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com February 27, 2010 Special thanks to Warren Mosler and Scott Fullwiler President Saakashviliʼs Liberty Act would guarantee disaster for the economy. The Democratic Republic of Georgia gained independence from the Soviet Union in 1991. Decades of Soviet rule followed by severe corruption brought a widespread deep distrust of government involvement in the economy. Popular resentment for the government and nonsensical economic theory joined forces to form the Opportunity and Dignity Act (Liberty Act). If adopted and adhered to, the nation and its citizens will be forced into avoidable hardship. Other countries are attempting similar policies only to ﬁnd that they cause economic instability and make it impossible for government to provide the essential services the nationʼs present and future prosperity depend on. Many countries have tried the same policies only to ﬁnd it causes tragic outcomes. The Liberty Act requires under normal times to: A) Conﬁne the governmentʼs budget to no larger than 30% of GDP. B) Conﬁne the governmentʼs budget deﬁcit to no larger than 3% of GDP. C) Conﬁne governmentʼs debt to a maximum of 60% of GDP. During wartime or recession, parts A and B may be breached (but not C). No later then four years after a recession the nation must have returned to the previous caps. This paper analyzes just one section of the Liberty Act and its expected consequences; it is not a complete evaluation of the entire Liberty Act. There is a widespread popular desire in Georgia for the economic condition to improve. Poverty and unemployment rates remain unacceptably high. Distrust in the lari results in a dollarization of the economy which causes the currency to be weaker in the exchange markets. Each year many talented Georgians emigrate and still more will unless the economy provides decent, stable job opportunities. The Liberty Act, if parliament adds it to the constitution, will destabilize the economy and prevent the country from reaching its potential. Georgia, like any small country, needs to import much of what it needs and wants. To import a nation must export. The problem is Georgia presently doesnʼt have enough of what the world wants to buy, and every year the country imports more than it exports. To grow this way, Georgia must acquire foreign currency from developmental organizations, foreign investment or some other assistance from the rest of the world. Without international assistance prices would rise until they reach world market levels. The President and the framers of the Liberty Act hope that promises of limiting governmentʼs debt and size will encourage foreigners to invest in Georgia, but for reasons explained in the next paragraph it will eventually do the opposite.
If anyone looks at the economic literature, they would be alarmed to ﬁnd no sound reasoning for a country with a ﬂoating currency to set its debt and deﬁcit limits relative to GDP. The limits in the Liberty Act are arbitrary and based on gold standard era economics when a governmentʼs spending was constrained by how much physical gold it could get from taxing or borrowing. The worldʼs economies left the gold standard because they found it to be too problematic. Countries discovered that when its citizens desire to save some of their income they do so by reducing their consumption. This causes the income to businesses to fall so businesses respond by cutting production, investment, lowering salaries and laying off workers. Citizens then ﬁnd they arenʼt able to reach their desired savings ratio. To make matters even worse the loans citizens and business owners took on are harder to repay if incomes are lowered, so they reduce consumption even more. The Liberty Act further makes things worse. Without any changes in government spending, this fall in GDP makes governmentʼs size relative to GDP increase. Taxes received by the government will decrease, leading to a bigger deﬁcit. Trying to meet its obligations under the Liberty Act, the government canʼt “fund” the private sectorʼs desire to save, instead they must cut government spending to meet the self-imposed restraints with no regard to the capability of the real physical economy. If there is insufﬁcient private spending that is not countered by decreased taxes and/or increased government spending what happens is decreased GDP. This would mean cuts to things like education, law enforcement, infrastructure and healthcare, the essential things a country needs for a healthy economy! This will reduce GDP even further. Itʼs not that Georgia doesnʼt have the resources to run its economy suddenly, there are plenty of people eager and willing to work, itʼs just that by adhering to the Liberty Act, there is not enough income buy what can be produced. The only options left for Georgians looking for work under the Liberty Act would be to ﬁnd ways to export more by developing their competitive advantage, taking pay cuts, or acquiring more foreign investment. So far this strategy has not eliminated high unemployment, underemployment and poverty. A country with workers sitting idle, their marketable skills atrophying and poor school system is not very attractive to foreign investors. A growing country, with a healthy highly educated workforce, good law enforcement and good infrastructure would on the other hand be very attractive to investors. If the situation gets bad enough, political turmoil can be expected as well. More Georgians will look for work in other countries, giving investors more reason to invest elsewhere. The beﬁt to having a ﬂoating exchange rate and a sovereign currency is that a country can always employ its own resources. Georgiaʼs government spending isnʼt revenue constrained. It issues the currency that its citizens use to pay taxes and save by ﬁrst running budget deﬁcits. If the private sector (domestic plus foreign) wished to save 10% and the government sector ran a budget deﬁcit of only 3% then GDP would shrink because savers wouldnʼt be able to meet savings targets without cutting spending. The Liberty Act even encourages the government to run a budget surplus to shrink the debt to GDP ratio or to avoid breaching the 3% limit during hard times. Running a budget surplus (taxing is greater than spending) drains the private sector of ﬁnancial assets. In 2009 the government had a deﬁcit worth 9.5% of GDP. If the government was required
Notice almost every recession (as illustrated by the grey bars) in the US was preceded by reducing the deﬁcit, and end by increasing it. Budget deﬁcits spike during the recession as automatic stabilizers activate. The recession free period between 1990 and 2000 was unusual because the private sector took on unprecedented levels of debt. The government canʼt run a balanced budget or shrink the national debt without causing a recession or depression unless the country can somehow run a trade surplus.
to reduce this to 3% in four years, it would mean the foreign and domestic sectors of the economy would have to be able and willing to reduce their ﬁnancial balances by 6.5% of GDP. In other words, unless the country runs a current account surplus of 6.5% of GDP (highly unlikely 1), Georgian families and businesses, must spend up to 6.5% of GDP more than their income by taking on more debt. This is not theory or prediction, itʼs cold hard fact. This action has been tried by many countries, and almost every time it has predictably caused the economy to go into a recession or depression. Many would object to this line of reasoning. They would say running government deﬁcits will cause inﬂation, high interest rates, or high future taxes. Their concerns are due to a misunderstanding of how a country with a monetary system like Georgiaʼs operates. Overnight interest rates (TIBR) are a policy decision by the National Bank of Georgia (NBG). When a government deﬁcit spends (spends more than it taxes), banks ﬁnd that the government (as deﬁned as the central bank + treasury) credited bank accounts more than it has debited. This leaves banks with more reserves. If this increase in reserves push interest rates below the NBGʼs policy rate, the government would have to drain reserves by selling government debt, raising reserve requirements, or pay interest on reserves. Otherwise if the NBG is content to let interest rates drop (as far as zero),
The IMF reports that Georiga ran a current account deﬁcit of 16.3% of GDP in 2009 and is expected to run an even larger deﬁcit of 17.6% in 2010.
Month to Month changes in the GEL/USD exchange rate and the consumer price index
Source: National Bank of Georgia and author's calculations
like the Japan has for well over a decade, they can simply let the excess reserves accumulate in the bankʼs reserve accounts. The NBG buys and sells by changing numbers in a computer. It has unlimited power to do this so it can always control the interest rate. It is not necessarily inﬂationary. The NBG recently learned and noted on their website 2 that the recent increase in reserves didnʼt lead to an increase in loan creation. This is because bank lending isnʼt reserve constrained. Banks make loans which create deposits. After the loan is made banks must acquire the reserves to meet the central bankʼs reserve requirements. If the NBG left the banking system short of reserves, it would lose control of the interest rate, therefore it acts to accommodate reserve demand at itʼs desired interest rate target. Bank lending is however capital, risk preference, and credit worthy borrower constrained. Now for the inﬂation argument, there are a few causes of inﬂation, some due to governments spending too much, some not. One way inﬂation can occur is if increases in spending does not cause increases in production. In an economy that is producing less then it could, there are plenty of ways Georgia can spend before this happens. If spending (say for irrigation projects3 ) improves the productivity of the country, real wages (wages minus inﬂation) will rise. Taxes, imports, and saving will all reduce how many times a lari spent by government circulates. Consumer spending, saving, investment and trade desires ﬂuctuate, so government can and should step in to ﬁll any employment gap that is caused by insufﬁcient local or foreign demand for Georgian labor. What if all this government spending does push the economy beyond its productive capacity and inﬂation pressures mount? Then taxes can be increased to prevent people from spending (the Liberty Act makes this difﬁcult by requiring a nationwide referendum) or government can reduce its spending. As illustrated in the
Inﬂation Report II Quarter 2009 http://www.nbg.gov.ge/uploads/publications/inﬂationreport/2009/ inﬂacia_2q_eng_web.pdf
For a list of ECSSD investments see http://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/ ECAEXT/EXTECASUMECSSD/0,,contentMDK:20772688~menuPK:2186664~pagePK:51246584~piPK: 51241019~theSitePK:1587162,00.html
chart above, in recent years most of Georgiaʼs inﬂation was caused by changes in the exchange rate, not over-utilization of Georgiaʼs resources. More recently unusual ﬂooding last spring temporarily raised the price of food, this was not a consequence of too much spending. The opposite argument could be made, that this was the result of not spending enough on ﬂood protection. Inﬂation in a country is undesirable, but Georgia has shown that it can still grow its economy despite some inﬂation. Trying to stop all inﬂation by forcing the economy to contract does more harm than good. So what about the exchange rate? Wonʼt the government deﬁcits fuel the purchase of more imports leading to a weaker currency and this type of inﬂation? Possibly, but it would likely be a one time depreciation, not a continuous one. Itʼs worth noting that imports are component of income and that this type of inﬂation could occur in any type of economic expansion, either government or privately generated. The inﬂuence governmentʼs budget deﬁcit has on direction and strength of the exchange rate is weak at best and depends on a complex set of factors. Critics for some reason ﬁnd it more acceptable if the private sectorʼs growth causes a weaker exchange rate because itʼs assumed to be more productive or efﬁcient than say a government run program (sometimes true sometimes false). The only way around it is to stop growth or restrict trade, neither option is beneﬁcial country as a 4 whole. The people who are hurt the most by a 3 falling exchange rate are the most afﬂuent who import expensive luxury 2 cars or giant ﬂat screen TVs for their new 1 mansions4 . A weaker Government deﬁcit, % to GDP currency will intensify the USD/GEL average nominal exchange rate countryʼs production of 0 2001 2002 2003 2004 2005 2006 2007 exports and weaken consumption of imports. Source: GEPLAC Judging by Georgiaʼs and other countryʼs experiences with running government deﬁcits, there is little treason to believe they will cause a dramatic drop in the exchange rate. To use the most extreme example, Japan has often run the worldʼs largest budget deﬁcit, and still (much to their dislike), has a strong currency and bouts of deﬂation.
Personally, I would like to see a heavy tariff placed on expensive luxury goods since buying them pushes the price of the currency down making it more expensive for higher national priorities, like businesses importing equipment for employees or pharmacies importing medicines for the sick. Most Georgians I imagine would ﬁnd it morally reprehensible for some people to fund their luxury lifestyle by making it expensive or impossible for others get lifeʼs necessities.
One thing that will help stabilize the lari in exchange markets would be strong tax enforcement since people need laris to pay taxes or face punishment. This will motivate people to acquire the currency by selling goods and services in laris. Georgiaʼs government should issue debt only in laris if is to avoid risk of insolvency. If it does borrow in a foreign currency it must do so very conservatively, perhaps requiring a 60% vote in the parliament. It can still sell lari denominated debt to foreigners. Itʼs ﬁne for private ﬁrms to borrow in foreign currency. If they canʼt repay their foreign currency debt a default will result. There is always that risk, thatʼs capitalism. Some might believe this analysis doesnʼt apply to a small country like Georgia, that there is no foreign demand for lari-denominated assets. Even the local population doesnʼt want to hold lari denominated assets, so it is impossible to design government policies to stimulate local demand. This is myth can be debunked by the simple fact that Georgia has maintained a current account deﬁcit for years, which by deﬁnition proves that the rest of the world wishes to hold lari denominated assets. This current account deﬁcit means that the country for the time being enjoys beneﬁts (imports) that are greater than costs (exports). The larger the trade deﬁcit, the fewer exports Georgia must sell for every import it buys. Even if the currency depreciates, if there is still a trade deﬁcit, the country enjoys real beneﬁts. The government response to this shouldnʼt be to slow economic growth and cause unemployment. Another powerful way to stabilize the currency, political climate, develop the economy and attract foreign investors is to set up a government job program. To the governmentʼs credit, they did attempt this5 , but it wasnʼt done with enough transparency, oversight and on a large enough scale to greatly reduce unemployment. Businesses were paid by government to hire workers, which businesses falsely claimed to have done to collect government funds. This failure shouldnʼt discourage future attempts to get it right. Other countries have implemented job creation programs with incredible success. Argentina quickly hired 13% of its workforce in the 2002 and paid them minimum wages. The cost of this program was the additional consumption of the new workers which was tiny, 1% of GDP. The beneﬁt was the useful work they provided which was large. So there was an economic as well as social beneﬁt. The work was devoted to improving social programs, infrastructure, and the quality of life in poor neighborhoods6 . A job guarantee program is a powerful way to stabilize an economy and quickly lower unemployment.7 Labor that would otherwise be wasted sitting idle, is put to use doing something economically beneﬁcial. It is good psychologically especially to men whoʼs self esteem comes from their work, and are more prone to
See Papava 2009 http://www.papava.info/publications/Papava_Anatomical%20Pathology%20Georgia's %20The%20Rose%20Revolution.pdf
For more about this see “EMPLOYER OF LAST RESORT: A CASE STUDY OF ARGENTINA'S JEFES PROGRAM” Wray and Tcherneva 2005 http://www.epicoalition.org/docs/ArgentinaJefes.htm
For academic literature regarding a job guarantee see Mitchell and Wray 2005 http://www.cfeps.org/ pubs/wp/wp39.html and Fullwiler 2005 http://www.cfeps.org/pubs/wp/wp44.html
depression if they are unemployed8. It provides a wage ﬂoor that prevents the type of instability caused by cycles of lower wages, unemployment and reduced spending, of the type that would occur under the Liberty Act. As of writing, destructive economic spirals are occurring inside the European Monetary Government debt as percent of GDP 2009 (est)
300 240 180 120 60 Japan
Union and the Baltic countries which ﬁxed their currency to the euro. The one supranational agency inside Europe which is able stop the spiral, the European Central Bank, has so far refused to provide the funding needed to stabilize the situation. Europe has subscribed to something called the Stability and Growth Pact which, like the Liberty Act, caps GDP deﬁcits at 3% and national debt at 60%. More than a few economists warned that such a plan is unsustainable and would lead to economic hardship 9. A quick glance of the graph above shows how unobtainable the 60% limit is in an economic downturn. The IMF projects deﬁcits over 60% for all major industrialized nations for years to come 10. For countries like the USA, UK, Japan, or Georgia, which issue their own currency this debt to GDP ratio is nothing to worry about. Itʼs not analogous to household debt11 . It never needs to be repaid and historically it never does get repaid. Since the government is the issuer of the currency, there is no risk of default. When a government borrows in a foreign currency (like Argentina in 2001), or it is unable to issue currency (like Spain or Greece or California presently), or is on a ﬁxed exchange rate (like Russia in 1998 or Latvia now) then it runs into solvency problems. Otherwise, the governmentʼs checks always clear and it can buy whatever the national economy can produce.
See Bruchell 2009 http://www.redorbit.com/news/health/1652155/ men_suffer_greater_depression_during_unemployment/
See Mosler 2001 http://www.epicoalition.org/docs/rites_of_passage.htm or Wray 2003 http:// www.cfeps.org/pubs/wp/wp23.html
See the IMFʼs World Economic Outlook, April 2009 For a more complete explanation read Wray 2010 http://www.newdeal20.org/?p=8230
The Liberty Act, will undermine economic and social stability. The Georgian economy suffers every year from high unemployment, underemployment, and poverty. The debt and deﬁcit caps in the Liberty Act will limit governmentʼs ability to ﬁght these problems. Instead it will make government be a cause of them. Presumably the authors of the act and other supporters hope that these set of policies will cause Georgia to stand out as an attractive place for foreigners to invest. They also fear the government will grow so large that it will leave no room for free enterprise. Governmentʼs size should be determined by legitimate political processes, not an arbitrary percentage relative to GDP. Since the act limits government spending and the private sector does not offer enough jobs, year after year the productive capacity of the economy remains below its potential. If these idle workers were used, it would make their lives better, and the economy would grow faster. To successfully compete for foreign investment and build wealth, government to needs to provide healthy, safe, educated workers, and good public infrastructure. To soften economic downturns, government needs effective means of stabilizing an unstable economy. The Liberty Act cripples the governmentʼs ability to do all these things. The caps are unworkable and undesirable. Georgians will suffer until the government and citizens realize this.
Further Reading Some of the claims in this paper are contrary to conventional wisdom held by many economists. This paper was written mainly for policy makers, and non-economists to understand. Because of this I tried to keep from getting too technical, or address every possible objection one might have to any of the claims made in this paper. Therefore economists may need further convincing by more comprehensive explanations to back up my claims. The constant debt ratio discussion goes back to the inter-temporal budget constraint. Professor Scott Fullwiler addressed this at length in his paper Interest Rates and Fiscal Sustainability published in the Journal of Economic Issues Vol. XLI No. 4 in 2007. A less tightly argued version is assessable in PDF form at http://www.cfeps.org/pubs/wppdf/WP53-Fullwiler.pdf Understanding how ﬁscal policy rules change when a country has a ﬂoating exchange rate is explained by Professor L. Randall Wray in his article Understanding Policy in a Floating Rate Regime found at http://www.cfeps.org/pubs/wp/wp51.htm. Much of it addresses objections to itʼs application to small open economies where there is an inelastic demand for imports and it is a price taker in international markets. For the technically minded and the decision makers at the central bank I recommend Understanding Modern Money: The Key to Full Employment And Price Stability by the same writer.
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