Macroeconomic Perpetuity and Income

Imparity in Chile

BY

Mehras Abaeian
Student ID: 1101601086

SUPERVISOR: Dr. ELSADIG MUSA AHMED

MMU MALAYSIA & SHARF UNIVERSITY

INTERNATIONAL CAMPUS, KISH ISLAND

 Macroeconomic Perpetuity and Income Imparity in Chile

Introduction

Arturo Rodrigo settled into his new office as economic advisor to President Aylwin. He had
waited 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 was
incompetent. 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 the
economic 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, the
economy 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 growth
surged. 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 poverty
line, 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 their
wages stagnate while social spending had fallen drastically.

It is now 1990 and President Patricio Aylwin, a centrist, is the head of a center-left coalition
known 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 in
compelling Pinochet to allow the plebiscite of October 1988 that cleared the way for the
Presidential and Congressional elections in December 1989. As Chile’s first democratically
elected 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 a
diverse 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.

Arturo’s task, as President Aylwin’s 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 abundantly
endowed with natural resources. It is the world’s 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 also
substantial 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
domestic needs -- Chile has as a consequence been oriented from the beginning toward foreign
trade 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 of
crude oil deposits within Chile.

In 1970 Salvador Allende was elected President on a populist platform. His Unidad Popular
coalition 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 with
Allende’s 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 taken
over 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 from
the first a determined enemy of Allende’s socialist policies -- was elected President. Aylwin
heads a coalition of 15 center-left parties, has cabinet members who took part in Allende’s
government, 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, Allende’s
economic advisors considered it to be the most serious problem faced by the country. Their
solution involved revolutionary reforms -- the nationalization of the mining, banking and
agricultural 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 the
economy that aggregate demand could be increased without sparking inflation. In 1971 there
were generalized wage increases, higher rates of money creation and significantly higher
government expenditure.

Under Allende the government’s payroll swelled -- between 1970 and 1972 public sector
employment 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 Allende’s
regime:
it was difficult to lay off workers, severance costs were high, and strikes could continue
indefinitely. 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 real
GDP 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 Central’s claims on the central government
increased 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 were
enforced. 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 substantial
government control. Interest rates were controlled and lending was largely directed by the
government. Family-run grupos, conglomerates of relatively conservative business firms,
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typically included a

3
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 UP
coalition was disintegrating. On 11 September 1973, the populist experiment came to an
abrupt 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 to
increase 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 trade
liberalization: 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 this
privatization process very large, highly leveraged grupos -- much different than the conservative,
family-run grupos 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 the
tripling 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 in
government 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 returned
to 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 at
an 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 was
replaced 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 inflation
resulted in rising real wages. Employment growth was sluggish in the mid-1970s, and the
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government’s main solution was a program in which the unemployed performed public works for

5
reduced wages.

This was a paradoxical time in Chile’s 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 remained
stubbornly high at 15 percent, real wages were still 27 percent below their 1971 level, and income
inequality 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. The
new 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 percent
on
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 from
the government regulations on private capital mobility as they did have access through their banks
to private foreign lending. Since the grupos were able to borrow at relatively low international
interest rates and lend at high Chilean lending rates, they were able to earn large arbitrage profits.

The grupos practiced unbridled self-lending (for example, in 1982 Banco Santiago granted 42
percent of its loans to its grupo) to expand into the export sector, getting heavily involved in
timber, 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 of grupo-related firms
started to face serious financial trouble, but were kept afloat thanks to the refinancing of bad
loans. In April 1981 the grupos’ financial fragility became apparent not only to the Chilean
authorities but also to international lenders as the Crav grupo declared bankruptcy.

The abundance of foreign credit in the early 1980s provided the financing necessary for the
unsustainable 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 the
export 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 to
reassume 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 of
benign neglect of the economy as the regime consolidated its power. When in April 1975, the so
called "Chicago Boys" took control of economic policy, a period of dramatic economic changes
began. 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 forces
were left free to guide most of the economy's decisions. This period was characterized by several
important economic achievements, bolstered by increased support from the US administration:
inflation was reduced greatly, the government deficit was virtually eliminated, the economy went
through 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 widened
significantly.
From an economic point of view, the era of General Augusto Pinochet Ugarte (1973–90) can be
divided 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 of
the Chilean economy. At that point, unemployment was extremely high, above 20 percent, and a
large proportion of the banking sector had become bankrupt. During this period, a pragmatic
economic policy that emphasized export expansion and growth was implemented. The second
period, from 1982 to 1990, is characterized by economic recovery and a further movement towards
a 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 the
rest of the world. However, this was not the first attempt at liberalizing international trade in Chile.
Between 1950 and 1970, the country went through three attempts at trade liberalization without
ever 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 quantitative
restrictions. A particularly interesting feature of the three attempts at liberalization is that, although
they took place under three different exchange-rate systems, they all collapsed, at least in part
because of a highly overvalued real exchange rate.
Starting in 1974, Chile adopted unilaterally an open trade regime characterized by low uniform
import tariffs, a lack of exchange or trade controls, and minimum restrictions on capital
movements. Starting in 1979, Chile's trade policy became highly liberalized; subsequently, there
were no quantitative restrictions, licenses, or prohibitions. A uniform import tax varying between
10 percent and 35 percent took effect, and, until 1980, real exchange rate over valuation generally
was 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-sector
distortions.
In 1973 import tariffs averaged 105 percent and were highly dispersed, with some goods subject to
nominal tariffs of more than 700 percent and others fully exempted from import duties. In addition
to tariffs, a battery of quantitative restrictions were applied, including outright import prohibitions
and prior import deposits of up to 10,000 percent. These protective measures were complemented
by a highly distorting multiple exchange-rate system consisting of fifteen different nominal
exchange rates. By August 1975, all quantitative restrictions had been eliminated, and the average
tariff had been reduced to 44 percent. This process of tariff reductions continued until June 1979,
7
when all tariffs but one (that on automobiles) were set at 10 percent. In the mid-1980s, in the midst
of the debt crisis, temporary tariff hikes were implemented; by 1989, however, a uniform level of
15 percent had been established.
During the early period (1975–79) of the military regime, the opening of Chile's external sector
was 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, a
loss in international competitiveness, and, in 1982, a deep crisis. In 1984-85 this situation was
reversed, and a policy of a depreciated and highly competitive real exchange rate was
implemented. The combination of these two policies—low tariffs and a competitive real exchange
rate—had a significant impact on Chile's economic structure. The share of manufacturing in GNP
dropped from almost 29 percent in 1974 to 22 percent in 1981. Productivity in tradable sectors
grew substantially, and exports became highly diversified. Chile had also diversified its export
markets, with the result that no individual market bought more than 20 percent of the country's
total exports. By the early 1990s, exports had become the engine of growth, and the Chilean trade
reform was winning praise from multinational institutions and observers of different ideological
persuasions. 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 the
highest rate of GDP growth in Latin America (the "Miracle of Chile"), with an annual increase of
4.2 percent.
In what was perhaps the surest sign of the success of trade reform, the new democratic government
of President Patricio Aylwin Azócar (1990–94), elected in December 1989, decided to continue the
opening process and reduced import tariffs to a uniform 11 percent. Interestingly, Aylwin's
economic team, including the minister of finance and the minister of economy, development, and
reconstruction, had been relentless critics of the trade reform process during its implementation in
the mid- and late 1970s.
Banking reform and the financial sector
A major policy objective of the military regime was the liberalization and modernization of the
banking sector. Until 1973 the domestic capital market had been highly repressed, with most banks
being government owned. Real interest rates were negative, and there were quantitative restrictions
on credit. The liberalization process began slowly, in early 1974, with the sale of banks back to the
private sector, the freeing of interest rates, the relaxation of some restrictions on the banking
sector, 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 to
liberalize the capital account of the balance of payments, lifting some restrictions on medium- and
long-term capital movements.
The opening of the capital account resulted in a massive inflow of foreign capital that contributed
to Chile's subsequent international debt problems. In 1980 capital inflows were more than double
those of 1979—US$2.5 billion versus US$1.2 billion—and in 1981 the level of capital inflows
nearly doubled again, to US$4.5 billion.
An important result of the reforms of the financial sector was that the number of financial
institutions and the volume of financial intervention both increased greatly. For example, in 1981
there were twenty-six national banks, nineteen foreign banks, and fifteen savings and loan
institutions (financieras), a number significantly higher than the eighteen national banks and one

8
foreign bank in operation in September 1973. Furthermore, between 1973 and 1981 the real
volume 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 major
obstacles. 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 the
proponents of the reforms had expected. In fact, domestic savings were at one of their lowest
levels in history from 1974 to 1982. There are several possible explanations for the behavior of
domestic savings. One of the most popular of these relies on the notion that the appreciation of
domestic assets that was taking place at the time, such as stocks and land prices, resulted in a real
accumulation of assets without saving. This increase in private-sector wealth was consistent with
higher levels of consumption at a given income. Third, and perhaps more important, the rapid
growth of the financial sector took place in an environment in which monetary authorities
exercised no supervision. As a result, many banks accumulated an unprecedented volume of bad
loans, a situation that led to the financial crisis of 1982-83. As a consequence of this crisis, a
number 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 way
the importance of bank supervision, Chile's financial sector had become highly stable and
dynamic.
Rural land market reform
At the time of the military coup, about 60 percent of Chile's irrigated land and 50 percent of total
agricultural land was in control of the public sector. Land reform had started in the 1960s with
expropriations of large landholdings (those larger than eighty basic irrigated hectares—BIH), and
the encouragement of small farms (about 8.5 BIH) managed by their owners. The Allende
administration favored large-scale farms under cooperatives and state-farm management over
private 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. In
a period of three years, 109,000 farmers and 67,000 descendants of the Mapuche had been
assigned property rights to small farms. About 28 percent of the expropriated land was returned to
previous owners, and the rest was auctioned off.
Three key legal issues were then clarified by decree law in 1978. Government authority to
expropriate land was repealed, the ceilings on landholdings (the equivalent of eighty BIH) were
removed, and the ban on corporate ownership of land was eliminated. At the end of 1978, all
farmland owned publicly had been distributed, and Cora was legally closed.
Reforms in the legislation that regulated land rentals and land subdivisions in 1980 added
flexibility 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 titles
independently 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, and
some important unions were dissolved. Thus, wage adjustments became mainly a function of
indexation, which, given Chile's history of inflation, had become an established element of any
wage negotiation. Indexation was kept in place until 1982, through ten years of declining inflation.
9
Starting in October 1973, the government mandated across the board periodic wage adjustments
tied 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 the
economy. The 1979 Labor Plan formalized this practice by requiring that collective bargaining
agreements allow for wage adjustments at or above the rate of inflation. In 1982 the indexation
clause of the Labor Plan was eliminated. The government continued the practice of periodically
announcing wage readjustments and bonuses, with the wage increases usually not keeping pace
with inflation and covering the non-unionized sector only. The dynamism of the economy in the
early 1990s resulted in actual wage increases above officially announced readjustments.
The Employment Security Law established that in the absence of "just cause" for dismissal, such
as drunkenness, absenteeism, or theft, a dismissed employee could be reinstated to the job by a
labor court. This law was replaced by a less costly system of severance payments in 1978. Decree
Law 2,200 authorized employers to modify individual labor contracts and to dismiss workers
without "cause". A minimum severance payment was established that was equivalent to one month
of salary per year of service, up to a maximum of five months' pay. This new system applied to all
contracts signed after August 1981.
The changes introduced by Decree Law 2,200, along with the 1979 reforms, which established
new mechanisms to govern union activity (Decree Law 2,756) and collective bargaining (Decree
Law 2,758), became known in Chile as the Labor Plan. Decree Law 2,756 departed significantly
from traditional legislation: union affiliation within a company became voluntary, and all
negotiations would now have to be conducted at the company level; bargaining among many
companies would be eliminated. According to the previous law, which had applied until the 1973
coup, once the majority of the workers of an enterprise chose to join an "industrial union" all
workers became part of that union. That is, one union would have exclusive representation of all
workers in an enterprise. The right to collective bargaining was granted to unions at the enterprise
level 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 Labor
Inspectorate. As in the past, the new law required participation of 10 percent of the workers or a
minimum of twenty-five workers (whichever was greater) for creation of a union. Workers were
not 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 and
temporarily lay off workers, which the previous law had prohibited. At the same time, Decree Law
2,758 established norms about collective bargaining, and in its Article 26 the law established that
unionized workers' nominal wages should be adjusted to at least match the rate of inflation. This
article, which became a severe constraint to downward real wage flexibility during the 1982-83
crisis, can be understood only in the context of a previously existing policy of 100 percent
indexation 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 April
1991, when some important changes proposed by the Aylwin administration were approved by the
National Congress (hereafter, Congress).
Public employment programs
Two public employment programs affected the labor market during the period of economic
reforms between 1975 and 1987. The Minimum Employment Program (Programa de Empleo
Mínimo—PEM) was created in 1975 at a time when unemployment had reached record levels. The
program, administered by local governments, paid a small salary to unemployed workers, who, for
10
a few hours a week, performed menial public works. At first, the government tightly restricted
entry into the program. Gradually, most of these restrictions were lifted, and a larger number of
unemployed people were allowed to participate. Thus, the proportion of the labor force employed
by the program remained virtually constant between 1977 and 1981, despite the economic
recovery and a reduction in the real value of PEM compensation.
When Chile entered a new and more severe recession, the number of individuals employed by
PEM in the Metropolitan Region of Santiago increased from about 23,000 in May 1982 to 93,000
in May 1983. An Employment Program for Heads of Households (Programa de Ocupación para
Jefes de Hogar—POJH), created in October 1982, employed about 100,000 individuals in the
greater Santiago area by May 1983. The two programs combined absorbed more than 10 percent of
the labor force of the greater Santiago area in May 1983. These programs were also implemented
in 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 in
the entire country.
Debt crisis: further reforms and recovery
The international debt crisis unleashed in 1982 hit the Chilean economy with particular severity, as
foreign loans dried up and the international terms of trade turned drastically against Chile. The
policies implemented initially to face the 1982 crisis can best be described as hesitant. In early
1983, the financial sector was nationalized as a way to avoid a major banking crisis, and a number
of subsidy schemes favoring debtors were enacted. The decision to subsidize debtors who had
borrowed in foreign currency during the period of fixed exchange rates, and to bail out the troubled
banks, resulted in heavy Central Bank losses, which contributed to the creation of a huge deficit in
public sector finance. This deficit, in turn, would become one of the underlying causes of the
inflation 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 the
manufacturing 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 of
measures, the economy did not show a significant response; unemployment remained
extraordinarily high, and the external crisis, which some had expected to represent only a
temporary setback, dragged on.
In early 1985, increasingly disappointed by the economy's performance, Pinochet turned toward a
group of pragmatic economists who favored free markets and macroeconomic stability. Led by
newly appointed finance minister Hernán Büchi Buc, an economist who had studied business
administration at Columbia University, the new economic team devised a major adjustment
program aimed at reestablishing growth, reducing the burden of the foreign debt, and rebuilding
the strength of the financial and manufacturing sectors. Three policy areas became critical in the
implementation of the program: active macroeconomic policies, consolidation of the market-
oriented structural reforms initiated in the 1970s, and debt-management policies geared toward
rescheduling debt payments and making an aggressive use of the secondary market. With the help
of the International Monetary Fund, the World Bank, and improved terms of trade, these policies
succeeded in achieving their objectives.
The macroeconomic program of a group of Chilean economists known as the "Chicago boys", who
had 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 exchange
rate. By contrast, the new macroeconomic program relied on active and carefully monitored
11
macroeconomic management. An active exchange rate policy, based on large initial exchange-rate
adjustments followed by periodic small devaluations, became one of the most important policies of
the post-1982 period. Between 1982 and 1988, the international competitiveness of Chilean
exports 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 to
reasonable interest-rate levels and to the prevention of capital flight.
The adjustment program that started in 1985 also had a structural adjustment component that was
aimed at consolidating the market-oriented reforms of the 1970s and early 1980s, including the
privatization process, the opening of the economy, and the development of a dynamic capital
market. 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 percent
level that they had reached during 1984 to a 15% uniform level; and promote exports through a set
of fiscal incentives and a competitive real exchange rate.
Perhaps the most important aspects of these structural reform measures were the privatization and
recapitalization 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 this
operation, the Central Bank issued domestic credit. The banks, in turn, paid a rate of 5 percent on
the nonperforming portfolios and promised to repurchase them out of retained profits. This
recapitalization program had as its counterpart a privatization plan that returned the ownership of
those banks and firms that had been nationalized in 1983 to the private sector. Economist Rolf J.
Lüders estimates that about 550 enterprises under public-sector control, including most of Chile's
largest corporations, were privatized between 1974 and 1990. By the end of 1991, fewer that fifty
firms remained in the public sector. The overall privatization program undertaken after 1985 has
been criticized by some Chileans and also by some international economists because banks and
manufacturing 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 international
comparative perspective. The most difficult, controversial, and costly reforms—including the bulk
of privatization, trade liberalization, financial deregulation, and labor market streamlining—were
undertaken in Chile in the 1975-80 period; the measures taken after 1985 were minor, in
comparison. The success of the post-1985 period was rooted in the early reforms. For example, the
boom in nontraditional exports that took place in the second half of the 1980s was only possible
because of investments begun almost ten years before. The markets' flexible and rapid response to
incentives 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 1980s
concerns the different foreign-debt conversion plans aimed at rapidly reducing foreign
indebtedness. 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 imports
and equivalent to roughly half of its foreign debt. The stock of foreign direct investment in Chile
was estimated to be between US$10 billion and US$13 billion, roughly 30 percent of GDP. About
US$4 billion of this was acquired through debt-equity conversions. The debt-swap program was

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ended when the growth of direct investment and the strength of the economy had done away with
the need for special incentives to attract foreign capital.

The economic situation facing the Aylwin government in 1990.

Despite the success of the structural reform and stabilization policies, not all is rosy. A high
proportion of Chileans -- estimated at around 45 percent by Torche (1987) -- were living below
the poverty line in the mid-1980s. Income inequality worsened through the crisis of 1982-83
before recovering somewhat: Table 1 shows that the share in national income of the highest
quintile increased steadily from 1970 to 1989, while the income share of the poorest two quintiles
declined from 1970 to 1982-83 before rising in the late 1980s. While unemployment fell
substantially in the late 1980s, real wages remain 22 percent below their 1970 level. Social
spending suffered great cutbacks in the wake of the 1982-83 economic crisis: per capita health,
housing and education budgets declined more than 20 percent.

Most analysts believe in 1990 that the economy has hit its capacity to grow. With the
unemployment rate at 6 percent -- its lowest level in two decades -- and substantial capital inflows
from abroad, investment is now seen as the constraint on growth. While capital formation has
increased steadily after the structural reforms of the mid-1980s (Table A7), it is still well below
the efforts that propelled countries like Korea and Singapore to high sustained growth, and real
interest rates remain quite high at over 10 percent. The financial system is in sound shape, due to
prudential supervision of the banks and five years of strong economic growth. Chilean financial
markets are relatively well-developed, due in part to the reform of the pension system: pension
funds are majority participants in the markets for mortgage bills, corporate bonds and Treasury
securities, and purchase a significant proportion of Banco Central notes.

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Table 1. Income Distribution in Chile: Selected Years, 1970-1989.

Share of Income Real Wage

Years Index, Dec. Unemployment
Lowest Middle Highest 1982=100 Rate
40 percent 40 percent 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 at
risk 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 sector
surpluses.

Policy decision.

As Chile’s first democratically elected President in sixteen years, and as head of a diverse
coalition 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 Allende’s fateful mistakes in the early 1970s of trying to do too much too quickly
without 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, Aylwin’s 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 the
Pinochet 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, Andres
Allamand. If Aylwin can get Allamand’s blessing, Arturo’s economic plan has a good chance of
Senate approval.

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 Figure 1
Copper Prices on the World Market

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 References

Wikipedia, The Free Encyclopedia

Basch, Miguel and Eduardo Engel, “Temporary Shocks and Stabilization Mechanisms: The Chilean
Case,” in Engel and Patricio Meller, eds., External Shocks and Stabilization Mechanisms, IDB,
1993.

Edwards, Sebastian and Alejandra Cox-Edwards, Monetarism and Liberalization: The Chilean
Experiment, 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 America, IDRC, 1995.

Gil, Frederico, The Political System of Chile, 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 Growth, 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 Performance, 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., Desarollo
Economico en Democracia, Ediciones Universidad Catolica 1987.

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