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Applied Theory: The Reforms in Chile
Manfred Bruchle
Universidad Mayor
There Ain't No Such Thing as aFree Lunch
Milton Friedman - An Appreciation
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1973
> Country inshambles
> Inflation +340%> Noforeign reserves
> FallingGDP
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Chicago Boys
> Non regulatedeconomy
> Opento the world> Minimumrole of the state
> Rigorousfiscal equilibrium
> Freefunctioning of the market
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El Ladrillo
> Written during early 1973
> Straightforward but comprehensiveliberalization plan
> Prices are keyto allocate resouces; they wouldreflect relative scarcities
> Anopen economyis the best antitrust policy
> Markets get it rightalmost all the time
> Consistently eliminate all obstaclesto privateinitiative and reduce influence of interestgroups
> State intervention bound toimpersonal rules
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Milton Friedman
Two Options:
> Slow recuperationof patient (country) withrisk of death
> Shock treatmentto revitalize patient, with
severe inmediate effects
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Milton Friedmans Letter
Key Economic Problems
> Inflation
> Promotion of a healthy Social Market Economy
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Milton Friedmans Letter
The Remedy
> Drasticallyreducethe rate of increase in thequantity of money
Reductionof fiscal deficit
> Fiscal deficit can be reduced by: Cuttinggoverment spending Raisingtaxes Borrowing at home or abroad
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Milton Friedmans Letter
Prerequisite for Ending Inflation
> Cutin fiscaldeficit
> Gradualism is notfeasable: Patient would not survive
> No way to end inflation that will not involve atemporarytransitional period ofsevere
difficulty
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Milton Friedmans Letter
Proposal
> 1.-Monetary reform:does have a psychological role
> 2.-Goverment commitment toreduce spendingby 25%within six months
> 3.-Anational stabilization loanfrom the public tosupplement the reduction of spending during first sixmonths
> 4.-A stabilizationloanfromabroadfor the samepurpose
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Milton Friedmans Letter
Results
Such a shock program could end inflation inmonths, and would set the stage for the
solution of your second major problem promoting an effective social marketeconomy.
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Impact of Measures
> The shock treatment contemplated a20% reduction inpublic spending, firing 30%of the state employees, anincrease in the VAT,privatize most of thestatecompaniesandend the savings and loansystem for
housing purposes
> GDP fell by12%,theunemploymentrate grew to16%andexportearnings fell by40%.
> However, the system started to showpositive resultsasof1977 when the so called boom period started.
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1930-1973: The Road to Socialism
The Chilean crisis has its origins in theeconomic problems the country had beenfacing for decades
> Gallopinginflation> The publicdeficit> High level offoreign debt> Thefallingagricultural activity
> The need to recuperate theincomefromcopper mining
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1930-1973: The Road to SocialismThe Allende Goverment
Country witnessed:
> Expropriations> Gallopinginflation
> Foodrationing
> Lossof political and economicrights
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Chile Public Companies(as % of GDP of each sector)
1965 1973
Mining Industry 13,0% 85,0%
Public services 25,0% 100,0%
Transportation 24,3% 70,0%
Communications 11,1% 70,0%
Financial sector n.a. 85,0%
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7074
788286
9094
98102
106
110114
1970
1971
1972
1973
Cooper Fish Agricultural Industrial
Rate of ProductionBase 1970 = 100
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Macroeconomic Indicators: 1970-1973
1970 1971 1972 1973
GDP Total Real Incr. ( % ) 2,1 9 -1,2 -5,6Balance of Trade Deficit(% of GDP) 12,5 13,3 15,9 15,1Public Sector Deficit( % of
GDP ) 2,7 10,7 13 24,7
Copper Price (US$/ pound) 0,64 0,49 0,49 0,81
Inflation ( % ) 34,9 22,1 260,5 605,1
Unemployment rate( %) 5,7 3,9 3,3 5
Real Exchange Rate 111,9 94,6 43,4 40,7
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External Accounts, Foreign ReserveHoldings & Foreign Debt (Millions of current
dollars)
1970 1971 1972 1973
Current Account -81 -189 -387 -295
Commercial Account
Exports / Imports 156 -16 -253 -138
Capital Account 268 -27 327 242
Balance of Payments 114 -300 -231 -112
Foreign Reserve Holdings 393 163 76 167Foreign Debt Public /Private 2767 2746 3002 3261
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Situation of Public Finances
Detail 1970 1973
Deficit as % of totalexpenses
13,0% 52,8%
Gross deficit as % ofGDP
3,1 21,3
Total expenses as %of GDP
23,9 40,5
Mixed and socialcompanies % ofdeficit of expenses
23,9 40,5
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0
500
1000
1500
2000
2500
Dec 1970 Dec 1971 Dec 1972 Sept.1973
Emission Prices
Rate of Prices and Emission
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Macroeconomic Conditions 1960 -1973
1960-73 1973
Inflation 47,6% 508,1%
Public deficit (% ofGDP)
6,0% 24,7%
Real GDP (averagegrowth rate)
3,4% -5,6%
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1973: The Road Towards a Free Society
Basic structures of a new economic strategy
> Guarantees ofproperty rightsand of a state of law> Themarketas the main instrument of assigning
resources> The Chileaneconomyopen to international competition> Macroeconomic equilibriumsas a fundamental
requirement for sustained growth> Asubsidiary rolefor the Government:
>Establishprioritiesfor economic policy>Maintainresponsibilityfor the system ofjustice,national securityand redistributionofincome
>Havingnon-discretionalpolicies>Social policiesfocused on sectors of extreme
poverty
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1973: The Road Towards a Free Society
Principal instruments to carry forward these duties:
> Thereduction of dutiesand the maintenance of ahighand stable realexchange rate
> A system offree prices
> Privatizationof firms
> Macroeconomic equilibriums
> Fiscal policy andstimulationof savings andinvestment
> Decentralizationof social security, education andhealth
> Focalizationof social spending
> Aninstitutionalframework
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Main Modernizations
Social security system Labor legislation
Capital market
Autonomy of Central Bank
Reform of public sector Privatization process
Close watch of free competition
Decentralization of public services: Health, Educationand Housing
Social policies focused on extreme poverty
Constitutional economic order
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67
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GDP Index 1973-1989
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Economic Reforms in Chile
> 1.- Public sector reforms> 2.-Trade liberalization> 3.- Financial sector reforms
> 4.- Pension reform> 5.- Monetary Policy: Central Bank Independence> 6.- Capital Flows and Foreign Investment> 7.- Wages and Prices> 8.- Property Rights
> 9.- Regulations> 10.- Black Markets
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Economic Reforms in ChilePublic Sector Reforms
> Rationalization of public spending> Privatizations
> Tax reform
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Economic Reforms in ChilePublic Sector Reforms
Rationalization of public spending> Problem:Persistentbudget deficits
Lack of fiscaldiscipline
(30% deficitof GDP in 1973)> Adjust Public Spending in 3 areas:
Publicinvestment, public sectorwagesandthe elimination of most of thesubsidiesimplicit in the operations of the state ownedcompanies
> Results: 1974deficitreduced to5% of GDP1976surplus of 2%of GDP
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Chiles Overall Budget Balance
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Economic Reforms in ChilePublic Sector Reforms
PrivatizationsFirst Round (1974-1983)
> Returning the assetsthat had beenexpropriated to the previous owners> Privitization of enterprises acquired by the
state i.e. banks and industries> State oowned enterprises reduced from596 in
1974 to 48 in 1983> Value added reduced from39% to 24% of
GDP
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Value Added in Public Enterprises in Chile
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Economic Reforms in ChilePublic Sector Reforms
Privatizations(ctd.)Second Round (1985)> Public utilitiesand companies in hands of
goverment since crisis of 1982> Value addedfrom state owned enterprisesdeclined to 13% of GDP in 1989
Third Round (1990)
> Infrastucture(Concessions)> Watercompanies> Value addedfell to9%of GDP
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Economic Reforms in ChilePublic Sector Reforms
Tax reform
Two major tax refoms:
> Value Added Taxintroduced at flat rate of
19%in 1975
> Drasticreductionof Corporate Income Tax(currently at17%), integrating it withpersonal income tax
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Economic Reforms in ChileTrade Liberalization
> Unilateraltariff reduction> 10%tariff on all imports (1974)
> Gradualreduction to6%in 2003
> Current weighted import duty:2%
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Economic Reforms in ChileEffects of Trade Liberalization
> Reductionof influence of special interests andcorruption
> Flat tariffeliminated distortionsthat retarddomestic economic growth> Exports increased considerably, from$3 billion
in 1974 to$29 billionin 2000> Diversificationof exports
(Copper declined from76%in 1974 to38%in2001)
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Chilean ExportsDiversification by Product
(as a % of GDP)
1973 1990
Copper 80,1 45,5
Other minerals:agriculture, forestry,fishing
1,9 11,9
Mining (ex. copper) 10,1 9,9
Industry 7,9 32,7
Total 100.0 100.0
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Chiles Exports of Goods and Services,1974-2000
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Economic Reforms in ChileFinancial Sector Reforms
> Liberalizationof the banking system in themid-1970s
> Privatizationof banks
> Liberalizationofinterestrates
> Reductionin reserve requirements
> Enlargmentof scope of banking business
> Newbanking law
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Economic Reforms in ChilePension Reform
> Privatizationof the Pension System in 1981
> Allows individuals to save retirement
money in fully fundedprivately managedaccounts
> Pension funds haveincreasedcontinuouslysince 1981 and in 2001 represented more
than50 percent of GDP
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Economic Reforms in ChileMonetary Policy: Central Bank
Independence
> 1989: a new law made the Central Bankindependent
> Central Bank set and reached inflation targets,successively lower each year. Since 2000target is2% to 4%annually
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1990
More than500
Inflation(% varience in 12 months)
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Economic Reforms in ChileCapital Flows and Foreign Investment
> Liberalization of foreign direct investmentby enactingDecree Law 600 to define the rules for foreigninvestment
> Withdrawal from the Andean Pact, whose protectionismand bias against foreign investment were incompatiblewith Chiles new development strategy
> This reform has resulted in amassive inflowof foreigndirect investment, increasing from$12.7 billionin 1974-1994 to$35.9 billionin 1995-2001
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Economic Reforms in ChileWages and Prices
> 1974: Govermentliftedrestrictions onallprices
> Wageswereliberalized
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Economic Reforms in ChileProperty Rights
> Long tradition ofrespectfor privateproperty
rightsand enforcement of contracts
> The respect for and strong enforcement ofprivate contractscontinuedeven through the
1973-1989 military regime
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Economic Reforms in ChileRegulations
> Major reform in the mid-1970s was theliberalization of the labor market, making itmore flexible
> Negotiationsbetween would determinewagesin the private sector> Moreflexibleconditions for hiring and laying
off employees> Reducedrestrictions on theseverance payfor
layoffs> Reformed collectivebargainingprocess
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Economic Reforms in ChileBlack Market
> Informal economy is very small (19.8% ofGDP)
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Main Lessons of the Reforms
> Reformspay off
After the crisis of 82-83, growth averaged 7%for the next fifteen years, saving and
investment boomed, unemployment fell andinflation was reduced to a 2-4% level
> It is important to bepatient
> Financialregulationand supervision iskey
> Tax and pension reformsare essential inpromoting investment and saving
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Conclusion
Reforms paid off:
> Moreinvestment
> Moreconsumption
> Moreeconomic efficacy
> Sustainedeconomic growth
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Economic Freedoms Payoff for Chile
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Per Capita GDP in Chile(1909-2006)
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Porcentage of Population Living In Poverty(1987 2003)
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> Reform should proceedsimultaneouslyacross all fronts
> Economic freedom leads toprosperitybecause free
economies allow forcompetition
Competition requires:
> The organization ofinstitutions, such as stable money
> Minimaland transparentregulation
> Minimal participationof the state in economic activity
> Strong enforcement ofproperty rightsandregulations
Conclusion
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THANK YOU
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