export subsidies in 1999.

If the EU spent as much on LDPs as the United States, the trade distortion due to an LDP scheme in the EU would be an estimated 23 percent higher than the trade distortion implied by the a850 million actually spent on export subsidies.

Finally, the U.S. LDP system is estimated to cause exports to increase by approximately 71 percent. LDPs increase U.S. wheat production by 17 percent, and most of the increase in production is exported.

It is important to note that any farmer receiving LDPs must own "base acres" upon which production §exibility contract payments (PFCs) are disbursed (base is land designated specifically for PFC payments).7 Because farmers need to own base to receive both coupled and the so-called "de-coupled" payments,8 decoupled payments are linked to coupled support.

In order to receive coupled support, farmers need to have "de-coupled" payments (but not vice versa). One needs to be a farmer with base acreage in agricultural use for PFC/MLA payments (the land can be idled but not in fruit and vegetable production). If there is coupled support, a farmer is more likely to plant because decoupled support is only continued if the land is in agricultural use.

Few farmers receive LDPs with no base, but many farmers with PFCs also get LDPs. It all starts with base acreage and the right to LDPs. Hence, one has to look at the policy in a global manner to get a proper perspective on the production effects of direct payments in the United States.

Because the United States has no acreage set-aside, and payments (not plantings) are restricted by a base acreage, it is important to evaluate the specific effects of direct producer payments such as the PFCs and the MLAs on production.

An important issue is the inclusion of U.S. PFC programs in the Green Box. How do direct payments to farmers affect their production decisions?

In the case of the United States, there are no restrictions on production. We can identify at least four mechanisms or categories of incentives whereby production increases as a result of direct payments to producers:
  1. Fixed costs are covered by the payments. So, farmers stay in production when they otherwise would use land for non-cereal production or non-agricultural use - or might leave the land idle and cease farming. The result is a higher level of production than otherwise would be the case. Fixed costs represent over 50 percent of the cost of wheat production, for example.
  2. Risk is reduced, leading risk-averse farmers to produce more than they would have done otherwise.
  3. Expectations for future payments are based on the status of being a farmer, and of land being in agricultural use for particular crops. So production is higher.
  4. Direct payments allow banks to make loans that they otherwise would not have made, thereby allowing farmers to stay in business and even increase their capacity through capital investments.

Several implications emerge from this analysis, including the need for changing the way in which EU and U.S. commitments have been made in terms of percent reductions in tariffs, export subsidies and domestic support levels as negotiated in the Agreement. The logic of support measures and commitments in the Agreement on Agriculture is seriously §awed.

New categories of support need to be introduced, and wholesale changes must be made in the current design of measuring and classifying support, before balanced and fair support reductions can be negotiated.

With the implementation time period of the Agreement on Agriculture near its end, the "peace clause"9 about to expire and new negotiations under way, it is important to bring the public policies of the United States and European Union in the cereals sector into clearer perspective.

In that way, one can address the disparities in support levels and trade distorting effects in such a way as to strengthen the reform process in general, and improve the fairness and effectiveness of future support reduction commitments.


This article was published in European Affairs: Volume number II, Issue number III in the Summer of 2001.

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