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Children of the Corn: The Renewable Fuels Disaster

Wednesday, January 4, 2012

How government policy can push more than 100 million people below the extreme poverty line.

Deficit hawks, environmentalists, and food processors are celebrating the expiration of the ethanol tax credit. This corporate handout gave $0.45 to ethanol producers for every gallon they produced and cost taxpayers $6 billion in 2011. So why did the powerful corn ethanol lobby let it expire without an apparent fight? The answer lies in legislation known as the Renewable Fuel Standard (RFS), which creates government-guaranteed demand that keeps corn prices high and generates massive farm profits. Removing the tax credit but keeping the RFS is like scraping a little frosting from the ethanol-boondoggle cake.

The RFS mandates that at least 37 percent of the 2011-12 corn crop be converted to ethanol and blended with the gasoline that powers our cars. The ethanol mandate is causing corn demand to outstrip supply by more and more each year, creating a vulnerable market in which even the slightest production disturbance will have devastating consequences for the world’s poor. It is time for the federal government to stop requiring cars to burn food.

Removing the tax credit but keeping the Renewable Fuel Standard is like scraping a little frosting from the ethanol-boondoggle cake.

Human mouths and motor engines provide the main sources of demand for corn. Market prices determine the form in which corn enters the food system; it may be an ingredient in your breakfast cereal, fed to cattle to produce steaks, or exported to Mexico to make tortillas. Market prices do not determine how much corn gets converted to ethanol for motor fuel use. The RFS mandate requires a massive quantity of corn to be converted to ethanol each year regardless of price or available supply.

Ethanol mandates were introduced in 2005, causing ethanol plants to sprout across the country. Firms could enter the ethanol industry secure in the knowledge that the government had guaranteed demand for their product. By the end of 2005, 4.3 billion gallons of ethanol-producing capacity existed and 1.8 billion gallons of capacity was under construction. One year later, capacity under construction had tripled and represented more production than existed at the time.

The ethanol construction boom gave the corn market fair warning of an impending increase in demand and enabled it to absorb the initial onslaught. Inventories accumulated and a record number of corn acres were planted in 2007. Nevertheless, production has been unable to keep up with demand. According to the most recent USDA estimates, carryover stocks into the 2012 crop year will be only 6.7 percent of annual use, a level seen only once since 1950. Ethanol policy is now affecting food prices more than ever.

It is time for the federal government to stop requiring cars to burn food.

The current price of corn on the Chicago Mercantile Exchange is about $6.50 per bushel—almost triple the pre-mandate level. What would the price be if ethanol production had been frozen at 2005 levels? In the 2005-06 crop year, 1.6 billion bushels of corn were used to produce ethanol; in the 2010-11 crop year, 5.0 billion bushels were. When corn is processed into ethanol, approximately one-third of its caloric value is retained in a byproduct known as distiller’s grains, which is fed to animals. Thus, an increase of 3.4 billion bushels of corn used for ethanol production implies a loss of 2.3 billion bushels to the food system, equivalent to about 16 percent of the total U.S. supply of corn.

If these 2.3 billion bushels were returned to the food system, users would increase consumption and farmers would reduce production until prices had declined enough to absorb the excess supply. In recent research, Michael Adjemian of the U.S. Department of Agriculture and I estimate that under current market conditions corn users would consume 2 percent more corn for every 10 percent reduction in price. Nathan Hendricks of Kansas State University estimates that U.S. farmers would plant 3 percent fewer acres to corn for every 10 percent reduction in price. Summing these effects implies that the market could absorb 5 percent more corn for every 10 percent price reduction. Thus, returning 16 percent of supply to the food system would reduce corn prices by about 32 percent.

A decline in corn prices would also stimulate declines in prices of other food commodities such as wheat, rice, and soybeans, which are substitutes for corn on both the supply and demand side. Michael Roberts of North Carolina State University and Wolfram Schlenker of Columbia University estimate that reducing corn ethanol production to zero would lower the price of calories from corn, soybeans, wheat, or rice by 20 percent.

The RFS mandates that at least 37 percent of the 2011-12 corn crop be converted to ethanol and blended with the gasoline that powers our cars.

Corn price increases have relatively small effects on grocery prices in the United States, which are dominated by processing and marketing costs. However, consumers in the poorest parts of the world spend a high proportion of their budget on food commodities such as corn. World Bank researchers Maros Ivanic, Will Martin, and Hassan Zaman estimate that the ethanol-induced price spike between June and December 2010 forced 44 million people below the extreme poverty line of $1.25 per day and that price increases from 2005-08 forced 105 million people below the extreme poverty line.

At most, removing the tax credit will cause ethanol production to drop to mandated levels. In 2011, ethanol production may exceed the mandate by as much as 1 billion gallons. Above-mandate ethanol production uses 0.37 billion bushels of corn and, after accounting for distiller’s grains, it removes 0.25 billion bushels from the food system, or 1.7 percent of total supply. Thus, even if all above-mandate ethanol production becomes unprofitable upon removal of the tax credit, corn prices will drop by only 3.4 percent.

Low stockpiles place the corn market in a perilous position. If the 2012 crop is even slightly smaller than expected, then prices will rise even further and plunge millions more people into extreme poverty. If they were unconstrained by mandates, ethanol producers would reduce their use of corn in response to high prices. Jim Costa (D-California) and Bob Goodlatte (R-Virginia) recently introduced legislation that would allow such a response; under their proposal the mandate would be reduced when corn stockpiles are low. This proposal is an important step in the right direction but is not enough. Eliminate the mandates completely and let the ethanol industry stand on its own feet.

Aaron Smith is an associate professor at the University of California, Davis.

FURTHER READING: Kenneth P. Green writes “Obama’s Energy Blueprint: Same Silliness, Different Day,” and “President Obama's Flawed Energy Blueprint.” Blake Hurst explains “Why I’m ‘Ginned Up’ about Regulation.” Christopher R. Knittel discusses “Corn Belt Moonshine: The Costs and Benefits of U.S. Ethanol Subsidies.” Steven F. Hayward reveals “The Secret to Brazil's Energy Success.”

Image by Rob Green | Bergman Group

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