Thursday, March 04, 2010

The Chile model

As social scientists, economists frequently conduct experiments to explain human behavior. Taking different groups, subjecting them to various incentives, and observing the responses can provide new insights into how markets function. They are, however, typically limited in scope.

While conducting experiments on a macro-level is near impossible, history does on occasion provide its own laboratory. Competing economic systems in North and South Korea offer definitive proof -- if there was still any lingering doubt -- over the failures of Stalinism and relative superiority of capitalism. Germany's division into separate states served as further evidence of Marxist-Leninism's illogic.

Although capitalism has now been acknowledged as the undisputed victor over communism -- except perhaps in the halls of various institutions of higher learning -- cross-country comparisons still serve a valuable role in assessing the performance of capitalism's sub-types. In the West, the triumph of Anglo-American style capitalism serves as a constant reminder of the Western European social democratic model's shortcomings. This is why the U.S., as the most high-profile practitioner of this strain of capitalism, finds itself under constant attack from many leftists as selfish and societally degenerate. After all, if the two sides are acknowledged to exist on the same moral plane the obvious superior economic performance of the U.S. renders the social democratic model a comparative failure.

As during the Cold War, this competition has also played itself out by proxy in Latin America. During the 20th century many countries in this region adopted economic policies which amounted to an embrace of the welfare state combined with Marxist-influenced expropriations of wealth, government-run enterprises and trade policies based on economic dependency theory. The results were predictably disastrous. Countries that were already poor remained so while Argentina, one of the world's richest countries at the turn of the century, was reduced to a middling economic power.

In the 1970s and 80s, however, one country began to emerge from this Latin American torpor: Chile. Under the authoritarian regime of Gen. Augusto Pinochet the economy was overhauled to be more in line with free market principles. Pinochet was neither a libertarian or disciple of Adam Smith, rather he simply observed Chile and Latin America's economic failings and realized a change in course was needed. The results speak for themselves:

Understandably, free marketers have pointed to Chile as a shining example of the bountiful harvest which can be reaped when economic freedom is promoted. Chile's boom has been so impressive that it is known as the "Miracle of Chile" and even has its own wikipedia entry. The country is now sufficiently developed that it has been extended an offer of membership in the OECD. Notably, while leftist parties in Chile have dominated the political scene since Pinochet's departure from power in 1990, they have opted to leave the economic model largely in place. Indeed, the Heritage Foundation's Index of Economic Freedom ranks the country #10 in the world.

Chile's economic miracle has received renewed attention in the wake of its recent earthquake -- most notably from the Wall Street Journal editorial board and Bret Stephens -- both as a stark reminder of the benefits of increased wealth as well as the wisdom of Milton Friedman, whose philosophy heavily influenced the "Chicago Boys" tasked with revamping the country's economy. Unsurprisingly the political left has struck back, attempting to diminish the Chilean experience and chalking up its ability to weather the earthquake as a testament to government regulation.

Leading the charge against the Chicago Boys' legacy is Salon's Andrew Leonard. After highlighting the role of government building code regulation (of course, a country must be wealthy in order to construct buildings which can withstand severe earthquake tremors) and -- with more justification -- lessons learned from Chile's previous experience with earthquakes, he gets into the meat of his argument, starting with a bit of character assassination:
But the earthquake is just a side show for the opinion page of the Wall Street Journal -- just another opportunity, however shameless, to push free market fundamentalism. One of the great blemishes on Milton Friedman's legacy is his association with the Pinochet government, which has been held responsible for murdering some 2, 000 to 3,000 people during its 17-year tenure, along with arresting tens of thousands of other citizens and enforcing harsh controls on the press and other civil liberties.

Friedman's acolytes have long tried to wish away the complicity of the Chicago boys and their guiding light in one of the darkest chapters of modern Chilean history, but the stain is tough to get out. If trampling all over the democratically expressed wishes of the people and instituting an authoritarian reign of terror are what it takes to achieve economic growth, is it really worth it?
For the record, Friedman had one 45 minute meeting with Pinochet and agreed to send him a letter outlining recommendations for improving Chile's economy. Simply click on the link Leonard provides and you can see a copy of Friedman's letter for yourself. As for the remainder, would Chile's citizens have been better served without the advice of the Chicago Boys? Would leaving them in the clutches of a failed economic model have been more compassionate?

He continues:
But a more pertinent question might be to ask just how much credit really is due Chicago-school economics for Chile's current relative prosperity? Mining alone accounts for 20 percent of Chile's GDP, and it is very much worth noting that the country's crown jewel, the copper industry, is completely dominated by one state-owned (emphasis in original) company, Codelco. Ponder that, for a second: Latin America's poster child for Chicago school economics features state control of the single most important economic resource. Huh.
Ponder this: Chile passed a Constitutional Mining Law to attract more private investment in the mining sector. It has succeeded, with Chile receiving over $20 billion in foreign investment since the measure was passed. Chalk that up as another success for economic liberalization. If state ownership of natural resources were to the key to prosperity, meanwhile, Venezuela would be booming instead of struggling to keep the lights on.
Chile also suffers from some of worst income inequality in the world, and in fact, only began to take serious steps to address income disparities after the plebiscite that ended Pinochet's rule. And how did the government do that? By raising taxes and social spending.
Leonard is really grasping at straws to make Chile look bad. The first link provides little evidence that Chilean inequality is dramatically different from any other Latin American country, and actually highlights that hundreds of thousands of Chileans have been brought out of poverty. His second link is broken while the third is a report by Ralph Nader's Public Citizen which includes this interesting quote:
As Chile’s former finance minister notes, "about 60 percent of Chile’s poverty eradication in the 1990s can be attributed to economic growth and 40 percent to social policies."
Public Citizen is citing a government official who thinks most poverty reduction can be traced to economic growth rather than his own administration's interventions -- and this is supposed to help their case?
But it's a job that's hardly finished, as evidenced by the reports of serious social disorder currently emanating from Chile, which some observers have compared unfavorably with Haiti.

Vast extremes in income equality do not make people happy, especially in the aftermath of huge disasters. That might be the true lesson of Chile, and it's one that the Chicago boys who make their home in the United States might do well to mull over.
In other words, some rioting occurred following the earthquake, which must mean that Chileans are miserable. Funny, one would think if that were true that citizens of the country would be looking to immigrate to neighboring Peru and Argentina instead of the reverse taking place.

Leonard, however, isn't the only one to hit back, with Paul Krugman also anxious to dispel the perception of Chile as a free market success story. His take, however, is even thinner and more glib than Leonard's, with this excerpt constituting the only real substance in his argument:
But there’s another point: the economics of Chile under Pinochet are a lot more ambiguous than legend has it. The way the story is told now, the free-market guys moved in, liberalized, and then there was a boom.

Actually, as you can see from the chart above, what happened was this: Chile had a huge economic crisis in the early 70s, which was, yes, partly due to Allende and the accompanying turmoil. Then the country experienced a recovery driven in large part by massive capital inflows, which mostly consisted of making up the lost ground. Then there was a huge crisis again in the early 1980s — part of the broader Latin debt crisis, but Chile was hit much worse than other major players. It wasn’t until the late 1980s, by which time the hard-line free-market policies had been considerably softened, that Chile finally moved definitively ahead of where it had been in the early 70s.

So: free-market policies are applied, and presto! prosperity follows — fifteen years later. (emphasis in original)
To make sense of Krugman's argument it helps to scroll up to the chart posted or click here.

Allow me to present another reading of what happened: Following Pinochet's coup the economy declined, bottoming out in 1975 and then steadily grew until the debt crisis hit in 1981-82. The economy entered into a slow recovery which accelerated in 1986 and hasn't let up since. Interestingly, the severity of the early 1980s debt crisis can be attributed to Chile's decision to ignore rather than embrace Milton Friedman's advice.

As wikipedia says:
Minister of Finance Sergio de Castro, departing from Friedman's well-known support for flexible exchange rates, decided on a fixed exchange rate of 39 pesos per dollar in June 1979, under the rationale of bringing Chile's rampant inflation to heel. The result, however, was that a serious balance-of-trade problem arose. Since the Chilean pesos inflation outpaced the U.S. dollars inflation, every year the Chilean foreign goods buying power increased, all fueled by foreign loans in dollars. When the bubble finally burst in late 1982, Chile slid into a severe recession that lasted more than two years.

Chile had a strong economic recession in 1982-1983, its second in eight years (in 1975, when GDP fell by 13 per cent, industrial production plunged by 27 per cent, and unemployment shot up to 20 per cent). Real economic output declined by 19% just in 1982 and 1983 and most of the recovery and subsequent growth took place after Pinochet left office, when market-oriented economic policies were additionally strengthened.

In his Memoirs ("Two Lucky People", 1998), Milton Friedman criticized De Castro and the fixed exchange rate.
The Chilean economic boom and the growing prosperity of its citizens is a testament both to the marketplace and the Chicago Boys whose policies unleashed its power. Let's hope more countries in Latin America opt to follow the path Chile has helped blaze. While left-wing detractors may insist the country's success is due to something other than its implementation of free market policies, the fact that successive governments have largely left Pinochet's reforms alone, engaged in expanded trade liberalization and received continued high marks for economic freedom prove the feebleness of their arguments.

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