Applied Theory: The Reforms in Chile

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Applied Theory The Reforms in Chile
There Ain't No Such Thing as a Free Lunch
Milton Friedman - An Appreciation

• Manfred Bräuchle
• Universidad Mayor

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1973

• Country in shambles
• Inflation 340
• No foreign reserves
• Falling GDP

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Chicago Boys

• Non regulated economy
• Open to the world
• Minimum role of the state
• Rigorous fiscal equilibrium
• Free functioning of the market

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El Ladrillo

• Written during early 1973
• Straightforward but comprehensive liberalization
  plan
• Prices are key to allocate resouces they would
  reflect relative scarcities
• An open economy is the best antitrust policy
• Markets get it right almost all the time
• Consistently eliminate all obstacles to private
  initiative and reduce influence of interest
  groups
• State intervention bound to impersonal rules

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Milton Friedman

• Two Options
• Slow recuperation of patient (country) with risk
  of death
• Shock treatment to revitalize patient, with
  severe inmediate effects

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Milton Friedmans LetterKey Economic
Problems

• Inflation
• Promotion of a healthy Social Market Economy

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Milton Friedmans LetterSource of
Inflation

• Goverment spending is 40 of national income
• One quarter of spending, not matched by explicit
  taxes

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Milton Friedmans LetterThe Remedy

• Drastically reduce the rate of increase in the
  quantity of money
• Reduction of fiscal deficit
• Fiscal deficit can be reduced by
• Cutting goverment spending
• Raising taxes
• Borrowing at home or abroad

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Milton Friedmans LetterPrerequisite for
Ending Inflation

• Cut in fiscal deficit
• Gradualism is not feasable
• Patient would not survive
• No way to end inflation that will not involve a
  temporary transitional period of severe difficulty

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Milton Friedmans LetterProposal

• 1.-Monetary reform does have a psychological
  role
• 2.-Goverment commitment to reduce spending by 25
  within six months
• 3.-A national stabilization loan from the public
  to supplement the reduction of spending during
  first six months
• 4.-A stabilization loan from abroad for the same
  purpose

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Milton Friedmans LetterProposal (Ctd.)

• 5.-A flat commitment by goverment that after six
  months it will no longer finance goverment
  spending by creating money
• 6.-Continuation of present policy of an exchange
  rate to approximate a free market rate
• 7.-Removal of obstacles that hinder the private
  market
• Suspend law against discharging employees
• Obstacles to establish new financial enterprises
• Wage and price controls
• 8.-Provide relief of cases of real hardship among
  poorest classes

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Milton Friedmans LetterResults

• Such a shock program could end inflation in
  months, and would set the stage for the solution
  of your second major problem promoting an
  effective social market economy.

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Impact of Measures

• The shock treatment contemplated a 20 reduction
  in public spending, firing 30 of the state
  employees, an increase in the VAT, privatize most
  of the state companies and end the savings and
  loan system for housing purposes
• GDP fell by 12, the unemployment rate grew to
  16 and export earnings fell by 40.
• However, the system started to show positive
  results as of 1977 when the so called boom
  period started.

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1930-1973 The Road to Socialism

• The Chilean crisis has its origins in the
  economic problems the country had been facing for
  decades
• Galloping inflation
• The public deficit
• High level of foreign debt
• The falling agricultural activity
• The need to recuperate the income from copper
  mining

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1930-1973 The Road to SocialismThe
Allende Goverment

• Country witnessed
• Expropriations
• Galloping inflation
• Food rationing
• Loss of political and economic rights

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Chile Public Companies(as of GDP of
each sector)

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Rate of ProductionBase 1970 100
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Macroeconomic Indicators 1970-1973

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External Accounts, Foreign Reserve
Holdings Foreign Debt (Millions of current
dollars)

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Situation of Public Finances
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Rate of Prices and Emission
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Macroeconomic Conditions 1960 -1973
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1973 The Road Towards a Free Society

• Basic structures of a new economic strategy
• Guarantees of property rights and of a state of
  law
• The market as the main instrument of assigning
  resources
• The Chilean economy open to international
  competition
• Macroeconomic equilibriums as a fundamental
  requirement for sustained growth
• A subsidiary role for the Government
• Establish priorities for economic policy
• Maintain responsibility for the system of
  justice, national security and redistribution of
  income
• Having non-discretional policies
• Social policies focused on sectors of extreme
  poverty

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1973 The Road Towards a Free Society

• Principal instruments to carry forward these
  duties
• The reduction of duties and the maintenance of a
  high and stable real exchange rate
• A system of free prices
• Privatization of firms
• Macroeconomic equilibriums
• Fiscal policy and stimulation of savings and
  investment
• Decentralization of social security, education
  and health
• Focalization of social spending
• An institutional framework

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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,
  Education and Housing
• Social policies focused on extreme poverty
• Constitutional economic order

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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 Persistent budget deficits
• Lack of fiscal discipline
• (30 deficit of GDP in 1973)
• Adjust Public Spending in 3 areas
• Public investment, public sector wages and
  the elimination of most of the subsidies implicit
  in the operations of the state owned companies
• Results 1974 deficit reduced to 5 of GDP
• 1976 surplus of 2 of GDP

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Chiles Overall Budget Balance
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Economic Reforms in ChilePublic Sector
Reforms

• Privatizations
• First Round (1974-1983)
• Returning the assets that had been expropriated
  to the previous owners
• Privitization of enterprises acquired by the
  state i.e. banks and industries
• State oowned enterprises reduced from 596 in 1974
  to 48 in 1983
• Value added reduced from 39 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 utilities and companies in hands of
  goverment since crisis of 1982
• Value added from state owned enterprises declined
  to 13 of GDP in 1989
• Third Round (1990)
• Infrastucture (Concessions)
• Water companies
• Value added fell to 9 of GDP

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Economic Reforms in ChilePublic Sector
Reforms

• Tax reform
• Two major tax refoms
• Value Added Tax introduced at flat rate of 19 in
  1975
• Drastic reduction of Corporate Income Tax
  (currently at 17), integrating it with personal
  income tax

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Economic Reforms in ChileTrade
Liberalization

• Unilateral tariff reduction
• 10 tariff on all imports (1974)
• Gradual reduction to 6 in 2003
• Current weighted import duty 2

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Market Liberalization Exports and
Imports (as a of GDP)
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Economic Reforms in ChileEffects of
Trade Liberalization

• Reduction of influence of special interests and
  corruption
• Flat tariff eliminated distortions that retard
  domestic economic growth
• Exports increased considerably, from 3 billion
  in 1974 to 29 billion in 2000
• Diversification of exports
• (Copper declined from 76 in 1974 to 38 in
  2001)

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Chilean Exports Diversification by Product(as a
of GDP)
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Chiles Exports of Goods and Services, 1974-2000
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Economic Reforms in Chile Financial
Sector Reforms

• Liberalization of the banking system in the
  mid-1970s
• Privatization of banks
• Liberalization of interest rates
• Reduction in reserve requirements
• Enlargment of scope of banking business
• New banking law

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Economic Reforms in Chile Pension Reform

• Privatization of the Pension System in 1981
• Allows individuals to save retirement money in
  fully funded privately managed accounts
• Pension funds have increased continuously since
  1981 and in 2001 represented more than 50 percent
  of GDP

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Economic Reforms in ChileMonetary Policy
Central Bank Independence

• 1989 a new law made the Central Bank independent
• Central Bank set and reached inflation targets,
  successively lower each year. Since 2000 target
  is 2 to 4 annually

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Inflation ( varience in 12 months)
More than 500
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Economic Reforms in ChileCapital Flows
and Foreign Investment

• Liberalization of foreign direct investment by
  enacting Decree Law 600 to define the rules for
  foreign investment
• Withdrawal from the Andean Pact, whose
  protectionism and bias against foreign investment
  were incompatible with Chiles new development
  strategy
• This reform has resulted in a massive inflow of
  foreign direct investment, increasing from 12.7
  billion in 1974-1994 to 35.9 billion in
  1995-2001

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Economic Reforms in ChileWages and Prices

• 1974 Goverment lifted restrictions on all
  prices
• Wages were liberalized

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Economic Reforms in ChileProperty Rights

• Long tradition of respect for private property
  rights and enforcement of contracts
• The respect for and strong enforcement of private
  contracts continued even through the 1973-1989
  military regime

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Economic Reforms in ChileRegulations

• Major reform in the mid-1970s was the
  liberalization of the labor market, making it
  more flexible
• Negotiations between would determine wages in
  the private sector
• More flexible conditions for hiring and laying
  off employees
• Reduced restrictions on the severance pay for
  layoffs
• Reformed collective bargaining process

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Unemployment (Average Oct-Dec)
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Economic Reforms in ChileBlack Market

• Informal economy is very small (19.8 of GDP)

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Main Lessons of the Reforms

• Reforms pay off
• After the crisis of 82-83, growth averaged 7
  for the next fifteen years, saving and investment
  boomed, unemployment fell and inflation was
  reduced to a 2-4 level
• It is important to be patient
• Financial regulation and supervision is key
• Tax and pension reforms are essential in
  promoting investment and saving

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Conclusion

• Reforms paid off
• More investment
• More consumption
• More economic efficacy
• Sustained economic 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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Conclusion

• Reform should proceed simultaneously across all
  fronts
• Economic freedom leads to prosperity because free
  economies allow for competition
• Competition requires
• The organization of institutions, such as stable
  money
• Minimal and transparent regulation
• Minimal participation of the state in economic
  activity
• Strong enforcement of property rights and
  regulations

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