Farmland prices are rising rapidly across Minnesota and the rest of the United States.
In our urbanized society, this affects few people directly, but the forces that drive such price increases affect other areas of the economy.
Data tabulations lag a lot, but much evidence supports estimated price increases of 25 percent to 30 percent in just the past two years. Even the tax statements for our own small farm show a tripling of value in less than a decade. Why so much?
The basic theory of land prices dates back to British economist David Ricardo. In 1821, he explored the basic economics of asset prices, whether for land, bonds or share of stock. The relationships he detailed still form the basis of finance theory.
In particular, the value of a perpetual asset, like the British “Consol” bonds that funded a quarter-century of war after the French Revolution, or like Minnesota farmland, depends on a very simple interaction of these factors.
The asset’s value equals its annual income divided by the interest rate expressed as a decimal. If the asset produces $100 in annual income and the interest rate is 5 percent, then $100/.05 = $2,000 in value.
The bigger the numerator – annual income – the more a rational person would pay for the asset. Similarly, the smaller the denominator or interest rate, the higher the value.
Right now, booming farm commodity prices have boosted the annual profit from an acre of land, so the numerator is perhaps twice as high as it was five years ago.
Low interest rates engineered by the Federal Reserve have cut the denominator by at least a third in the same period.
Following this argument, rising land prices may be a rational response to two fundamental factors of increasing profitability from farming and low interest rates.
However, remember that land is a perpetual asset that does not mature, as a 26-week or 20-year Treasury bond does. The valuation formula depends on the annual income and interest rate continuing forever.
Thus, what one rationally could pay for a long-term asset like land depends not only on profitability and interest rates today but also on expectations of what they will be decades into the future.
Ricardo’s theories emphasized human rationality. The “efficient market hypothesis” that has dominated finance in recent decades takes that further.
It argues that an asset’s market price reflects all the relevant information currently available, not only about the present but in expectations for the future. This does not mean markets collectively reflect perfect foresight, only that no one can systematically make better decisions than the market.
If you accept this hypothesis, then one square mile of land in the Corn Belt selling for $5 million or more is the best estimate of its true worth. However, we had a period in the 1970s when people bid up farmland values, and then they collapsed in the early 1980s. And we all know how housing prices doubled in the decade to 2008 and since have plunged. Could the same thing be happening again?
Yale economist Robert Shiller, one of the few people to correctly call the bubble in housing prices, now argues there is a similarly unsustainable one in farmland prices. Many agricultural economists and older farmers agree.
Bubbles may stem from irrationality, something the geezer generation within economics is loath to accept. In late 2007, even as the housing bubble began to collapse, Eugene Fama, the father of efficient market theory, famously denied that bubbles can even exist. “The word ‘bubble’ drives me nuts,” he said.
However, as someone who lived through the boom and bust 30 years ago, I am convinced that largely irrational “herding behaviors” played a large role then and are again now. Just as Citigroup CEO Charles Prince argued in 2007 that “as long as the music is playing, you’ve got to get up and dance,” some farmers believe they must pay extreme land prices to stay in the game.
As in the 1970s, some demand for land results from the frantic search for higher yields or safer assets that arises when uncertainty and fear dominate outlooks. Like the Gadarene swine of the New Testament, hedge fund managers and other investors rush wildly about, seeking safety or higher yields in gold, Swiss francs, Brazilian reis, oil futures and, perhaps, U.S. agricultural land.
A few see the Fed as the instigator of all of this. First, its low interest rates over the past four years make buying farmland cheaper, and its repeated commitments to keeping interest rates low for an extended period accentuate the incentives. Its recent initiative to lower long-term rates further compounds the problem.
Secondly, some blame easy money for a bubble in commodity prices themselves, including those of farm products, thus artificially inflating the profits numerator in valuation calculations.
Finally, a ballooning monetary base threatens inflation that drives investors to seek supposedly inflation-proof assets.
History and better economic theory eventually will rule on this question. In the meantime, there are interesting microeconomic aspects to the farmland boom as well. But these require another column.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.