The Liberty Act is Fatally Flawed

By: Jeff Reisberg tschaff@gmail.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),

1 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

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

inflacia_2q_eng_web.pdf
3For 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
4 beneficial country as a
whole. The people who
are hurt the most by a
3 falling exchange rate are
the most affluent who
2 import expensive luxury
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
0 countryʼs production of
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.

4 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

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

%20The%20Rose%20Revolution.pdf
6For 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
7For 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 France 0
UK US Georgia Germany
Source: IMF

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.

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

men_suffer_greater_depression_during_unemployment/
9See 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 IMFʼs World Economic Outlook, April 2009
11 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/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 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.