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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 Some folks will say it is because the packaging specifications that the CCC requires are expensive and out of date.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.

 

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