From The MPC Newsletter
October 9, 2009
The Dairy Safety Net:
Mend It, Don’t End It
By Geoffrey Vanden Heuvel
Dairy producers are in terrible
shape right now. Clearly, the government’s current dairy safety net is not
working as it should. On September 21, National Milk Producers Federation put
out a press release informing the rest of us that they are working on “sweeping
changes” to the structure of the dairy industry as we know it. They are
proposing eliminating the support price program and the MILC program and
replacing it with a still undefined “revenue insurance” program, as well as
essentially deregulating class II, III and IV in the federal order program and
replacing that with a “competitive pay price” as the class I mover. In fairness
to National Milk, we will let them flesh out their proposal before we make any
substantive comments on it but the question for today is can the current program
be fixed.
The Dairy Product Price Support Program (DPPSP) and the Federal Milk Marketing
Order (FMMO) program are two major components of the government dairy safety
net. Both are important, and policies guiding both need to be adjusted and
coordinated to make them effective safety net tools.
The objective of the DPPSP is to clear the market of surplus products and
provide “support” or a floor under milk prices. Clearly, as currently practiced,
this system is not working adequately. USDA’s Commodity Credit Corporation (CCC)
is the entity that has the responsibility to actually purchase the surplus dairy
products and it has not actually bought any cheese under the DPPSP for over 15
years. Why? Some folks will say it is because the packaging specifications that
the CCC requires are expensive and out of date. But that is not the whole
reason. A much larger factor is that the FMMO pricing formulas have a fixed make
allowance embedded in them that virtually guarantees a profit margin for cheese
plants as long as they sell their cheese for the average NASS cheese price. (The
National Agriculture Statistics Service cheese price, which drives the milk
pricing formulas, is determined by a survey of what the average price cheese
plants sell their cheese for.) Because of the way the milk pricing formulas
work, cheese plants make the same margin regardless of whether the cheese price
is $2 a pound, $1.50 a pound or $1.00 a pound. To protect that margin all they
have to do is make sure that they are selling their cheese for the average
market price. The cheese plants incentive is to make sure they get paid the NASS
price for their cheese, as long as they do, the producers absorb all of the
price risk. Cheese makers are clearly unwilling to take the risk of selling
cheese to the CCC program and how can we blame them? The system does not
penalize them for selling cheap cheese. This is a misplaced incentive. It can be
fixed.
How could the existing system be fixed? First, the federal order class III and
IV formulas should floor the product value portion of the formula at the support
purchase price. If cheese makers decide to sell their cheese for a price below
the CCC purchase price, they should bear the cost of that decision, not
producers.
Second, the make allowance needs to be reconfigured and made variable. When
cheese prices are low, cheese makers need to have a smaller make allowance. The
make allowance should increase as cheese prices go up. This change would give
cheese makers an incentive to move cheese prices up because they would have a
financial stake in the outcome. It would also motivate them to push back
production when cheese prices and therefore plant margins were low.
A third change needs to be the mix of products that the CCC purchases. Right now
they only purchase butter, nonfat dry milk and cheddar cheese (although they
have not really purchased cheese in many years). They could purchase other types
of commodity dairy products. The support price should be raised to narrow the
gap between the support price and the cash cost of production. As our experience
of the last year has taught us, the support program really does act as the floor
on milk prices. Producers are not able to quickly adjust the milk supply when
the supply/demand balance gets out of whack. As bad as it has been, without the
government involvement how low would prices have actually gotten. $5 per
cwt.????
What is the right level of support price? That is a good question. Up until
1977, the Secretary of Agriculture had the discretion to adjust it up or down
based on his evaluation of what price was necessary to keep the dairy industry
stable. The 1977 farm bill removed that discretion from the Secretary and
mandated that the support price be 80% of parity. The practical impact of that
policy was to raise the support price from $8.26 per cwt in 1977 to $13.49 per
cwt in 1981. Clearly, that was too much. Since 1981 the support price has been
reduced all the way down to $9.90 per cwt (although it is really closer to $9.00
in practice). The current farm bill has given the Secretary some discretion in
setting the support price, which he used a couple of months ago to raise it
temporarily. Should he extend that? Should it be higher? I would think something
in the $11.50 range would be more reasonable. Producers get the same price
signal to reduce production when they are losing $3 per cwt, as they do when
they are losing $5.50 per cwt. The wreckage and the long term damage is just
less.
What about the Chicago Mercantile Exchange (CME)? There is a lot of criticism of
the prominent role the CME plays in pricing milk. In concept there is nothing
wrong with the CME. But as producers we need someone at the Exchange who is
interested in keeping the price up. In a normal market the sellers should be
interested in driving the price up and the buyers should be interested in
driving the price down. But as I explained above, the sellers of cheddar cheese
really don't care what they sell the cheese for as long as it is the “market”
price, because the formula gives them a fixed make allowance regardless of what
the market price is. This has lead to a perverse situation where neither the
sellers nor the buyers really care to drive the price up. Fixing the formula as
I suggested above would help to address this, as would having our cooperatives
either individually or collectively participating as buyers at the CME (instead
of sellers, one of the biggest cheese sellers at the CME during the past six
months was a major cooperative who shall remain unnamed).
We need to resist the calls to shut down the dairy industry's involvement with
the CME. I have seen no competitive pay price proposal that offers a better
outcome for producers than the one I have outline above. The problem with a
competitive pay price system (deregulation) is that in most of the country there
is no competition for milk. Without competition, cheese plants will construct
formulas, even without government regulation, that transfer all the price risk
to producers. That is what happens in Idaho now. They have no regulation, but
the results are the same.
In summary, remember that the dairy safety net functions at the bottom of the
price cycle. We still need to add a program to manage our growth so that the
range of the price cycles is reduced. But given the nature of the dairy industry
(milk is very perishable and cows cannot be turned off and on like a light
switch) having a safety net is very important. Clearly the safety net that has
existed for decades in the dairy industry needs some repairs, but totally
scrapping it is a very risky proposition and not necessary. Let’s mend it, not
end it.
Milk Producers Council