On 27 March the Ministry of Agriculture published a project on soft agriculture credits on its official webpage. The project aims at helping agribusiness entrepreneurs improve the primary production, processing, storage and sale of agricultural produce and to ensure they have access to cheap and affordable monetary means. The three components of the project are: 1) zero-rated commodity credits (payment by installments) for small farmers; 2) soft agricultural loans for medium and large size farms – at a maximum interest rate of 8 percent (financing for working capital and the purchase of supplies for the short term); and 3) soft agricultural loans for agribusiness enterprises at a maximum interest rate of 3 percent (financing for fixed assets and technology for the long term). The project will be financed by the Agriculture Development Fund and implemented by the Agency for Agriculture Project Management. According to the project, loans will be issued by commercial banks (and consequently, the commercial banks will make decisions on the issuance of loans), whilst the difference between the market interest rate and the upper limit of interest established by the state will be covered by the Agriculture Development Fund. The source of income for this fund is yet unknown, but one can assume that part of tax (customs) revenues will contribute towards it. The government has officially declared the development of agriculture as one of its top priorities whereas, judging from the description of this project, the main direction of the implementation of strategy is to make a state investment (not a subsidy) of up to one billion lari in this field.
Some statistical indicators
Today, agriculture accounts for nine percent of Georgia's Gross Domestic Product (GDP), amounting to approximately 2.3 billion lari at current prices. This sector employs 48 percent of the Georgian population. When adjusted for the rate of inflation, the investment the state intends to make in the sector actually amounts to about half of the total value of products and services created in this sector. This high indicator is quite unprecedented. One can hardly name any market economy which has seen state investment of such a scale in a single field (relative to the output of that field) over the past 50 years. Moreover, as the statistical data shows, the agricultural sector does not actually utilize much technology and is therefore a very labor-consuming field – as opposed to other fields in which 52 percent of the country's employed population produce 91 percent of the GDP.
I will be one among many happy citizens if this very risky endeavor of the Georgian government bears fruit and increases the welfare of each and every person. I also hope that investments on such a scale are the product of a well thought-out strategy and not merely a populist pre-election promise for luring voters upon which the Georgian government now has no other choice but to deliver. At the same time, as an expert, I want to analyze the economic results of this decision and communicate my doubts to the interested public on why the desired outcome will be difficult to achieve in the long term.
A macroeconomic analysis of the situation (in the context of a sector)
An artificial decrease of interest rates on the market should, as a result of increased investments, lead first to an increase in employment and then to an increase in income. The latter should then lead to an enhancement of market capacity which, in turn, should create favorable conditions for an increase in production, employment and income in agriculture. This is the rationale behind the well-known Liquidity Preference Theory as developed by J. M. Keynes. This theory has been tried and applied in many countries at various times, and the illusion was created amongst the international community that this very theory made it possible to overcome the Great Depression. In reality, the theory is faulty and does not improve the economic situation. This has been proved by both a number of scientific studies as well as in practice. A decrease in interest rates creates a so-called boom in the market. The demand on cheap loans initially soars, causing increased economic activity. For example, the cultivation of land, the purchase of chemicals and fertilizers as well as labor tools and technology intensify. The impression that employment rises is created. Banks, which issue loans at interest rates lower than market rates, are viewed as a source of increased money supply which eventually causes the general price level of the market, and hence prices on products, to rise. Demand on expensive products plummets and, with it, production levels fall. As a result, under the conditions of increased prices, production returns to its natural level, i.e. to the output level it had before the start of the economic boom. In reality, nothing changes. By influencing general demand, the production level remains the same in the long term, but creates the illusion of a rise in employment and income in the short term. Inflation can be contained by applying monetary levers; but when so done, foreign currency reserves are wasted and inflation still occurs thereafter. Moreover, restrictive monetary policy increases the price of loans in other sectors of economy, adversely affecting the levels of economic activity and production. In the Keynesian model, interest rates are decreased by applying monetary instruments. In our case, this happens at the expense of the Agriculture Development Fund - although this makes no difference to the result. No one can deny that so-called cheap credit is a source for increasing the money supply.
Subsidizing the banking business
In reality, the entire agricultural development strategy is built upon a model of subsidizing the banking business. Had it not been for subsidies, we would have faced the problem of an upper limit on prices. This is the maximum price at which a product can be sold. When the upper price limit is below the market equilibrium price, the market experiences a shortage of product. For example, we all remember the long queues for bread in the 1990s. In this particular case, the product which is in shortage is bank loans, whilst the interest rate is the price of that product. The proposed interest rates in the soft agricultural credit project are below the market rate (which stands at an annual 18 percent, on average). Were it not for the subsidies, the demand for loans would have exceeded the amount of supply and would not only have failed to create short-term economic activity, but would have endangered the stability of the banking business as the benefits of saving would have exceeded the benefits of loans. In other words, the spending of an organization would have exceeded its revenues.
The government of Georgia understands the importance of a stable banking system perfectly well. Consequently, it creates appropriate guarantees and, at the same time, entrusts the entire risk of the project onto banks. In other words, decisions taken by banks should ensure such a development of the Georgian agricultural sector that will guarantee the recovery of the investment made. Will the banks be able to make rational decisions? The rational business behavior of an economic subject depends on how correctly that subject evaluates alternatives in the decision-making process; how correctly it plans and uses the limited resources in its possession. Decision making implies ceding one resource for another. If the value of a resource sold exceeds the value of its purchase, the decision of an individual is rational and he/she receives benefits as a result of such an exchange. The risk, i.e. the probability of losing income, conditions the rationality of a person's decision. Once such a risk disappears, the likelihood of taking an incorrect decision increases. For example, you want to use your savings to purchase shares in a company which will increase your future income. In such a situation, you would, of course, thoroughly study the activities of companies to select the best one, because a wrong decision may cost you all your savings. Let's take another example. The state guarantees you compensation in case you lose your savings. How much would this assurance affect your decision? Would you try to study the activities of companies as thoroughly as you would in the previous case? Naturally, a bank is an organization with a core business of issuing loans. But if banks are not taking a risk when issuing loans, the likelihood of banks making incorrect decisions significantly increases. In such a case, the bank is less interested in who receives loans or how the recipient will develop his/her business, et cetera.
Another problem is related to an excess in the demand for loans because of a decrease in their price. The market price communicates exact information to an economic subject about the real economic situation; based on this, both consumers and entrepreneurs take decisions on what kinds of economic activity they should undertake in the existing situation. When the market price is distorted, an economic subject gets a false impression that his/her activity is based on his/her rational behavior. Once people realize that taking out loans requires less sacrifice, the number of loan seekers will sharply increase and, with it, demand on the market. However, with that increased demand it will become impossible to figure out who is capable of making accurate estimates about his/her future revenues. The probability of loans being issued to those who are able to use them for profitable projects therefore shrinks and, vice versa, the probability of issuing loans to those who will waste them rises. At the end of the day, the increase in demand will artificially trigger a boom, which, for many people, will create the illusion of a boost to employment and income.
One should also note that the soft agriculture credit project is a sort of experiment conducted in the reality of Georgia. There are numerous examples of subsidizing agriculture across the world. However, judging by the description of the project, in this particular case we are dealing not with subsidies, but with social investments being implemented through subsidizing banks. The future will show how justified this experiment was. However, the fact that the experience of other countries has not really been considered in this project, gives an indication of institutional weakness.
That such experiments do not tend to end well can be seen in the experience of many countries. For example, when US exports to European countries plummeted after WWI, the government launched an agriculture assistance policy. The Agriculture Credits Act, a normative act concerning loans for agriculture, was published in 1923 and was one of the ways the US government was attempting to resist acute recession in the 1920s. The act envisaged the establishment of a soft loan mechanism for farmers. A network of twelve Federal Intermediate Credit Banks was set up across the country with the objective of issuing soft loans to farmers. Today, no one argues that this failed. It accelerated the agricultural crisis that was expressed in excess production, as a large amount of produce could not be sold because of the decreased demand from European countries, which led to a sharp drop in prices. This complicated the situation of farmers, especially during the period of the Great Depression. To help farmers out, in 1929 the government of President Hoover developed a price support policy that envisaged the purchase of excess production (mainly grain). In fact, the US government became one of the largest consumers, thereby pushing up prices on agricultural products. Encouraged by this fact, farmers further increased the scale of production, but the results of doing so proved to be too heavy a burden for the 500 million USD fund and the policy ended in failure. In the 1930s, the government of President Roosevelt devised the New Deal Program (the Agricultural Adjustment Act of 1933), which established quotas for farmers. As a result, the production level shrank and it became possible to increase prices.
None of the above cited government activities improved the welfare of farmers. In reality, the following happened: 1) a segment of farmers felt better because the income of another segment of farmers decreased (Roosevelt's policy); 2) the income of every farmer decreased because soft loans encouraged them to produce production which was not in demand (the 1923 act); and 3) the income of farmers was maintained at the expense of short-term subsidies, though that took away a fund worth 500 million USD. Since then, the issue of supporting farmers has been high on the pre-election agendas of US politicians. Having considered their past experience, US politicians finally focused their attention on President Hoover's strategy – which they believed was the most rational of the three approaches listed above. The price support policy is now known as the income support policy and is aimed at stabilizing prices on agricultural products. Under this policy, farmers are given direct subsidies to maintain their income. Subsidies represent income created in other sectors of the economy and impede the process of economic growth. Over the period of the 1950s and 1960s, subsidies were constantly increased. Today, subsidies have reached such a level that a refusal to continue them may cause great political instability. This problem is faced not only by the United States but other Western countries as well, especially France. The Georgian project of soft agricultural credit bears some resemblance to the 1923 act of the US government, but the difference is that it involves commercial banks which are insured against loss by an ambiguous development fund.
Economy of Scale
Georgia is a land-deficient country and yet 48 percent of the population lives in rural areas and are engaged in agriculture. The land fit for agriculture does not exceed one hectare per capita. The unit cost of production in this sector largely depends on the volume of output. The shortage of agricultural land often renders the use of machinery senseless because cost of such machinery significantly increases the unit cost. Under such conditions, it is almost impossible to turn agriculture into a capital-intensive field. Consequently, Georgian produce will find it very difficult to be competitive in price on both local and international markets. In order to make agribusiness worth running, farms must be enhanced.
In many countries worldwide, one farmer cultivates tens or hundreds of hectares and, owing to the economy of scale, achieves low costs per unit of production. The rural population of Georgia is mainly engaged in subsistence farming. Only a part of their produce makes it onto the market and, moreover, it faces a problem in sales because of high prices (however, I think that a certain part of market demand on local agricultural produce is created by a group of loyal people who think that local produce is of higher quality). Thus, some of the expensive produce is sold on the market whilst another part faces problems of sale. Farmers, therefore, apply to the state for assistance and the government, for its part, seeks solutions. This time around, the government sees the investment of a billion lari as the solution. In our view, this will not solve the problem of high costs because with small-size land parcels households will fail to reduce the unit costs of production whilst the development of farming requires the urbanization of the rural population. This is a very painful issue. Urbanization takes place when the industrial sectors of the economy develop. Thus, the development of agriculture as a field and a business becomes reasonable only when a high economic growth rate is ensured and the rural population is able to find such jobs which bring in higher income than they currently have. Only after that can one think about whether or not we will be able to replace our imports and increase the export of our agricultural production.
Social investments – at the expense of what?
The source of social investments is social savings. Saving occurs when tax (and customs) revenues exceed social costs within a unit of time (creating a budget surplus). In this case, a well-founded vision should be in place that social saving, which has been transformed into an investment, is more advantageous than private saving, which is also viewed as a source of creating new business projects. Over the period of the past four years there was no budget surplus. Nor did the annual average rate of economic growth allow the planning of a surplus budget. Hence, no social savings occurred. In such a case, the source of the one billion lari investment is not a social saving, but stems from other social projects which had been planned, but will no longer be implemented. We, the taxpayers, want to know which projects have had their financing rejected; what the benefits of those projects would have been; and by how much the benefits of an investment in agriculture exceeds the benefits of those rejected projects. To put it simply, this requires a cost-benefit analysis which, despite my best efforts, I have failed to secure. No previous Georgian government ever made such analysis and it is extremely unfortunate that the new government is following in that defective tradition.
An Institutional problem
Any project, especially a social project, must be preceded by a study. As far as I am aware, no such study was conducted into this agricultural project (at least, the results of any such study have not been made public). What was the basis of the decision to make such a large-scale investment? How badly do Georgian farmers today need tools, chemicals and fertilizers at the cost of a low interest loan? Why are we sure that cheap loans will enable Georgian farmers to replace imports and increase exports? Where is the guarantee that the main objective of this investment will not become the maintenance of the stability of the banking system and/or why are we placing the banking system under such risk? What is the term of recovery for investments? What will be the average return on investment for the sector? How will society benefit from this investment? What are the risks associated with the implementation of the project and how are these risks minimized and/or insured against? What indicators will be used to evaluate the progress of the project and how will those indicators be measured? Who will monitor the implementation of the project and how? Why have financial institutions not shown an interest in agribusiness until now? The answers to these and many other similar questions are yet unknown to us. A project should not be initiated, planned and managed in such a manner. This all indicates the institutional weakness of the project. In this particular case, the activity of the Ministry of Agriculture does not meet the elementary requirements of social administration. Even assuming that the project can increase the welfare of society, the institutional weakness of the project will impede the formation of desired results.
Despite my negative attitude towards subsidies in general, subsidizing agriculture is a common practice worldwide. The aim of a subsidy is to assist the rural population at the expense of the urban population which have succeeded in developing their businesses. Subsidies run counter to the philosophy of business development because part of the income, which is seen as a source of investment and a source for the development of innovative business projects, is meted out to those citizens who fail to create business projects. This reduces business activity and, accordingly, the rate of economic growth. At the same time, the issue of equality is important for a group of people. A successful business sector must make some sacrifices for unsuccessful businesses to enable the latter to operate normally. In terms of content, this is understandable and the policy of equalizing also needs to be taken into account. However, the published project on soft agriculture credit has exceeded all expectations. It is not about assistance to the rural population, but about the development of agriculture with the vision that this sector will become a successful business sector. In this case, we are dealing with an attempt to artificially accelerate progress which, as a rule, does not bring success.
Why do we try to imitate those countries where agriculture is subsidized? New Zealand is the best example from recent history: for decades, New Zealand was an agrarian country and the state made huge efforts to develop agriculture. In 1984, however, the government refused to continue subsidizing the sector and stopped implementing the price support policy; it abolished trade barriers; allowed access to loans only at market interest rates; allowed prices on agricultural land and capital to increase up to market prices; closed down all agricultural support programs; abolished subsidies on the use of transport and machinery (31 March 1986); and abolished benefits on first year investments in the agriculture sector. In fact, the state said no to assisting agriculture in any form. Twenty-nine years have passed since then. The country's economy has grown 2.2 times. The agriculture sector produces twice as many products as it did in the 1980s. Also, in the early 1980s, the share of agriculture in New Zealand's GDP comprised 25 percent, today it has dropped to 5 percent. The number of agricultural employees has also decreased owing to urbanization. All that, however, has not impeded the growth of its agriculture sector. Quite the opposite, the volume of exports significantly increased as a result of increased agricultural output.