September 19, 2010


Episode Two: The Agony of Reform: Chapter 7: Chicago Boys and Pinochet (The Commanding Heights, PBS)

NARRATOR: The Chicago Boys were a group of economists at Chile's Catholic University who had been sent to the University of Chicago as exchange students. There, they absorbed the ideas of the "Chicago School" of economics, with its almost revolutionary belief in free markets.

MILTON FRIEDMAN, Professor Emeritus, University of Chicago: What characterized the Chicago School was a strong belief in minimal government and an emphasis on free market as a way to control the economy.

NARRATOR: Professors like Arnold Harberger and Milton Friedman taught their students to distrust state planning and government control. When the Chicago Boys returned to Chile, they brought with them ideas that were a direct challenge to the dependency theory.

ARNOLD HARBERGER: This small group stayed together through the Allende years. And they used to meet I think every Tuesday for lunch. And they would keep a kind of running document which said how they would reform this economy, how this economy has to be reformed, what is to be done to get out of the swamp that they were putting themselves in.

SERGIO DE CASTRO, Finance Minister, Chile, 1974-1982: Unfortunately, due to the idiosyncrasies of the military mind, the generals preferred a controlled economy; that is, an economy that would obey orders.

NARRATOR: Javier Vial, an influential businessman sympathetic to the junta, was trying to push the military in the direction of the free market.

JAVIER VIAL: So I called Milton Friedman and invited him to come to Chile.

NARRATOR: So Milton Friedman, the most famous free-market economist in the world, came to lecture in Chile.

MILTON FRIEDMAN: I went down to Chile and spent five days giving a series of lectures on the Chilean problem, particularly the problem of inflation and how they should proceed to do something about it.

NARRATOR: Friedman's first talk was at the Catholic University. His theme: the inescapable link between free markets and freedom.

MILTON FRIEDMAN: The emphasis of that talk was that free markets would undermine political centralization and political control.

ARNOLD HARBERGER: He said that that you cannot have a repressive government for long within a genuinely free economic system.

NARRATOR: But Friedman was also persuaded to visit the grim conference center from which Pinochet ruled Chile. Friedman told Pinochet that he needed to take decisive and immediate action to defeat inflation.

JAVIER VIAL: Friedman says: "Well, I'm going to give you an example. If you cut the tail to a dog in pieces, step by step you will kill the dog. This is the same as inflation. You have to cut it at once, and then the country will start moving."

ARNOLD HARBERGER: Milton's presence probably helped to stiffen the spine of people who were trying to insist on better economic policies. That's the period when the takeoff of the Chilean economy really began and major reforms were made.

NARRATOR: In Santiago, the junta called on the Chicago Boys to rescue the economy. Five hundred state-owned businesses were privatized. Government budgets were cut. Import tariffs were swept away. The markets were given free rein.

SERGIO DE CASTRO: The basic thrust was to increase exports and abolish artificial price controls.

MILTON FRIEDMAN: Here was the first case in which you had a movement toward communism which was replaced by a movement toward free markets.

NARRATOR: There was much pain for the poorest. The cost of living went through the roof. The gap between rich and poor got wider, and stayed that way.

ALEJANDRO FOXLEY, Finance Minister, Chile, 1990-1994: They were starting a very big process of transformation of the economy without any regard of what happened to people. And we ended up at one point in time with 30 percent unemployment rate.

NARRATOR: According to the Chicago Boys, the gain was worth the pain. Chile became the fastest growing economy in Latin America.

ALEJANDRO FOXLEY: They were able to start a process of deregulating the markets, opening up the economy, so that's their contribution. They were able to anticipate a global trend, and Chile has benefited from that.

INTERVIEWER: But at a price?

ALEJANDRO FOXLEY: At a very high price, believe me. At a very high human price.

MILTON FRIEDMAN: The Chilean economy did very well, but more important, in the end, the Chilean military junta was replaced by a democratic society. Free markets did work their way in bringing about a free society.

NARRATOR: This is the monument to the 2,400 who died or disappeared during the dictatorship. The brutality of Pinochet's regime left little enthusiasm for change in the rest of Latin America.

CLIVE CROOK, Deputy Editor, The Economist: The fact that the Pinochet regime was politically unsavory allowed the left to make an association between market reforms on the one hand and repressive authoritarian governments on the other, and that was a terribly damaging connection.

MILTON FRIEDMAN: The intellectual elite, as it were, were on the side of Allende, not on the side of Pinochet. They regarded me as a traitor for having been willing to talk in Chile.

ARNOLD HARBERGER: Friedman then became a figure of hate, and they organized demonstrations against him wherever he went, and this went on for a period of years.

NARRATOR: The protests reached their climax when Friedman was awarded the Nobel Prize in 1976.

MILTON FRIEDMAN: At the Nobel ceremonies in Stockholm, I was subject to abuse in the sense that there were large demonstrations against me. There was a concerted effort to tar and feather me.

CLIVE CROOK: In the minds of many people, the reforms in Chile were tainted by the political caste of the regime that did set back the cause of liberal economics. It made other countries more resistant to the idea of market reforms than they otherwise would have been.

It is a peculiar irony that when the libertarian Right complains that the Thatcher/Clinton/Blair/Bush Third Way is fascist they are correct, but it was developed by the libertarian Right back when it was more sensible.


The main goal and consequence of the pension reform is to improve the lot of workers during their old age. As I will explain, the reform has a lot of side effects: savings, growth, capital markets. But we should never forget that the reform was enacted to assure workers decent pensions so that they can enjoy their old age in tranquility. That goal has been met already. After 14 years and because of compound interest, the system is paying old-age pensions that are 40 to 50 percent higher than those paid under the old system. (In the case of disability and survivor pensions, another privatized insurance, pensions are 70 to 100 percent higher than under the old system.) We are extremely happy.

But there have been other enormous effects. A second--and, to me, extremely important--one is that the new system reduces what can be called the payroll tax on labor. The social security contribution was seen by workers and employers as basically a tax on the use of labor; and a tax on the use of labor reduces employment. But a contribution to an individual's pension account is not seen as a tax on the use of labor. Unemployment in Chile is less than 5 percent. And that is without disguised unemployment in the federal government. We are approaching what could be called full employment in Chile. That's very different from a country like Spain, with a socialist government for the last 12 years, that has an unemployment rate of 24 percent and a youth unemployment rate of 40 percent.

Chile's private pension system has been the main factor in increasing the savings rate to the level of an Asian tiger. Our rate is 26 percent of GNP, compared to about 15 percent in Latin America. The Asian tigers are at 30 percent. The dramatic increase in the savings rate is the main reason that Chile is not suffering from the so-called tequila effect that plagues Mexico. We do not depend on short-run capital flows because we have an enormous pool of internal savings to finance our investment strategies. Chile will grow by about 6 percent of GNP this year, the year of the "tequila effect." The stock exchange has gone down by only 1 or 2 percent and will be higher at the end of the year. Chile has been isolated from short-run capital movement because its development is basically rooted in a high savings rate.

Pension reform has contributed strongly to an increase in the rate of economic growth. Before the 1970s Chile had a real growth rate of 3.5 percent. For the last 10 years we have been growing at the rate of 7 percent, double our historic rate. That is the most powerful means of eliminating poverty because growth increases employment and wages. Several experts have attributed the doubling of the growth rate to the private pension system.

Finally, the private pension system has had a very important political and cultural consequence. Ninety percent of Chile's workers chose to move into the new system. They moved faster than Germans going from East to West after the fall of the Berlin Wall. Those workers freely decided to abandon the state system, even though some of the trade-union leaders and the old political class advised against it. But workers are able to make wise decisions on matters close to their lives, such as pensions, education, and health. That's why I believe so much in their freedom to choose.

Every Chilean worker knows that he is the owner of an individual pension account. We have calculated that the typical Chilean worker's main asset is not his small house or his used car but the capital in his pension account. The Chilean worker is an owner, a capitalist. There is no more powerful way to stabilize a free-market economy and to get the support of the workers than to link them directly to the benefits of the market economy. When Chile grows at 7 percent or when the stock market doubles--as it has done in the last three years--Chilean workers benefit directly, not only through higher wages, not only through more employment, but through additional capital in their individual pension accounts.

Incentive effects of unemployment insurance savings accounts: Evidence from Chile (Gonzalo Reyes Jan van Ours Milan Vodopivec, 9 February 2010, Vox)
In 2002, Chile introduced a new unemployment insurance programme that combines social insurance with self-insurance. Unemployment contributions, paid by both workers and employers, are split between individual-level insurance savings accounts and a common, solidarity fund, the latter being cofinanced by the government. To stimulate reemployment, benefit recipients first draw resources from their savings accounts and, upon depletion, from the solidarity fund. The potential benefit duration is five months.

Withdrawals from individual accounts are triggered by separation from the employer, regardless of the reason. Insufficient resources on individual accounts trigger withdrawals from the common fund, if the claimant satisfies the usual conditions of continuing eligibility under typical unemployment insurance. Only those who, prior to unemployment, have worked under permanent contracts and were laid off for reasons attributable to the employer, can access solidarity funding. But, even if they do qualify, workers may opt not to choose the option of using solitary funding – presumably to avoid additional conditions on the benefit receipt.

By the end of 2008, the programme had about three million active contributors, representing almost 80% of private sector wage and salary workers, and distributed benefits to more than 100,000 members, approximately one quarter of the unemployed.

New evidence on the incentive effects of the Chilean programme

What kind of work incentives can one expect from the Chilean system? Theoretical modelling of Orszag and Snower (2002) shows that workers who rely on unemployment insurance savings accounts internalise the costs of their unemployment and thus they have the incentive to search harder for jobs than workers not relying on the savings accounts. Applying this logic to the Chilean programme and realising that the Chilean programme is of a “hybrid” nature, we derive the following predictions:

* For persons eligible to savings accounts only, the amount accumulated on their accounts will not affect their job-finding rate.
* In contrast, for workers using solidarity funding, we can expect that their job-finding rate will increase in proportion to the share of potential benefits that can be financed by their own savings accounts.
* Moreover, as the benefit expiration date approaches, we can expect that workers who use the solidarity fund will increase the intensity of their job search or reduce their reservation wage, thereby increasing the rate of job-finding (see Mortensen 1977), and no such effect will be detected for workers not using the solidarity funding.

We investigated the validity of these predictions using administrative records of the Chilean unemployment benefit programme, both the contribution histories and paid benefits, for a sample of prime age men and women who lost a permanent job by 2007 (about 50,000 men and 25,000 women). In Reyes et al. (2010) we analyse the labour market position of men and women separately. Here, for brevity, we only report results for prime age men.

The empirical results provide strong support to the above predictions.

Stabilisation and growth under dictatorships: Lessons from Franco’s Spain: Is democracy essential for economic growth? This column presents new evidence from General Franco’s 1959 Spanish Stabilisation Plan showing that a dictatorship can successfully implement major policy reforms. This also sheds light on the effectiveness of structural adjustment policies. Without the reforms, Spanish GDP per head in 1975 would have been lower by as much as one third. (Leandro Prados-de-la-Escosura Joan R. Rosés Isabel Sanz Villarroya, 22 March 2010, Vox)
From 1950 to 1975 Spain evolved from a closed and isolated economy to integrating with the rest of European economies, albeit remaining as a dictatorship. After the Civil War (1936-39), the new autocratic regime introduced anti-market policies that dramatically altered the previous economic policy. Effective possession of legislative and judicial powers gave General Franco’s dictatorship the ability to alter economic and political rights without restraint. These new measures resulted in high inflation rates, the development of black markets, and a severe contraction of international trade.

In the early 1950s, some of these regulations were relaxed and a cautious liberalisation process began. The new international context dominated by the Cold War helped decisively to rehabilitate the regime of General Franco in the international community. Growth accelerated during the 1950s on the basis of capital accumulation and efficiency gains. The US-Spain cooperation agreements in 1953 helped to further the growth in economic confidence (Calvo-González 2007).

In July 1959, an inward-looking growth crisis, triggered by a dramatic shortage of foreign reserves, led a new technocratic cabinet to introduce a simultaneous liberalisation of domestic markets and international economic relations. Following advice from the IMF and the Organisation for European Economic Cooperation, a conventional stabilisation programme was enforced.

* First, a stabilisation operation was executed to reduce inflation, mainly due to a lack of monetary discipline. Public spending was controlled, the issue of new public debt limited, and the Bank of Spain’s rate of discount increased.
* Second, domestic markets were partly liberalised by suppressing regulations and simplifying administrative procedures.
* Third, authorities partly liberalised foreign trade and the Peseta was integrated into the Bretton Woods system, accompanied by the introduction of a more realistic exchange rate, while restrictions on foreign direct investment were relaxed.

All major contingency measures were successful. Inflation declined, the budget deficit disappeared, and foreign capital began to flow into the country. By implementing the new policy, Franco’s regime showed its commitment to orthodox macroeconomic policies and offered a precedent of responsible behaviour to domestic and foreign investors.

The Mystery of Fascism: Mussolini - as he would like to have been remembered (David Ramsay Steele, Liberty)

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Posted by Orrin Judd at September 19, 2010 9:12 AM
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