In the comments to a Marginal Revolution post on the economic progress of Chile, Chilean commenter E. Barandiaran really went to town. Unfortunately his comments appear to have been too long for typepad to handle, as they are split up and separated by many intermediate comments. Since he doesn’t have a blog himself (though he should, just for this sort of occasion), I will consolidate them here.
Tyler, let me tell you why I disagree with you about the history of Chile since September 11, 1973.
1. Period September 1973 — April 1975. By September 1973, the Chilean economy had been ruined by Allende government. The emergency policies of the military government were largely focused on eliminating the price controls that had been the source of many black markets and on restoring property rights. Although the government was running a large deficit, the sharp increase in the price of copper until June 1974 (a result of the first oil crisis) generated enough revenue to reduce the deficit. By the end of 1974, the subsequent decline in the price of copper had forced a large devaluation of the “escudo” (later replaced by the peso) but it was not enough to eliminate the fiscal deficit. For several months the Military Junta discussed what to do and finally decided to apply the plan presented by Jorge Cauas, the new Minister of Finance (an engineer with graduate studies in economics at Columbia University–he was not a Chicago boy– and a Vice-President of the Central Bank in the late 1960s).
2. Period April 1975- June 1979. In early 1975, GDP per capita was 30% lower than in 1970 (just before Allende became President) and inflation was still well over 100% per year. Cauas Plan was a radical reform of the public sector, including large increases in revenue (the VAT was introduced) and large reductions in expenditures. In mid 1975, unemployment was around 30%. The low dollar value of the new peso and the plan quickly succeeded in eliminating the large fiscal deficit and the economy recovered, although inflation remained high. By mid 1979, and despite the continued low price of copper, GDP per capita was again at the level of 1970. By 1976, the strong recovery allowed the government to go ahead with the liberalization of trade policy and domestic markets (there was a large reform of the financial system but it did not amount to its liberalization).
Especial note on exchange rate policy. In those years, when inflation was very high, most economists were concerned about the feedback between domestic prices and the exchange rate. It was part of the exchange rate policy to adjust the rate according to inflation (Cauas had been part of the team that introduced “indexation” in the late 1960s). In June 1976, when there was already a fiscal surplus and to force a reduction in inflation, the government decreed a 10% appreciation of the dollar value of the peso that was followed by another one in April 1977 (Tyler, you should know that José Piñera, the brother of the new president Sebastián Piñera, both Ph.D. in Economics from Harvard U., was the one that recommended the appreciation). The first appreciation succeeded in reducing inflation with little impact on exports, but the second one failed. There was then a discussion about exchange rate policy, and at the end of 1977, the government opted for a “tablita” as a way to a fixed exchange rate (I invented the “tablita” but it was recommended to the government by other economists; the basic idea was to adjust the nominal exchange rates by a high fraction of last month CPI over a period long enough to bring inflation down to the US level). Yes, at that time most economists agreed that Chile needed a fixed exchange rate system (for some economists, including myself, it was a second best to the elimination of a national currency). This view was not in opposition to Friedman’s view of exchange rate systems because he only advocated free floating rates among major currencies, but he was reluctant to get rid of a fixed exchange rate system for countries like Chile. In addition, regardless of all theoretical arguments, the history of exchange rate systems does not provide any conclusive evidence that a country like Chile will benefit from abandoning a fixed exchange rate system. In Chile, the “tablita” succeeded in bringing inflation down to the US level without affecting exports. Finally, on June 30, 1979, the government decided to fix the exchange rate at 39 pesos per dollar.
Note: Please take into account that the “tablita” introduced in Argentina in December 1978 was quite different from Chile’s; in Argentina they manipulated the idea so instead of adjusting the exchange rate by a high fraction of last month CPI, they opted for adjusting it by a LOW fraction of last month CPI and therefore they created what was called “atraso cambiario”.
TO BE CONTINUED.
3. Period July 1979 – December 1981. This was a period of high growth. In 1981, GDP per capita was at least 15% higher than in 1970, unemployment was below 10%, and inflation was at the US level. In this period, the government undertook large reforms of labor markets, pensions, education, health, mining, and others. The reforms accelerated after the 1980 Constitution was approved (actually, two constitutions were approved, one for the period March 1981 to March 1997 in which Pinochet would be president for two consecutive 8-year periods, and the one that would be fully implemented after March 1997). It was the period in which the economy changed radically because the private sector emerged as the driving force of the economy while the public sector was limited to well-defined activities and was properly financed (there were large fiscal surpluses to finance the pension reform). It was a period in which domestic private banks grew sharply, funded by both domestic deposits and foreign borrowing (domestic banks intermediated most of the inflow of foreign capital) that fueled the expectation of declining interest rates, at least until March 1981. Most of the banks’ funds were invested in new productions because mining was pending on the approval of a new code based on the special provisions of the 1980 Constitution. There were large changes in relative prices but inflation was at the US level (a high level by today’s standards). In particular, the high growth of domestic demand did not create inflationary pressures because of the new openness of the economy (in addition, Chile benefited from the large increase in the price of copper during the 1980 oil crisis). There was no “atraso cambiario” as in Argentina.
4. Period January 1982 – December 1984. This was a period of crisis, a huge crisis precipitated by the sharp increases in interest rates in world markets (a result in turn of the new US monetary and fiscal policies). Over 90% of the foreign debt had been contracted by the private sector—intermediated through the banks—and invested in activities with a long period of maturation (think in apples and timber). The new enterprises didn’t have the capacity to service their debts that had been contracted at floating interest rates (the rates were adjusted every 6 months) and to make things worse the FLOW of domestic deposits into banks had been declining sharply since late 1980 (in my view this was due to the recovery of the housing market that provided an alternative investment for household savings). Unfortunately, many economists argued that the problem was the fixed exchange rate and started to recommend a devaluation of the dollar value of the peso. Their arguments were based on the wrong idea that the borrowing (and therefore the deficits) of private enterprises was similar to the borrowing (and the deficits) of governments. The debate about what to do took several months and finally on June 14, 1982, the government made the mistake of devaluing the peso. Apples didn’t mature faster, but dollar-denominated debts increased sharply. To make things worse, the devaluation unleashed a debate about the “right” exchange rate. After three months of large uncertainty, a new exchange rate policy became credible because it acknowledged a large devaluation of the peso (from 39 to 66 pesos per dollar) and the restoration of the indexation of the nominal exchange rate. In late September, the government focused its attention on the financial crisis that was already paralyzing the economy. The weaknesses of the political institutions of the “temporary” constitution were evident in early 1982 when the owners of heavily indebted enterprises started to ask Pinochet for bailouts. Most owners had agreed with the political strategy underlying the approval of the two constitutions, but now they wanted Pinochet to bail them out. There was a large bailout that took more than a year to define and implement but that was enough to prevent the bankruptcy of most enterprises. It succeeded because the government had been running surpluses and could finance the bailout by issuing bonds that were placed with the new Pension Funds (at the beginning of the new pension systems, the investment of the funds was limited to banks’ time deposits and government bonds). The economy collapsed in 1982-83 and unemployment was back to 25-30% as in the 1975 crisis. By early 1984 the economy was ready to start growing again but there were still some political groups close to Pinochet that were pressing for new economic policies (apparently they persuaded Pinochet that he would not be able to continue as president after March 1989 because of the economic crisis and that he needed to change to populist policies). The new policies introduced in April 1984 lasted only a few months because quickly it became evident that they were affecting the incipient recovery and generating inflation (one of the main fears of the Chilean population at that time).
TO BE CONTINUED.
THIRD AND FINAL PART.
5. Period January 1985 – March 1990. This period was marked by the fast recovery of the economy and the political developments that led to a newly elected government in March 11, 1990. Apple trees finally started to bear fruit—and we are talking about a lot of trees. In addition, and despite low prices of copper, the Mininig Code favored large private investments in new low-cost copper mines—investments that also take years to mature. Despite the challenge that a new bold opposition to Pinochet posed to the constitutional calendar for Pinochet to continue for a second period —in October 1988 the NO won the referendum to vote on a second term followed by a long period of uncertainty until March 11, 1990, when P. Alwyin assumed as the newly elected president— the reforms of the earlier periods were strengthened and their benefits appreciated. It’s not clear whether the good performance pressed the opposition to accept the reforms or the opposition’s acceptance of the reforms facilitated the good performance, but before Alwyin assumed the presidency there was a clear majority supporting the new economic policies.
6. Period March 1989 – Late 1997. This was the best period since 1973. High growth was the result of important domestic forces —including a new government interested in deepening the reforms of the previous periods and in strengthening democracy, and the maturation of investments, in particular in copper— and the easy access to world capital markets after the end of Latin America debt crisis (controls in capital inflows were introduced but were not significantly different from those before the 1982-83 crisis). Perhaps the two most important differences in the new investments of this period were the acceptance of private capital for building infrastructure for public services and the expansion of foreign interests in the economy. Since the new government was looking forward to ensure growth and to overcome the tragedy that Chile had suffered between September 4, 1970 (when Allende assumed the presidency) and March 11, 1990, expectations of Chile becoming a developed country became common among businesspeople.
7. Period Late 1997 – March 2000. The Asian crisis put an end to high growth. It was not because the crisis itself affected Chile. It was because Chile failed to implement good policies. Regardless of the particular fears that the government could have had about the possible negative effects of the crisis, the decision to increase interest rates had a large negative effect on the many medium and small enterprises that relied heavily on the banking system to finance. Growth quickly slowed down and unemployment increased to close to 10%. Rather than introducing corrections to monetary policy, the government started to look backward, perhaps urged by the lefty parties in the government coalition (this was the time when Pinochet was arrested in London). This change precipitated calls for government intervention in labor markets at the same time when businesspeople were asking for further liberalization of these markets. Finally the government coalition turned to the left and elected Ricardo Lagos as president, although he was no longer the socialist that he had been during Allende’s government.
8. Period March 2000 – March 2010. This period has put an end to the Chilean miracle. Although most reforms have survived, there have few new reforms that could have given Chile a strong private economy. In the last ten years, we have seen a sort of crony capitalism emerge —one in which the government works together (not too closely) with big enterprises in regulated industries (including banks, or perhaps specially banks) that allows government to obtain benefits from these industries for their main constituencies and the enterprises to do business with government protection. Medium and small enterprises have been the losers of this crony capitalism because they have to comply with many regulations that impose large costs to their businesses and have no government protection. Despite the extraordinary high price of copper in the past 6 years, Chile has grown not more than 15% in the last 12 years (GDP per capita) and unemployment is still close to 10%. Although at least half of the Treasury’s windfall of the past 6 years has been saved, over 40% has been spent, partly on social programs that have benefited low income people but not as much as one would have expected from the large amounts, partly on programs that have turned out to be very expensive (in particular Transantiago), partly on providing better services. Today a large part of the population expect the government to provide all sorts of social assistance, although the effective value of the assistance to the beneficiaries is quite low (the inefficiencies of assistance programs are already clear in the relief programs undertaken today).