milton freidman applied in chile

8/13/2019 Milton Freidman Applied in Chile

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Applied Theory: The Reforms in Chile

Manfred Bruchle

Universidad Mayor

There Ain't No Such Thing as aFree Lunch

Milton Friedman - An Appreciation


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1973

> Country inshambles

> Inflation +340%> Noforeign reserves

> FallingGDP


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Chicago Boys

> Non regulatedeconomy

> Opento the world> Minimumrole of the state

> Rigorousfiscal equilibrium

> Freefunctioning of the market


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El Ladrillo

> Written during early 1973

> Straightforward but comprehensiveliberalization plan

> Prices are keyto allocate resouces; they wouldreflect relative scarcities

> Anopen economyis the best antitrust policy

> Markets get it rightalmost all the time

> Consistently eliminate all obstaclesto privateinitiative and reduce influence of interestgroups

> State intervention bound toimpersonal rules


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Milton Friedman

Two Options:

> Slow recuperationof patient (country) withrisk of death

> Shock treatmentto revitalize patient, with

severe inmediate effects


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Milton Friedmans Letter

Key Economic Problems

> Inflation

> Promotion of a healthy Social Market Economy


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The Remedy

> Drasticallyreducethe rate of increase in thequantity of money

Reductionof fiscal deficit

> Fiscal deficit can be reduced by: Cuttinggoverment spending Raisingtaxes Borrowing at home or abroad


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Prerequisite for Ending Inflation

> Cutin fiscaldeficit

> Gradualism is notfeasable: Patient would not survive

> No way to end inflation that will not involve atemporarytransitional period ofsevere

difficulty


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Proposal

> 1.-Monetary reform:does have a psychological role

> 2.-Goverment commitment toreduce spendingby 25%within six months

> 3.-Anational stabilization loanfrom the public tosupplement the reduction of spending during first sixmonths

> 4.-A stabilizationloanfromabroadfor the samepurpose


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Results

Such a shock program could end inflation inmonths, and would set the stage for the

solution of your second major problem promoting an effective social marketeconomy.


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Impact of Measures

> The shock treatment contemplated a20% reduction inpublic spending, firing 30%of the state employees, anincrease in the VAT,privatize most of thestatecompaniesandend the savings and loansystem for

housing purposes

> GDP fell by12%,theunemploymentrate grew to16%andexportearnings fell by40%.

> However, the system started to showpositive resultsasof1977 when the so called boom period started.


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1930-1973: The Road to Socialism

The Chilean crisis has its origins in theeconomic problems the country had beenfacing for decades

> Gallopinginflation> The publicdeficit> High level offoreign debt> Thefallingagricultural activity

> The need to recuperate theincomefromcopper mining


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1930-1973: The Road to SocialismThe Allende Goverment

Country witnessed:

> Expropriations> Gallopinginflation

> Foodrationing

> Lossof political and economicrights


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Chile Public Companies(as % of GDP of each sector)

1965 1973

Mining Industry 13,0% 85,0%

Public services 25,0% 100,0%

Transportation 24,3% 70,0%

Communications 11,1% 70,0%

Financial sector n.a. 85,0%


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7074

788286

9094

98102

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110114

1970

1971

1972

1973

Cooper Fish Agricultural Industrial

Rate of ProductionBase 1970 = 100


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Macroeconomic Indicators: 1970-1973

1970 1971 1972 1973

GDP Total Real Incr. ( % ) 2,1 9 -1,2 -5,6Balance of Trade Deficit(% of GDP) 12,5 13,3 15,9 15,1Public Sector Deficit( % of

GDP ) 2,7 10,7 13 24,7

Copper Price (US$/ pound) 0,64 0,49 0,49 0,81

Inflation ( % ) 34,9 22,1 260,5 605,1

Unemployment rate( %) 5,7 3,9 3,3 5

Real Exchange Rate 111,9 94,6 43,4 40,7


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External Accounts, Foreign ReserveHoldings & Foreign Debt (Millions of current

dollars)

1970 1971 1972 1973

Current Account -81 -189 -387 -295

Commercial Account

Exports / Imports 156 -16 -253 -138

Capital Account 268 -27 327 242

Balance of Payments 114 -300 -231 -112

Foreign Reserve Holdings 393 163 76 167Foreign Debt Public /Private 2767 2746 3002 3261


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Situation of Public Finances

Detail 1970 1973

Deficit as % of totalexpenses

13,0% 52,8%

Gross deficit as % ofGDP

3,1 21,3

Total expenses as %of GDP

23,9 40,5

Mixed and socialcompanies % ofdeficit of expenses

23,9 40,5


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0

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2500

Dec 1970 Dec 1971 Dec 1972 Sept.1973

Emission Prices

Rate of Prices and Emission


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Macroeconomic Conditions 1960 -1973

1960-73 1973

Inflation 47,6% 508,1%

Public deficit (% ofGDP)

6,0% 24,7%

Real GDP (averagegrowth rate)

3,4% -5,6%


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1973: The Road Towards a Free Society

Basic structures of a new economic strategy

> Guarantees ofproperty rightsand of a state of law> Themarketas the main instrument of assigning

resources> The Chileaneconomyopen to international competition> Macroeconomic equilibriumsas a fundamental

requirement for sustained growth> Asubsidiary rolefor the Government:

>Establishprioritiesfor economic policy>Maintainresponsibilityfor the system ofjustice,national securityand redistributionofincome

>Havingnon-discretionalpolicies>Social policiesfocused on sectors of extreme

poverty


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1973: The Road Towards a Free Society

Principal instruments to carry forward these duties:

> Thereduction of dutiesand the maintenance of ahighand stable realexchange rate

> A system offree prices

> Privatizationof firms

> Macroeconomic equilibriums

> Fiscal policy andstimulationof savings andinvestment

> Decentralizationof social security, education andhealth

> Focalizationof social spending

> Aninstitutionalframework


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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, Educationand 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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Rationalization of public spending> Problem:Persistentbudget deficits

Lack of fiscaldiscipline

(30% deficitof GDP in 1973)> Adjust Public Spending in 3 areas:

Publicinvestment, public sectorwagesandthe elimination of most of thesubsidiesimplicit in the operations of the state ownedcompanies

> Results: 1974deficitreduced to5% of GDP1976surplus of 2%of GDP


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Chiles Overall Budget Balance


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PrivatizationsFirst Round (1974-1983)

> Returning the assetsthat had beenexpropriated to the previous owners> Privitization of enterprises acquired by the

state i.e. banks and industries> State oowned enterprises reduced from596 in

1974 to 48 in 1983> Value added reduced from39% to 24% of

GDP


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Value Added in Public Enterprises in Chile


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Privatizations(ctd.)Second Round (1985)> Public utilitiesand companies in hands of

goverment since crisis of 1982> Value addedfrom state owned enterprisesdeclined to 13% of GDP in 1989

Third Round (1990)

> Infrastucture(Concessions)> Watercompanies> Value addedfell to9%of GDP


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Tax reform

Two major tax refoms:

> Value Added Taxintroduced at flat rate of

19%in 1975

> Drasticreductionof Corporate Income Tax(currently at17%), integrating it withpersonal income tax


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Economic Reforms in ChileTrade Liberalization

> Unilateraltariff reduction> 10%tariff on all imports (1974)

> Gradualreduction to6%in 2003

> Current weighted import duty:2%


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Economic Reforms in ChileEffects of Trade Liberalization

> Reductionof influence of special interests andcorruption

> Flat tariffeliminated distortionsthat retarddomestic economic growth> Exports increased considerably, from$3 billion

in 1974 to$29 billionin 2000> Diversificationof exports

(Copper declined from76%in 1974 to38%in2001)


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Chilean ExportsDiversification by Product

(as a % of GDP)

1973 1990

Copper 80,1 45,5

Other minerals:agriculture, forestry,fishing

1,9 11,9

Mining (ex. copper) 10,1 9,9

Industry 7,9 32,7

Total 100.0 100.0


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Chiles Exports of Goods and Services,1974-2000


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Economic Reforms in ChileFinancial Sector Reforms

> Liberalizationof the banking system in themid-1970s

> Privatizationof banks

> Liberalizationofinterestrates

> Reductionin reserve requirements

> Enlargmentof scope of banking business

> Newbanking law


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Economic Reforms in ChilePension Reform

> Privatizationof the Pension System in 1981

> Allows individuals to save retirement

money in fully fundedprivately managedaccounts

> Pension funds haveincreasedcontinuouslysince 1981 and in 2001 represented more

than50 percent of GDP


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Economic Reforms in ChileMonetary Policy: Central Bank

Independence

> 1989: a new law made the Central Bankindependent

> Central Bank set and reached inflation targets,successively lower each year. Since 2000target is2% to 4%annually


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More than500

Inflation(% varience in 12 months)


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Economic Reforms in ChileCapital Flows and Foreign Investment

> Liberalization of foreign direct investmentby enactingDecree Law 600 to define the rules for foreigninvestment

> Withdrawal from the Andean Pact, whose protectionismand bias against foreign investment were incompatiblewith Chiles new development strategy

> This reform has resulted in amassive inflowof foreigndirect investment, increasing from$12.7 billionin 1974-1994 to$35.9 billionin 1995-2001


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Economic Reforms in ChileWages and Prices

> 1974: Govermentliftedrestrictions onallprices

> Wageswereliberalized


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Economic Reforms in ChileProperty Rights

> Long tradition ofrespectfor privateproperty

rightsand enforcement of contracts

> The respect for and strong enforcement ofprivate contractscontinuedeven through the

1973-1989 military regime


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Economic Reforms in ChileRegulations

> Major reform in the mid-1970s was theliberalization of the labor market, making itmore flexible

> Negotiationsbetween would determinewagesin the private sector> Moreflexibleconditions for hiring and laying

off employees> Reducedrestrictions on theseverance payfor

layoffs> Reformed collectivebargainingprocess


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Economic Reforms in ChileBlack Market

> Informal economy is very small (19.8% ofGDP)


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Main Lessons of the Reforms

> Reformspay off

After the crisis of 82-83, growth averaged 7%for the next fifteen years, saving and

investment boomed, unemployment fell andinflation was reduced to a 2-4% level

> It is important to bepatient

> Financialregulationand supervision iskey

> Tax and pension reformsare essential inpromoting investment and saving


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Conclusion

Reforms paid off:

> Moreinvestment

> Moreconsumption

> Moreeconomic efficacy

> Sustainedeconomic 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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> Reform should proceedsimultaneouslyacross all fronts

> Economic freedom leads toprosperitybecause free

economies allow forcompetition

Competition requires:

> The organization ofinstitutions, such as stable money

> Minimaland transparentregulation

> Minimal participationof the state in economic activity

> Strong enforcement ofproperty rightsandregulations

Conclusion


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THANK YOU

milton freidman applied in chile

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