One
of the most fascinating topics in economic and social research is
the issue of development. What allows some countries to "quantum
leap" to higher levels of income per capita, and how do they remain
at those high levels?
The
literature on economic growth, development, and prosperity mostly
agrees that the key to prosperity is open markets, sound
institutions, and particularly a strong rule of law. The reason is simple.
Open markets allow for competition, which is the only method, as F.
A. Hayek wrote in the Road to Serfdom, "by which our activities can
be adjusted to each other without coercive or arbitrary
intervention of authority." Competition, at the same time, requires
the organization of institutions, such as stable money, minimal and
transparent regulation, minimal participation of the state in
economic activity, and a strong enforcement of property rights and
regulations.
The
annual Heritage Foundation/Wall Street Journal Index of Economic
Freedom provides a framework for understanding how open countries
are to competition; the degree of state intervention in the economy
(whether through taxation, spending, or overregulation); and the
strength and independence of a country's judiciary in enforcing
rules and protecting private property.
The
10 factors of the Index show the degree of economic freedom in a
given country. Some countries may have a substantial degree of
freedom in all factors; others may have a degree of freedom in just
a few. One of the most important findings of the Index is that, as
Hayek foresaw more than 60 years ago, economic freedom is required
in all aspects of economic life--that is, in all of the 10
factors--in order for countries to improve their economic
efficiency and, consequently, the living standards of their
people.
Chile illustrates Hayek's idea. For more
than 30 years, the country has persisted in opening its markets,
allowing more and more competition, and fostering a strong rule of
law, and these efforts have paid off in many ways. Chile today has
one of the highest per capita gross domestic products (GDPs) in
Latin America, has experienced high levels of economic growth, and
conveys an institutional trust that has attracted local and foreign
investment. Most important, it has severed itself from reliance on
international aid, on which most Latin American countries depend.
By following the 10 steps to economic freedom, Chile has become
more prosperous. Continuing on this road will transform Chile into
a developed economy for future generations.
Chile has set the example of how a country
can escape from the cycle of aid and dependence to the cycle of
self-generated growth. Other Latin American countries and the rest
of the developing world should be encouraged to follow the Chilean
example. Many developing countries have slipped back from reforms
into aid and bailout dependency, while others have never exited aid
dependence at all.
The
United States should do all it can to support the Chilean effort
and publicize the great triumph of prosperity through free and open
markets. Success breeds imitation. As more and more countries begin
to imitate the "Chilean model," the world will experience more
growth, development, stability, and peace.
HOW CHILE DID IT: 10 Steps
Chile's reforms began in the mid-1970s
under the government of General Augusto Pinochet and have continued
to the present. Using the Index as a framework, it is possible to
identify the areas of economic freedom in which reform has
progressed in Chile.
STEP 1: Trade
Policy
Trade policy was one of the first things Chile reformed,
beginning in 1974 with the dismantling of quotas and other
non-tariff barriers. In addition, the Chilean government
established a uniform tariff rate of 10 percent on all imports,
with the exception of a few agricultural products. During a crisis in the
early 1980s, the tariff was temporarily increased to 15 percent,
remaining at that level until 1990. The reduction process continued until
1998, when the Chilean Congress approved a law reducing the tariff
rate by 1 percentage point per year until it reached 6 percent in
2003.
The
lowering of tariffs had four important effects. First, the
influence of special interests and the corruption associated with
them was significantly reduced; with all sectors of the economy
facing the same protection, the government could no longer offer
special deals. Second, the flat tariff eliminated the distortions
that usually retard domestic economic growth. Third, exports
increased considerably, from $3 billion in 1974 to $29 billion in
2000. (See Chart 1)
Fourth, it diversified exports; the share of copper exports, for
example, decreased from 76 percent of total exports in 1970 to 38
percent in 2001, while non-traditional exports share increased from
10 percent to 38 percent during the same period.
Overall, the implementation of a low
uniform tariff helped to boost the domestic economy by giving
producers access to inputs of better quality at lower prices,
increased consumers' welfare by increasing the variety of and
lowering prices for goods and services, generated more income for
the country, and helped to eliminate corruption.
STEP 2: Fiscal
Burden
The Chilean tax code went through two major reforms. The
first, in 1975, introduced a flat-rate value-added tax of 18
percent. The second,
in 1984, simplified and reduced the corporate tax, which is
currently set at 16 percent. In 2002, according to the Index, "the
top income tax rate [was]...lowered from 45 percent to 43 percent
and will be lowered to 40 percent in 2003." According to the Centro de Estudios
Publicos (CEP), a public policy foundation based in Santiago,
Chile, "tax evasion in Chile, estimated at around 22 percent of
potential tax revenues, is the lowest in Latin America and not
significantly different from many developed countries"
In
addition to the tax reform, the reform of the mid-1970s included a
rationalization of public expenditures, which in prior years had
gone out of control. According to the CEP, "measures to adjust
public spending [were implemented]...in three areas: public
investment, public sector wages, and the elimination of most of the
subsidies implicit in the operations of the state owned
companies." By
1976, the government had a fiscal surplus of 1.37 percent of GDP;
since then, it has averaged a fiscal surplus of 0.87 percent. (See
Chart 2)
STEP 3:
Government Intervention
According to the CEP, the first of three major rounds of
Chilean privatization began in 1974. The first, which lasted from
1974 to 1983, included "most farms and some industries [as well
as]...industries that had been acquired by the state during the
government of President Allende. This included mostly industries
and banks." The
second round, in 1985, included "public utilities plus the
re-privatization of companies that had returned to the government
during the [1982-1983] crisis." The third round, in 1990,
"comprised basic infrastructure (through concessions) and water
companies." The CODELCO (a copper company), a bank, and the
principal oil company still remain in state hands, but the share of
public enterprises in the GDP declined from 39 percent in 1973 to 9
percent in 1998. (See Chart 3)
STEP 4: Monetary
Policy
In 1989, a new law made the Central Bank independent. The
bank has a
board of...five members nominated by the
president and approved by the senate. Each one has a 10-year term.
Every two years there is a change in one of the board members. They
are independent from the government (cannot be removed from their
position.) The Ministry of Finance has the right to participate in
board meetings but does not have a voting power.
Prior to the reform, Chile's inflationary
history was horrible. The inflation from 1961 to 1989 averaged
about 75 percent, reaching as high as 500 percent in 1974. (See
Chart 4) The new independent Central Bank set and reached inflation
targets, successively lower each year, until inflation was at very
low levels. Since 2000, the target has become permanent--2 percent
to 4 percent annually.
Two
other factors may have contributed to the decline in inflation: a
general fall in global inflation during the 1990s and the growing
strength of the Chilean economy, which increased confidence that
the Central Bank could maintain the value of the currency.
Nevertheless, giving the Central Bank more independence was a key
domestic decision in strengthening an important institution and
ensuring a stable currency.
STEP 5: Banking
and Finance
Liberalization of the banking system began in the
mid-1970s. The CEP reports that the major reforms included the
privatization of all but one state-owned bank, liberalization of
interest rates, reduction in reserve requirements, and enlargement
of the scope of banking businesses. The financial crisis of 1982-1983 led
the government to implement more reforms. This time the government
strengthened banking supervision with the introduction of a banking
law in 1986. Today,
Chile's supervision of banks is considered one of the best in
emerging markets.
The liberalization of the banking system
and stronger bank supervision have led to increased
penetration--measured by the increase in deposits and loans as a
percentage of GDP--and more bank consolidation. According to the
Bank for International Settlements, "Banking loans amounted to 70
percent of GDP and total deposits to 61 percent of GDP in 2000.
These figures compare with 54 percent and 47 percent, respectively,
in 1990." In
addition, "the Chilean regulatory environment has been stable since
the 1980s" Today,
the Economist Intelligence Unit (EIU) reports, "the banking system
is well capitalized and prudently managed, and it is ranked among
the most solid in the world."
Another major reform in the financial
system was privatization of the pension system. This reform allows
individuals to save retirement money in fully funded privately
managed accounts rather than relying on the government transfer
program of collecting payroll taxes from the active population and
transferring them to retirees as pensions. Administradora de Fondos
de Pensions (AFP) are private companies in charge of managing
retirement funds. Under the new reform, people can move their money
to another AFP if they think their funds are not being managed
properly.
Eliminating transfers had enormous
implications for economic growth and the advancement of other
reforms. According to the CEP, pension funds have increased
continuously since 1981 and, in 2001, represented more than 50
percent of GDP.
Perhaps more important, the growth of the pension system exerted
pressure to privatize state-owned companies and liberalize trade in
order to provide pension owners with domestic and foreign
investment opportunities.
STEP 6: Capital
Flows and Foreign Investment
According to the EIU, in the mid-1970s, the Chilean
government took two major steps toward liberalizing foreign direct
investment. First, it enacted Decree Law 600 to define the rules
for foreign investment. Second, it "withdrew from the Andean Pact,
a regional organization whose protectionism and bias against
foreign investment were incompatible with Chile's new development
strategy."
RWINC Consultants, a Chilean business
consulting firm, reports that Decree Law 600 "has been recognized
by the international business community as one of the most modern
and flexible legal frameworks for foreign investment in the
world." The decree
law guarantees non-discriminatory and non-discretionary treatment
of foreign investors. When the investment application is approved,
the foreign investor enters into a contract with the state, a
contract that neither the Chilean government nor a regulation can
modify unilaterally. Foreign investment is acknowledged in
the form of freely convertible currency, physical goods that can be
imported, technology in any form that can be capitalized,
capitalization of foreign loans and debts in freely convertible
currency and whose contract was authorized by the Central Bank, and
capitalization of profits transferable abroad.
RWINC also reports that "the policy of the
Chilean State is that in case more favorable regulations than those
established in the contract are enacted, the investor has the right
to request an amendment to reflect the new regulations." This
reform has resulted in a massive inflow of foreign direct
investment, increasing from $12.7 billion in 1974-1994 to $35.9
billion in 1995-2001.
Chile now has a very open policy for
capital controls. In the 1990s, the government required that
"foreigners wishing to move funds into Chile...make non-interest
bearing deposits at the Central Bank." In 1998, the percentage of money
required to be deposited in the Central Bank was reduced to 10
percent, and later that year, the rate was reduced to zero. This year, within the
framework of the U.S.-Chile Free Trade Agreement, the Chilean
government agreed to repeal the law.
STEP 7: Wages
and Prices
Wages and prices were liberalized at the beginning of the
reform process, in 1974. That year, the government lifted
restrictions on all prices in the economy. This was a clear signal of a nascent
market economy, which uses the price system as an "information"
mechanism that leads to a more efficient allocation of
resources.
Wages were also liberalized. In the
mid-1970s, according to Vittorio Corbo, professor of economics at
Chile's Catholic University, "collective bargaining was suspended
and, with the exception of the minimum wage and public sector
wages, the government did not intervene much in the determination
of private sector wages."
STEP 8: Property
Rights
Chile has a long tradition of respect for private property
rights and enforcement of contracts. According to the EIU,
"contractual agreements in Chile are probably the most secure in
Latin America, and the local public administration is generally
honest." The
respect for and strong enforcement of private contracts continued
even through the 1973-1989 dictatorship. Throughout society, there
is a widespread understanding and trust that the law must be
respected, and the courts enforce the law effectively.
STEP 9:
Regulations
The reforms of the past three decades have
simplified--where possible--and reduced the regulatory cost of
doing business in Chile. One major reform in the mid-1970s was the
liberalization of the labor market, making it more flexible. Until
1974, the labor market was extremely rigid. According to Vittorio
Corbo, "Rigidities took the form of labor immobility, unlimited
compensation for labor dismissal, minimum wages...[and] special
salary conditions."
The
1974 reform established that negotiations between employer and
employee would determine wages in the private sector. It also set
new, more flexible conditions for hiring and laying off employees,
reduced restrictions on the severance pay for layoffs, and reformed
the collective bargaining process into one in which the union
negotiates at the company level. At the same time, the 1974 reform made
starting a new business in Chile more expeditious, and applications
are now typically approved within a month. Corruption in the bureaucracy is very
low.
STEP 10: Black
Market
Chile has an informal economy, but it is very small.
Friedrich Schneider, professor of economics at Johannes Kepler
University of Linz in Austria, did a study on the size of the
informal economy in 110 countries around the world. According to
Schneider's study, Chile's informal economy is about 19.8 percent
of gross national product (GNP)--the lowest proportion of informal
economy to GNP in Latin America and lower than the informal economy
in Belgium, Spain, Italy, Portugal, and Sweden, all of which are
developed economies.
THE RESULTS: PROSPERITY
The
Chilean reform process has continued for almost 30 years, turning
Chile into one of the freest economies in the world today. The
Chilean reform process over the past nine years has been
remarkable, particularly compared to the rest of the region (see
Chart 5), as chronicled by The Heritage Foundation/Wall Street
Journal Index of Economic Freedom. While the rest of Latin America
has remained, on average, near the threshold between "mostly
unfree" and "mostly free" economies, Chile not only has moved
across the "mostly free" category of economic freedom, but also has
crossed--in 2002--the threshold into the "free" category.
What
is most remarkable in Chart 5 is that to move from "mostly free" to
"free," a country must undertake extensive reforms in all 10 fronts
of economic freedom. In achieving the status of a "free" economy,
Chile undertook reforms in the fiscal, trade, monetary policy,
wages and prices, banking, and black market fronts in just the past
nine years, in addition to the comprehensive reform efforts carried
out in all 10 fronts since 1974.
And
it paid off. Chile's reforms paid off with more investment, more
consumption, more economic efficiency, and sustained economic
growth. Since 1995, Chile's compounded growth rate has been 12
percent, while the average for the rest of Latin America has been
only 1 percent.
(See Chart 6) Chile's income per capita has doubled since 1974,
when the reforms started.
Chile's sustained growth increased the
country's standard of living, particularly for the poor. The
poverty rate has fallen since the 1980s in terms of incidence,
depth, and severity. In 1998, the World Bank reported that 17
percent of Chileans were living in poverty (compared to 40 percent
in 1987), while 4 percent were living in extreme poverty. The number of pupils
enrolled in primary education "jumped from 28 percent in 1991 to 82
percent in 1996 and the average time to graduate from primary
school fell from 12.4 years to 9.7 years during the same period." Today, 94 percent of
the population has access to improved water, and 97 percent has
access to improved sanitation.
The
reform process in Chile provides important insight into what
developing countries need to do in order to actually develop. The
first lesson is that reform should proceed simultaneously across
all 10 fronts of economic freedom. Hernan Buchi, Chilean Minister
of Finance from 1985 to 1989, has stated simply that "it is
necessary to proceed with all reforms simultaneously and increase
the pace in accordance with the perceived prospects for success....
[T]here is synergy among reforms: one reform helps another."
Buchi has also pointed out that some
reforms are necessary to reinforce the effects of other
reforms:
Progress is impossible in the absence of a
properly functioning financial sector operating in accordance with
the rules of the market. A private banking sector channeling credit
to profitable projects is of primary importance for setting the
economy on the proper path.... [T]here is another reform that must
be implemented at [the] initial stage.... I refer to the opening of
trade. If the entire economy is moving towards an increase in
efficiency resource distribution, it is important that the changes
in the competitiveness of the various sectors be stimulated by
opening foreign trade. Belated reform in this area modifies the
conditions facing economic agents and lessens the credibility of
the entire reform process.
While bold reforms do require some degree
of political consensus, two things are critical to advance reform
and place a country on a sustainable growth path. The first is
leadership. As Buchi suggests, successful liberalization requires
"a strong visible leader, someone who is willing to absorb
criticism and who, in addition to requirements in the area of
technical competence, must also possess perseverance and an
overriding faith in the market and free enterprise."
Leadership--unfortunately lacking in the developing world and much
of the developed world--is essential to advance reforms over long
periods.
The
second critical element is respect for the law and private
property, as the means to ensure that the rules of society are not
changed arbitrarily or outside due process.
CONCLUSION
Economic freedom leads to prosperity
because free economies allow for competition, which is the only
method by which the daily activity of millions of people can be
coordinated without coercion. Competition, at the same time,
requires the organization of institutions, such as stable money,
minimal and transparent regulation, minimal participation of the
state in economic activity, and a strong enforcement of property
rights and regulations.
The
10 factors of the Index of Economic Freedom provide an excellent
framework for evaluating the degree to which different countries
permit competition, intervene in the economy, and protect property
rights. One of the most important findings of the Index is that
economic freedom is required in all of the 10 factors in order for
countries to improve their economic efficiency and, consequently,
the living standards of their people.
The
reform process in Chile illustrates this fact. In addition, the
Chilean reform experience indicates that leadership is an essential
component in helping a country's economy reach its full
potential.
The
United States should support countries like Chile in their reform
efforts and hold them up as examples to the rest of the developing
world. The Chilean history of economic freedom says that
development is possible. It takes leadership, faith, and political
will, but it pays off.
For
that reason, the United States government should encourage Chile to
continue on its path to prosperity by doing all in its power to
support the Chilean reforms. Success breeds imitation, and the
world will experience more growth, development, stability, and
peace as more and more countries imitate the Chilean model.
Ana I. Eiras
is Senior Policy Analyst for Economic Freedom in the Center for
International Trade and Economics at The Heritage
Foundation.