U.S. Economy in 2008

by Lisa A. Miller June 2008

As we prepare for upcoming political elections, the media buzzes with animated discussion about the state of the U.S. economy. Suddenly, the price of food and fuel are conversational hot buttons, and economic pundits are expressing fear about reduced consumer spending. If consumers continue to feel their pocketbooks pinched, will their slowed buying habits have a ripple effect across business sectors?

Michael Swanson, Ph.D. VP, Senior Economist & Agricultural Economist, Wells Fargo & Co.

We sat down with Dr. Michael Swanson, vice president and agricultural economist for Wells Fargo, to talk about what’s agitating our economic pulse and to hear his prognosis for the year ahead. Wells Fargo is one of the largest agricultural lenders in the U.S., and Swanson’s responsibilities include the analysis and forecasting of key agricultural commodities such as wheat, soybeans, corn and cotton. Because agriculture is extremely energy-intensive and now closely tied to biofuel production, his specialization includes the impact of energy on agriculture. Together these two elements make for a dynamic marketplace.

Monitor: Tell us about the impact of energy on agriculture, and how the current climate of inflated food prices might affect the agricultural industry.

Michael Swanson: Agriculture has always been an energy-intensive sector. It takes diesel fuel to run tractors and farm equipment as well as propane to dry grains at the end of the season. Natural gas and potash — which is transported all over the world — are essential to fertilizer production; insecticides and herbicides are energy-intensive chemicals, too. Then there’s the energy used in food processing: slicing, sorting, drying, packaging, milling, baking and so on. The Bureau of Economic Analysis, which surveys, measures and classifies industry inputs over five-year periods, determined that agriculture is one of the most energy intensive sectors in our economy. Every segment of the food industry — transportation, heating, input and packaging — devours energy.

When most consumers think about the agricultural industry, they simply think about farmers and food. But as we build more ethanol and biodiesel plants, we change the relationship between grain as food and grain as fuel. This new relationship resets the value on crops and how much people will pay for them, with the result that now the alternative value of crops is influenced by the alternative value of energy — and this doubly intensifies the relationship of energy into agriculture. Energy as an input had already sensitized the cost factor of production, but now the outputs are valued by their potential for conversion into energy. So, we’ve really increased the volatility in the agriculture sector.

M: How is energy related to the rising price of food products?

MS: The price is affected because we’ve reset the value on crops. If you own an ethanol plant and you know that the price of ethanol is $3/gallon and that a bushel of corn will yield three gallons, then you also know that you can get at least $9 of value out of that bushel. You also know exactly how much you can pay for corn before you are no longer making a profit.

If you are a chicken farmer selling your chicken wholesale for $1.20/pound, you know how many pounds of corn it takes to make a pound of chicken. You also know how much you can pay for corn before you start losing money. So either the price of chicken has to climb so you can afford that corn, or you will not buy it. By transforming crops into energy, we have produced a new buyer, and that buyer can set the price he is willing to pay. The chicken farmer has to match that price or lose out. You can think of energy as the motor of inflation, but biofuels are the transmission of that energy.

M: How is the relationship between crops and fuel changing the face of the agricultural industry?

MS: The situation affects growers of all sizes and plays a role in determining what crops are grown. If an acre can produce cotton, it can also yield corn or soybeans. Naturally, growers are going to shift to the crops that bring in more money. Thanks to increased ethanol production, we’ve seen demand for about 18 million additional acres of corn. The competition for those acres is transmitting that energy effect across the entire agriculture sector.

Adding to the problem is the resulting shortage of those other crops that can’t bring in as much income. If you’ve been growing something that is not going into energy, such as dry beans, you’re going to ask yourself, “Based on the price of my output and the cost of my input, what should I grow to make the most money? If I can grow corn and make $300/acre, why would I grow dry beans and only make $120/acre?” This rationale results in less dry beans getting planted, which decreases the supply and drives up the price until dry beans make as much money as corn.

It’s a matter of water seeking its own level. Government legislation may attempt to control or encourage various crops through subsidies, but when you subsidize something, growers produce more of it than the market demands on its own. So if you increase government subsidies to grow corn for ethanol, you increase the demand for corn going into ethanol. The government can’t make water flow uphill, no matter how many pages of legislation it writes.

M: What is the effect of all this on potential lenders?

MS: This situation is problematic for lenders that provide capital for agricultural equipment. If the higher prices of corn, wheat, soybeans and cotton are based on government-subsidized, high-priced energy crops, what happens if those subsidies go away and the demand for that energy drops? Or conversely, what if the demand goes up? If you lend to somebody, ultimately the driver of their revenue stream is energy rather than food production. How do you mitigate the risk?

It’s imperative that ag lenders understand the linkage between high priced crops as being driven by energy. They need to have a very clear outlook and risk profile on energy. Unless they thoroughly understand this mechanism, they don’t have an accurate sense of their risk profile as it relates to their portfolio.

Lenders must also exercise discipline. If your competitor is offering a more aggressive finance package than you are — 
simply to take customers away from you — is it wise to follow down that path? Look at what happened to the home mortgage market: bankers and credit officers chose to match the market, creating circumstances they now regret. You are probably better off losing some business than matching bad business.

M: What are your thoughts about the economy as a whole?

MS: It’s difficult to comment definitively in an article like this because of the lag time between our conversation and actual publication, but what we are seeing has been very interesting. Consumer spending, which is considered the main engine of the economy, has shown fairly modest growth but not a contraction. Unless people lose their jobs, consumer spending tends to be one of the most stable components of national GDP activity — and at the moment, job loss is pretty minimal.

The real driver of economic cycles is investment, and we’re seeing a “Dr. Jekyll and Mr. Hyde” split personality out there. The housing/residential investment has shown quarter-after-quarter contraction, which has really dragged down the overall investment side and limited employment. Non-residential investments have been fairly good. I attribute the latter to a tremendous growth in export sectors. The weak dollar, which needs a couple of years to build up a head of steam in terms of exports, is doing a remarkable job helping us export while dampening import competition. Another positive factor is our government’s willingness to step up to the plate in terms of spending, and this should help offset slow consumer spending and erratic investment.

But we are still seeing softening of the economy and, due to credit issues and tightness in credit markets, we should expect a substandard growth rate for another year or so. If there is going to be more bad news, it will likely be from the consumer side as people find themselves pressured by housing values and debt, which will further slow spending.

The Fed may continue to cut percentage points off its target rates, but I think its role, in terms of ability to control the market, is overblown. I prefer to watch business functions and trade factors. Interest rates are generally not a swing factor for a business that is contemplating investment. Besides, it cuts both ways: When the Fed reduces interest rates, it also constrains income for people who invest money. So businesses may save money, but a lot of retirees and people with wealth would see their current incomes slashed as well. I think the stimulation needs to come from people and businesses thinking they can make money by investing more. Confidence is a huge part of it.

M: The Economic Stimulus Package includes $45 billion in investment incentives for businesses. Will that help?

MS: In terms of saving tax costs, the business component of the package allows businesses to accelerate depreciation by taking a long-term expense and making it a short-term expense, but they also give up that deductibility in the future. I suspect the Economic Stimulus Package was more of a political tool than a solution based on economic reality: If you could stimulate the economy to greater long-term growth by borrowing lots of money and giving it to people to spend, then that would be your long-term strategy. But again it’s a double-edged sword, because they are borrowing money from the future to spend it today — and they are still going to have to pay that money back in the future. At some point, that taxation will slow down future economic activity, too. In the end, it merely becomes an exercise in inter-allocation between time periods.

M: What’s your outlook for the future?

MS: Businesses are more confident than we give them credit for. I’ve covered a lot of territory in many different states during the past six months, and most businesses have a fairly positive outlook right now. For the most part, they are not seeing a lot of dramatic downturns, so I think business spending is going to be relatively good. However, borrowing conditions are probably going to become more difficult, because we’ve had lots of easy money for the last four or five years — and conditions, terms and spreads were quite favorable for businesses.

We are perhaps moving back to a more normal situation. With less credit available, a lot of the larger syndicated deals are less likely to get done the way they were a year or two ago, but terms, structures and spreads have actually improved. That is, if you are doing mortgages today, you are certainly doing better mortgages than you were a year ago. Both the spread and probably the collateralization on that asset are much better. Competition and desire to “stay in the game” had forced some lenders to structure transactions that were not very profitable. Subsequent losses and retrenchment have set back some of that marginal competition, allowing those still in business to impose better terms, structure and spread. It’s probably a more positive environment.

We are also seeing that alternative rates of return in other industries transmit competition as well. If I can make better money financing cars than financing equipment, the money will flow to where the better margins exist. Right now there are some very attractive margins in a lot of the other deals, and that will pull money out from competing with finance in other sectors. Money is very fungible, and it flows where the returns are, on a risk-adjusted basis. The key is to know your markets and to thoroughly understand the industries within which you are lending.

Lisa A. Miller is a freelance writer who has worked in the equipment financing industry for 12 years.

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