economics assignment mehras

8/7/2019 Economics Assignment Mehras

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Macroeconomic Perpetuity and Income Imparity in Chile

Introduction

Arturo Rodrigo settled into his new office as economic advisor to President Aylwin. He hadwaited a long time to be part of a democratic government. Sixteen years ago Arturo was among

those Chilean centrists who welcomed the coup, as the overthrown leftist government wasincompetent. He had not, however, welcomed the long military dictatorship that followed.

Sixteen years of military rule under General Augusto Pinochet had produced many changes in theeconomic picture of Chile: some were for the better, some were not. Now, sixteen years after

the military ousted the last populist government in Chile, Arturo was once again in a position to

influence economic policies.

Chile had changed since the military takeover in 1973. After some rough economic times, theeconomy posted strong gains in the late 1980s. Real GDP growth had averaged 6.2 percent per

year, unemployment fell to 6.3 percent from a peak of 30 percent in 1982, and export growthsurged. However, sixteen years of conservative economic policies and authoritarian rule had

taken their toll on the working class: almost half of the population was living below the povertyline, and real wages remained 19 percent below their 1970 level. Income inequality had

worsened, especially in the first decade of the Pinochet regime, when the poor had seen theirwages stagnate while social spending had fallen drastically.

It is now 1990 and President Patricio Aylwin, a centrist, is the head of a center-left coalitionknown as Concertacion. Chileans, while satisfied with recent macroeconomic successes, have

become concerned about poverty; in fact, the poverty issue and low income levels were critical incompelling Pinochet to allow the plebiscite of October 1988 that cleared the way for the

Presidential and Congressional elections in December 1989. As Chiles first democraticallyelected President in sixteen years, Aylwin must deliver to those treated worst during the

prolonged adjustment process of the 1980s. At the same time he must tread carefully -- he has adiverse coalition, the right still controls enough seats in the Senate to block policy changes, and

General Pinochet has refused to relinquish control of the military.

Arturos task, as President Aylwins advisor, is to devise a strategy to reduce income inequality

rapidly without sacrificing the macroeconomic gains of the military regime.

A country of islanders.

Chile, a country stretching along 2600 miles of the Pacific coast of South America, is abundantlyendowed with natural resources. It is the worlds largest producer and exporter of copper: it

produces 24 percent of world output of copper ore and CODELCO, the state-owned copper

corporation, holds about 20 percent of the world's known copper reserves. There are alsosubstantial deposits of nitrates and of iron. Arable land is appropriate for the production of fruits,

vegetables and wine, while there are as well substantial forested areas for timber exploitation.

With a population of just over 13 million, its resources in these areas have been in excess of


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domestic needs -- Chile has as a consequence been oriented from the beginning toward foreigntrade and international markets. As political scientist Federico Gil states, "the Chilean people ...

are in reality islanders". This international dependence is heightened by the relative shortage ofcrude oil deposits within Chile.

In 1970 Salvador Allende was elected President on a populist platform. His Unidad Popularcoalition had the goal of transforming Chile into a socialist society. The socialist experiment was

marked by property confiscations, economic mismanagement and general chaos, and ended withAllendes death during the 1973 military takeover led by General Augusto Pinochet. Pinochet

liberalized the economy to increase the role of markets and privatized many of the firms takenover by the Allende government. In 1989, Pinochet, after losing a plebiscite, allowed free

elections to be held. Patricio Aylwin, a centrist who welcomed the 1973 coup -- he was fromthe first a determined enemy of Allendes socialist policies -- was elected President. Aylwin

heads a coalition of 15 center-left parties, has cabinet members who took part in Allendesgovernment, and recognizes the need to include the right in the governing process.

The Economy under Allende: 1970-1973

Unequal income distribution is not a new issue for Chilean democrats: in 1970, Allendeseconomic advisors considered it to be the most serious problem faced by the country. Their

solution involved revolutionary reforms -- the nationalization of the mining, banking andagricultural sectors and much of the manufacturing sector -- along with a policy of expansionary

aggregate demand. It was thought at the time that there was sufficient excess capacity in theeconomy that aggregate demand could be increased without sparking inflation. In 1971 there

were generalized wage increases, higher rates of money creation and significantly highergovernment expenditure.

Under Allende the governments payroll swelled -- between 1970 and 1972 public sectoremployment grew at an average of 11.4 percent per year. Unions were very powerful and able

to negotiate wages for entire industries. Labor law was highly protective during Allendesregime:

it was difficult to lay off workers, severance costs were high, and strikes could continueindefinitely. Also, wages were generally adjusted 100 percent to past inflation.

The populist policies did spur growth in 1971: real GDP grew at 7.7 percent, unemployment fell

to 4 percent and real wages increased 23 percent. This growth was short-lived. By 1972 realGDP was declining, and continued massive government spending increased the fiscal deficit to

over 30 percent in 1973. To finance the enormous deficit the government sold loans to Banco

Central, which subsequently printed money: Banco Centrals claims on the central governmentincreased tenfold from 1970 to 1972, helping inflation reach a 600-percent annual rate (see Table

A2). Black markets developed and widespread price controls and commodity rationing wereenforced. Real wages fell 25 percent in 1972 -- an omen of hard times to come for the working

class.

Even before being nationalized by Allende, the financial sector was under substantialgovernment control. Interest rates were controlled and lending was largely directed by the

government. Family-rungrupos, conglomerates of relatively conservative business firms,


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typically included a


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bank to secure access to scarce loans at negative real interest rates.

In October of 1972 members of opposition parties took part in a national strike as a protest to

what some considered erroneous government economic and educational policies. Toward

mid-

1973 the opposition parties were demanding the resignation of President Allende and the UPcoalition was disintegrating. On 11 September 1973, the populist experiment came to anabrupt end as the armed forces staged a coup. At that time, the country was politically divided

and the economy was in shambles.

The Pinochet-era economic reforms.

Policies changed dramatically under the military government of General Augusto Pinochet. The

military regime had three main economic objectives: (i) liberalization of the economy toincrease the role of markets, (ii) privatization to return firms to the private sector and restructure

the public sector, and (iii) stabilization of inflation and avoidance of a balance of payments crisis.

Liberalization began with the freeing of most controlled prices in late 1973, followed by

sweeping deregulation of domestic financial markets and the beginning of extensive tradeliberalization: trade tariffs were reduced from an average of 105 percent to a uniform 10 percent

ad valorem

rate by 1979. The privatization effort was centered on the sale of most of the real assets that had

been transferred to the state during the Allende administration. Partially as a result of thisprivatization process very large, highly leveragedgrupos -- much different than the conservative,

family-rungrupos of the pre-military era -- emerged.

Stabilization was initially concerned with reducing inflation, but the government initially took an

ineffective approach with both annual money growth and inflation remaining at about 300 percent.At the end of 1974 and during 1975, government macroeconomic policy focused on correcting

the balance-of-payments deficit provoked by the collapse in the world price of copper and thetripling of oil prices. In April 1975 the Banco Central introduced a contractionary monetary

policy, and the government eliminated the fiscal deficit by 1976 through a reduction ingovernment spending. The initial impact of this program was a GDP fall of 12.9 percent in 1975

and an abrupt increase in unemployment (see Table A1). By 1977, economic growth returnedto Chile and the annual inflation rate fell to 84 percent.

In early 1978, the fiscal accounts were balanced, money growth was low, but inflation remained atan 80 percent annual rate. In January 1978 Chile introduced the preannouncement of the rate of

exchange rate devaluation as the main anti-inflation measure. In 1979 the devaluation wasreplaced by a fixed exchange rate. General Pinochet publicly announced that not even the devil

could induce the government to revalue the currency.

The Pinochet government eliminated the bargaining power of workers by suspending collective

bargaining and prohibiting union activity. Wage readjustments were decreed by the government.These adjustments were based on partial indexation to past inflation in 1974-75, and on total

indexation beginning in 1976. Total indexation to past inflation combined with declining inflationresulted in rising real wages. Employment growth was sluggish in the mid-1970s, and the


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governments main solution was a program in which the unemployed performed public works for


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reduced wages.

This was a paradoxical time in Chiles economic history, a time that some Chileans referred to as

the boom. Output growth averaged 7.9 percent per year from 1977 to 1981, the availability of

imported goods increased dramatically, and inflation finally fell to 9 percent in 1981 (see Tables

A1 through A3). But not all Chileans were taking part in this boom: unemployment remainedstubbornly high at 15 percent, real wages were still 27 percent below their 1971 level, and incomeinequality was worsening as the richest 20 percent were gaining an ever-larger share of income.

The Labor Plan of 1979 of Labor Minister Jose Pinera did little to cheer the working class. Thenew labor law greatly reduced workers bargaining power by further repressing labor unions,

restricting collective bargaining to the firm level, allowing for termination with loss of severance

pay when strikes continued for 60 days, and allowing for arbitrary dismissals. General Pinochet,however, stated proudly that the new labor law assures workers an increase in remuneration of at

least 100 percent of the increase in the cost of living through its mandatory 100 percent

indexation of wages to past inflation.

Financial liberalization begun in 1974 with privatization, the removal of credit and interest

rate ceilings, and a drastic reduction in reserve requirements (from 85 percent to 10 percenton

demand deposits) was completed in April 1980 with the removal of controls on foreign borrowing

by banks. (see Table A9 for measures of savings.) The large Grupos had benefited greatly fromthe government regulations on private capital mobility as they did have access through their banks

to private foreign lending. Since thegrupos were able to borrow at relatively low internationalinterest rates and lend at high Chilean lending rates, they were able to earn large arbitrage profits.

Thegrupospracticed unbridled self-lending (for example, in 1982 Banco Santiago granted 42

percent of its loans to itsgrupo) to expand into the export sector, getting heavily involved intimber, mining, paper and fishing. However, as prices in Chile rose relative to those in foreign

markets, export profitability declined substantially. In late 1980 a number ofgrupo-related firmsstarted to face serious financial trouble, but were kept afloat thanks to the refinancing of bad

loans. In April 1981 thegrupos financial fragility became apparent not only to the Chilean

authorities but also to international lenders as the Cravgrupo declared bankruptcy.

The abundance of foreign credit in the early 1980s provided the financing necessary for theunsustainable explosion in private expenditures at the time of the boom. By the end of 1981 Chile

was burdened by a large foreign debt and an insolvent domestic financial system (see Table A8).The fixed exchange rate combined with backward wage indexation and the massive capital

inflows to lead to a 35 percent real appreciation, which greatly reduced the competitiveness of theexport sector.

In 1982 the bubble burst: real output collapsed 15 percent and the unemployment rate shot up to

30 percent. Real interest rates rose, the currency was devalued sharply, and roll-over of domestic

debt was curbed. In 1982 over 800 firms declared bankruptcy, and in 1983 regulators had toreassume control of the five largest private banks.


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Military government's free-market reforms, 1975-81

After the military took over the government in September 1973, there was a year and a half ofbenign neglect of the economy as the regime consolidated its power. When in April 1975, the socalled "Chicago Boys" took control of economic policy, a period of dramatic economic changesbegan. Chile was transformed gradually from an economy isolated from the rest of the world, with

strong government intervention, into a liberalized, world integrated economy, where market forceswere left free to guide most of the economy's decisions. This period was characterized by severalimportant economic achievements, bolstered by increased support from the US administration:inflation was reduced greatly, the government deficit was virtually eliminated, the economy wentthrough a dramatic liberalization of its foreign sector, and a strong market system was established.Along with these achievements, drops occurred in the standard of living of the poorest citizens,poverty jumped dramatically, wages declined, and the gap between rich and poor widenedsignificantly.

From an economic point of view, the era of General Augusto Pinochet Ugarte (197390) can bedivided into two periods. The first, from 1975 to 1981, corresponds to the period when most of the

reforms were implemented. The period ended with the international debt crisis and the collapse ofthe Chilean economy. At that point, unemployment was extremely high, above 20 percent, and alarge proportion of the banking sector had become bankrupt. During this period, a pragmaticeconomic policy that emphasized export expansion and growth was implemented. The secondperiod, from 1982 to 1990, is characterized by economic recovery and a further movement towardsa free market economy, although at a slower pace than that of the early 1980s.

Trade policy

One of the fundamental economic goals of the military regime was to open up the economy to therest of the world. However, this was not the first attempt at liberalizinginternational tradein Chile.Between 1950 and 1970, the country went through three attempts at trade liberalization withoutever reaching full liberalization. Moreover, all three attempts quickly ended in frustration and in a

reversion to exchange controls, the use of multiple exchange rates, and massive quantitativerestrictions. A particularly interesting feature of the three attempts at liberalization is that, althoughthey took place under three different exchange-rate systems, they all collapsed, at least in partbecause of a highly overvalued real exchange rate.

Starting in 1974, Chile adopted unilaterally an open trade regime characterized by low uniformimport tariffs, a lack of exchange or trade controls, and minimum restrictions on capitalmovements. Starting in 1979, Chile's trade policy became highly liberalized; subsequently, therewere no quantitative restrictions, licenses, or prohibitions. A uniform import tax varying between10 percent and 35 percent took effect, and, until 1980, real exchange rate over valuation generallywas avoided. By 1990 Chile was the only country, according to the World Bank, whose index of

liberalization reached the maximum possible level of 20, indicating an absence of external-sectordistortions.

In 1973 import tariffs averaged 105 percent and were highly dispersed, with some goods subject tonominal tariffs of more than 700 percent and others fully exempted from import duties. In additionto tariffs, a battery of quantitative restrictions were applied, including outright import prohibitionsand prior import deposits of up to 10,000 percent. These protective measures were complementedby a highly distorting multiple exchange-rate system consisting of fifteen different nominalexchange rates. By August 1975, all quantitative restrictions had been eliminated, and the averagetariff had been reduced to 44 percent. This process of tariff reductions continued until June 1979,
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when all tariffs but one (that on automobiles) were set at 10 percent. In the mid-1980s, in the midstof the debt crisis, temporary tariff hikes were implemented; by 1989, however, a uniform level of15 percent had been established.

During the early period (197579) of the military regime, the opening of Chile's external sectorwas accompanied by a strongly depreciated real exchange rate. In 1979, however, the authorities

adopted a fixed-exchange rate policy that resulted in an acute over valuation of the Chilean peso, aloss in international competitiveness, and, in 1982, a deep crisis. In 1984-85 this situation wasreversed, and a policy of a depreciated and highly competitive real exchange rate wasimplemented. The combination of these two policieslow tariffs and a competitive real exchangeratehad a significant impact on Chile's economic structure. The share of manufacturing in GNPdropped from almost 29 percent in 1974 to 22 percent in 1981. Productivity in tradable sectorsgrew substantially, and exports became highly diversified. Chile had also diversified its exportmarkets, with the result that no individual market bought more than 20 percent of the country'stotal exports. By the early 1990s, exports had become the engine of growth, and the Chilean tradereform was winning praise from multinational institutions and observers of different ideologicalpersuasions. Largely thanks to the boom in exports between 1986 and 1991, particularly the

increasing growth in exports of fresh fruits and manufactured products, Chile experienced thehighest rate of GDP growth in Latin America (the "Miracle of Chile"), with an annual increase of4.2 percent.

In what was perhaps the surest sign of the success of trade reform, the new democratic governmentof President Patricio Aylwin Azcar(199094), elected in December 1989, decided to continue theopening process and reduced import tariffs to a uniform 11 percent. Interestingly, Aylwin'seconomic team, including the minister of finance and the minister of economy, development, andreconstruction, had been relentless critics of the trade reform process during its implementation inthe mid- and late 1970s.

Banking reform and the financial sector

A major policy objective of the military regime was the liberalization and modernization of thebanking sector. Until 1973 the domestic capital market had been highly repressed, with most banksbeing government owned. Real interest rates were negative, and there were quantitative restrictionson credit. The liberalization process began slowly, in early 1974, with the sale of banks back to theprivate sector, the freeing of interest rates, the relaxation of some restrictions on the bankingsector, and the creation of new financial institutions. International capital movements, however,were strictly controlled until mid-1979. In June 1979, the government decided to begin toliberalize the capital account of the balance of payments, lifting some restrictions on medium- andlong-term capital movements.

The opening of the capital accountresulted in a massive inflow of foreign capital that contributed

to Chile's subsequent international debt problems. In 1980 capital inflows were more than doublethose of 1979US$2.5 billion versus US$1.2 billionand in 1981 the level of capital inflowsnearly doubled again, to US$4.5 billion.

An important result of the reforms of the financial sector was that the number of financialinstitutions and the volume of financial intervention both increased greatly. For example, in 1981there were twenty-six national banks, nineteen foreign banks, and fifteen savings and loaninstitutions (financieras), a number significantly higher than the eighteen national banks and one
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foreign bank in operation in September 1973. Furthermore, between 1973 and 1981 the realvolume of total credit to the private sector increased by more than 1,100 percent.

At least in terms of increasing the degree of financial intermediation, liberalization was a success.However, it was apparent from the beginning that capital-market liberalization faced three majorobstacles. First, interest rates were very high. Second, in spite of the significant growth in the

extent of financial intermediation, domestic savings had not increased to the extent that theproponents of the reforms had expected. In fact, domestic savings were at one of their lowestlevels in history from 1974 to 1982. There are several possible explanations for the behavior ofdomestic savings. One of the most popular of these relies on the notion that the appreciation ofdomestic assets that was taking place at the time, such as stocks and land prices, resulted in a realaccumulation of assets without saving. This increase in private-sector wealth was consistent withhigher levels of consumption at a given income. Third, and perhaps more important, the rapidgrowth of the financial sector took place in an environment in which monetary authoritiesexercised no supervision. As a result, many banks accumulated an unprecedented volume of badloans, a situation that led to the financial crisis of 1982-83. As a consequence of this crisis, anumber of banks went bankrupt during 1983-84, were placed temporarily under government

control, and then were reprivatized. By 1992, after monetary authorities had learned the hard waythe importance of bank supervision, Chile's financial sector had become highly stable anddynamic.

Rural land market reform

At the time of the military coup, about 60 percent of Chile's irrigated land and 50 percent of totalagricultural land was in control of the public sector. Land reform had started in the 1960s withexpropriations of large landholdings (those larger than eighty basic irrigated hectaresBIH), andthe encouragement of small farms (about 8.5 BIH) managed by their owners. The Allendeadministration favored large-scale farms under cooperatives and state-farm management overprivate ownership of agricultural land. Starting in 1974, the military government began using Cora

to end agrarian reform by distributing land to establish family farms with individual ownership. Ina period of three years, 109,000 farmers and 67,000 descendants of the Mapuche had beenassigned property rights to small farms. About 28 percent of the expropriated land was returned toprevious owners, and the rest was auctioned off.

Three key legal issues were then clarified by decree law in 1978. Government authority toexpropriate land was repealed, the ceilings on landholdings (the equivalent of eighty BIH) wereremoved, and the ban on corporate ownership of land was eliminated. At the end of 1978, allfarmland owned publicly had been distributed, and Cora was legally closed.

Reforms in the legislation that regulated land rentals and land subdivisions in 1980 addedflexibility to the rural land markets. But perhaps more crucial aspects of the reforms were the

separation of water rights from the land itself and the legal possibility of transferring water titlesindependently of land transactions.

Labor-market reform

Immediately after the 1973 coup, many labor institutions, that is, traditional channels of influence,such as government offices, which unions used to get their voices heard, were disbanded, andsome important unions were dissolved. Thus, wage adjustments became mainly a function ofindexation, which, given Chile's history of inflation, had become an established element of anywage negotiation. Indexation was kept in place until 1982, through ten years of declining inflation.
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Starting in October 1973, the government mandated across the board periodic wage adjustmentstied to the rate of inflation. Lower wages were adjusted proportionally more than higher ones.From 1973 to 1979, indexation to past inflation with varying lags was the norm throughout theeconomy. The 1979 Labor Plan formalized this practice by requiring that collective bargainingagreements allow for wage adjustments at or above the rate of inflation. In 1982 the indexationclause of the Labor Plan was eliminated. The government continued the practice of periodicallyannouncing wage readjustments and bonuses, with the wage increases usually not keeping pacewith inflation and covering the non-unionized sector only. The dynamism of the economy in theearly 1990s resulted in actual wage increases above officially announced readjustments.

The Employment Security Law established that in the absence of "just cause" for dismissal, suchas drunkenness, absenteeism, or theft, a dismissed employee could be reinstated to the job by alabor court. This law was replaced by a less costly system of severance payments in 1978. DecreeLaw 2,200 authorized employers to modify individual labor contracts and to dismiss workerswithout "cause". A minimum severance payment was established that was equivalent to one monthof salary per year of service, up to a maximum of five months' pay. This new system applied to allcontracts signed after August 1981.

The changes introduced by Decree Law 2,200, along with the 1979 reforms, which establishednew mechanisms to govern union activity (Decree Law 2,756) and collective bargaining (DecreeLaw 2,758), became known in Chile as the Labor Plan. Decree Law 2,756 departed significantlyfrom traditional legislation: union affiliation within a company became voluntary, and allnegotiations would now have to be conducted at the company level; bargaining among manycompanies would be eliminated. According to the previous law, which had applied until the 1973coup, once the majority of the workers of an enterprise chose to join an "industrial union" allworkers became part of that union. That is, one union would have exclusive representation of allworkers in an enterprise. The right to collective bargaining was granted to unions at the enterpriselevel and also to union federations and confederations. This resulted in some negotiations at the

industry level with the participation of the Ministry of Labor and Social Welfare through the LaborInspectorate. As in the past, the new law required participation of 10 percent of the workers or aminimum of twenty-five workers (whichever was greater) for creation of a union. Workers werenot required to be represented by a union in collective bargaining.

Decree Law 2,758 stipulated that in the event of a strike, a firm could impose a lockout andtemporarily lay off workers, which the previous law had prohibited. At the same time, Decree Law2,758 established norms about collective bargaining, and in its Article 26 the law established thatunionized workers' nominal wages should be adjusted to at least match the rate of inflation. Thisarticle, which became a severe constraint to downward real wage flexibility during the 1982-83crisis, can be understood only in the context of a previously existing policy of 100 percentindexation across the board. In 1982, at the onset of the debt crisis, Article 26 was amended,eliminating the downward inflexibility of real wages. This reformed law was in effect until April1991, when some important changes proposed by the Aylwin administration were approved by theNational Congress (hereafter, Congress).

Public employment programs

Two public employment programs affected the labor market during the period of economicreforms between 1975 and 1987. The Minimum Employment Program (Programa de EmpleoMnimoPEM) was created in 1975 at a time when unemployment had reached record levels. Theprogram, administered by local governments, paid a small salary to unemployed workers, who, for


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a few hours a week, performed menial public works. At first, the government tightly restrictedentry into the program. Gradually, most of these restrictions were lifted, and a larger number ofunemployed people were allowed to participate. Thus, the proportion of the labor force employedby the program remained virtually constant between 1977 and 1981, despite the economicrecovery and a reduction in the real value of PEM compensation.

When Chile entered a new and more severe recession, the number of individuals employed byPEM in the Metropolitan Region of Santiago increased from about 23,000 in May 1982 to 93,000in May 1983. An Employment Program for Heads of Households (Programa de Ocupacin paraJefes de HogarPOJH), created in October 1982, employed about 100,000 individuals in thegreater Santiago area by May 1983. The two programs combined absorbed more than 10 percent ofthe labor force of the greater Santiago area in May 1983. These programs were also implementedin other regions of the country. The PEM program was cut back drastically in February 1984.Likewise, by December 1988, there were only about 5,000 individuals employed by the POJH inthe entire country.

Debt crisis: further reforms and recovery

The international debt crisis unleashed in 1982 hit the Chilean economy with particular severity, asforeign loans dried up and the international terms of trade turned drastically against Chile. Thepolicies implemented initially to face the 1982 crisis can best be described as hesitant. In early1983, the financial sector was nationalized as a way to avoid a major banking crisis, and a numberof subsidy schemes favoring debtors were enacted. The decision to subsidize debtors who hadborrowed in foreign currency during the period of fixed exchange rates, and to bail out the troubledbanks, resulted in heavy Central Bank losses, which contributed to the creation of a huge deficit inpublic sector finance. This deficit, in turn, would become one of the underlying causes of theinflation of the early 1990s. Different exchange-rate systems were tried, including a floating rate,only to be abandoned rapidly and replaced by new plans. Policies aimed at restructuring themanufacturing sector, which had entered a deep crisis as a consequence of the collapse of some of

the major conglomerates, the so-called groups (grupos), were implemented. In spite of this array ofmeasures, the economy did not show a significant response; unemployment remainedextraordinarily high, and the external crisis, which some had expected to represent only atemporary setback, dragged on.

In early 1985, increasingly disappointed by the economy's performance, Pinochet turned toward agroup of pragmatic economists who favored free markets and macroeconomic stability. Led bynewly appointed finance minister Hernn Bchi Buc, an economist who had studied businessadministration at Columbia University, the new economic team devised a major adjustmentprogram aimed at reestablishing growth, reducing the burden of the foreign debt, and rebuildingthe strength of the financial and manufacturing sectors. Three policy areas became critical in theimplementation of the program: active macroeconomic policies, consolidation of the market-oriented structural reforms initiated in the 1970s, and debt-management policies geared towardrescheduling debt payments and making an aggressive use of the secondary market. With the helpof the International Monetary Fund, the World Bank, and improved terms of trade, these policiessucceeded in achieving their objectives.

The macroeconomic program of a group of Chilean economists known as the "Chicago boys", whohad guided Pinochet's early economic policies, had relied on a hands-off "automatic adjustment"strategy. By mid-1982 this approach had generated a severe over valuation of the real exchangerate. By contrast, the new macroeconomic program relied on active and carefully monitored


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macroeconomic management. An active exchange rate policy, based on large initial exchange-rateadjustments followed by periodic small devaluations, became one of the most important policies ofthe post-1982 period. Between 1982 and 1988, the international competitiveness of Chileanexports was increased greatly by a real exchange-rate depreciation of approximately 90 percent.This policy not only helped generate a boom in nontraditional exports but also contributed toreasonable interest-rate levels and to the prevention ofcapital flight.

The adjustment program that started in 1985 also had a structural adjustmentcomponent that wasaimed at consolidating the market-oriented reforms of the 1970s and early 1980s, including theprivatization process, the opening of the economy, and the development of a dynamic capitalmarket. There were several structural goals of the 1985 program: rebuild the financial sector,which had been nearly destroyed during the 1982 crisis; reduce import tariffs below the 35 percentlevel that they had reached during 1984 to a 15% uniform level; and promote exports through a setof fiscal incentives and a competitive real exchange rate.

Perhaps the most important aspects of these structural reform measures were the privatization andrecapitalization of firms and banks that had failed during the 1982-83 crisis. As a first step in this

process, the Central Bank bought private banks' nonperforming portfolios. In order to finance thisoperation, the Central Bank issued domestic credit. The banks, in turn, paid a rate of 5 percent onthe nonperforming portfolios and promised to repurchase them out of retained profits. Thisrecapitalization program had as its counterpart a privatization plan that returned the ownership ofthose banks and firms that had been nationalized in 1983 to the private sector. Economist Rolf J.Lders estimates that about 550 enterprises under public-sector control, including most of Chile'slargest corporations, were privatized between 1974 and 1990. By the end of 1991, fewer that fiftyfirms remained in the public sector. The overall privatization program undertaken after 1985 hasbeen criticized by some Chileans and also by some international economists because banks andmanufacturing firms were sold too rapidly and at "very low prices."

Chile's structural adjustment of the second half of the 1980s was unique from an internationalcomparative perspective. The most difficult, controversial, and costly reformsincluding the bulkof privatization, trade liberalization, financial deregulation, and labor market streamliningwereundertaken in Chile in the 1975-80 period; the measures taken after 1985 were minor, incomparison. The success of the post-1985 period was rooted in the early reforms. For example, theboom in nontraditional exports that took place in the second half of the 1980s was only possiblebecause of investments begun almost ten years before. The markets' flexible and rapid response toincentives was also a direct consequence of the microeconomic reforms of the 1970s.

One of the most hotly debated issues of the Chilean recovery of the second half of the 1980sconcerns the different foreign-debt conversion plans aimed at rapidly reducing foreignindebtedness. When the debt crisis erupted in 1982, Chile's foreign debt was US$17.2 billion, one

of the highest debts per capita in the world. Through the aggressive use of a variety of debt-conversion plans, between 1985 and 1991 Chile retired an estimated US$10.5 billion of its debt,most of which was converted into equity in Chilean companies.

Chile's net international reserves totaled US$9 billion in 1992, enough to cover a year of importsand equivalent to roughly half of its foreign debt. The stock of foreign direct investment in Chilewas estimated to be between US$10 billion and US$13 billion, roughly 30 percent of GDP. AboutUS$4 billion of this was acquired through debt-equity conversions. The debt-swap program was
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Table 1. Income Distribution in Chile: Selected Years, 1970-1989.

YearsShare of Income Real Wage

Index, Dec.

1982=100

Unemployment

RateLowest

40 percent

Middle

40 percent

Highest

20 percent

1970 11.5 32.7 55.8 113.1 5.7

1979-81 11.1 31.3 57.6 94.4 16.5

1982-83 10.0 30.5 59.5 101.4 27.4

1989 12.6 27.9 59.5 92.0 6.3

Source: Instituto Nacional de Estadisticas. Monthly Report. As presented in Laban and

Larrain (1995) and Romaguera, Echevarria, and Gonzalez (1995).

The newly independent Banco Central is concerned about two main issues. First, the country is atrisk of an inflationary outburst. Real GDP has grown explosively the past two years (7.4 percent

and 10 percent) and in the last quarter of 1989 the annualized rate of inflation is 30 percent(Table A1). Second, massive capital inflows -- much of it foreign short-term and portfolio

investment in Chilean financial assets, although foreign direct investment is increasing as well --are putting substantial pressure on the exchange rate to appreciate. Fiscal policy has, at least until

now, helped in the fight against inflation and real exchange rate appreciation with its public sectorsurpluses.

Policy decision.

As Chiles first democratically elected President in sixteen years, and as head of a diversecoalition of center and left parties, Aylwin must address the concerns of organized labor and

those that were hit hardest during the adjustment process in the Pinochet era. All parties learned

from Salvador Allendes fateful mistakes in the early 1970s of trying to do too much too quicklywithout sufficient public support. But even the right recognized the necessity to meet the social

problems -- in health and education in particular -- left behind by the Pinochet government.

Meeting those problems without yielding to what Edgardo Boeniger, Aylwins Secretary General,calls the populist temptation of over-spending, debt and inflation will severely test the new

Chilean consensus.

As an economic advisor to President Aylwin, Arturo Rodrigo must design a strategy to improve

the situation of the poor immediately. Aylwin, knowing that the remaining representatives of thePinochet regime in the Senate can block anything deemed too leftist, will need a complete

analysis of the costs and benefits of all policy options. Arturo must have his plan ready for a

meeting tomorrow with Aylwin and the leader of the rightist Renovacion Nacional party, AndresAllamand. If Aylwin can get Allamands blessing, Arturos economic plan has a good chance of

Senate approval.


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References

Wikipedia, The Free Encyclopedia

Basch, Miguel and Eduardo Engel, Temporary Shocks and Stabilization Mechanisms: The ChileanCase, in Engel and Patricio Meller, eds., External Shocks and Stabilization Mechanism s , IDB,

1993.

Edwards, Sebastian and Alejandra Cox-Edwards, Monetarism and Liberalization: The Chilean

Experimen t, University of Chicago Press, 1991.

Ffrench-Davis, Ricardo, Manuel Agosin and Andras Uthoff, Capital Movements, Export Strategy, and

Macroeconomic Stability in Chile, in Ffrench-Davis and Stephany Griffith-Jones, eds Coping

With Capital Surges: The Return of Finance to Latin Americ a , IDRC, 1995.

Gil, Frederico, The Political System of Chil e , Houghton-Mifflin, 1966.

Laban, Raul and Felipe Larrain, Continuity, Change, and the Political Economy of Transition in Chile,

in Dornbusch and Edwards, eds., Reform, Recovery and Growt h , NBER, 1995.

Marshall, Jorge and Klaus Schmidt-Hebbel, Chile: Fiscal Adjustment and Successful Performance, in

William Easterly, Carlos Alfredo Rodriguez and Schmidt-Hebbel, eds., Public Sector Deficits and

Macroeconomic Performanc e , World Bank 1994.

Romaguera, Pilar, Cristian Echevarria and Pablo Gonzalez, Chile, in Gustavo Marquez, ed., Reforming

the Labor Markets in a Liberalized Economy , IDB 1995.

Torche, A., Distribuir el Ingreso para Satisfacer las Necesidades Basicas in F. Larrain, ed., DesarolloEconomico en Democraci a , Ediciones Universidad Catolica 1987.


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