Was It the Free Market That Failed in Chile?

Chile has become something of a tender point for free-market believers this past year. The Chilean economy has taken a nose dive, and the substantially free-market program that until 1981 drew attention as a miracle now looks more like a debacle.

What went wrong? Chile's economic program seemed to be going in the right direction. Prices and interest rates were decontrolled, more than 400 businesses were returned to the private sector, tariffs were slashed across the board, and social security was transferred to the private sector—to name the mainstays of the so-called free-market experiment. Among other signs of success, inflation fell from 340 percent in 1975 to 10 percent in 1981; and from 1977 to mid-1981, GNP was growing at about 8 percent a year.

Now, however, the Chilean economy is a mess. Gross national product fell 13 percent last year, and unemployment rose to about 25 percent. The peso today is worth less than half what it was against the dollar in early 1982. Many banks have survived only through government bail-outs and are now under state management. This past spring, when world oil prices were plummeting, the best news the government development agency, CORFO, could find for its economic report was that Chile's state petroleum monopoly was pumping record amounts of crude oil.

What happened to Chile's economic miracle? The standard explanation, from the Los Angeles Times to the Nation, is that the Chilean government adhered too strictly to a free-market model. This experiment in capitalism, say those who have criticized it all along, has proved that a laissez-faire system won't work.

In fact, however, the smash-up of Chile's economic system began not with the principles of free economic activity but with two mistakes made by the free-market team of government economists: they failed to acknowledge an implicit state guarantee of private banks, and they fixed the peso to the dollar. With the resulting problems, Chile's military rulers are proving to be fair-weather friends of the market. Instead of sharpening their commitment to economic freedom, they seem ready to junk it. Their behavior points to some bottom-line conflicts between capitalism and political repression.

To find the start of today's troubles means going back to the mid-'70s. Chile was suffering from world recession while trying to find a way out of the economic shambles left by the socialist government of President Salvador Allende. When "the Chicago boys," a group of Chilean economists trained at the University of Chicago, brought a detailed free-market program for economic recovery to the new president and chief of the junta, Augusto Pinochet, he was willing to listen.

Pinochet backed the economists because they had a comprehensive plan, and they had answers to problems the military men were still trying to understand. These problems ranged from triple-digit inflation to a lack of credibility with foreign bankers. No one was in a hurry to lend money to Chile after the grand-scale nationalizations and economically destructive policies of Allende's administration.

The Chicago boys were not backed all the way, however; they had to fight continually against many of the generals in Chile's new military regime, who tended to favor heavy state control of industry. The free-market policies were under pressure to produce fast results in order to win continued tolerance from the military. There was no time to linger over details or to fine-tune huge reforms. Juan Carlos Mendez, who became budget director in 1975, described his across-the- board cuts in government spending as "not a very scientific way to do it.…But the important thing was to bring the deficit to zero."

When the government auctioned off the state-owned banks to the private sector, all seemed well. The idea was that once the government had bowed out, private competition would ensure that credit went to good investments. But there was a sleeper.

Before the nationalizations under Allende, banks had operated with fixed interest rates on loans and deposits. Under Pinochet, bankers were free for the first time to do whatever the market would allow. As Chile's business climate improved under the new economic program, foreign bankers became eager to lend. By 1981 dollars were pouring into Chile by way of loans to Chilean banks. Signs of progress were easy to see, with new apartment buildings going up in Santiago, factories opening, and imported consumer goods filling the shops. Everyone wanted a piece of the action. Maids and janitors moved their savings from the mattresses to mutual funds. Inflation was coming under control, real wages were rising, and unemployment was falling. With the dramatic economic changes in Chile, no one stopped to question exactly where the money borrowed from foreign bankers was going.

Foreign lenders apparently looked at Chile's growing reserves as a guarantee that their private loans would be repaid. Lenders took little care that their dollars were wisely invested, apparently because they believed the Chilean government would not allow a major bank default. The government gave no such guarantee of private debt, which would have gone against free-market principles. In this atmosphere, strong bank regulation was viewed by many as a hindrance to the market, and the government tended to stay out of the affairs of private banks.

Then, in 1979, the third consecutive year of 8 percent growth in GNP, the government fixed the exchange rate between the peso and the dollar. The aim was to attract foreign capital with a guarantee that pesos could be turned back into dollars at the original rate. At the time, prospects seemed good that growth would continue and the guarantee could be honored. Chronic economic stagnation of earlier times had given Chile little experience with the business fluctuations that accompany free markets.

While some members of the Chicago team disagreed in private with the fixed-exchange-rate policy, they backed it in public. The economists were still fighting unfriendly generals in government and thought they could not afford to jeopardize their whole program with open dissension over their own policies.

The economic program by this time included a massive changeover from a state-subsidized, pay-as-you-go social security plan to a private pension plan. A school voucher system was under way, and a new labor law allowed union activity but restricted it to open-shop, local unions. Transportation had been deregulated for the air, taxi, and intercity bus industries. There was even talk of deregulating first-class mail delivery.

But the careless bank practices and the fixed exchange rate held hidden dangers. In May 1981, a major sugar refinery failed in a spectacular and disturbing way. The refinery was run by a respected Chilean businessman, Jorge Ross. Private banks had loaned money to his company, CRAV, on the strength of his reputation, without watching how the money was used. What came out in the newspapers after the failure was not only that the company had been headed for bankruptcy but that it had gone under with a resounding thud by speculating in the futures market. Private banks had to pick up big pieces of the bill.

Shaken by this incident, the government rushed out a strict banking law three months later. The law limited the amount of capital banks could lend to any single corporation or person and prohibited them from accepting stock as collateral.

The banking law came too late to change the disastrous policies of several major banks. World recession had begun, and the price of Chile's main export, copper, was falling. The dollar was on the rise, taking Chile's peso along with it because of the fixed exchange rate. This created artificially high prices that discouraged demand for Chilean exports. Banks began finding it harder to get credit and could no longer hide bad loans by rolling them over.

The Chicago boys in the ministries of finance and economy and in the central bank were reluctant to violate free-market principles, but they did. They thought they had no choice. Foreign lenders tend to look at the overall credit-worthiness of a country, rather than at individual borrowers. The government fear was that the failures of several large banks would make it hard for even the best Chilean investments to attract credit. Afraid of scaring away foreign capital, Chile's government intervened to prop up four failing banks and four loan companies in the fall of 1981.

The investigations that followed the bail-outs found a rats' nest of loan pyramiding, stock-market manipulation, and doctored books, according to the Chilean newspapers. Some banks had kept bad loans on their books, reluctant to recognize their losses; some had obtained loans for sister companies that had then redeposited the loan money in the banks to generate more lending power without a corresponding increase in the capital base of the banks. Practices like these build up a financial house of cards that finally collapses when the bank cannot get enough new credit to hide its losses.

Once intervention began, it was hard to stop. The willingness to bail out banks meant that some private-sector risk was being transferred to the state, and the government policy of paying full interest to depositors after a bail-out meant that the public had an incentive to deposit savings in the riskiest banks offering the highest interest rates. Recently, the government has again intervened to save additional banks. The state is now able to ration much of the credit to the private sector—exactly what the original sale of the banks to private owners had been designed to prevent.

As the banking problems were exposed and recession deepened, Chile began losing foreign reserves. Holders of pesos, no longer optimistic about the future of the economy, began converting their pesos to dollars for safety. Fear of devaluation led to further losses of dollar reserves, which in turn made devaluation harder to avoid.

In theory, the Chilean government had no need to devalue. The Chicago boys had learned in graduate school that in a free-market economy, with a fixed exchange rate, prices would adjust automatically in times of hardship. The price level would fall, and the exchange rate would come into line without a devaluation.

In practice, there were two obstacles to an automatic drop in price level. One was a clause in the 1979 labor law that put a floor on union wages. The other was the immediate psychological problem of asking people to accept lower salaries in a country accustomed to double- and triple-digit inflation. Chileans have a sophisticated understanding of wild inflation, but a drop in nominal prices was altogether outside their experience.

By June 1982, Pinochet decided that a downward adjustment of prices was politically impossible. He had already fired his most influential free-market advisor, Sergio DeCastro, who had backed the fixed exchange rate. The Chilean government devalued and later floated the peso, which fell more than 100 percent against the dollar over the following months.

The devalued peso created more problems for the economy, which was already troubled by the bank crisis and the lowest copper prices in decades. Firms that had borrowed in dollars were unable to meet their debt payments. Businesses failed and unemployment shot up, while the government faced a growing budget deficit because of declining tax and copper revenues.

As a result of these economic difficulties, the free market may have lost its most important backer. Pinochet, proud of the Chicago boys and their policies when times were good, is now edging toward populism.

Since April 1982, Pinochet has dismissed three Chicago-trained finance ministers in succession, starting with DeCastro, who was the mastermind of the Chicago boys' team. The current finance minister, Carlos Caceres, is a free-market thinker and one of the two Chilean members of the Mont Pelerin Society, a private international club that favors individual freedom. But Caceres has a reputation as an academic, not as a politician. He is working without the help of the old economic team, most of whom have been fired since the recession began.

While Pinochet says he still supports the market model, tariffs have been boosted to 20 percent from the previous uniform rate of 10 percent; on selected goods, tariffs have gone even higher. Other moves away from the free-market program include a plan to send state managers into bankrupt companies and the temporary fixing of interest rates this past January. Pinochet has started public-works programs such as road building; like higher tariffs, these may serve mainly to muster support for the regime. Economic freedom is now being traded away in the name of pragmatism, and with the effect of buying time for the generals.

What will happen next in Chile? Only a year ago, some Chileans explained the lengthy stay of the military (not scheduled to step down from government until 1989) as an effort on the part of the generals to ensure that the free-market program had really taken root. That argument doesn't explain much these days. Pinochet may be giving ground on his economic policies today with the idea of moving again toward a free market when the economy recovers. But he has fired most of his advisors who would know how to make that move.

A possible result of the economic troubles is that Pinochet will topple, taking the armed forces with him, and democracy will be restored. But the mechanics of such an event would be difficult. The moderate Christian Democrats are disorganized, with wide differences between left- and right-wing factions and no clear platform. The Communists are organized but few.

It seems more likely that the same bayonets that once backed the free market will now be used to back state meddling in the private sector. The change would not be as great as the old free-market label implies. Chile was never a model free market, whatever that may be. The claim to economic distinction came from the sharp differences between Allende socialism and the plan the Chicago boys were able to negotiate with the military. State spending dropped from more than half of yearly GNP under Allende to a quarter of GNP under Pinochet—but a quarter is still a hefty fraction.

Chile was never whole-hearted in its acceptance of laissez-faire policies and had parted reluctantly in the first place with industries regarded as "strategic" by influential generals. Even when the Chicago boys were at their height, the state owned 19 of the largest companies in Chile, including the copper mines, which accounted for more than 40 percent of exports in 1980, the last boom year.

The signs in Chile are that free markets and dictators are not a match made in heaven. What was always an uncomfortable marriage is breaking up. The dictatorship is surviving, so far. The free-market program is not.

The conflict between dictatorship and free enterprise may have meant from the start that Chile's economic program could not endure because of its political context. A free-market system rests on the premise that Big Brother is not needed to manage the economy. But the centralized power of dictatorship provides constant temptation for Big Brother to tinker with business. Put together, the two systems add up to a schizophrenic and unstable national lifestyle.

It may still be too early to draw conclusions about the viability of a free market in Chile. The program was established only a few years ago and was imposed without democratic consent on people who had not known such a degree of economic freedom since before the depression of the 1930s. Chileans had to learn rapidly a new way of doing business, without the state as a third party to most transactions. And Chileans did respond swiftly to profit incentives. They developed new export industries such as fruit, lumber, and light manufacturing, and unemployment was decreasing until 1981, as the private sector absorbed workers formerly on the state payroll.

If the free-market policies are not changed beyond recognition, the Chilean economy could still come back strong. The question in Chile is not whether those policies strengthen the economy. It is whether a free market can survive the vagaries of dictatorship.

Claudia Rosett is the author of a previous investigative piece in REASON, "Chile's Economic Revolution," April 1982. She is coauthoring a book with Daniel Gressel on Chile's free-market program, sponsored by the Manhattan Institute for Policy Research.