According to the U.S. Department of Agriculture, the price of farmland, averaged across the whole country, fell in 2015. That puts the official seal on what people involved with farming in the Midwest have felt for two years — that the peak of the farmland price boom has passed and that there is considerable potential to fall. It also matches data compiled by researchers in the Applied Economics department of the University of Minnesota.
This won’t affect the national economy, but it will be a big issue in rural Minnesota and other farming areas. This drop also gives teachers like me examples to use when discussing the work of a broad range of economists.
Start with British economist David Ricardo of early 19th century. He laid out how interest rates and the income derived from some asset combine to determine the market price of that asset. If the applicable interest rate rises, the price of the asset — whether it be a share of stock, a bond or an acre of Jackson County farmland — falls. When rates fall, as they did in 2008-09, asset values rise.
Similarly, when the net income rises from an asset such as interest on bonds, rents on South Minneapolis apartments or net profits from growing corn, the value of the asset itself rises. But when such annual income drops, the market value of the asset itself also drops.
For a perpetual asset, one such as farmland that can conceivably produce income forever, the rational market value at any time is simply the annual income divided by the interest rate expressed as a decimal. This assumes that both the interest rate and annual income will not vary in the future.
Note these careful qualifications. The calculated value is that which a rational person would pay. There is nothing of buying out of “irrational exuberance” or selling in a herd mentality. And the calculation depends on assumptions about the future that we all know will not hold true.
That brings us up to date to Yale economist and Nobel laureate Robert Shiller. He is tied to the USDA announcement in several ways. First, he is an expert in the economics of real estate who correctly identified the housing price bubble leading up to 2006 and predicted its collapse. Secondly, he has been studying U.S. farmland price patterns over the last decade and argues that there now is an unsustainable bubble in those prices. Third, he is a leader among those contemporary economists who question Ricardo’s “what would a rational person do” theorizing as inadequate. Instead of depending on an a priori (“before-the-fact”) assumption of human nature, Shiller and other behavioral economists start from how human brains actually work as is being described by modern psychologists.
There is great irony in Shiller’s 2013 Nobel. He shared it with two others, one of whom was Eugene Fama, a finance specialist who took Ricardo’s assumption of rationality to its ultimate ends. In Fama’s world of dominant rationality, bubbles cannot arise. He is famous for saying “The word ‘bubble’ drives me nuts” in a September 2007 interview in the Minneapolis Fed’s The Region quarterly magazine.
This was three weeks after the first indications of the collapse of the largest bubble in the global economy in 80 years, a collapse that would progress through the failure of Wall Street investment bank Bear Stearns in March 2008 and Lehman Brothers seven months later. Fama legitimately deserved the Nobel for his very broad and insightful scholarship over decades, but on his key assumptions, history is proving him wrong and Shiller’s group right.
So as someone who predicted at least four years ago that farmland prices would drop and whose work focuses on why bubbles develop in the first place, Shiller is the economist of the hour.
The implications of the drop in farmland prices reach further, however, to macroeconomists like Federal Reserve Chairwoman Janet Yellen, former Minneapolis Fed chief Narayana Kocherlakota and Paul Krugman, another Nobel economst. All have been champions of the ultra-low interest rate policy pursued by the Fed over the past seven years. Krugman, and particularly Kocherlakota, have called for even greater monetary expansion — even suggesting moving into negative interest rate territory, as has been done in Europe. And all three discount the effects of such low interest rates on asset prices. That is a serious error. Now the Yellen-led Fed is inching interest rates up, but the bubble in land prices has already happened.
As Ricardo explained 195 years ago, interest rates are one of the two key factors that determine asset prices. Lower interest rates push up such prices. Farmland prices rose in part because ag commodity prices were high, part of a global commodities “supercycle” largely driven by the burgeoning Chinese economy. But they also rose because of unprecedentedly low interest rates.
Many macroeconomists argue that it is impossible to determine what a “correct” price is for an acre in the Red River Valley or for a share of stock. If one cannot know that, how can one decide whether Fed policy is making farmland or bonds or apartment houses too expensive or too cheap? It’s better, they say, to look at measures of price inflation of goods and services as a guide to monetary tightness and looseness. This, to put it very politely, is disingenuous.
Yes, economists cannot objectively know some correct prices for assets. But when a central bank has kept all interest rates well below historic levels and short-term ones below the level of consumer inflation for several years in a row and prices of a wide range of assets have boomed in the while, the probability of cause and effect is high, to put it mildly. And history shows that, unlike former Fed Chair Ben Bernanke’s sanguine views on the ease of mopping up busts after they occur, sharp rises followed by collapses of asset prices have real economic and social costs.
That brings us to Minnesota. Rural Main Street and ag-related businesses everywhere in the state are on a roller coaster that is starting down the first big hump. It won’t be the early 1980s all over again, but we are getting into something big in terms of farm financial problems.
How may such problems work their way through the economy? That must wait for a later column. What about the other half of the land price equation — that of farm product prices? I have written about that in the past two years, and it also deserves its own treatment. This story will be a big one in the Upper Midwest, and despite predictions by some ag economists that the price drop will be over in two more years, it is a story that is far from over.