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There Ain't No Such Thing as a Free Lunch Milton Friedman - An Appreciation

Applied Theory: The Reforms in Chile


Manfred Bruchle Universidad Mayor

1973

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Country in shambles Inflation + 340% No foreign reserves Falling GDP

Chicago Boys

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

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

Milton Friedmans Letter Key Economic Problems

> Inflation > Promotion of a healthy Social Market Economy

Milton Friedmans Letter Source of Inflation

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

Milton Friedmans Letter The 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

Milton Friedmans Letter Prerequisite 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

Milton Friedmans Letter Proposal


> 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 Letter Proposal (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 Letter Results


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 Socialism The Allende Goverment

> > > >

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

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(as % of GDP of each sector)


1965 Mining Industry Public services Transportation Communications Financial sector 13,0% 25,0% 24,3% 11,1% n.a.

Chile Public Companies

1973 85,0% 100,0% 70,0% 70,0% 85,0%

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Rate of Production Base 1970 = 100

114 110 106 102 98 94 90 86 82 78 74 70

Cooper

Fish

Agricultural

Industrial

1970

1971

1972

1973

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Macroeconomic Indicators: 1970-1973


1970 2,1 1971 9 1972 -1,2 1973 -5,6

GDP Total Real Incr. ( % ) Balance of Trade Deficit (% of GDP) Public Sector Deficit( % of GDP ) Copper Price (US$/ pound) Inflation ( % ) Unemployment rate( %) Real Exchange Rate

12,5
2,7 0,64 34,9 5,7 111,9

13,3
10,7 0,49 22,1 3,9 94,6

15,9
13 0,49 260,5 3,3 43,4

15,1
24,7 0,81 605,1 5 40,7

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External Accounts, Foreign Reserve Holdings & Foreign Debt (Millions of current dollars)
1970 Current Account Commercial Account Exports / Imports Capital Account Balance of Payments Foreign Reserve Holdings Foreign Debt Public / Private -81 156 268 114 393 1971 -189 -16 -27 -300 163 1972 -387 -253 327 -231 76 1973 -295 -138 242 -112 167

2767

2746

3002

3261
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Situation of Public Finances


Detail Deficit as % of total expenses 1970 13,0% 1973 52,8%

Gross deficit as % of GDP


Total expenses as % of GDP Mixed and social companies % of deficit of expenses

3,1
23,9 23,9

21,3
40,5 40,5

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Rate of Prices and Emission

2500

Emission
2000 1500 1000 500 0 Dec 1970 Dec 1971

Prices

Dec 1972

Sept.1973

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Macroeconomic Conditions 1960 -1973


1960-73 Inflation Public deficit (% of GDP) Real GDP (average growth rate) 47,6% 6,0% 3,4% 1973 508,1% 24,7% -5,6%

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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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100

120

140

160

180

20
88 133 115

40

60

80

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988
167

GDP Index 1973-1989

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 Chile Public Sector Reforms

> Rationalization of public spending > Privatizations > Tax reform

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Economic Reforms in Chile Public 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 Chile Public 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 Chile Public 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 Chile Public 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 Chile Trade 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)


70 60 50
36,9 42,0 43,0 54,0 49,0 57,4 56,0

40 30 20 10 0
23,8 25,2

1960

1970

1980

1985

1986

1987

1988

1989

1990

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Economic Reforms in Chile Effects 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)


1973 Copper Other minerals: agriculture, forestry, fishing Mining (ex. copper) Industry Total 80,1 1,9 1990 45,5 11,9

10,1 7,9 100.0

9,9 32,7 100.0 38

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 Chile Monetary 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)


160 140 120 100 80 60 40 20 0

More than 500%

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

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Economic Reforms in Chile Capital 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 19741994 to $35.9 billion in 1995-2001
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Economic Reforms in Chile Wages and Prices

> 1974: Goverment lifted restrictions on all prices > Wages were liberalized

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Economic Reforms in Chile Property 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 Chile Regulations


> 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)


16 14 12 10 8 6 4 2 0 1975 1977 1979 1981 1983 1985 1987 1989

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Economic Reforms in Chile Black 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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THANK YOU

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