liberty act review

8/9/2019 Liberty Act Review

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The Liberty Act is Fatally FlawedBy: Jeff Reisberg [email protected]

February 27, 2010

Special thanks to Warren Mosler and Scott Fullwiler

President Saakashvilis Liberty Act would guarantee disaster for the economy. TheDemocratic Republic of Georgia gained independence from the Soviet Union in 1991.Decades of Soviet rule followed by severe corruption brought a widespread deepdistrust of government involvement in the economy. Popular resentment for thegovernment and nonsensical economic theory joined forces to form the Opportunity andDignity Act (Liberty Act). If adopted and adhered to, the nation and its citizens will beforced into avoidable hardship. Other countries are attempting similar policies only tofind that they cause economic instability and make it impossible for government toprovide the essential services the nations 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 governments budget to no larger than 30% of GDP.B) Confine the governments budget deficit to no larger than 3% of GDP.C) Confine governments debt to a maximum of 60% of GDP.

During wartime or recession, parts A and B may be breached (but not C). No later thenfour years after a recession the nation must have returned to the previous caps. Thispaper analyzes just one section of the Liberty Act and its expected consequences; it isnot 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 resultsin a dollarization of the economy which causes the currency to be weaker in theexchange markets. Each year many talented Georgians emigrate and still more willunless the economy provides decent, stable job opportunities. The Liberty Act, ifparliament adds it to the constitution, will destabilize the economy and prevent thecountry from reaching its potential.

Georgia, like any small country, needs to import much of what it needs and wants. Toimport a nation must export. The problem is Georgia presently doesnt have enough ofwhat 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 developmentalorganizations, 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 limitinggovernments debt and size will encourage foreigners to invest in Georgia, but forreasons explained in the next paragraph it will eventually do the opposite.
mailto:[email protected]:[email protected]


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If anyone looks at the economic literature, they would be alarmed to find no soundreasoning for a country with a floating currency to set its debt and deficit limits relative toGDP. The limits in the Liberty Act are arbitrary and based on gold standard eraeconomics when a governments spending was constrained by how much physical goldit could get from taxing or borrowing. The worlds economies left the gold standard

because they found it to be too problematic. Countries discovered that when its citizensdesire to save some of their income they do so by reducing their consumption. Thiscauses the income to businesses to fall so businesses respond by cutting production,investment, lowering salaries and laying off workers. Citizens then find they arent ableto reach their desired savings ratio. To make matters even worse the loans citizens andbusiness owners took on are harder to repay if incomes are lowered, so they reduceconsumption even more. The Liberty Act further makes things worse. Without anychanges in government spending, this fall in GDP makes governments size relative toGDP increase. Taxes received by the government will decrease, leading to a biggerdeficit. Trying to meet its obligations under the Liberty Act, the government cant fundthe private sectors 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/orincreased government spending what happens is decreased GDP. This would meancuts to things like education, law enforcement, infrastructure and healthcare, theessential things a country needs for a healthy economy! This will reduce GDP evenfurther. Its not that Georgia doesnt have the resources to run its economy suddenly,there are plenty of people eager and willing to work, it s just that by adhering to theLiberty Act, there is not enough income buy what can be produced. The only optionsleft for Georgians looking for work under the Liberty Act would be to find ways to exportmore by developing their competitive advantage, taking pay cuts, or acquiring moreforeign 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 schoolsystem is not very attractive to foreign investors. A growing country, with a healthyhighly educated workforce, good law enforcement and good infrastructure would on theother hand be very attractive to investors. If the situation gets bad enough, politicalturmoil 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 countrycan always employ its own resources. Georgias government spending isnt revenue

constrained. It issues the currency that its citizens use to pay taxes and save by firstrunning budget deficits. If the private sector (domestic plus foreign) wished to save10% and the government sector ran a budget deficit of only 3% then GDP would shrinkbecause savers wouldnt be able to meet savings targets without cutting spending. TheLiberty Act even encourages the government to run a budget surplus to shrink the debtto GDP ratio or to avoid breaching the 3% limit during hard times. Running a budgetsurplus (taxing is greater than spending) drains the private sector of financial assets. In2009 the government had a deficit worth 9.5% of GDP. If the government was required


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to reduce this to 3% in four years, it would mean the foreign and domestic sectors of theeconomy would have to be able and willing to reduce their financial balances by 6.5% ofGDP. In other words, unless the country runs a current account surplus of 6.5% ofGDP (highly unlikely 1), Georgian families and businesses, must spend up to 6.5% ofGDP more than their income by taking on more debt. This is not theory or prediction,its cold hard fact. This action has been tried by many countries, and almost every timeit has predictably caused the economy to go into a recession or depression.

Many would object to this line of reasoning. They would say running governmentdeficits will cause inflation, high interest rates, or high future taxes. Their concerns aredue to a misunderstanding of how a country with a monetary system like Georgiasoperates.

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 thatthe government (as defined as the central bank + treasury) credited bank accountsmore than it has debited. This leaves banks with more reserves. If this increase inreserves push interest rates below the NBGs policy rate, the government would have todrain reserves by selling government debt, raising reserve requirements, or pay intereston reserves. Otherwise if the NBG is content to let interest rates drop (as far as zero),

1 The IMF reports that Georiga ran a current account deficit of 16.3% of GDP in 2009 and is expected torun an even larger deficit of 17.6% in 2010.

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 cant run a balanced budget or shrink the national debt without causing a recession or depression

unless the country can somehow run a trade surplus.


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like the Japan has for well over a decade, they can simply let the excess reservesaccumulate in the banks 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 theinterest rate. It is not necessarily inflationary. The NBG recently learned and noted ontheir website2 that the recent increase in reserves didnt lead to an increase in loancreation. This is because bank lending isnt reserve constrained. Banks make loanswhich create deposits. After the loan is made banks must acquire the reserves to meetthe central banks reserve requirements. If the NBG left the banking system short ofreserves, it would lose control of the interest rate, therefore it acts to accommodatereserve demand at its desired interest rate target. Bank lending is however capital, riskpreference, 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 increasesin spending does not cause increases in production. In an economy that is producingless then it could, there are plenty of ways Georgia can spend before this happens. Ifspending (say for irrigation projects3) improves the productivity of the country, realwages(wages minus inflation) will rise. Taxes, imports, and saving will all reduce howmany times a lari spent by government circulates. Consumer spending, saving,investment and trade desires fluctuate, so government can and should step in to fill anyemployment gap that is caused by insufficient local or foreign demand for Georgianlabor. What if all this government spending does push the economy beyond itsproductive capacity and inflation pressures mount? Then taxes can be increased toprevent people from spending (the Liberty Act makes this difficult by requiring anationwide referendum) or government can reduce its spending. As illustrated in the

2 Inflation Report II Quarter 2009 http://www.nbg.gov.ge/uploads/publications/inflationreport/2009/inflacia_2q_eng_web.pdf

3 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

Source: National Bank of Georgia and author's calculations

Month to Month changes in the GEL/USD exchange rate and the consumer price index
http://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/ECAEXT/EXTECASUMECSSD/0,,contentMDK:20772688~menuPK:2186664~pagePK:51246584~piPK:51241019~theSitePK:1587162,00.htmlhttp://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/ECAEXT/EXTECASUMECSSD/0,,contentMDK:20772688~menuPK:2186664~pagePK:51246584~piPK:51241019~theSitePK:1587162,00.htmlhttp://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/ECAEXT/EXTECASUMECSSD/0,,contentMDK:20772688~menuPK:2186664~pagePK:51246584~piPK:51241019~theSitePK:1587162,00.htmlhttp://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/ECAEXT/EXTECASUMECSSD/0,,contentMDK:20772688~menuPK:2186664~pagePK:51246584~piPK:51241019~theSitePK:1587162,00.htmlhttp://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/ECAEXT/EXTECASUMECSSD/0,,contentMDK:20772688~menuPK:2186664~pagePK:51246584~piPK:51241019~theSitePK:1587162,00.htmlhttp://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/ECAEXT/EXTECASUMECSSD/0,,contentMDK:20772688~menuPK:2186664~pagePK:51246584~piPK:51241019~theSitePK:1587162,00.htmlhttp://www.nbg.gov.ge/uploads/publications/inflationreport/2009/inflacia_2q_eng_web.pdfhttp://www.nbg.gov.ge/uploads/publications/inflationreport/2009/inflacia_2q_eng_web.pdfhttp://www.nbg.gov.ge/uploads/publications/inflationreport/2009/inflacia_2q_eng_web.pdfhttp://www.nbg.gov.ge/uploads/publications/inflationreport/2009/inflacia_2q_eng_web.pdf


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chart above, in recent years most of Georgias inflation was caused by changes in theexchange rate, not over-utilization of Georgias resources. More recently unusualflooding last spring temporarily raised the price of food, this was not a consequence oftoo much spending. The opposite argument could be made, that this was the result ofnot 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 tostop all inflation by forcing the economy to contract does more harm than good.

So what about the exchange rate? Wont the government deficits fuel the purchase ofmore imports leading to a weaker currency and this type of inflation? Possibly, but itwould likely be a one time depreciation, not a continuous one. Its worth noting thatimports are component of income and that this type of inflation could occur in any typeof economic expansion, either government or privately generated. The influencegovernments budget deficit has on direction and strength of the exchange rate is weakat best and depends on a complex set of factors. Critics for some reason find it moreacceptable if the private sectors growth causes a weaker exchange rate because its

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 isbeneficial country as awhole. The people whoare hurt the most by afalling exchange rate arethe most affluent whoimport expensive luxurycars or giant flat screenTV s f o r t h e i r ne w

mansions4. A weakercurrency will intensify thecountrys production ofexports and weakenconsumption of imports.Judging by Georgias

and other countrys experiences with running government deficits, there is little treasonto believe they will cause a dramatic drop in the exchange rate. To use the mostextreme example, Japan has often run the worlds largest budget deficit, and still (muchto their dislike), has a strong currency and bouts of deflation.

4 Personally, I would like to see a heavy tariff placed on expensive luxury goods since buying thempushes the price of the currency down making it more expensive for higher national priorities, likebusinesses 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 bymaking it expensive or impossible for others get lifes necessities.

0

1

2

3

4

2001 2002 2003 2004 2005 2006 2007

Government deficit, % to GDP

USD/GEL average nominal exchange rate

Source: GEPLAC


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One thing that will help stabilize the lari in exchange markets would be strong taxenforcement since people need laris to pay taxes or face punishment. This will motivatepeople to acquire the currency by selling goods and services in laris.

Georgias 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 a60% vote in the parliament. It can still sell lari denominated debt to foreigners. Its finefor private firms to borrow in foreign currency. If they cant repay their foreign currencydebt a default will result. There is always that risk, thats capitalism.

Some might believe this analysis doesnt apply to a small country like Georgia, thatthere is no foreign demand for lari-denominated assets. Even the local populationdoesnt want to hold lari denominated assets, so it is impossible to design governmentpolicies to stimulate local demand. This is myth can be debunked by the simple factthat Georgia has maintained a current account deficit for years, which by definitionproves 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) thatare greater than costs (exports). The larger the trade deficit, the fewer exports Georgiamust sell for every import it buys. Even if the currency depreciates, if there is still atrade deficit, the country enjoys real benefits. The government response to thisshouldnt be to slow economic growth and cause unemployment.

Another powerful way to stabilize the currency, political climate, develop the economyand attract foreign investors is to set up a government job program. To thegovernments credit, they did attempt this5, but it wasnt done with enough transparency,oversight and on a large enough scale to greatly reduce unemployment. Businesseswere paid by government to hire workers, which businesses falsely claimed to have

done to collect government funds. This failure shouldnt discourage future attempts to

get it right. Other countries have implemented job creation programs with incrediblesuccess. Argentina quickly hired 13% of its workforce in the 2002 and paid themminimum wages. The cost of this program was the additional consumption of the newworkers which was tiny, 1% of GDP. The benefit was the useful work they providedwhich was large. So there was an economic as well as social benefit. The work wasdevoted to improving social programs, infrastructure, and the quality of life in poorneighborhoods6. A job guarantee program is a powerful way to stabilize an economyand quickly lower unemployment.7 Labor that would otherwise be wasted sitting idle, isput to use doing something economically beneficial. It is good psychologicallyespecially to men whos self esteem comes from their work, and are more prone to

5 See Papava 2009 http://www.papava.info/publications/Papava_Anatomical%20Pathology%20Georgia's%20The%20Rose%20Revolution.pdf

6 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

7 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
http://www.cfeps.org/pubs/wp/wp39.htmlhttp://www.cfeps.org/pubs/wp/wp44.htmlhttp://www.epicoalition.org/docs/ArgentinaJefes.htmhttp://www.papava.info/publications/Papava_Anatomical%20Pathology%20Georgia's%20The%20Rose%20Revolution.pdfhttp://www.cfeps.org/pubs/wp/wp44.htmlhttp://www.cfeps.org/pubs/wp/wp44.htmlhttp://www.cfeps.org/pubs/wp/wp39.htmlhttp://www.cfeps.org/pubs/wp/wp39.htmlhttp://www.cfeps.org/pubs/wp/wp39.htmlhttp://www.cfeps.org/pubs/wp/wp39.htmlhttp://www.epicoalition.org/docs/ArgentinaJefes.htmhttp://www.epicoalition.org/docs/ArgentinaJefes.htmhttp://www.papava.info/publications/Papava_Anatomical%20Pathology%20Georgia's%20The%20Rose%20Revolution.pdfhttp://www.papava.info/publications/Papava_Anatomical%20Pathology%20Georgia's%20The%20Rose%20Revolution.pdfhttp://www.papava.info/publications/Papava_Anatomical%20Pathology%20Georgia's%20The%20Rose%20Revolution.pdfhttp://www.papava.info/publications/Papava_Anatomical%20Pathology%20Georgia's%20The%20Rose%20Revolution.pdf


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depression if they are unemployed8. It provides a wage floor that prevents the type ofinstability caused by cycles of lower wages, unemployment and reduced spending, ofthe type that would occur under the Liberty Act.

As of writing, destructive economic spirals are occurring inside the European Monetary

Union and the Baltic countries which fixed their currency to the euro. Theone supranational agency inside Europe which is able stop the spiral, the EuropeanCentral 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 theLiberty Act, caps GDP deficits at 3% and national debt at 60%. More than a feweconomists warned that such a plan is unsustainable and would lead to economichardship9. A quick glance of the graph above shows how unobtainable the 60% limit isin an economic downturn. The IMF projects deficits over 60% for all major industrialized

nations for years to come10

. For countries like the USA, UK, Japan, or Georgia, whichissue their own currency this debt to GDP ratio is nothing to worry about. Its notanalogous to household debt11. It never needs to be repaid and historically it neverdoes get repaid. Since the government is the issuer of the currency, there is no risk ofdefault. When a government borrows in a foreign currency (like Argentina in 2001), or itis unable to issue currency (like Spain or Greece or California presently), or is on a fixedexchange rate (like Russia in 1998 or Latvia now) then it runs into solvency problems.Otherwise, the governments checks always clear and it can buy whatever the nationaleconomy can produce.

8 See Bruchell 2009 http://www.redorbit.com/news/health/1652155/

men_suffer_greater_depression_during_unemployment/

9 See Mosler 2001 http://www.epicoalition.org/docs/rites_of_passage.htm or Wray 2003 http://www.cfeps.org/pubs/wp/wp23.html

10 See the IMFs World Economic Outlook, April 2009

11 For a more complete explanation read Wray 2010 http://www.newdeal20.org/?p=8230

0

60

120

180

240

300

Japan France UK US Georgia Germany

Government debt as percent of GDP 2009 (est)

Source: IMF
http://www.newdeal20.org/?p=8230http://www.epicoalition.org/docs/rites_of_passage.htmhttp://www.cfeps.org/pubs/wp/wp23.htmlhttp://www.newdeal20.org/?p=8230http://www.newdeal20.org/?p=8230http://www.cfeps.org/pubs/wp/wp23.htmlhttp://www.cfeps.org/pubs/wp/wp23.htmlhttp://www.cfeps.org/pubs/wp/wp23.htmlhttp://www.cfeps.org/pubs/wp/wp23.htmlhttp://www.epicoalition.org/docs/rites_of_passage.htmhttp://www.epicoalition.org/docs/rites_of_passage.htmhttp://www.redorbit.com/news/health/1652155/men_suffer_greater_depression_during_unemployment/http://www.redorbit.com/news/health/1652155/men_suffer_greater_depression_during_unemployment/http://www.redorbit.com/news/health/1652155/men_suffer_greater_depression_during_unemployment/http://www.redorbit.com/news/health/1652155/men_suffer_greater_depression_during_unemployment/


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The Liberty Act, will undermine economic and social stability. The Georgian economysuffers every year from high unemployment, underemployment, and poverty. The debtand deficit caps in the Liberty Act will limit governments ability to fight these problems.Instead it will make government be a cause of them. Presumably the authors of the actand 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 solarge that it will leave no room for free enterprise. Governments size should bedetermined by legitimate political processes, not an arbitrary percentage relative toGDP. Since the act limits government spending and the private sector does not offerenough jobs, year after year the productive capacity of the economy remains below itspotential. If these idle workers were used, it would make their lives better, and theeconomy would grow faster. To successfully compete for foreign investment and buildwealth, government to needs to provide healthy, safe, educated workers, and goodpublic infrastructure. To soften economic downturns, government needs effectivemeans of stabilizing an unstable economy. The Liberty Act cripples the governmentsability to do all these things. The caps are unworkable and undesirable. Georgians will

suffer until the government and citizens realize this.


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Further Reading

Some of the claims in this paper are contrary to conventional wisdom held by manyeconomists. This paper was written mainly for policy makers, and non-economists tounderstand. 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. Thereforeeconomists may need further convincing by more comprehensive explanations to backup 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 FiscalSustainability published in the Journal of Economic Issues Vol. XLI No. 4 in 2007. Aless tightly argued version is assessable in PDF form at http://www.cfeps.org/pubs/wp-pdf/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 aFloating Rate Regime found at http://www.cfeps.org/pubs/wp/wp51.htm. Much of itaddresses objections to its application to small open economies where there is aninelastic demand for imports and it is a price taker in international markets. For thetechnically minded and the decision makers at the central bank I recommendUnderstanding Modern Money: The Key to Full Employment And Price Stability by thesame writer.
http://www.cfeps.org/pubs/wp/wp51.htmhttp://www.cfeps.org/pubs/wp/wp51.htmhttp://www.cfeps.org/pubs/wp-pdf/WP53-Fullwiler.pdfhttp://www.cfeps.org/pubs/wp-pdf/WP53-Fullwiler.pdfhttp://www.cfeps.org/pubs/wp-pdf/WP53-Fullwiler.pdfhttp://www.cfeps.org/pubs/wp-pdf/WP53-Fullwiler.pdf

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