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The Economic

Transformation of Chile:
A Personal Account

The Economic Transformation of Chile: A Personal Account


Copyright 2010 by HACER.org
All rights reserved. No part of this book may be reproduced or
transmitted in any form or by any means without written permission
from the author.
ISBN 978-0-557-15966-6
Printed in USA

The Economic
Transformation of Chile:
A Personal Account
__________

Hernn Bchi

Contents

Prologue .......................................................................... vii


Introduction .................................................................... xiii
1. Summer of 1975 ................................................................. 1
2. Of Miracles and Programs ............................................... 15
3. The First Dilemmas .......................................................... 31
4. The Real Modernizations ..................................................51
5. Work, Capital and Freedom ............................................. 89
6. Opting for Human Capital ............................................. 115
7. Reform Becomes Law .................................................... 141
8. Time of Crisis ................................................................ 151
9. How to Get the Economy Back on its Feet .................... 165
10. After the Battle ............................................................... 185
11. The Model Endures ........................................................ 195

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Prologue
During the preparation of the English-language edition of this book, the
world experienced the global financial crisis in September 2008, of
which the bankruptcy of the investment bank Lehman Brothers is the
best known symbol.
It is interesting to note the ways in which the events of the current
crisiseconomic collapse, weak bank balances, loss of confidence in the
financial system, drying up of credit, and further deterioration of the
economyare similar to those of the system-wide crisis experienced by
Chile in the early 1980s at the halfway point of that countrys economic
reform process. While the scale of the crises may be different, their
dynamics are similar, because both deal with phenomena that affect the
behavior of economic actors.
Even more remarkable is the fact that the political issues at stake
todaywhether or when the central bank should intervene, whether or
when the government should use public resources, how much moral
hazard there is in bailing out lenders, the best tools to use, how to get the
financial system going again, and what a future regulatory framework
should look likeare also similar to those debated in Chile back then.
Moreover, while the world has not seen a crisis of this magnitude
since the Great Depression of the 1930s, financial crises have been
common around the world in recent decades. These have common
features, and have affected developed countries, like Sweden, as well as
developing countries, like Chile. The crisis suffered by the latter during
the early 1980s has features that make it worth studying.
The economic collapse and the costs assumed by the Chilean
government in order to restructure the financial system in the 1980s
place that countrys crisis among the most significant relative to the size
of the countrys GDP. Nevertheless, the subsequent recovery was rapid,
and the long-term growth and economic reforms that followed were
extraordinary and without precedent in the countrys history.

viii
It is impossible at this time to redirect the bulk of this volume to deal
with the current global financial crisis. That is a task better left for other
analyses. However, it is worth highlighting certain common features and
lessons learned, in the following pages, given that this edition is nearing
publication as the most serious financial crisis since the Great Depression
unfolded.
The first feature is the facility with which an economic problem can
lead to a financial crisis and recession of unprecedented magnitude. A
small rolling rock can create a devastating avalanche when a vicious
cycle is allowed to develop. It begins with the loss of confidence in the
financial system, followed by a drying up of credit, which then leads to
more serious economic problems.
The lesson is clear. Action must be decisive and timely, carried out
with the instruments at hand to prevent a chain reaction. But this is easier
said than done, especially if at the beginning of an apparent crisis it is not
clear whether the problem is systemic or restricted to a few institutions or
individuals. Moreover, economic crises are difficult to understand, for
both policymakers and the general public.
The main problem lies in the role and structure of the financial
system. Economies function on the basis of trust. This is especially true
in the case of banks, which are the nerve center of economic activity.
Unfortunately, the way in which these wealth-creating institutions have
evolved places them in a precarious position relative to a generalized loss
of public confidence. Their obligations are mostly of a short-term nature,
and are in liquid capital of fixed nominal value. Their assets, on the other
hand, are not, even when they appear to be.
Short-term credit granted to a company ceases during a general
liquidity crisis, because it becomes difficult for the company, regardless
of its solvency, to pay it back. A bond with wide marketability before the
wholesale loss of confidence loses its liquidity and quickly loses much of
its value when the crisis lets loose. In the past, depositors would make a
run for cash. Today, developing countries make a run for hard currencies,

ix
and in the current crisis, depositors around the world have sought refuge
in U.S. Treasury bills.
Because governments have given their central banks a monopoly on
the issuing of currency, they are the only entities that can act in crises
like the current one, providing the instruments that the public and
business sectors then begin to demand in greater measure. And because
such events are infrequent, laws and regulations lag behind events. This
aggravates the crisis by making the policy decision process more
difficult. For example, it is not unusual for the market to have given rise
to institutions that are essentially banks, but which the law does not
recognize as such. This creates a situation that makes the central banks
role as lenders a last resort more difficult.
Without a doubt, indecision by policy makers was exacerbated in
Chile, and similar indecision has exacerbated the current global crisis. In
some ways, the job of central banks is more difficult in developing
countries, where, when a loss of confidence occurs, economic actors flee
toward hard currencies, usually the U.S. dollar, which local central banks
are unable to provide. In the current crisis, the run was toward U.S.
Treasury bills, the value of which is determined by the American
government.
In the case of Chile, two major factors in unleashing the crisis were
the collapse of the terms of exchange and a violent shift in external
financing.
In Chile, once the crisis was overcome, laws governing banks and
other financial institutions were restructured in order to create more
efficient mechanisms to address future insolvency crises. Loans coming
due at the time were given priority of payment. An expedited process
was created whereby other creditors could approve or reject
capitalization agreements with their debtors, thus making the different
institutions liabilities less rigid. At the same time, banks were required
to maintain cash reserves equal to their deposits with priority of payment.
This was all done with the intention of making the central banks job
easier, by not subjecting it to the dilemma of providing liquidity while at

x
the same time using public funds to bail out lenders. The latter occurred
in Chile with external credit and other deposits, either through the
granting of government guarantees over such contracts or through the
direct infusion of capital by the government into the most seriously
affected institutions.
During the current crisis, the policy proposals that have been put
forth in various countries have been varied, but they all share increased
capital requirements as a major feature. Another common proposal has
been that of preventing institutions from becoming too big. In reality,
this latter proposal is debatable, because problems are equally difficult to
overcome whether they affect a few large institutions or a lot of large
ones at the same time.
Reforming the regulatory framework, as is being considered today,
was also a priority during the Chilean crisis in the early 1980s, when the
aforementioned framework was modified and improved. However,
Chiles situation was different. The crisis then occurred in an emerging
market, without a strong regulatory and business culture, while today we
face a globalized world rich in traditions and a wide network of state
regulatory institutions. It is doubtful, as was in the Chilean case, that the
current crisis can be attributed mainly to a lack of regulation, so we need
to be careful and precise in enacting future reforms.
Finally, in Chile, a very important part of the recovery process
consisted of identifying mechanisms by which to restore the solvency of
banks and other financial institutions. This was not easy in a country
suffering from a significant loss of wealth and lacking a developed
capital market. Moreover, it was important to accomplish this without
running the risk of nationalizing aforesaid institutions for an extended
period of time.
Various mechanisms were tried, such as the purchase of bad assets
by the Central Bank that were under an agreement of concrete
provisions. When the government provided capital, it allowed taxpayers
to acquire shares long term, allowing them to pay for them from future

xi
tax payments. Tax levies were also modified in order to allow banks to
retain a greater part of its cash flow.
Additionally, the government aided bank debtors whom it considered
economically viable, partially freeing them from the risk of the
depreciating peso in the case of debt in foreign currencieswhich, as
noted, had been taken on when the country had a fixed exchange rate that
had to be abandoned during the crisis. The government also restructured
loans, mainly home and small business loans, to include more convenient
payment periods and interest rates in both local and foreign currencies.
These policies provided rapid relief to debtors and prevented a huge
number of bankruptcies and the consequent costly liquidation of
foreclosed and repossessed assets. It allowed individuals and businesses
to renew their normal activities and attend to their financial obligations.
This led to a better rate of recovery by creditor banks.
The external debt did not experience a cutback of capital, but it did
have an extension of payment periods. This gave some creditors the
opportunity to sell off debt at market prices, a process that was enabled
by securing debt by both foreign and Chilean investors, under titles
XVIII and XIX of the Chilean Central Banks new exchange rules. Major
companies saw their capital increased and their owners change through
this process. This launched a new awakening of the countrys
entrepreneurial spirit.
Recently, we have seen several developed countries adopt multiple
policies with the purposes described above. Some are similar to those
implemented in Chile in the 1980s, and many are not. Hopefully, as
happened in Chile, in the near future we will be able to say that
confidence has been restored, the economy has recovered and grown as
never before, and capital markets emerged strengthened.
However, to achieve all of this, the required policies need to be
implemented today. Most of the world still does not understand what
happened to the global financial system, or how a problem in an
important but relatively small sectorreal estate, particularly subprime
mortgageslaunched a collapse of the world economy.

xii
We are bound to see many studies and doctoral dissertations on this
topic, perhaps even a Nobel Prize. However, well before that time,
policymakers must act today to help overcome the crisis and resume the
rapid growth of previous years. In Chile, during the 1980s, looking back
at historical precedent proved very useful. Surely, for policymakers
today, it will prove just as effective.

xiii

Introduction
It has been fourteen years since the first edition of this book was
published, so we thought it was important to issue this revised edition.
It has not been our intention to write a new book, but to complement
the first editions analysis with the insight gained by the intervening
years. In that spirit, we have avoided making substantial modifications
and have simply provided a context for the events described in the
original document from the viewpoint afforded by the passing of time.
By the same token, we have decided to mention a few subsequent events
that were difficult to ignore, given their relevance to the contents of the
book. Consequently, the book should be read with the context of the
nineties in mind (except for the situations that needed updating, as
previously explained).
Specifically, Chapters 1 and 2 have been modified to provide
historical context for readers who were not there or who do not
remember the actual events. This was not necessary during the early
nineties, when we published the first edition, since facts and their
circumstances were then vivid in peoples memories. Moreover,
proximity in time would have made it impossible to try to approach these
events from a historical vantage point.
In the chapters that describe major reforms in detail, the changes are
intended to update or include facts both relevant to the account and
necessary to understand subsequent events (although this update is
neither complete nor exhaustive).
A new final chapter has also been added, to analyze the evolution of
the reforms between 1990 and today, the dates of which correspond to
when the Concertacin, a coalition of political parties, took office and
still holds executive power today. Once again, it is meant to be a broad,
rather than detailed analysis, since this issue in itself would probably
warrant a book of its own. The most outstanding aspect in this enquiry is
the causal relation between the significant and comprehensive reforms

xiv
designed and carried out during the seventies and eighties, and the
progress that Chile has experiencedwhich was remarkably rapid until
1997 and more tempered after that.
The influence of the reforms that crystallized in the second half of
the eighties is decisive in all of the areas in which progress is observed
after the nineties. For example, the definitive moderation of inflation can
be explained by, among other reasons, the financial discipline shown
both by the Treasury and by public enterprisesa process that took time
and effortand by the Central Bank, whose final structure was
established in 1989 and is still operative today. The beginning of rapid
economic growth can be traced to the countless reforms in different
sectors that made possible spectacular growth in areas as diverse as
copper mining and forest exploitation. The rapid economic growth that
was enabled by these reforms, combined with a great number of social
policies that were already beginning to bear fruit in the early nineties,
resulted in improved social indicators.
The slackening in economic and social progress over the last ten
years cannot be ascribed to the fact that the level of well-being reached
in Chile makes it difficult to maintain rapid growth rates. This,
unfortunately, is not the case. Empirical evidence shows that some
countries have experienced spectacular changes in their development
levels over the last forty years. Countries that have managed to leave
poverty behind and increase their level of well-being have done so by
maintaining high growth rates during at least three decades.
The explanation for this waning in Chiles growth rate lies mainly in
the weaker conviction toward providing the necessary conditions for
generating wealth and employment shown by successive governments
after 1990. Despite thisand perhaps despite governments themselves
the optimistic aspect that I can highlight is that citizens who have
profited from the countrys progress by gaining access to a job, to a
decent home, and to better health and education for their families
instinctively recognize the conditions that benefit them. Therefore, this
population is the critical mass that makes it easier to get back on course

xv
if national leaders finally lay aside obsolete ideological visions and
provide them with the conditions necessary for development.
After revising this book fourteen years later, it is striking to find it
still relevant today. However, this relevance has both an upside and a
downside. The upside is that the general principles that inspired the great
reforms accomplished are applicable to countries that are just setting out
on reform or have yet to do so. The downside is that in many areasfor
instance, laborarguments that should have been moot long ago are still
being brought up in opposition to reform. Behind reality lies the
explanation for the gradual decrease in growth rates seen over the last ten
years.
This fresh reading reminds me of an important lesson: in order for
policies to be successful and long lasting, they must be comprehensive
and sufficiently deep, and they must tackle the fundamental economic
questions. Given these conditions, reforms take on a life of their own,
thus becoming harder to modify in the future, when the excess of
ideology interferes with development.
This experience can be verified across different areas. In areas where
reforms were more comprehensive, they have endured (or have been
more difficult to change). On the other hand, in areas where they were
weaker or incomplete, backsliding has been significant. For example, if
we look at areas such as health or pensions, we find that the former has
come to a standstill and has had to overcome countless obstacles in
recent yearsleading to worse results. Reform in the pension system, on
the other hand, has remained strong and it is only in the last year that
proposals for modifications have been made. These proposals maintain
the foundations of the system while adding universal benefits more
appropriate to a welfare-state model and their effects remain to be seen.
The inertia of policies, both good and bad, lasts much longer than a
single presidential term.
Critics of Chiles social and economic transformation, who in the
early nineties still questioned the benefits of the reforms carried out by
the military government, never imagined the results that the reforms

xvi
would bring about in decreasing poverty, lowering child mortality,
increasing access to higher education, and making advancement
available to all Chileans. Yet these results are real today.
Transforming a countrys economy, thus enabling its population to
reach higher standards of living, requires awareness that reform is not
owned by any specific group or by any political partyor even by the
government that accomplished it. Effective public policies belong to the
people and are an integral part of the country that implemented them.
When this concept takes root, people rationally defend the policies rather
than seek to undermine them through the political process. Ideally, good
policy will become an integral part of a countrys culture. Unfortunately,
Chile has not managed to incorporate all of the elements that foster
development into its values and culture. It has embraced some, but not
all. And that explains some of the backsliding.

CHAPTER ONE

Summer of 1975
It all began for me in the summer of 1975, while I waited for a bus on a
hot street in Santiago. I had recently returned from the United States,
after taking a two-year post-graduate course at Columbia University in
New York, and was still feeling a bit of a stranger in my own hometown.
I was planning to work at a consulting firm with a group of friends and
eventually set up a construction company.
Our plans were already underway and were most likely on my mind
when an old classmate turned up at the bus stop. That encounter changed
my plans completely. My friend told me that he was working for the
government National Planning Bureau, known as Odepln (Oficina de
Planificacin Nacional), which at the time was committed to carrying
out an economic restructuring and recovery program, and was in need of
a large number of young, qualified people to work in the Economy and
Treasury ministries.
A year and a half had passed since the onset of the military
government headed by General Augusto Pinochet Ugarte. By then the
foundations for the transformation of the Chilean economywhich by
the mid-nineties had become known as an economic miraclehad
already been laid down. Although the military had managed to impose
order at the top, the imbalances and distortions effected by decades of
state control still endured. The performance of state enterprises had
improved, but these companies were still generating astronomical losses.
The state was disproportionately large, and the allocation of resources
escaped all notion of efficiency. Scope for action in the private sector
was very limited, and capital flight of companies was a widespread
phenomenon. Furthermore, Chile was still locked in a closed economy
model. A scant fifteen months into the military government, the situation
was difficultdifficult due to international hostility, difficult in the
aftermath of the oil crisis that put an end to Chiles best decade in terms

2 Summer of 1975
of trade in a long time (19641974), and difficult because unsolved
structural management problems were weighing down the economy.
My friend explained that the first priority, then, was to straighten out
the management of public enterprises, which accounted for no less than
half of the governments deficit. In his opinion, things were being
handled competently and seriously, with the long term in mind.
Why not consider the possibility of cooperating in this task, even if
it were just for a short time? he asked me point blank.
I did, and my time in the governmentfifteen years in allwas not
short. Between 1975 and 1990, I contributed in various areas, working
toward the transformation of the country: first as an adviser for the
Economy Ministry, later as Undersecretary of the same ministry (1979
1980), Undersecretary of the Health Ministry (19801983), National
Planning Minister (19831984), Banks and Financial Institutions
Superintendent (19841985), and Minister of the Treasury (19851989).
This process involved the effort of many people for whom I later had a
chance to speak as their candidate for the presidential election of
December 1989.
I witnessed how, amid failures and victories large and small, Chile
underwent a truly revolutionary liberalization process. I also saw the
country successfully overcome the abrupt fall in its terms of trade that it
experienced in 1974. Later on, the country was also successful in
defeating the external debt crisis during the eighties, before any other
country in the region did so. I was part of a team that prevailed over the
challenges posed by that crisis, which affected the global financial
system and forced us to restructure banks, among other things. None of
these challenges was free of difficulties.
Despite all of the difficulties and challenges, this proved to be the
most important period in my professional life. It was an exciting time,
during which it was my responsibility to become engaged in numerous
action fronts in the modernization program carried out by the Chilean
military government.

Hernn Bchi 3
Deep down, I think that this group, this government, and the
circumstances that Chile was going through in those years gave me great
opportunities to strengthen my interest in the countrys development and
to draw on my ability to put principles and concepts into practice,
applying them to the cause of creating opportunities for the countrys
poorest. This possibility of translating scientific abstractions into
actionsignificantly affecting the lives of people and of societywas
what truly captivated me and kept me in government longer than I ever
would have imagined.
When I joined in 1975, the outlook might have been ominous, but
the pervading spirit at the economy ministry was optimistic and full of
confidence.

The Mark of Messianic Socialism


The first two years of Salvador Allendes socialist government (elected
in 1970 with 36.2 percent of the vote) showed me what the rest of the
world found out after the fall of the Berlin Wall: that socialist rhetoric is
one thing, but its leaders and promoters behavior is, unfortunately,
another. I realized then that individuals, whatever their ideology or
political leanings may be, all behave in much the same way. This being
the case, socialisms alleged identification with the poorer strata of
society could be a simple faade set up by socialists to reap personal or
group advantages They used the same logic and the same dynamics as
the loathsome monopolistic privileges they denounced and sought to
dismantle. As a Russian citizen remarked many years later, theirs was
also a market system, only instead of operating through a market
economy, it operated through a market bureaucracy.
It was precisely that bureaucracy that left in its wake a legacy of
poverty and deracinated institutions, as well as a society fragmented by
bitter social and political divisions. In 1972, Chiles economic growth
ranked second-to-last in Latin America. By the time Allendes

4 Summer of 1975
government fell, the countrys annual inflation rate was 286 percent, and
it reached 508 percent three months later, after a few distortions created
by fixed-price policies had been amended. External accounts were out of
control and the governments deficit exceeded 25 percent of GDP. In just
three years, the socialist government increased the countrys foreign debt
by 23 percent. With the benefit of hindsight, and bearing in mind that
while all this was happening the country was still profiting from the high
price of copper, it becomes even easier to understand how misguided that
governments ideology was.
By the end of Allendes administration, savings and gross domestic
investment, at 6 percent and 7.9 percent respectively, were at their lowest
since the early sixties. Since 1970, the economy had been registering
successive and significant balance-of-payments deficits. The state was
gradually taking control of means of production, through
nationalizations, expropriations, confiscations, and interventions. As a
result, the direct managerial participation of the state in the economic
output of all sectors rose to over 73 percent in 1973, except in
manufacturing, where it rose to 40 percent. There were price controls on
most essential goods, under the excuse that fixing prices was needed for
lower income citizens to have access to those goods. Protectionist levies
were such that a 105 percent average nominal import tariff was in effect
at the end of 1973 (with maximums ranging between 220 percent and
750 percent), as well as a variety of non-tariff restrictions, to all intents
and purposes precluding the import of qualified goods in over 3,000 of a
total of 5,125 existing tariff positions.
During the Allende governments last year, 1973, the country was
practically paralyzed by workers strikes. Violence ruled the streets. The
General Secretary of the Socialist Party suggested setting up a peoples
tribunal made up of the workers trade union federation (Central
Unitaria de Trabajadores, or CUT), industrial associations, and other
groups, in order to judge the political and economical delinquents who
are directly responsible for the state of sedition promoted by

Hernn Bchi 5
reactionaries...1 Chaos reigned. Although it is not essential to this
account, it must be emphasized that this chaos was not only economic
but, fundamentally, also social and political. The imprint of socialist
ideology was also clearly visible in the political area, as was its intention
to monopolize political power completely, even when it meant
disregarding the rule of law. Therefore, the Chamber of Deputies voted
on August 22, 1973, stating that, the present Government of the
Republic has, from the start, attempted to gain complete power, with the
obvious purpose of subjecting all individuals to the strictest state control,
both economic and political, and thus establish a totalitarian system. In
turn, several months into the military government, Patricio Aylwin,
president of the Christian Democratic party (and later my opponent and
the winner in the 1989 presidential elections), fully justified military
intervention. He said that the economic crisis, the attempt by Unidad
Popular to monopolize power by any means, the moral chaos, and the
institutional destruction to which Mr. Allendes government has led the
country, have caused the level of collective despair and anguish in most
Chileans that precipitated the Armed Forces uprising
Essentially, the failure of Salvador Allendes project is connected to
the irrational faith shown by Chilean socialism that life and society could
change, and in fact would change, as a result of top-down institutional
measures that would presumably be able to change black into white. This
same top-down, command-and-control approach justified the use of any
means to achieve those ends.
I have always felt deep mistrust for such hubris. Socialism tried to
clothe itself in scientific robes, using extremely complicated formulas
and relatively high-sounding terminology, but at its core, it was nothing
but a crude utopia, supported by feet of clay. As an ideology, socialism
was nothing more than messianic belief based on principles such as the
following: that people could improve their lot without sacrifice and
personal effort, that the right to private property goes hand in hand with
1

Telephone interview July 14 1973. Qu Pasa magazine anniversary issue.

6 Summer of 1975
injustice, and that the only important issue is not how to produce more
wealth but rather how to distribute it. In reality, however, these are
nothing but crude and foolish fantasies.
It seemed to me, at the beginning of the seventies, that this kind of
system could never work, and the proof provided by Allendes
government in Chile was categorical and conclusive. It anticipated the
failure that would become manifest on a worldwide scale only two
decades later. Socialism was doomed to failure. On analyzing the
outcome, I think that we should be surprised not so much at its downfall,
but at the fact that it survived for as long as it did. The only explanation
for this is the brutal degree of control that it imposed on entire societies
through propaganda, the manipulation of intermediate organizations,
political control, police repression, and expropriation of all potential
expressions of free life in society.
In addition to the harsh methods, which socialist governments used
to monopolize power and control in the former Soviet bloc, socialist
doctrine effectively capitalized on the idealism of Western intellectuals
to gain a foothold in the West. My generationand many otherswere
captivated by the rhetoric of state control and the panaceas it offered.
Socialism did not offer a solutionfor it was not a solutionbut rather
the hope that the situation of the underprivileged would improve, and
based its legitimacy on this faith.
Time proved this promise and this belief to be irrational. Latin
American history did not follow Fidel Castros lead, as every progressive
voice raised in the seventies had claimed it would. At the end of the day,
not only did socialism fail to live up to the expectations around the world
that it had fed on for years, but it also revealed a sordid sideespecially
in the Eastern bloc countriesin terms of injustice, privilege,
arbitrariness, oppression, corruption, terrorism, jails, clinics, control
systems, and repressive mechanisms of refined cruelty. Glimpses of this
had already been seen during the socialist government years in Chile.
Two decades later, following the dissolution of the Soviet Union and the
fall of Honecker and the Ceausescus, much more would become known.

Hernn Bchi 7
Once againeven though it means stretching beyond the scope of
this documentwe cannot avoid reflecting on how good intentions and
promises of hope can lead entire countries down the road of disastrous
policies that only sow poverty and conflict. Socialism and communism
are not unique in this respect. This could prove an important area for
historical and sociological analysis: to identify clearly the institutional
and cultural elements that prevent societies from embarking on ventures
of this type, which lead to such colossal costs, especially for societys
poorest.

Socialism Was in Chile before Allende


As surprising as many people might find this, what the socialist
government carried out in Chile was not entirely different from the
countrys political history since the thirties. The Unidad Popular
government may have taken practices and tendencies to an extreme, no
doubt, but the paths taken to nationalize, confiscate, expropriate, and
restrain the private sector had been cleared a long time ago.
Moreover, these practices and tendencies were not exclusive to
Chile. One way or another, they were part of the predominant experience
and thinking in all of Latin America at the time. Chile simply went
farther down this road, becauseamong other reasonsobservance of
laws and regulations in this country was objectively much stricter than in
others. This compounded the problem.
In the sixties, labor and foreign trade laws, to name two examples,
were probably just as interventionist in Chile as in Peru, Brazil, or
Venezuela, but in those countries, the relative impunity with which these
laws could be infringed provided some degree of relief and made it
possible for their economies to neutralize the damage that they caused to
some extent. In Chile there was no such flexibility.

8 Summer of 1975
Commitment by the Government: The Roadmap
It was General Augusto Pinochet, hardly an eloquent but certainly a very
tenacious military man, who dared to challenge voguish myths and put
the countrys economic transformation into effect. The most important
decision made by the new government in the early seventies was to
follow the path prescribed by reality rather than by ideology, opening the
economy to the world at a time when global trends pointed in the
opposite direction: national economies under firm state control.
Long before Margaret Thatcher (19791990) liberalized the
economy in Great Britain or Ronald Reagan (19811989) led the
conservative revolution in the United States, Chile carried out a number
of privatizations and deep structural economic reforms. By becoming one
of the most open economies in the world, the country became a pioneer
in privatizing inefficient state companies and in promoting private
enterprise. Twenty-five years before the European Union made balance
of fiscal accounts a membership requirement, the military government
included it among its economic objectives.
In October 1973, the government lifted price controls on almost all
goods. The prices of only about 30 articles remained fixed, while over
3,000 were freed up. However, not all of the signals sent out by the
government at the time were encouraging. There were serious and urgent
needs in all areas. Not only did the Central Bank lack reserves, but the
country faced a $400 million deficit. Additionally, there was not full
consensus within the governments economic team as to what path to
take. Murmurs, alarmist voices, and attempts to prove that the economic
team was leading the government and the country to ruin, constantly
reached the governing Junta, is Chilean writer Arturo Fontaine A.s2
recollection of those days. The government undertook unpopular but
necessary measures to straighten out the countrys accounts.
Liberalization of prices was accompanied by a strong devaluation. Prices

Arturo Fontaine A., Los economistas y el presidente Pinochet, p. 53

Hernn Bchi 9
skyrocketed, and the direction of the countrys economic policy was
increasingly called into question by all sides.
This is what makes politics so complicated. Political options are
hardly ever black and white. There are gray areas, conflicts between one
value and another and, quite often, serious internal contradictions. No
group is free of philosophical misunderstandings and personality
conflicts.
Deeply immersed in this social, economic, and political milieu, the
two main architects of these transformationsMinister of the Treasury
Jorge Cauas, and Minister of Economy Sergio de Castroprepared a
recovery program. In April 1975, Law Decree 966 was enacted, naming
Jorge Cauas Superminister and granting him the greatest economic
policy-making power that anybody ever had in Chile in the twentieth
century. His designation was an attempt to correct the existing lack of
coordination and to establish homogeneity in an area in which
undisciplined strongholds made commitment to a uniform and consistent
policy implementation plan difficult. The plan reaffirmed the goal of
implementing the principles of a market economy. Concretely, it meant
applying shock treatment by reducing government spending by 20
percent, dismissing 30 percent of public employees, and privatizing most
state enterprises.
It is important to note that, in addition to the disaster bequeathed by
Allendes government, at that time the Chilean economy faced a
dramatic change in external conditionsfrom the surging price of oil to
the falling price of copperthat would never again reach the levels it
had during the decade of 19641974. Even without the depredations left
behind by Allendes socialist policies, these factors alone would have
made management of the countrys economy a difficult task.
What persuaded me to work for the government, given such
challenging and adverse circumstances? First, it was my belief that this
time things were being done differently. I felt that economic
policymaking was in the hands of a remarkable group of extremely
responsible and technically qualified people. I believed not only in their

10 Summer of 1975
optimistic new vision for Chile, but alsoand this is always important
that they were working without regard to partisan interests, both
individually and as a group. I saw no hidden agendas, which had
frustrated the good intentions of many governments in the past. Finally, I
was impressed by the steadfast vision that the team shared with General
Pinochet of a free, developed Chile, ready to offer equal opportunity to
all of its citizens.
The roadmap that guided the economic liberalization was a
document that became known as El Ladrillo (The Brick), drawn up by a
group of young professionals between the ages of twenty-six and thirtyfive. Concerned by the direction that the country was taking during the
socialist government, they met on a weekly basis and discussed
liberalization of prices, tariffs, real property, and banks. This group
formed largely under the auspices of a joint program run by the
Universidad Catlica de Chiles School of Economics and the University
of Chicagoworked conscientiously to develop a dispassionate
diagnosis of the Chilean economy. The task took a long-term view and
was implemented outside the scope of political partiesalthough some
of the economists on the team were active in rightist and center groups. It
seemed a quixotic endeavor. Everything was done with great discretion.
As far as documents go, El Ladrillo is neither very long nor very
comprehensive when compared to what was actually done, but it reflects
the development process of a different critical and intellectual
consciousness by people who were tired of being asked to believe in
implausible, farfetched promises. Eschewing the alarmist rhetoric and
socialist triumphalism prevalent at the time, they made a very important
contribution toward changing Chiles reality and destiny.
El Ladrillo, which placed individual freedom at the center of
economic activity, reached military circles and became the guiding
economic policy document for the duration of the military regime.
Barely three weeks into the new government, over 200 copies of El
Ladrillo had been distributed among the new authorities.

Hernn Bchi 11
The team that drew up this plan shared not only a desire to leave
economic stagnation and state control behind, but they also had another
important common denominator: they all had absorbed free market
theory at the University of Chicago. They set to work in 1973, and their
ideas became so important to the course that the country was taking that
they became known as the Chicago Boys.
Although by education I did not strictly fit the Chicago Boy
profile, I never felt like an outsider. On the contrary, I found respect,
acceptance, loyalty to teamwork, a genuine disposition to service, and
openness. I believe that the military rendered a decisive and fundamental
service to the country, which not only changed Chiles history for the
better, but also steered it toward an unexpected future of reconciliation
and prosperity.
The costs exacted on Chile by decades of socialist policies, and
carried to extremes during Allendes government, is beyond measure,
both in terms of poverty and deterioration in standards of living. It took a
leap in progress, sustained over decades, to overcome the past difficulties
and leave them behind. Strangely enough, many Chileans are still not
sufficiently aware of the reasons for the price paid or of who were truly
responsible for it.

Can the Model Be Replicated?


When asked whether the Chilean experience can be replicated in other
countries, I invariably answer yes. Yes, insofar as its principles are
concerned, it can be reproduced, because they are equally true and
effective everywhere. However, specificshow things should be done,
the pace of the liberalization process, the order in which things should be
done, and, just as importantly, the group of people who will carry out the
reformsall vary from country to country. No matter how successful an
experience has been, it is never completely reproducible, and that is
where the creativity of both experts and politicians enters.

12 Summer of 1975
As far as I witnessed, General Pinochet never rejected the reforms
proposed by his ministers, as long as they were appropriately presented
and defended, yet he never agreed to them easily. He listened and
insisted on hearing different opinions. Various groups holding
conflicting positions coexisted within the government. Reform projects
were subjected to the harsh scrutiny of different parties. There were those
who defended the governments political stability and refused to support
measures that might seem to contribute to further deterioration of the
populations economic situation. There were also economists who placed
their bets on long-term benefits.
The President moderated, arbitrated, persuaded, and, in the end,
either made the decisions or presented them toand defended them
beforethe government Junta. Behind each decision lay a web of
debate, research, conflict, pressure, consensus, and struggle. This is true
of any government task, even in an authoritarian regime. Restricted as
they may have been, the levels of participation in General Pinochets
government were much more sensitive to public opinion than is thought
to have been the case. Not even a government as strong as General
Pinochets could function in opposition to a whole countryin the long
run, no government can, especially when it is broadening individual
freedoms.
Economic liberalization in Chile had to overcome tremendous
adversity: generalized international hostility toward the military
government and negative external conditions for the prices of the
countrys exports, coupled with financial difficulties. However, these
same circumstances held one great advantage: rejection and isolation
killed any illusions about any alternative models for development. Such
alternative models have been the death of many other Latin American
governments, which were confidentas seems to have been the case in
Ral Alfonsns administration in Argentina (19831989)that they
could solve their economic problems based on the sympathies of world
public opinion and international solidarity. Such internationalist
utopian dreams turned out to be groundless and foolish. Dependency on

Hernn Bchi 13
international economic aid and handouts from rich nations is not only
humiliating, but also fundamentally unproductive. However generous,
international aid can never compensate or correct structural distortions in
an economy. In the end, aid can become a dangerous anesthetic. Even if
populist politicians reject the idea, aid never exonerates governments
from the compelling need to restructure, adjust, and modernize their
economies.
I believe it is best to be realistic when facing this responsibility. In
general, I reject fundamentalist beliefs, even liberal ones. Modernizing
our countries is not a task for gurus or preachers of messianic liberalism.
On the contrary, I consider it a challenge befitting sensible politicians
and reasonable expertspublic servants with keen insights not
necessarily acquired from books, but from experience, and who can
apply those insights to their work. In this area, unyielding commitment to
consistency, unbounded doctrinal zeal, and dogged ideological
determination often cause more harm than good. After all, achieving
liberal reform is not as difficult these days. Being an authority on the
subject is not a requirement. It is simpler than that. All one need do is
notice which economies have been successful and which have not. All
one need do is compare and draw a few conclusions. But one cannot just
stop at this point, as theorists tend to do. It is important to act on these
conclusions, realistically and imaginatively.

Hernn Bchi 15
CHAPTER TWO

Of Miracles and Programs


Chiles economic transformation over the last thirty years is a story of
success. From the mid-eighties until the Asian crisis in 1997, the
countrys economy grew at a 7.2 percent average annual rate, followed
by a 3.5 percent growth rate between 1998 and 2005. But what has
become known as Chiles economic miracle was anything but that. It was
a program. Miracles are heaven-sent gifts outside the sphere of human
agency. Programs, on the other hand, are temporal and must be
painstakingly implemented by human beings. They also carry another
inherent earthly trait: the risk of failure.
The project conceived in Chile translated into a program that was
pragmatic and unflinchingly realistic. There was nothing supernatural
about it. It was based on opening the Chilean economy to the world and
revitalizing a languishing private sector. A single import-tariff system
was set. State enterprises were privatized. The list of initiatives adopted
is extremely long. There must be a check on inflation, creation of an
autonomous Central Bank, balancing of fiscal accounts, opening of space
for the private sector, creation of a new pension system, decentralization
of education, development of a social safety net for the poor with an
emphasis on human capital, and more. Numerous considerations were
kept in mind during the development of this program, which entailed a
huge effort to deliver a comprehensive, consistent, and coordinated
answer to the countrys main problems.

Precedents: Who Invented the Wheel?


The Program was not an especially original creation, at least regarding its
confidence in the market and in private enterprise. From the late sixties

16 Of Miracles and Programs


and through the mid seventies, the model of the Asian countries was
clearly observable to anybody who cared to analyze it.
During the fifties and sixties, John Cowperthwaite, a devotee of
Adam Smith (and fellow Scotsman), implemented free market economic
policies in Hong Kong, transforming the poverty-stricken peninsula into
a world-leading example of sustained growth. In Taiwan, multi-year
plans to strengthen industry and increase exports peaked during those
years. Much the same happened in South Korea. Singapore also has
shown how to transition from the Third World into the First in one
generation.
In the late seventies, on the other hand, Brazil was heading into a
slump, which it cannot be said to have completely left behind, despite the
fact that during the sixties, Brazils liberalization experience led to
almost twenty years of spectacular economic growth, with 9 percent
GDP growth rates. Going farther back, we find Germany and Japan as
precedents, rising on the basis of market incentives and the dynamism of
private enterprise.
Chile did not invent the wheel: the true road to development had
been known for many years. The originality of the Chilean experience
was not to be found in the contents of the economic program as much as
in the courage it took to set out on a lonesome and difficult path at a time
when the rest of Latin America was going in the opposite direction. It
was also to be found in the decision to advance toward a free economy
even though the country had set out on the path toward state control and
socialism long ago, well before Allendes time.
This is what makes the Chilean experience remarkable: to have
embarked on a process to reform and revive the economy that went
against programmatic illusions then prevailing throughout the region.
From socialism to populism, these illusions all shared a strong belief in
state intervention and in the revitalizing effect of expansionary monetary
policiesboth of which went against all historical evidence.
Particularly laudable was the recognitiondespite the difficulties
aheadthat the way out of the long, dark tunnel in which Chile found

Hernn Bchi 17
itself lay in the opposite direction from that in which the country had
been headed for decades. Credit is also due to the transformations having
been carried out realistically and seen through successfully to
completion.
At the time, defending the free market was no easy task. Not among
supporters of the new regime could one find agreement on the
advantages of economic liberalization. In that context, persuading the
population of the benefits of the free market was a tough sell. The idea of
the paternalist state was too deeply embedded in the national mindset to
be removed overnight. Minister of Economy Sergio de Castro, in a book
on his role in the reforms, describes the mental obstacles that he faced in
how exhausting it was to convince people. He points out:
I dont think we were fully aware at the time of the mental
restrictions we faced, because all military men reacted that way. Its true
that we found the same response from priests, trade unions, businessmen,
civil servants, CEPAL [United Nations Economic Commission for Latin
America and the Caribbean] economists, engineers, professors, etc. The
thing is that our basic postulate, that is, giving individuals absolute
freedom to do whatever they wanted in economic matters, seemed
inconceivable to a vast majority of the people who had been educated in
a different viewpoint and thought that this viewpoint only needed
corrections.1
We also faced constant and brutal criticism from the military
governments opponents. We were attacked in a particularly vicious and
uncharitable way. There was not a single criticism that we did not hear:
that our project was not only technically misguided, but also socially
genocidal and politically reactionary; that the development model was
tailored to suit the interests of a repressive and illegitimate dictatorship;
that it did not address Chiles needs; and that nothing we did would last,

Patricia Arancibia C and Francisco Balart. El Arquitecto del Modelo


Econmico, p. 189.

18 Of Miracles and Programs


because it was doomed to disappear along with the political regime that
had promoted it.

The Two Phases


The Chilean economic revolution comprised two major phases:
stabilization and modernization.
The first phase was based on the view that keeping accounts in order
is preferable to having unbalanced accounts. This seems like a truism
today, but it was not that evident at the time. The hierarchy of the
socialist government was oblivious to basic macroeconomic
equilibriums, which is an attitude that would be ridiculed today. In the
late 1960s and for quite some time after, economic thought held that a
small amount of imbalance was not necessarily bad, and that growth was
well worth a certain amount of price instability. After all, what
difference did it make?
The question at the time was how much inflation could be tolerated.
The combined effects of the model promoted by U.N. Economic
Commission for Latin America and the Caribbean (Comisin Econmica
para Amrica Latina y el Caribe, or CEPAL) and macroeconomic
instability were taken to ridiculous extremes by Allendes government
(as Ral Prebisch, one of the main supporters of autarkic growth, points
out). This anticipated the disastrous economic populist policies that
would exacerbate problems throughout the region over the next few
years. Examples of such disasters include the governments of Alan
Garca in Peru (19851990, but after being reelected in 2006 he has been
a convert to economic liberalism); Ral Alfonsn in Argentina, to a lesser
degree (19831989), and Jos Sarney in Brazil (19851990). It was like
a contagion that spread to devastating effect to the economies of the
region.
General Pinochets government adopted a reform and modernization
program that firmly rejected that approach. It blamed government

Hernn Bchi 19
distortions for the extremely damaging consequences that had thwarted
the countrys development for decades.
To balance accounts, especially when external conditions for Chile
were worsening, meant above all to stabilize the economy and restore
some conditions of rationality that were essential to productivity.
However, in Chile the military regime intended to go quite a bit farther.
There was an urgent problem that had to be dealt with immediately:
putting out the fires that were consuming every sector of the Chilean
economy. But the fundamental question was how the country would
embark on a modernization process that would address the structural
dysfunctions and distortions throughout the economy.
The government acted simultaneously on both fronts. It did not
tackle modernization once the economy had been stabilized. The
campaigns for stabilization and modernization were concurrent. From the
outset, the emphasis was on addressing the chaos prevalent in the country
in September 1973. As soon as the economy was brought under control,
the government set out to work on its longer-term objectives.
The difficulties during this process appeared to be never-ending. The
price of copperabout which Allende had complained so much because
during his government it was lower than during that of his predecessor,
Eduardo Frei Montalva (19641970)began to drop at an alarming rate.
If Pinochet had enjoyed the higher real prices for copper that Allendes
government had, the challenge of stabilizing the economy would have
been far less overwhelming. As we have already mentioned, the price of
copper from 1964 to 1974, when seen in historical context, were
exceptional. They would not reach comparable values again until 2005.
The transformation of the Chilean economy was launched in the
midst of a chaotic state of affairs. In October 1973, the same month in
which prices were freed and some measure of stability was attained, the
OPEC oil embargo struck, causing a dramatic deterioration in Chiles
terms of trade. By the next year, Chile was paying four times more for oil
and selling copper at half the price.

20 Of Miracles and Programs


In 1975, Minister Jorge Cauass recovery program was implemented,
marking the beginning of a period of great hardship. Cauasa serious,
meticulous, brave man, and one of the driving forces behind the
transformationimposed a strict check on spending on the public sector.
This was intended to address an extremely critical fiscal deficit. This
period, which became known as the shock policy years, was tough
because the countrys margin for action had been reduced to pathetic
levels. The Cauas plan reflected the courage to acknowledge this reality
and then dealt with it creatively by means of the severest austerity plan
possible. There was no choice but to thoroughly reform a public sector
including government agencies plus state companiesthat was evidently
oversized. Consequences were felt immediately. GDP fell by 12 percent
and unemployment skyrocketed to 16 percent. An active social policy
focusing on the needier sectors was established in an effort to reduce the
impact of the shock as much as possible. The Minimum Employment
Program (PEN) was financed by the central government and
administered by local city councils. These numbers are dramatic, but
should not be seen in isolation of their context. Imagine Chile today with
the price of copper at $3$4 per pound for the last three years. Now also
imagine that this situation has gone on for ten years, that savings are nil,
and that monetary policy has degraded the currency to absurd extremes.
Let us also suppose that all incentives to save, employ, and invest have
been destroyed and that peace is hard to maintain. Let us consider what
would happen in this hypothetical country if its external conditions were
to change abruptly and if it were to see the price of copper drop below
the dollar barrier. That is the reality, only worse, which Jorge Cauas
plan had to confront
At that time, Chile faced the darkest hour of its twin crises. After
that, the situation slowly began to improve. It was during Ministers
Cauas and de Castros terms in government (19741976 and 1976
1983, respectively) that the first plans for reform were drawn and
implementedliberalization of trade, the financial sector and prices, and
a comprehensive overhaul of the tax systemover a period that lasted

Hernn Bchi 21
until the debt crisis in 1982. That year the global financial crisis, with
interest rates of over 16 percent, hit all developing countries, including
Chile.
At the time that the crisis hit, the country began a new phase of
reform, which lasted from 1982 to 1985. This period was full of
uncertainty and doubt, but all things considered, the country kept on
track on the essentials.
And so it began, in 1985, the last period of the Chilean economic
revolution, which was my responsibility to lead as Minister of the
Treasury. During these years, the country managed to recover from the
debt crisis, reformulated the principles priorities of a market economy,
and intensified several modernizations. All in all, this reform period
came through the restoration of democracy with the government of
President Patricio Aylwin (19901994) unscathed, and has continued
give or take a few adjustmentsto the present day.

The Ingredients of Success


The success of Chiles economic liberalization process rested on at least
three key factors. First is the political will to reestablish a viable
economy that would be responsive to the Chileans aspirations to greater
well-being. This political will, sustained with great tenacity by General
Pinochet, never faltered and was the element that gave continuity to the
process. At several critical moments, General Pinochet stayed the course,
despite difficulties and pressures. This happened in 1975, when he
backed the Economic Recovery Plan designed by Cauass team. Even
when a new economic team took overwhen Luis Escobar Cerda was
sworn in as Minister of the Treasury (19841985)the main guidelines
were maintained. Moreover, when the new minister stepped in, the
government was also joined by professional staff that played a decisive
role during my subsequent period in that same office. Chile had six
ministers of the treasury between March 1982 and February 1985, which

22 Of Miracles and Programs


shows how turbulent a period this wasalthough, fortunately, the
ultimate course was not changed.
When analyzing these years, the question frequently comes up as to
why Pinochet and the government Junta, despite the difficulties, stuck to
their decision to back the opening-up and modernization of the economy.
There are those who believe that he had acquired a deep understanding of
the economic proposals in El Ladrillo, while others think he placed his
trust in his advisers technical capacity. But also, apparently, General
Pinochet had decided to be the promoter of a true revolution for the
country.
Even so, the Presidents support of the economic teams work was
never a blank check. Far from it. The team was under permanent
scrutiny, from a distance. During my time as Minister, I do not think I
ever felt safe in my position. I knew that I could be dismissed from the
government at any moment. At the end of the year, when General
Pinochet would make changes in his team, every minister had to be ready
to look for a job elsewhere. In that respect, our own situation was
extremely vulnerable.
The second factor, which, in my view, explains the success of the
reform, is that the economic reform development project was in the
hands of a competent professional team. As in any large project, the
successful implementation of the economic reforms does not depend on
one man alone, but rather on hundreds, or even thousands of people
working toward the same goal. When the challenge is this great, just as
in the rebuilding of a country following an earthquake or other natural
disaster, it is important to tackle the problem from all sides. This requires
not only experts in macroeconomics, but also people who can handle the
situation in other areas and cope with sensitive issues such as education
and health.
Miguel Kast, an economist with a degree from the Universidad
Catlica who took post-graduate courses at the University of Chicago,
played a fundamental role in the recruiting of young professionals. He
was a born leader whodespite his premature death at age thirty-three

Hernn Bchi 23
occupied two ministries and the presidency of the Central Bank and,
despite the sense of urgency of the moment, managed to put together
teams that generated the changes needed to carry out the reforms.
The third factor was a belief in what we were doing that was strong
enough to transcend our individual interests. One way or another, we
were all part of and agents for a greater whole, which was not the
economic team or even the military regime, but the idea of Chile finally
being rescued from mediocrity in order to be able to take advantage of
the immense potential of its resources andmore importantlyof its
people.
Our background was mainly academic and, on the whole, we were
rather clumsy as far as profitable activities went. Any parallel business
would have been considered not only suspicious but scandalous. It is a
known fact that salaries were extraordinarily modest, and austerity within
the ministries, even in leadership posts, reached puritanical levels.
This idea translated into a mistrust of anybody making any personal
gain out of his or her position in government. The alliance between the
government, the banking system, and industrywhich had apparently
gone unhindered in countries such as Japan and Korea, and which
generated collusion and complicity between ministers and managers,
between companies and government institutionsbecame unthinkable in
Chile. If General Pinochet and the military accepted the economic model,
it was because, among other things, it preempted discretionary measures.
The tight relationship between governments and companies, which
during the eighties was considered peculiar to the Asian Tigers
resulting in major concentration, favored export sectors being arbitrarily
chosen, and industrial policies being forged on the basis of exemptions
and privileges. This situation, in which the state places its bets on
specific economic sectors, would never have worked under the military
government.
This not only guaranteed greater economic efficiency, but also
created a cleaner and more transparent public administration. Chile was
probably able to optimize its investments efforts because, to a great

24 Of Miracles and Programs


extent, it was the market that determined the competitive advantages of
different sectors. It is true that Southeast Asian countries did very well,
but it is also true that, in certain areas, they have done very badly, to the
detriment on the return of their high investment rates. For example, in the
early eighties, South Koreans paid the price for the failure of industries
that their government had decided to favor a few years before. They
favored interventionism and the state placed its bets on the development
of certain industries. In the end, this policy backfired.
Being wary of state control does not mean that constant care must
not be taken to strengthen the private sector, but this was done in Chile
as a general policy, not to favor one sector, industry, or individual.

Change and Consensus


The presence of political backing and a sound transformation program,
as well as a team that was qualified and motivated to carry it out, was
one thing; whether the changes were implemented effectively was
another. It is important to make this distinction, because the Chilean
economic revolution was not done by the book. The recurrent accusation
that we faced from reform opponents that we were some kind of fanatic
gang, determined to apply standardized University of Chicago recipes
come what may and whatever the cost, could not have been more
wrongbecause there were no recipes in Chile. Had there been, perhaps
everything would have been easier for us.
The successful completion of a transformation requires more than
that it be properly conceived from a technical point of view. Sometimes
governmentsin fact, almost all governmentshave good ideas that go
awry because they never get past the sphere of theory, ideals, and
speculation. Therefore, something more than good ideas is required. A
certain skill in generating consensus is also needednot just at the top
levels, which was the kind of consensus the Chilean opposition was

Hernn Bchi 25
interested in at the timebut especially at the grassroots level, among
ordinary people.
That is a fact: transformations cannot be carried out when the whole
country is against them or when the initiatives are not accepted by the
citizens. It will not work, even, as I have noted, in an authoritarian
government such as General Pinochets.
What we learned is that the approval level for reforms can always be
increased as long as the team promoting the changes has a detailed
knowledge of the problems that it is trying to solve. Knowledge is
essential regarding theory and practice, the broad lines and the detail, the
historical background of problems and of the current situation.
It is a thorough knowledge of thingsof the specific tax system
applied in a given activity, of the cargo dispatch system used in sea
transport, of the way companies that generate electricity and those that
distribute it operate, or of how public transportation in Santiago actually
works, to name a few examplesthat makes it possible to move the
discussion from the ideological sphere to the practical one and find indepth solutions, using creativity and common sense.
None of this was easy, of course. Talking about liberalization is not
the same today as it was fifteen or thirty years ago. The international
climate today is much more receptive toward free market solutions than
it was then. In the wake of socialist bankruptcy, the crisis of CEPAL
models, and the huge economic and political fraud played out in the
eighties by Latin American populism in its various styles, the
convergence of viewpoints is much greater. For example, the mention of
the word privatization is no longer scandalous.

From Words to Action


A member of a delegation of Russian economists who visited the
Libertad y Desarrollo (Freedom and Development Institute) in 1991 got

26 Of Miracles and Programs


it right, I think, when he pointed out that the originality and significance
of the Chilean case lay in its practitioners knowing how to apply
universally valid economic principles to the specific circumstances of
our country. That was probably the secret. The merit in the initiatives
themselves, such as the trade opening-up and tariff relief program, the
tax and pension systems reforms, or the privatizations, is that they were
not tied to the principleswhich are universal and known to anyone
but to the practical stages and mechanisms that these modernization steps
involved. The greatness of an economic policy is always measured in the
smaller detailsthe hows far outweigh the whats.
In this respectin its details, its fine-tuning, and patient
artisanshipthe Chilean revolution cannot be exported as a whole. The
successful pension system reform carried out in Chile, its operative
structure, and transition mechanisms will not necessarily be applicable
for Mexico or for the Russian Federation. The principles will work just
as well wherever they are applied, but methods will no doubt need to be
different. Circumstances and conditions will almost certainly not be the
same. The Chilean model cannot be transplanted from one setting to
another in its pure form.
The lesson to be learned from Chile points firmly in another
directionto the fact that no problem is insurmountable and that the
solution to a societys chronic troubles does not lie in third countries or
in foreign aid, and definitely not in a hypothetical international
solidarity. It depends exclusively on the effort that each country makes
to correct its own imbalances and overcome its own adversities.
Chile had plenty of both. The country, which the military
government took over, was in a shambles. Where did Chile find the
energy to leave this predicament behind? From delving down into its
own reserves, and nowhere else. As contradictory as it may sound, Chile
was able to break free because it had reached rock bottom.
Unconsciously, the country had been heading toward a dead end for
years. There came a point when, given the populations despair and the

Hernn Bchi 27
new governments sense of urgency, conditions were ripe for a drastic
change of course.

A Few Observations
The catastrophic panorama in Chile in 1973 calls for a few qualitative
observations:
This was a homemade crisis. Unlike other crises that the country
experienced later on, which were induced by external factorsthe
first oil crisis in October 1973 and the debt crisis in 1982the crisis
during Allendes last year was brought on solely by irresponsible
economic policies. One need only remember that, when confronted
by the concern expressed by vast sections of public opinion over the
excessive growth of the money supply (119 percent in 1971, 139
percent in 1972, and 337 percent in 1973), the president of the
Central Bank at the time remarked that this was a bourgeois
variable, and irrelevant to the construction of Chilean-style
socialism.
The lack of control in the Chilean economy between 1970 and 1973
was a radicalized expression of the Keynesian panaceas so widely
practiced and recommended in the sixties. It was a period of
accelerated expansion, but it was also a period of recklessness. In
fact, world growth rates were very high during those years, except
in Chile, because even during the 1960s boom, the country was
bogged down by state controls. Between 1950 and 1970, the yearly
GDP growth rate in Chile was only 1.4 percent, whereas in
developed countries with comparable income levels it averaged 3.1
percent.2
Governments at the time thought they had found the philosophers
stone of prosperity and wealth. At the first sign of economic fatigue
or contraction, they resorted to expansionary monetary policies,
which began turning the wheels of growth again. At first the
2

World Bank 1980. Chile: An Economy in Transition.

28 Of Miracles and Programs


formula seemed effective, but in time, it took a heavy toll.
Gradually, the medicine lost its effectiveness, and the pressure of
inflation, which would spin out of control during the next decade,
was set in motion. The world paid the price during the seventies.
If Chile is often seen today as a model for economic recovery
through reliance on the energy of the market, it should also be kept
in mind that it was once also a leader in state control and public
sector hypertrophy. By 1973, 85 percent of the countrys mining
production was connected to state-controlled enterprises, while 70
percent of transport and 40 percent of industry was linked to the
state3. To a certain extent, the country turned back from centralized
state control earlier than any other Latin American economy,
because it already had gone farther down that road. In 1975, twentyfour months into the new government, there was still a lot to be
done. Fifteen of the twenty largest companies in Chile were state
controlled.4
It could be argued in good faith that the Chilean economy in 1973
was dysfunctional and inefficient, but that this was nevertheless
acceptable from an ethical point of view, insofar as it had been
organized in terms of the requirements and needs of the poorest
sectors of society. But this was not the case. Quite the contrary,
social policies in Chile at the time were not only indifferent to 20
percent of the population that survived in extreme poverty, but were
also clearly regressive in nature. On issues such as housing, health,
and education, the poorvoguish speeches and political rhetoric
notwithstandinginvariably held the short end of the stick. For
many reasonsbecause they had no political power, were not part
of any pressure group, and were never invited to take part when
state wealth was distributed the poorest, who lacked access even
to basic education, could do nothing but look on helplessly when
slogans such as university for all were bandied about.
The Chilean economy in 1973 was not only in ruins, it was also a
reflection of a disillusioned society that had lost all self-confidence.
3
4

C. Larroulet. Reflexiones entorno al Estado Empresario en Chile, p. 184.


Las cien mayores empresas de Chile en 1975, Informe Econmico 19751976

Hernn Bchi 29
The entrepreneurial spirit had practically died out. The best that a
student could hope for was to find a job in the public sector or in
one of the companies controlled by the state. Complex cultural,
historical, and anthropological hypotheses were posited both at the
university level and in conservative circles regarding Chileans lack
of drive and disinclination for business and hard work. Why were
our people not as disciplined as the Germans? Why were we not as
hardworking as the Japanese? In the search for answers to these
questions within the national soulin the collective unconscious
resulting from an ill-fated cross between the natives (allegedly
rather lazy) and the Spanish (allegedly good warriors but bad
producers)no one stopped to think that this, more than a racial
limitation or defect, was a problem of incentives, of an oversized
state, and of a suffocated private sector. Nobody stopped to wonder
why South Koreans, for exampleAsian spirituality
notwithstandingwere at the time achieving economic growth rates
that even the most developed countries in the world would have
wished for.

The Questions
Was the reorganizing and adjustment process of the Chilean economy
botched? Could things have been done differently? Which costs can be
ascribed to the Cauas plan and which must, on the contrary, be put down
to the socialist experience and the oil crisis? How manageable were the
problems that the economy began showing in 1982? How much progress
had been made since then? Did the 19821984 crisis mean that a fresh
start had to be made? To what extent can it be argued that the model was
unresponsive to social issues?
This book is an attempt to answer these and other questions. The
following chapters move in that direction. But explanations, counterexplanations, details, and clarifications aside, the basic facts need be kept
in mind: the facts of a country whose decisions during the seventies went

30 Of Miracles and Programs


against the tide; of a region that during the eighties and despite prevailing
problems, on the whole made good choices. Because whereas in the
thirties, after the Great Depression, Latin America misguidedly chose the
path that led to state interventionism, the crisis in the eighties did at least
help the region come to terms with the market. For a few years, at least.

CHAPTER THREE

The First Dilemmas


When one is faced with the reality of a stagnant economy and the
intention is to revive it with a liberalizing spirit and with the long term in
mind, the dilemma posed is nearly always the same. The challenge lies,
on the one hand, in stabilizing the existing situation, and on the other, in
carrying out the structural reforms needed to modernize the productive
sectors and the economic structure of the country.
Put in these terms, it seems simple enough. There appear to be two
independent management processes. Actually, however, there is no such
independence. Both areas are intimately connected. Consequently,
initiatives made in one direction will have an impact on the otherand
often, they will even conflict. But this is not the only problem that an
economic reform team must solve in the initial phase of its efforts.
In all likelihood, the approach to the need to stabilize and modernize
will be set within a scale of priorities. Where do you begin? Would it be
better to stabilize first, and only then, once a certain basic balance has
been reached, move on to the structural reform stage? Or, the other way
aroundwould it be a better idea to fix the underlying problems in the
economy immediately, since the situation is out of control anyway, and
could hardly grow any worse, and public opinion shows a passive
resignation toward the future? These questions came up again and again
during the first two years of military government in Chile. It is true that
there was an initial agreement that the most urgent task facing the new
administration was regaining control of tax, monetary, and exchange
policies, which were completely out of hand when Allendes government
fell. These preliminary assignments were associated with stabilization;
that is undeniable. But even so, there was still a broad scope within
which to set priorities, deciding between measures designed to fix things
quickly and measures designed to introduce changes.
At the end of the day, a simultaneous two-pronged approach was
decided on, because the need for deep structural changes in the economy

32 The First Dilemmas


met with intellectual support in Chile. Talk of structural and even
revolutionary change had been going on in Chile for a long time. But the
changes that liberal economists had in mind were of a different kind.
They were serious, not rhetorical, changes, oriented in a totally different
direction from the one proposed by the Leftwhich was embodied in
Chile by a radical faction of the Christian Democratic party. This party
subscribed to a mixture of economic illiteracy and political euphemism
known as the non-capitalist road to development, a supposed third
way between socialism and the free market.

Liberal Consciousness and Criticism


As mentioned in previous chapters, these changes were crystallized into
a program in 1972 and 1973 in a document known as El Ladrillo,
produced after extensive research and discussion by a large group of
professionals. This group was convinced that Allendes government, far
from representing a detour in the evolution of Chilean economy, was
simply the final step in a way of thinking that had taken over the
management of the economy long beforeseveral decades before.
While the country headed toward a grave crisis, perhaps nothing was
as decisive to the course that the country would take as that groups
seemingly Byzantine discussions. Again, as noted, El Ladrillo reflects
the process that shaped a critical and intellectual consciousness in people
who were tired of being asked to believe in fantasies. These people
distancing themselves from the alarmist rhetoric of those years and from
the socialist triumphalism then prevalentmade a vital contribution
toward changing Chiles reality and destiny.
If not for the determination of a group of Chileans to drastically
change the countrys destinyan objective shared by General
Pinochetthe military government would probably have confined its
efforts to stabilizing the economy over a period of one or two years, as
far as it could be done by that point, and returning it to the structures in

Hernn Bchi 33
force prior to 1970. There is no doubt that if that had happened, Chile
would have simply continued marching through the miasma of ideology
and underdevelopment, much like Venezuela or Argentina, whose GDP
per capita in the fifties exceeded that of many European countries, are
still doing.

Where Was Shock Therapy Applied?


There were many other dilemmas and tensions during the first stages in
the modernization of Chilean economy, apart from the one already
discussed. One of the recurring dilemmas in any liberalization process is
deciding whether it is preferable to opt for shock therapy or to make
reforms more gradual. Some believed that if measures were taken
gradually, their effects on the population would be less severe, while if
they were taken abruptly and without preparation, political consequences
could be serious. One of Pinochets main advisers once remarked that
The Chicago Boys policy was like feeding a baby fried egg. Admiral
Lorenzo Gotuzzo, who was Minister of the Treasury at the time, would
respond to these criticisms with a metaphor: A certain man loved his pet
cat so much that when the cats tail became gangrenous and had to be cut
off, instead of doing it and getting it over with, he sliced a little bit off
every day.1
If my ideas on this issue may seem extreme, my personal experience
is conclusive. In light of what I witnessed, even when rigorous shock
policies were adopted, their implementation will always or nearly always
be gradual in practice. On the other hand, if the intention from the outset
is to introduce change gradually, then chances are that nothing will
actually get done in the end, or that the progress made will not be
sufficient. Cases in point are Argentina, Brazil, and Mexico, which,

Patricia Arancibia Clavel, El Arquitecto del Modelo Econmico Chileno, p.


219.

34 The First Dilemmas


despite all their efforts, still have not been able to achieve high, sustained
growth that is unrelated to recovery from previous downturns.
Generally, at the heart of the controversy between gradualists and
non-gradualists lies a conflict between those who support change and
those who resist it. The central dilemma is not whether things should be
done slower or faster. The real dilemma is whether to do them or not.
Tariff reduction, for example, which in Chile is presented as
emblematic of shock therapy, was far from being a rash measure. Quite
the contrary, in retrospect, it seems very gradualistic.
The final objective of the tariff reform, which at the start was closely
connected to the objective of dispelling the prevailing economic chaos
and achieving stabilization, was to open up the countrys economy, to
put an end to international isolation, and to reach a structure of low,
uniform tariffs as soon as possible. These tariffs had to be low in order to
make full integration of the Chilean economy into the world economy
easier, and uniform to avoid the discriminatory distortions that a
differentiated tariff structure inevitably entails.
Trade liberalization was intended not only to enable the country to
profit from its comparative advantages, but also to strengthen domestic
producers by making them more competitive, even as the process of
price liberalization was beginning.
This process, in which I took part, was also very gradual. In 1973,
most prices were fixed by the authorities. The Industry and Commerce
Office (Dirinco, Direccin de Industria y Comercio) was one of the most
dreaded public agencies in Chile. It was actually the only company that
worked efficiently in its mission to make it impossible for producers to
operate and flourish. In 1979, six years into the military government,
there were still some controlled prices in Chile. The last two to be
liberalized were the prices of bread and public bus fares.
The liberalization of prices was unavoidable, but even in this area the
dilemmas were critical, because if the government was really determined
to achieve stabilization, it could not afford to liberalize every single price
overnight. Three price areas were initially created: free prices, informed

Hernn Bchi 35
prices, and fixed prices. The process was as much political as it was
economic, and it took several years to reach full liberalization.

External Opening-Up
The first stage in tariff reduction took place in 1974 and comprised three
general reductions. Tariffs ranging between 220 percent and 750 percent
dropped to a single 160 percent rate; those between 35 and 215 percent
were cut to between 5 and 65 percent, and tariffs below 30 percent were
not modified. But there were other adjustments that year. In June, the
maximum tariff was reduced further, but the lower tariffs were increased
to take them to desired levels. It is estimated that during 1974, the
average tariff dropped from 105 percent to 57 percent. The statistically
most frequent tariff dropped from 90 to 55 percent.
In August 1975, the second stage of the external opening-up program
set a 1035 percent tariff structure as its objective. A reduction schedule
was drawn up to this end; some steps were accomplished ahead of time,
and the goal was reached ahead of schedule, in August 1977.
The announcement of the goal of a uniform 10 percent tariff
launched the third stage, on December 2, 1977; a new reduction schedule
was set up for the following eighteen months and, as a result, the single
tariff did not become fully effective until June 1979.
Thus, it took five years and three months in all to complete the
Chilean tariff reform. It is difficult to characterize this today as a
devastatingly short period. It seems an extremely reasonable time
frameassuming that the objective was to actually open up the
economy, not to leave it as closed as it always had been. In any case, we
must not forget that later on, during the debt crisis in 1983 and 1984,
tariffs increased again to 35 percent, but were very soon back to 15
percent, and to 11 percent a few years later. These fluctuations reflected
moments of doubt between keeping on track and returning to the past.

36 The First Dilemmas


Finally, trade liberalization was carried out with the long term in
mind and in the spirit of permanently rectifying the Chilean economys
structural problems.
Now, the opening-up strategy was developed while the government
simultaneously set up a framework that was more receptive to the
exchange of goods. This was articulated in the tariff reduction policy and
in an open-door policy for foreign capital and services. In 1974, Law
Decree 600, which in 1974 set up rules for foreign investors, was part of
the major structural reforms carried out by the regime. These initial
reforms radically challenged the prejudices that socialism had managed
to instill in the public with remarkable success. The prevailing doctrine
prescribed that economies should be closed in order to avoid being
devoured by rapacious transnational capitalists, who were always ready
to strangle unsuspecting economies and subject them to their domination.
In 1976, Chile even had to withdraw from the Andean Pacta trade
agreement comprising Bolivia, Colombia, Ecuador, and Peru that was
intended to promote regional integrationto avoid the traps of these
outdated, empty concepts.
It might not raise eyebrows today, but at the time that DL600 was
passed, it went against the prevalent orthodoxy. Foreign investment
generated panic, even among those who were not devoted to socialism. It
was thought that any remotely liberal policy in this area would mean
that, sooner than later, the country and all of its companies would wake
up one day to new owners.
This was sheer political superstition and economic ignorance. Capital
does not move in overnight. Countries are not invaded by foreign
investors, as caricatured by Marxist economic thought. Quite the
contrary, it is extremely difficult to attract investment, especially longterm investment, as the Third World, China, and Fidel Castro have found
out. Large flows of foreign investment did not reach Chile until many
years after DL600 was passed.
The problem is that if there is no foreign investment, problems
become exacerbated, because in order to finance new investments, the

Hernn Bchi 37
country either must make titanic efforts to increase its internal savings or
resign itself to falling into debtwith all of the risks that this entails and
which Latin America suffered firsthand in the eighties. The huge irony in
all of this is that in the end, an oversized external debt compromises
national sovereignty much more than foreign investment does. In fact,
Latin American treasury ministers spent the entire decade of the eighties
negotiating and renegotiating their foreign debtshardly an edifying
spectacle. This anxiety could have been avoided if the debt resources had
been obtained through foreign investment. In that case, the investors, not
the authorities, would have had to deal with the problem.
The central idea behind the whole opening-up effort was that Chile
would develop only if it managed to become part of the world economy.
The provincial concept of socialist development had to be defeated once
and for all. The fear that underdeveloped countries would never be able
to improve their situation and would remain forever condemned to
exploitation at the hands of industrialized nations turned out to be
completely groundless. In practice, quite the opposite proved true. Poor
countries can afford to grow more rapidly than rich countries. It took
England, the leader of the Industrial Revolution, eighty years to double
its gross domestic product. It took the United States only forty. It took
Japan considerably less, and China reached this duplication in just seven
years. The reason for this global acceleration of growth is the fact that
the path to development had already been opened and did not need to be
discovered all over again. The logic of development has its mysteries.
Relatively underdeveloped countries become prosperous gradually and
achieve their first successes through labor-intensive industries. There
was a time when nothing was held in lower regard than Japanese toys
and other products. South Korea started out in manufacturing with
products that were quite inferior. There are many more examples.
Countries have to start somewhere. The important thing is to open up to
world economy in the process.
The belief that economies must be closed or, at best, form part of
closed regional blocs, is a mistake. This explains why Latin Americas

38 The First Dilemmas


much-vaunted regional integration has never been more than a rhetorical
clich. The whole of Latin Americaincluding Brazil, Argentina, and
Mexico, the giants in the regionaccounts for less than 4 or 5 percent of
world GDP. The Andean Pact project was even more insignificant, and
therein lay the trap. Integrating into 1 percent or 2 percent part of the
world economy may seem comforting to some minds, but what can
eventually be gained from this integration is worthless compared to the
opportunities that are lost as a consequence of close-minded regional or
sub-regional trade agreements. Not that regional integration is useless. It
can in fact be very helpful, as long as it does not stop countries, either
individually or in groups, from being part of the world that is, at the end
of the day, the big market.

Exchange Policy
A large dose of realism, combined with the imperative need to introduce
deep, long-term counteractive measures, was the main characteristic of
Chilean exchange policy at the beginning of the military government. In
this field as well, the socialist administration had managed to do away
with the exchange market by means of multiple prohibitions, absurd
discriminations, and obstacles galore. This muddle of interventions
naturally projected numerous distortions over the countrys productive
sectors. Exchange arbitrariness was largely responsible for Chile
manufacturing many products in which it had no comparative advantage
whatsoever and neglecting the exploitation of areas and resources in
which it did. The foreign exchange market had been completely
dismantled and the dollar rate oscillated between the 25 escudos fixed by
the Central Bank for certain imports and its black-market exchange rate
at 1000 escudos.
Thus, the task was arduous. The function of the exchange rate as an
adequate standard by which to allocate resources needed to be restored.
Consequently, the first decision was to abolish the socialist governments

Hernn Bchi 39
multiple-rate system and correct the overvaluation of the peso, which
was changed from the escudo to the peso in 1975, and had accumulated
over the previous years. A 229 percent devaluation was implemented in
1973, and it is estimated that for food and raw material imports the
devaluation meant an increase exceeding 1,000 percent, because this area
benefited from formal access to a preferential dollar exchange rate.
Overall, the exchange system was restored, and a fluctuating
exchange rate was maintained until 1979. This rate varied in terms of
domestic and world inflation, and the level of reserves accumulated the
reduction of nominal tariffs and stabilization objectives. Adjustments
exceeded inflation when the price of copper fell (1975), when tariffs
were reduced (August 1974 and December 1977), and when the fixed
dollar was announced (June 1979) in order to establish a better
correlation between internal and international inflation.
Exchange rates readjustments were smaller when the combination of
fiscal, monetary and exchange policies resulted in a spectacular turn in
the balance of payments in 1975. The expected deficit had been reduced
by 80 percent, and foreign currency reserves were increasing at an
accelerated rate, surpassing all predictions. In the first few months of
1976 alone, reserves increased by $250 million.
In June 1979, the government announced a fixed exchange rate,
which remained in place until mid-1982. This exchange policy was
highly controversial, especially toward the end of the period. (Further
reference to this point will be made in the discussion of the 1982 crisis.)
Since 1985, exchange policy has been similar to the policy maintained
until 1979 in that rates were adjusted in terms of domestic and world
inflation, international reserves, and the general international payments
situation. The objective explicitly introduced in this period was to
maintain an exchange rate that would be consistent with a long-term
balance of payments and at the same time high enough to promote an
increase in exportsthe only way to solve the external debt problem for
goodwhich would lead the way to future growth for Chilean economy.
The idea was that the real exchange rate should be high for structural and

40 The First Dilemmas


not artificial reasons. Toward that end, domestic spending had to be
adjusted in order to adapt the ratio between the prices of tradable and
non-tradable goods, increasing the relative price of the former. Other
measures aimed at making a higher real exchange rate possible were the
reduction of tariffs and of other taxes on foreign trade. Simultaneously,
investment in state infrastructure was focused more intensively on
support projects for exporters, and this, along with an accelerated
deregulation process, improved the countrys competitiveness.

Monetary Redemption
Priorities in monetary management were clear from the start. The
effectiveness and credibility of national currency as a payment method
needed to be restored, after having been seriously compromised by the
socialist government. What else could be expected of an irresponsible
monetary policy in which all that the Central Bank did was to simply
keep track of the substantial amounts of money that it transferred on a
daily basis, following political orders, to financial firms and companies,
which had been intervened into by the state? For several years, monetary
management had been nothing but a system to finance the treasury.
The phase that the country was beginning, however, would require a
responsible monetary and financial policy that was capable of offering
efficient incentives to saving and expeditious channels through which
these savings could be geared toward credit for investment. This
necessarily entailed redefining the role of the Central Bank by orienting
it toward conducting monetary policy. It also implied the need to
generate a capital market that would have some degree of development
and independence. The increased scope for activity that was gradually
allowed to intermediary agents played an important role in the
liberalization process, including the perfecting of the indexation
mechanism created in 1968 by Freis government, the Unidad de
Fomento (UF), to ensure that interest rates were real, since inflation was

Hernn Bchi 41
still high. Without the UF, a unit of account that reflects variations in the
consumer price index in Chile, the currency would inevitably have had to
be pegged to the dollar, or rely on other less efficient mechanisms in
order to continue functioning into the long term.
The high interest rates prevalent in Chile during most of this phase
reflect not only the high cost of capital in a country that was extremely
de-capitalized at the beginning of this period, but also the difficulty in
creating a capital market in the country.

Government Revenues and Spending


Fiscal policy solutions were also drastic. For government revenue, the
initial objective was to sort out the tax system and separate the ultimately
perverse correlation between income and expenditure, since Chile was
riddled with special laws taxing specific acts or activities for very
specific ends, even at a local level. The cornerstone of tax reorganization
was, in any case, the introduction of the value-added tax (VAT) to avoid
market distortions, given its advantages in terms of performance, control
efficiency, and neutrality. Later on, in the eighties, the tax system
included an incentive to reinvestment in companies, which had an
extremely positive impact in strengthening the investment rate. It is
impossible to describe this in just a few words, but it is nevertheless
important to point out that the process leading to a tax system with few,
efficient, and neutral taxes that did not seriously affect savings,
investment, or the development of exports, was a long process requiring
many years workeven though it was begun early and forcefully.
There was also some margin for cutting spending, by either
eliminating or drastically reducing agencies and programs that the
previous government had enlarged or created solely for political
reasonsincluding the Agrarian Reform Corporation (Corporacin de la
Reforma Agraria) and the Agricultural Development Institute (Instituto
de Desarrollo Agropecuario), both connected with the agricultural

42 The First Dilemmas


reform that Chile had undergone in previous governments, as well as
Dirinco, in charge of price control. By 1975, due to the fall in the price
of copper and the exchange crisis, Minister Cauas was forced to apply a
20 percent reduction on all government spendingincluding wages and
spending in both local and foreign currency. However, cutting spending
is one thing, but restructuring the public sector and, more importantly,
the public enterprises, is another.
It is true that in most cases, deficits in these enterprises were the
consequence of distorted tax rates that had been set with openly
demagogical intentions. But the solution was not simply a question of
adjusting rates. In most cases, it involved a complete reorganization. All
of this took time; it took so much time, in fact, that it was not until 1980,
seven years after reform was launched, that the first phase of the
restructuring and rationalization of the Chilean public sector and fiscal
enterprises could be said to have been completed.
It is estimated that approximately half of the governments deficit
was generated by state companies. The task in this area was difficult, as I
know firsthand, since it was on this that I first worked when I joined the
government. In general, solutions were designed on a case-by-case basis.
Some companies were privatized immediately or returned to their
rightful owners. Attempts were made, as part of a long-term plan, to
reorganize others, correcting distortions both in their pricing systems and
in their productive processes. Generally speaking, the problem with state
enterprises is that there is confusion regarding their objectives. On the
one hand, they define efficiency objectives, as they should. On the other,
they feel compelled to fulfill social service goals. They operate between
these two extremes, which is almost always a problem when it comes to
trying to hold them accountable. One day they justify their shortcomings
by claiming to be fulfilling social objectives, then the next day they
reject the idea of giving their activity meaningful social content, claiming
that they cannot afford to work at a loss. You cannot win. As I learned
from my experience, restoring these companies objectives is very
difficult. It is exceedingly difficult to get their administrators to

Hernn Bchi 43
understand that state enterprises must be, first and foremost, enterprises,
and as such, they are under an obligation to make a profit. If the
government or the community wants the railway company to reach a
remote little town or the price of kerosene to be less than its market
value, well then, that means the government or the community will have
to provide the required subsidies. But it is not a state companys role to
assume, in very questionable ways, social service missions that have
been poorly evaluated and often achieve nothing. Accordingly, it is
essential to define roles so that no one can claim to have been misled. In
my experience, solving problems begins with an awareness of the need to
not confuse the interests of the company with the potential interests of
society.
As in other areas, here too the economic team had to act innovatively
to make sure that independent public enterprises did not stray from the
economic programs general guidelines. The idea of setting up a holding
company to control them was never carried out. At times, the economic
team lacked the political weight to even appoint members to boards of
directors. Resorting to extremes, a decree was issued preventing public
companies from incurring any extra expenses or any debt above a certain
amount without the Treasurys approval. It was a seemingly drastic
solution, but there was no other way to keep the situation under control
in a moment of crisis.
Today there is much discussion in countries around the world about
what should be done first: restructure state enterprises prior to privatizing
them or privatize them immediately, just as they are, leaving it up to the
private sector to reorganize and modernize them. It is worth noting that
the Chilean experience in this area produced rather hybrid solutions.
They are not solutions that can be distilled into any general rule, much
less be followed as a recipe. Every country must determine a strategy and
draw up a schedule to suit its needs. In Chile, the only enterprises that
were privatized immediately were productive units that were very small
or that had been taken over illegally by the socialist government, via

44 The First Dilemmas


legal loopholes2 (resquicios legales) that made a mockery of the spirit of
the law and of basic concepts of political morality.
In the case of most other state enterprises, the decision was to
reorganize them first, for several reasons. Foremost among them was the
question of economic and political opportunities. After Allende, the
private sector was undercapitalized and had essentially no purchasing
power. Politically, also, calls for bids by investors would have been
much more strongly resisted in the seventies than we can imagine today.
Socialism was still a very dominant trend in that decade.

The Totalitarian Script


The economy picture at the end of 1973 was one of devastation. The
price system was no longer relevant to economic decision making.
Isolation had practically cut the Chilean economy off from the worlds
international connections. In addition to a burdensome, protectionist
tariff policy, an elaborate system of quantitative restrictions and absolute
prohibitions complicated the problems, affecting international trade even
further. Chiles fiendish customs regulations were enough to make even
the most tenacious and enthusiastic importers and exporters run out of
patience.
Every important economic activity depended directly or indirectly on
the state, through either direct control, the appointment of interlocutors,
or price controls. Enterprises that were controlled or taken by the
government were granted access to limitless open credit with the Central
Bank. Large issues of paper money devoured the currencys purchasing
powerduring the last stages, in a matter of days. Inflation in 1973 was

Legal loopholes (resquicios legales) was the name given to the governments
practice of searching through legislation that was dated or had been issued in
different contexts, in order to apply it and attain an objective which was not
authorized by law; for example, expropriating a company by using a long
forgotten law passed in the thirties.

Hernn Bchi 45
just over 500 percent, but in the months prior to military intervention, the
speed at which destabilization was increasing implied much higher
annualized rates.
All this only seemed to be chaotic and the result of local
improvisation. In fact, the same script that had been followed in all true
socialism regimes, from Czechoslovakia to Cuba, from Poland to
Nicaragua, was being followed here too, to the letter. The strategy, quite
sinister in essence, was the sameto strengthen and magnify the
political power of the state system, come what may, to control companies
immediately either by direct expropriation or intervention, to destroy the
price system via outrageous inflation and subsequent price controlsall
with the sole purpose of weakening property rights. The end goal is to
confiscate, nationalize, and control everythingnot just the economy,
not just things, but people as well.
This totalitarian logic has been always the same, give or take a
couple of variations. And so it will remain. For totalitarianism, the
concentration of power is an ever-present, overarching goal. The threat
from Soviet Communism may have disappeared, but it would not be at
all surprising if other totalitarian systems were to appear in the future.
Several could crop up, for example, from radical environmentalism,
which today provides a pretext to attack private enterprise and the market
economy and to gain power over people, including those of us who are
genuinely concerned about nature. Their weapons will always be the
same. If the market is destroyed, all other freedoms become nominal.
Economic control gives political control teeth. That the process in Chile
was quite advanced is reflected in the fact that a political distribution
channel had begun to operate through the Committees of Supplies and
Prices (JAP, Juntas de Abastecimientos y Precios,), a source of so many
bad memories.
It seems strange that none of this was perceived as having been
premeditated, even by people in Chile who experienced this process
firsthand. The problems, beginning with rampant inflation, were
perceived as the consequence of ineptitude on the part of economic

46 The First Dilemmas


policy makers. But behind this apparent bungling, there lay in fact a
more sordid plot, and the coldest minds in the regimeas well as the
Soviet Communist Party of courseknew this.

The People Behind the Numbers


The crisis that was overcome had a decisive financial dimension to it, but
it also presented a delicate double human dimension. On the one hand,
any measure taken affected both private individuals and government
officials, and things needed to be done in a way that would minimize the
pain. On the other hand, it was essential to have competent professionals
that could accomplish the tasks at hand. Fortunately, in this respect, not
all was lost. There were still some reserves of professionalism to be
found, to varying degrees, both in government administration and in state
enterprisesresponsible officials, technicians who knew their job, and
decent people with good intentions on whom the new government could
rely for support in the restructuring and modernization process.
Even so, however consistent the market-based development strategy,
and however firm its intellectual grounding, at the outset of the
governments administration, nobody could be certain how much of this
strategyor any other consistent strategywould be enforceable or in
what sort of time frame it could work. In many respects, the initial
phases of the Chilean economic revolution felt like groping in the dark,
given the countrys situation after Allendes thousand days in office. The
country faced not only a massive inflation crisis, but also a crisis in its
balance of payments that nobody really knew how to solve.
Obviously, when inflation crisis coincides with an external crisisas
it did in Peru, for example, after Alberto Fujimori took over the
government from Alan Garcathe governments scope for action to
stabilize and liberalize the economy is much more limited and the
challenge much greater.

Hernn Bchi 47

Lessons from the Chilean Experience


Chile is proof that it is possible to move from an inefficient economic
model to a market economy. But it is also proof of three other concepts.
First, there are no easy ways out. Second, transition processes take a long
time, longer than one would wish. And third, there is no such thing as a
universally valid formula, especially regarding the details of
implementation. What worked in Chile may not necessarily work in
Peru. What Guatemala does will not necessarily be applicable in the
Russian Federation.
The Chilean process was too adversely affected by the external
crisis. Chile went from Unidad Popular straight into the oil crisis and
then into the debt crisistwo of the main economic convulsions of the
twentieth century. It was like having providentially survived a fierce fire
with serious bruises, only to be run over in the street twice.
There is another lesson in all this. One cannot face a crisis and
expect its effects to go unnoticed. There is evidence that this is the worst
option. It is what Alan Garcas shameless populism did in Peru (1985
1990) and what other Latin American presidents have done. There is also
evidence as to how much good it did them. The anesthesia of populism
wears off after a few weeks. Afterward, returning to reality can be much
more violent. In Argentina in 2001, people ended up raiding
supermarkets.
It seems strange that in most common citizens perception, truly
serious stabilization and economic reform programs are associated with
dramatic social costs. More than strange, it seems unfair, because these
costs are not a product of the programs themselves but of prior
distortions. A countrys accounts do not improve simply by returning to
economic rationality. It is to be expected that they will continue to
deteriorate for some time because of time lags in this area, which can be
quite protracted. One governments mistakes are often paid for by the

48 The First Dilemmas


next. Chile is a clear example of how the mistakes made by one
generation can end up dragging down the fate of the next.
By the same token, one must be cautious when making comparisons,
not only for the sake of intellectual rigor, but also of political decency.
Advocates of the social market economy in Chile would point out that
the purchasing power of wages in the first years of Allendes government
was substantially higher than it was during the military government. But
that was a fallacy, not simply because the numbers for both stages had
been doctored, although it is possible to find many distortions, but
because both realities were extremely dynamic in very different senses.
While the purchasing power in Allendes time led to a precipice, because
the country was firmly headed toward disaster, during the military
government it was the starting pointtough, brutal and whatever else
one might want to say about itof a much more sustained long-term
recovery process.
The phase comprising the reorganization and the first structural
reforms during the Chilean military regime was a long process. Not
everything was done immediately and simultaneously. But in a way, it
was all interconnected. Tariff reduction affected fiscal revenue. The
adjustment in the exchange rate was a key factor in external opening-up
and in the new development strategy. The value-added tax was decisive
in making it possible for exporters to compete internationally, since it
exempted them from the cascade of taxes under the previous system. It
never would have been possible to reimburse them for paid taxes
otherwise.
After only three or four years time, the Chilean business structure
opened up to a vast transformation process. Businesses began to lose
their fear of exporting. Even more revealing is the fact that they began to
stand on their own two feet. Before then, they were extremely dependent
onand requested everything fromthe government. Now they know
how to compete not only in Chile but also globally. After having strongly
resisted opening up, the fact is that they showed remarkable adaptation
skills in the face of new circumstances. Non-traditional exports grew in

Hernn Bchi 49
importance, especially after 1977. The only year in which exports did not
increase was 1981, but at that time, the country was facing a huge crisis,
although we Chileans were not yet fully aware of it. It was not
businessmen who were to blame, but rather the imbalances about which
they could do nothing.
This process yielded important lessons, which proved valuable when
it came to perfecting the system. Many times tariff reduction is blamed
for problems brought on by the exchange rate. Businessmens
recollection of the dramatic impact of the opening-up process is more
closely related to the undervaluation of the dollar in 1981 than to tariff
reduction per se. The country did indeed swing between extreme options.
It was of course unthinkable that the exchange rate in Chile in 1981
could remain as high as it had been three years beforebut it was also
unreasonable for the country to function with the dollar as cheap as it
was that year. It is undeniable that those variations, which today seem
extreme, were accompanied by incredibly sudden changes in the
availability of foreign investment and in the prices of the products that
the country imported and exported.
Between 1973 and 1980, the Chilean economy showed unmistakable
and vigorous signs of recovery. After the sharp 12.9 percent drop in GDP
in 1975, the economys growth rate increased. The government chalked
up major successes in stabilization, although inflation was still quite
high. The balance of payments was increasingly favorable. The rate of
investment became steadier. Non-traditional exports reacted with
surprising dynamism. All of these factors contributed toward creating a
scenario of favorable perspectives. Granted, there remained some
unsolved problems, such as a low level of internal savings and an
alarmingly high interest rate, but by 1980 the country reflected barely a
shadow of the economic shambles in which it had been seven years
before.
This was the process headed by the first stabilization measures and
the first great structural reforms of the military regime. That is where it

50 The First Dilemmas


all started. Without them, Chile would never have become what it is
today.

CHAPTER FOUR

The Real Modernizations


As all textbooks teach and as anybody who has watched economic
forums on television knows, macroeconomic stability is decisive in
preserving the stability required for an economy to function.
But we cannot forget that this stability does not in itself guarantee
the modernization of an economy. Opening up an economy by reducing
tariffs and setting up a realistic exchange rate will be of little use if, for
example, at the same time port operations are not liberalized or customs
and civil service legislationwhich are the source of the real walls of
para-tariff measures that obstruct tradeare not reformed as well.
For the same reason, along with major monetary, exchange, and
fiscal reforms, every economic liberalization project must envision
sectoral restructuring in terms of ideas and objectives that rarely find
their way into economics textbooks or televised debates. Any economic
structure needs consistency in order to function properly, and the
principles that make up its foundation must be present at the top, too. In
Chile, in order to make sure that the economic project was consistently
applied, thousands of professionals who advocated free market ideas
were placed across different ministries. This made it possible for the
different ministries to work in coordination, tearing down barriers and
working toward the same objective. Hence, the most significant progress
was made precisely in the areas where there were people who supported
reform. This was not a miracle, but the natural response to coordinated
work.
Among the numerous lessons from the Chilean experience is the
realization that reforming the Constitution is insufficient if regulations
remain unchanged. Cleaning up the superstructure is insufficient if, as far
as workers everyday experiences are concerned, the weeds of state
control continue to grow. The ruler who never leaves the realm of
principles and grand political guidelines will gain little if he does not

52 The Real Modernizations


come down to the ground level, where people are really in touch with the
nations problems.
In this respect, economic liberalization and reform require
tremendous hard work. Thousands and thousands of rules, procedures,
and operational mechanisms in the public sector must be synchronized.
This entails not only arduous work but also the task of getting large,
generally very heterogeneous, groups of people to agree on a course of
action.
State control dynamics are always all-embracing, and go beyond
simply closing the economy or imposing price controls. State control
pervades all areas, large and smallfrom the design and management of
policies to the systems administration models and the criteria used to
interpret regulations. Change must therefore be exhaustive and reach all
sectors, labor, and capital markets. That is precisely where the epic
aspect of the economic transformation led by General Pinochet lies. The
main guidelinesthe macro partwere set out at the same time as the
details that made it possible for the transformation to be carried out were
developed. All of this was done in an adverse milieu, in which
international criticism offered no respite and internal opposition groups
never relented in their antagonism.

Regulations and Property: The Pillars of the Market


The guiding idea in the reform program was that markets should operate
in as natural a way as possible. For this to happen, at least two important
requirements must be met. One is that property rights in the different
sectors must be well defined. The other is that regulations must be
compatible with the principles, the mechanics, and the flexibility
inherent to a market economy.
Put this way, reform seems a simple task, but carrying it out is not
easy, because it entailseven for the staunchest liberalgoing against

Hernn Bchi 53
numerous myths and impulses molded by decades of state
interventionism. That is when the connection between statism and
peoples legitimate aspirations for prosperity and security becomes
evident.

Guaranteed Success?
State interventionism takes advantage of those aspirations. The security
that things will not change for the worse, that nobody will lose his job,
that no inefficient factories will be forced to close, that no foreign
competitors will be allowed in, that nobody will be allowed to sell at
cheaper prices, that pensions will be generous and available for
everyone, are all held out as enticement. State control is a straitjacket that
binds and immobilizes the future, deactivates risks, slows down
technological change, and evades the challenges of innovation. For
example, Chiles vineyard law, issued in 1967, forbade planting new
vineyards, thus ensuring a perfect monopoly to established vintners, on
the grounds that this was part of the battle against alcoholism1. Nothing
could be worse than this, if the objective is to generate wealth. Wealth
does not spring from rigidity but from flexibility. It is not the fruit of
conservation but of change. It is not born of a rejection of the future but
of the ability of each society to meet future challenges and opportunities.
It does not come from a tendency to repeat the same thing day after day,
but from the challenge to innovate. An economy in which everyone
wants guaranteed success will be inert, stagnant, and regressive. It is the
worst possible scenario, because rigidity and stagnation lead to
ossification. This means that the rich will continue to be rich, even if
they make mistakes in their business deals, while the poor will continue
to be poor, however much effort they make to improve their lot in life.

Joaqun Lavin I. El Enriquecimiento de las Personas en Chile, p. 21.

54 The Real Modernizations


For want of a better name, the task of reforming an economy, sector
by sector, by moving from state control to a market model is often
referred to as deregulation. The name could hardly be more
unsatisfactory because the task at hand is not to end regulations, but to do
away with interventionist regulations, to generate rules that recognize
property rights in each sector and to solve the conflicts in each sector
efficiently.
The most successful societies in history have not been the ones that
rejected change, but those that remained open to the future. They are also
the ones in which strong institutional safeguards ensured the full exercise
of property rights.
Most people do not find it hard to envision the scope of property
rights in agriculture or in industry, because in these sectors, some ancient
traditions regarding the protection and transfer of these rights have been
internalized by nearly all civilizations. But when it comes to conferring
property in areas such as mining, telecommunications, or water, many
people become confused and succumb to fallacious reasoning.
Technological innovation has begun to open up new fields to the
notion of property. For example, airspace, as either flight routes or the
electromagnetic spectrum, has only begun to acquire economic value
during the twentieth century. Previously it had never been a scarce and
finite good. It lacked utility. It was the development of aviation, radio
broadcasting, and telecommunications that endowed it with economic
value. Unfortunately, this occurred at a time of worldwide predominance
of state interventionism. Consequently, in this sector, the state became
the key agent, and this prevented the consolidation of property rights,
which should have followed naturally.
In Chile it was necessary to sweep across all sectors of the economy
in order to remove the weeds of state control. This is what made the
Chilean economic revolution so extensive and deep-rooted. The struggle
in every sector was dramatic. This was not only because of the reaction
of many groups whose vested interests were threatened or because the
regulations in force were invariably long-standing as a result of political

Hernn Bchi 55
and intellectual tendencies enforced in the thirties. It was also because
the most acknowledged experts in many specialized areas with
traditionally weak legal or cultural links to the concept of propertysuch
as ports, telecommunications, or transport, to name a fewhad
internalized an interventionist mindset.
The sweep was almost exhaustive. However, some areas went
practically untouched. For example, absolutely no substantial initiative
was taken in relation to the workmens compensation system, for several
reasons. The system contained, and still contains, some reasonable
features. It works well and receives substantial support from the private
sector. On the other hand, at the time when social legislation was revised,
the system had yet to mature. The law creating it had been recently
passed. The system was not fully operational and the contingent of
workers it was to finance over the next decades had not reached
retirement age. A large part of the systems technical reserves were
invested in hospitals, and its books were satisfactory. But none of these
factors was enough to ensure that maximum benefits were being obtained
at minimum cost, as would have been the case in a competitive system
open to the participation of private administrators ready to provide the
same services. In spite of this, the effort required to embark on a
comprehensive reform was not worthwhile at that point in time, given
other priorities pending on the agenda.
If there is any general conclusion to be drawn from the
modernization that the military regime carried out in various sectors, it is
that the greater the degree of state intervention, the poorer the
performance of the area and, consequently, the easier the recovery. The
effort required was much greater in areas that had still not hit bottom or
in those whose performance, albeit not optimal, was at least somewhat
adequate.
In addition to regulations and institutions, it was also necessary to
reform thinking. Entire agencies would need to adapt to new objectives.
For example, a customs service or a bank regulator does not operate in
the same way under a socialist government as in a market economy. The

56 The Real Modernizations


focus needs to be completely different. But in some cases, the problem
was not just a matter of focus. In fact, several agencies, such as the price
control office (Dirinco), had completely lost their raison detre. Not long
after the beginning of the military government, the person who took over
the management of this organization handed in his resignation, realizing
that there was little that he could contribute within the new scheme of
things, in which the first measure taken was the liberalization of prices.
In looking at each of the sectors and areas modernized by the
military government, the observer finds, alongside realities that are
exclusive to Chile, problems and experiences that may prove valuable in
liberalization programs in other parts of the world. The following list
cannot be exhaustive nor can it reflect all of the significance and the
complexity of the changes accomplished. I have tried, however, to
deliver a fair portrayal of the reforms that were undertaken.

Agriculture
According to United Nations Food and Agriculture Organization
statistics, 5.7 percent of Chiles land is arable.2 This land became the
scene of one of the most violent episodes during Allendes socialist
government.
The scandal of land reform centered on the fact that land had been
taken from its ownersvia an expropriation process that did not include
adequate compensationand not handed over to anybody. Allendes
Minister of Agriculture himself warned that any estate exceeding 80
hectares would be expropriated. By the end of 1972, this threat had been
carried out in full.3 By 1973, over 4,400 properties totaling 6.4 million
hectares had been seized. The beneficiariesincluding settlements and
CORA cooperatives (Corporacin de la Reforma AgrariaAgrarian
2

United Nations Food and Agriculture Organization, 1990. Production


Yearbook, Vol. 44, 1991.
3
Simon Collier and William F Sater. A History of Chile, p. 337.

Hernn Bchi 57
Reform Corporation)were nothing but political pasturing herds and
legal nonentities, or in some cases shell entities invented in order to
invalidate the right to property.
The agricultural sector inherited by the military government was in
chaos, not only because of the land reform but also because of a
systematic lack of incentives to national producers that was decades old.
Nevertheless, Chiles agricultural sector retained a substantial moral
reservoir of natural notions of land property, which socialism, despite its
best efforts, had managed to wound but not kill.
The advantage that the military government had in this field was that
legislation regarding farm property rights had existed from time
immemorial. Regulations were very clear and were part of the Civil
Code. No new legislation was required. For this reason, the
governments task consisted in reestablishing the notion of property to
wherever it had disappeared. The problem was serious, since more than
50 percent of the land with productive value had already been
expropriated. Not that the rest had escaped. Far from it; a high proportion
of the remaining arable land belonged to smallholders who in turn
created other types of inertia in the countrys agricultural development.
Nothing else can account for the fact that in 1973, the countrys
agricultural production was comparable to its production in 19364.
The restitution of agricultural property was carried out among high
political tensions. The way in which the agrarian reform was applied and
the situation it created in the rural sector was one of the Allendes
governments most critical fronts.
The attitude with which the urban middle class observed the
disintegration of rural society was strange and often contradictory. On
the one hand, the vast majority thought it unfair that the land should be
taken from its owners by means of the broad discretion that the agrarian
reform plan bestowed on officials. On the other hand, many believed that
the owners of large estates were largely responsible for the country not
4

James Whelan. Out of the Ashes, p. 565.

58 The Real Modernizations


making progress. It was assumed that large landowners, secretly allied
with foreign capital, which was by nature exploitative, were conspiring
to prevent the estates from thriving. Given that the country was being
exploited externally by transnational companies and internally by the
wealthy, the agrarian reform could, to many nave people, appear to be a
good solution.
In this setting of social turmoil, expropriations, and violence, very
few people considered that agriculture was simply not profitable because
price levels were fixed by the government. Hardly anybody noticed the
fact that, of all the economic sectors, agriculture was the most punished
by the countrys economic isolation. Protectionist measures were
adopted in the name of national industry, with no regard for agriculture.
Since there was absolutely no awareness of our countrys true
competitive advantages, the entire economic system revolved around
industrialization. Behind industrialization lay economic interests and
votes to be won. The powerful industrial labor unions, the workers
unions, and the business lobbies benefited from policies that favored the
industrial sector.5 With prices fixed and wages increased, it was
inevitable that agricultural production would be expected to pay the cost.
In 1972, the country was spending 52 percent of its export profits on
importing food.6
For the same reason, clearly the process of property restitution in the
sector needed to go hand in hand with the gradual liberalization of
agricultural prices. Acknowledging property rights and establishing the
conditions to make agricultural production viable were both necessary in
order for the market to function. It was a complicated and huge task. The
agricultural sectors operations were completely distorted, so it was hard
to know where to start. When the government controlled the prices of
products, it also openly subsidized seeds and fertilizers. This gave it the
pretext to interfere in the rest of the chain of production. In a way, almost

Juan Andrs Fontaine. Transicin Econmica y Poltica de Chile, p. 5.


6
Collier and Sater, p. 340

Hernn Bchi 59
the entire productive cycle in agriculture was a lie, from the economics
point of view. None of the prices reflected what things were really worth.
Regularizing farm property rights took many years. The land reform
gave rise to an enormous amount of lawsuits, many of which were still
unresolved in the mid-eighties. There was even a law that offered people
who sued the government the option of trading their claims for shares in
the companies that were privatized during my time as Minister of the
Treasury. Only then was the cycle of wealth transfers, which the reform
had set in motion, completed. Generating alternative channels for buying
supplies and restructuring the price system and the marketing
mechanisms of agricultural production also took a long time. The
government went on granting grain loans much longer than it would have
preferred to do. The idea was that the state should withdraw from the
sector as soon as possible, but in the case of some products this took
quite some time. Price bands, which to this day trigger so much debate,
reflect this gradual process of introducing market mechanisms into the
sectorand are far more respectful of market principles than of price
fixing.
Nevertheless, these bands were a solution worth considering. They
were applied to wheat, sugar, and oil, with the purpose not of fixing
prices but of protecting producers from the relatively violent fluctuations
in the international market. These fluctuations were generated in most
cases by other countries subsidy programs, which entailed unfair
competition.
The first challenge that the implementation of price bands had to
overcome arose from Cartesian reasoning: if all products are subject to
price fluctuations, then why not have specific bands for each one?
Obviously, this line of reasoning could lead to the worst-case scenario:
trying to provide stability for everyone, which ultimately would mean
providing it for no one, as socialism ended up confirming. Nothing can
be more vulnerable than forced stability. Therefore, if price bands were
established for some products, it was only for political reasons. The
products involved had great impact on national agricultural production;

60 The Real Modernizations


they were exposed to the pressures of very volatile external markets and
were part of a chain of broad effects, especially in a political sense. In
comparison with the support that European countries and even the United
States give to their farmersgranting subsidies worth up to 2 percent of
gross national productprice bands may seem insignificant, but they
played a very important role in stabilization. On the other hand, to try to
emulate developed economies agricultural policies would have placed
an intolerable burden on a country striving to leave economic stagnation
behind.
The real objective of price bands isfor producers peace of mind
to minimize fluctuations between sowing and harvest seasons as much as
possible, especially when they are caused by political decisions made by
other governments. Bands were set by analyzing the movement of prices
throughout the previous five years, and they had to be flexible enough at
both ends to reflect both rises and falls in international prices when these
variations are not purely circumstantial.
The military regime inherited a prostrate, unviable agricultural
sector, and left it in a positively dynamic state for the following
government. The prices of products, supplies, credit, and marketing
channels were completely liberalized. The only exceptionin addition to
the loans designed for small producers due to political considerations
was the aforementioned price bands policy, which presented only minor
problems for products in which the country is not self-sufficient.
However, when there is a surplus, or a tendency toward a surplus of a
product, the situation becomes more complicated because it forces the
government to buy the surplus and become involved in the marketing
process. The problemas countries like Germany or the United States
can attestcan take on very serious proportions when seasons of
abundant harvest not only cover domestic consumption needs but also
leave a large enough surplus for export.
The liberalization of agriculture caused apprehension, rather than
opposition, among farmers. Many perceived that their situation would
deteriorate by transitioning to a free and open system. They assigned

Hernn Bchi 61
more importance to the benefits that they stood to losecheap supplies
and easy creditthan to the opportunities they would gaingreater
competitiveness, freedom to set their own prices, and access to external
markets. Other problems added to this apprehension, such as the
deterioration in the exchange rate between mid-1980 and mid-1982. The
agrarian reform, in fact, had brought about a huge transfer of wealth from
the sector affected by expropriation to the Treasury. By design, only the
state had stood to gain in the process, since it paid less than market value
for the land that it expropriated and soldat higher prices, one would
assumeto the parceleros (smallholders). For those affected, the reform
had been an act of plunder that robbed the agricultural sector of capital.
This problem weighed heavily on the economy for a long time. It became
necessary to pass laws forgiving part of the parceleros debt. Meanwhile,
the farmers who kept the land to which the law authorized them found to
their dismay that it was very difficult to keep up the standard of living
that they had enjoyed when they owned the entire property.
The compensation conditions established by the agrarian reform
were clearly unjust, and this injustice had been abetted by the law. The
farmer concerned received a small down payment for part of his land
with the rest paid in bonds that were indexed at only a percentage of the
inflation rate. It was clearly a case of state exploitation.
But this was not the only plunder occurring in Chile during those
years. The pension system was subjected to a similar fraud. Retirement
pensions were an average of the wages earned over the last five years, of
which only the first three were increased due to inflation. In a country
with the inflation rates that Chile had at the time explains why very soon
all Social Security Service pensioners had been reduced to minimum
pensions.
In the agricultural sector, the military government decided to respect
the situation that had been created by the application of the agrarian
reform in cases in which it had been applied according to law. In cases in
which the expropriations or interventions had been illegal, the lands were
restituted without delay. For the farmers grouped in cooperatives or in

62 The Real Modernizations


settlementsand consistent with its decision to create property rights
the government parceled the land and, if the property was too large or
indivisible, called for bids.
Sale of parceled land was conditional on a clause that prohibited the
transfer of the property, which had little effect. People always managed
to find loopholes to transfer their property, whether to their neighbor next
door or across the road or to a businessman in the city. There was
nothing wrong with this. These transfers are a key part of a dynamic
economy. To a great extent, this was an important way in which fresh
capital made its way into the agricultural sector to support the beginnings
of the fruit sector in Chile.
Based on the fruit industrys success, there are those who claim
today that the agrarian reform was a key factor in the fruit-growing boom
in the eighties. That is pure demagogy mixed with science fiction.
Following that same logic, it could be held that the Third Reich was a
key factor in postwar Germanys economic prosperity. Former
landowners would have had to be very obtuse indeed, which they were
not, to have not taken advantage of the incentives to growing fruit crops
if those incentives had always been there. Those incentives had never
existed before; when they did appear, farmers took advantage of them.
In my opinion, the aim of the agrarian reform was never economic. It
was political. By the time the government took over, the countrys far
Left had already done a great deal toward setting workers against
employers and businesses. Politicization of the industrial unions was the
result of patient, long-drawn-out, coordinated effort. The manipulation of
these organizations successfully drove a sharp wedge into the relations of
authority, leadership, commitment, and affinity that should have existed
between businessmen and workers. This marked the beginning of the
breakdown of the natural socioeconomic ties in urban Chilean society.
In rural areas, this disruptive process began later. In the sixties, rural
society still responded to the traditional model, which was not perfect,
but was at least free of ideological class warfare. Rural areas were much
more conservative than the cities. At its core, the agrarian reform was

Hernn Bchi 63
intended to sever the traditional connections between agricultural
employers and workers. In this, it was undeniably successful.
It was not agrarian reform that modernized the Chilean countryside.
Modernization came about entirely and exclusively as the result of
confidence in market mechanisms, the re-establishment of property
rights, and the work of a farsighted government that did all that it
couldin relation to ports, transport, health policy, export incentives
to facilitate Chilean agricultures entry into new markets. The change in
relative prices in agriculture opened up new economic and mental
horizons in the sector. Rural areas became industrialized. Change was
swift and it relegated to the past experiences that had been common
during Allendes timesuch as, for example, the price of a television
being equivalent to the price of several cows. This situation was soon
reversed. Today it is not unusual for a small agricultural producer to own
a car. Today, cars can be found in rural areas, and they do not belong
only to the employers. Rural workers no longer wear the once-common
ojotas-improvised footwear made out of tire rubberand can frequently
be seen riding bicycles, as they do in Argentina, a fact that impressed me
the first time I visited that country.
The military government incorporated agriculture into the VAT
general tax system. This sector is also subject to a land tax that finances
the cost of the legal system for property protection. These contributions
help remind landowners that real estate has a social cost. This tax
benefits local municipalities. The sector is also subject to an income tax,
although in certain cases farmers are allowed to opt for a presumed
income tax, designed to save taxpayers from the costs of a full
accountancy.
In terms of results, the country recovered its agricultural production
capacity quite swiftly. Food imports, which had reached $511 million in
1973, decreased to $361 million two years later. Everything happened
very quickly. The transformation of agriculture took much longer, and
encompassed the emergence of the fruit and forestry businesses, which
definitively changed the profile of Chilean agriculture. In 1992, fruit

64 The Real Modernizations


exports were worth $982 million, compared to $18 million in 1973.
Forestry exports reached $420 million in 1992, while the cellulose and
paper industry contributed a further $685 million. By contrast, in 1973,
forestry exports were barely $6 million and cellulose and paper
contributed $30 million.

Mining
Mining is one of the Chilean economys most important sectors. For
many years, copper was the main export, and Codelco, the state company
that controlled the main copper deposits, was the largest company in
Chile.
In the Chilean mining sector, state control had gone quite far; its
roots went all the way back to colonial times, when legislation had an
openly centralizing and legalistic bias. Although the Mining Code, issued
in the thirties, welcomed private participation in the sector reasonably
well, it was by no means isolated from the socialist intellectual currents
being voiced in the public arena at the time. Later on, the situation
gradually became even more radicalized. By the late sixties, the
dominant opinion was that mining was far too important to be left in the
hands of private enterprise.
The numbers underscore the sectors importance. Known as Chiles
salary, in 1970 the copper industry represented 70 percent of the
countrys trade. Many believed that the $120 million yearly revenue that
it brought belonged to the state and should benefit the whole population7.
Therefore, some sectors argued, the state itself should be in direct
charge of the countrys most important deposits. And so, in 1971, all of
the parties represented in the Chilean Congress endorsed the
constitutional amendment that nationalized the countrys main copper
mines, which today are run by North American companies.

Simon Collier and William Sater, p. 334.

Hernn Bchi 65
The 1980 Constitution did nothing to improve this state of affairs.
The five clauses on miningundoubtedly too manyunder article 19,
subsection 24 of the Constitution, which guarantees the right to property
right, are better suited to a set of rules and regulations than to a
constitution. Their wording does not exactly endorse the market or
private enterprise. Statism comes across in the text and between the lines.
Property seems to have been reduced to a system of administrative
concessions, subject to the moods of government bureaucrats, and as
vulnerable as everything that can be given or taken away by the state.
But that is not all. In some working drafts of the constitutional text,
state intervention and interference in the sector were even stronger.
Fortunately, internal debate managed to lower the states profile
somewhat. My impression of this preliminary wording was very
unfavorable. At my first opportunity, I discussed the issue with Sergio de
Castro. It is important to note that in addition to the Chilean public
opinion of the sixties and seventies, many military officers, who were in
charge of running Codelco, saw mining activities as inextricably linked
with national security.
The military regime, in a stark exception to its own reform efforts,
going against everything that it had done in other areas, came very close
to establishing more state control in mining than had existed in 1973.
There was even a moment in 1980 when it was feared that in this area
things would not only remain unchanged, but would actually backslide.
Fortunately, cooler heads later prevailed, and important amendments
were made to the original text. But even so, the final result was far from
optimal.
The situation began to improve when, during Jos Pieras term in
office as Minister of Mines, the Mining Law (1981) was passed, which
rose to the level of constitutional amendments, finally achieving what the
Constitution had not: complete recognition of property rights in the
sector. The new Mining Code, issued at a later date, completed the
framework that would guarantee the participation of private companies.
In this sector, as in others, property is fundamental. There was general

66 The Real Modernizations


consensus regarding the fact that mining required a different legal regime
from the one applied on land in order to, among other things, encourage
dynamism in the sector. If the owner of the mines should also own the
land on which the mines lie, the sector tends to greater inertia and the
incentive to explore diminishesa serious problem in a country in which
mining wealth is not within easy reach. As small-scale miners know, it is
not just a matter of picking wealth off the ground.
The Mining Law and the Code that followed had other worthy
qualities. They defined and clarified the concept of eminent domain,
created a system for protecting property, and practically reduced the
margin of bureaucratic discretionary control in the allocation of
concessions to zero, since concessions were now to be allocated not by
the administrative authority but by judicial power. This is not to say that
this path was free of conflict, but at least it guaranteed more equitable
and reasonable channels through which to resolve disputes.
Naturally, all of this upset many peoples preconceived notions.
Most people find it hard to understand that private propertyhere and in
any other fieldis the best way that a society and an economy can
optimize the use of natural resources, whether renewable or nonrenewable, real or apparent, scarce or relatively abundant. Nothing
advances the common good and public utility better than the system of
private property. Judging by its inaction and lack of incentive to exploit
its mines, the state is the worst mining entrepreneur in Chile.
Codelco, increased its number of workers by 43 percent between
1969 and 1973, while production decreased by 19 percent during the
same period. Between 2001 and 2006, the production cost per pound of
copper increased by 83 percent. At present, a large part of the mining
sector is in the hands of private investors who produce much more and at
lower costs than Codelco.
In addition, most of Codelcos deposits are not being exploited. They
are a buried wealth that benefits no one and whose economic value is by
no means indefinitely guaranteed.

Hernn Bchi 67
Another triumph for modernization in this area was the integration of
mining activities into the general tax system, mainly by means of the
value-added tax and the income tax. There were those who, in view of
the solidity that had been conferred on mining property, suggested that it
would be convenient to establish a royalty on what was considered
national wealth. On the basis of these arguments, a royalty on mining
companies was set up in Chile in 2005, which in my opinion, was a step
back in the countrys economic liberalization. A clear decision is crucial
regarding whether we want to move toward clearly defined rights or
open up the arena to collective discussions that will end up eroding the
concept of property rights.
Experience shows that this kind of tax has deplorable distorting
effects. Mining in Argentina has developed at a slower pace than would
have been expected due to the effect of these taxes, among other reasons,
which vary from province to province.
The Argentine case is not an exception. Royalties is a major topic in
mining policy around the world. The United States Congress has
discussed proposals to introduce such a system, which could eventually
make that industry competitive.
Other institutional changes were also important in the development
of mining in Chile in the eighties. For example, water rights regulations
played a decisive role, especially in the northern regions of the country.
In short, the main accomplishments in the sector were to guarantee
property rights; to deregulate, so that everyone could produce freely; to
open up the sector along with the entire economy to foreign investment;
and to liberate prices, supplies, and the entire mining ancillary support
structure. This was enough for the sector to achieve unprecedented and
spectacular growth. Huge investments have been made in the Chilean
mining sector; mining operations occur in conditions that would have
been unimaginable before the reforms. Private enterprise has reached
places that previously no one thought could be reached.
At El Indio and La Coipa, gold was extracted at an altitude of 4,000
meters. At La Escondida, copper that had never risen to the surface is

68 The Real Modernizations


being extracted. Oddly enough, in those areas where the state retained a
higher proportion of property rightsas it has in lithium, for example
development has been much slower and more complicated, to say the
least.
A different strategy regarding property issues was adopted for crude
oil and natural gas, about which I was never too happy. Chile is poor in
black gold and, within this poverty, opts for a state-control model. I
doubt that creating a structure more receptive to private investment
would have changed Chilean geology for the better and led to the
discovery of more deposits, but I have no doubt that it would have helped
our industries to capitalize on their opportunities more efficiently.
Argentina, in President Carlos Menems time, for example, decided
on a more aggressive option involving the direct sale of the areas in
which it had varying degrees of information regarding oil deposits. It was
clear that the country would benefit from this arrangement. In fact,
viewed from todays perspective, the nineties brought rapid development
in investment and in the discovery of natural gas and oil in the transAndean region. When this strategy was modified after the crisis in 2001,
progressive deterioration ensued, which will exact heavy tolls in the
future due to the lack of investment for the discovery of new deposits.
The buyers paid a certain price and committed to a certain royalty. There
is no doubt in my mind that if the oil system in Chile had decidedly
accepted private investment, Chileans would have participated in the
Argentine oil industry, for a time at least, as they did in the electricity
field.
In oil-related matters, in any case, a great majority of countries
remains tied to concession-based schemes. Exceptions are very rare: the
United States, where the owner of the land also owns the oil below the
ground, is one. Yet, even there, the problem crops up in state or federal
lands.

Hernn Bchi 69
Energy
The energy sector became extremely important shortly after the military
government took over. This was during the oil crisis, when the
international market registered a jump in the oil price that seriously
threatened the large Western economies. The main mechanism applied to
address this crisis was the price system. After much discussion, the
alternative of an emergency program to force the substitution of one fuel
for another was abandoned. Instead, the government opted for a policy to
allow the price of oil-derived fuels to reach levels that would reflect the
real cost of fuel. This comprised several factors: the cost of importing the
product (Chile is a net importer), the real costs of distribution, the valueadded tax, and specific taxes applied on gasoline and diesel, to pay for
use of the transport infrastructure.
Completing this structural reform took time. The Chilean fuel market
had previously included a vast amount of cross-subsidies. For example,
subsidies to reduce the price of kerosene meant an increase in the price
of premium gasoline. This set a correlation, which, contrary to the
conventional wisdom, benefited wealthier people, since it offered them
cheaper fuel with which to heat their homes, and in the long run was
detrimental to the maintenance of the countrys car fleet. Subsidies also
favored inhospitable and remote regions. During an intermediate stage,
great care was taken to calculate, as precisely as possible, the subsidies
that, when deducted from the price of different products, allowed the
National Oil Company (Empresa Nacional de Petrleo) to sell some
products at reduced prices in certain regions.
The idea of organizing the market in these terms was not born of an
obsession with accounting rules. Clearly, until the price system had been
allowed to function, it had been very difficult for private individuals to
import products. Argentina understood this and achieved stabilization in
a very short period, notwithstanding the backsliding that took place after
2000. In Peru and in other countries, the process has gone along at its
own pace.

70 The Real Modernizations


It was extremely interesting to notice the effect that prices exerted on
energy consumption. Indeed, consumption of gasoline dropped. On the
other hand, the use of coal, electricity, and firewood increased. It was, in
practice, a textbook case: how the price system is capable of creating
equilibrium in a crisis situation. The country broke its previous trend
toward an increase in oil consumption. Kerosene, a type of fuel
theoretically intended for the poor but in fact very commonly used by the
wealthy, gradually became less popular.
At first sight, this establishment of a price system seems relatively
easy due to its application to a tradable product such as oil, which enjoys
the reference of international prices. But it turned out to be far from easy,
owing to the lack of transparency in the subsidies and the way in which
the state enterprise established prices.
In the area of electricity, where competition is hard to achieve, the
task of establishing prices was much more difficult. In this, Chile was a
pioneer. The system created even predates the one implemented in
England to reform the sector in the eighties.
The challenge consisted in coming up with a price system and a way
to organize the electrical grid, so that rates would function as if
competition existed. This required great intellectual creativity, which
created a model that was later applied to reform the telecommunications
and the potable water systems. It is probably far from perfect, but it did
lay a good foundation, open to the sectors dynamism and to future
improvements.
The electricity rates reform got the market working right from the
start, as far as this could be done. In Chile, at least for large consumers,
there is freedom of prices and in service contracting. A large mining
enterprise can, for example, contract with different energy suppliers and
then have the energy sent to its industrial plantvia easementeven
through the transmission networks may have been built by a losing
bidder.
For smaller consumers, the system features an evaluation carried out
on a regular basis, which estimates the alternative distribution costs of a

Hernn Bchi 71
well-functioning company. This estimation is binding on the distributor
during a certain number of years, after which the evaluation is repeated.
Energy production costs of the energy, on the other hand, are calculated
through a much more complex mathematical model, based on marginal
cost.
This approach received no end of criticism. Why use a system, some
people asked, that is so complicated and hard to understand? That was a
strange reaction. Since when do consumers need to understand the
means by which the goods and services they purchase are priced?
Whoever wishes to analyze this can do so, but to argue that
understanding of prices must precede usage or consumption is absurd.
Must one understand how the electrical grid and a light bulb work in
order to turn a light on or off?
By implementing the new rates system, the government attained
much higher energy efficiency levels. Each individual and every
company knows better than any bureaucrat when and at what time it is
convenient to consume more electricity, as well as where, how, and at
what time it is convenient to save.
But the government went farther than simply rationalizing prices. It
also reformed the sectors corporate structure. In order to make the
system better reflect market reality, some companies were divided into
generators, transmitters, and distributors. The reorganization was far
from perfect, because political problems cropped up in the interim.
Endesa, the large electric company, was never broken up. It merely spun
off a few small distribution companies. But Chilectra (Compaa Chilena
de Electricidad), which is the private enterprise that distributes electric
energy, was divided into generation and distribution. Distribution, in
turn, was subdivided geographically. All of this work greatly simplified
the subsequent privatization of these enterprises. That was the aim of the
sectors restructuring process, which made it possible to put an end to the
arbitrariness that forced companies to charge higher industrial rates in
order to compensate for lower residential rates. The intent behind these
rate subsidies had been to benefit the poor, but it was the wealthiest who

72 The Real Modernizations


benefited more in the end. It is not the poor who consume the most
energy, yet they are hit the hardest when the economy stalls.
The work that we carried out in the electrical sector was very
gratifying. It was intellectually creative and managerially efficient. The
market reacted very favorably. Large consumers found that, practically
overnight, they had been granted the power to negotiate with companies
that previously were monopolies. Entire neighborhoods changed their
electricity consumption habits. Decade-long trends were reversed. Many
people reacted very negatively to the new winter rate, which was in
fact sound, since the excessive electricity consumption during the winter
monthsand especially after twilightmade it necessary to install
power stations to reinforce the system during peak hours. These rates
were a way of telling consumersobviously not the poorestthat
because they were turning on their electric appliances during these hours,
the company was forced to incur additional costs and that it was not fair
to pass on these costs to people whose consumption during those hours
was more frugal. Power consumption in wealthier neighborhoods
decreased considerably. To waste energy became costly. Importantly, the
additional charge was linked to a cost factor and not to a tax. Energy in
Chile, aside from VAT levies, cannot bear any further taxes, and this
prevents distortions in the allocation of resources.
Coal was a distinct and problematic case. Problematic because, in
spite of the energy crisis in the seventies and the high prices in force in
the sector, a large part of the exploitation of the Lota and Schwager
mines was still unprofitable. Major restructuring was necessary at both
mines. In addition, privatizing Schwager, the poorer of the deposits
whose layers were becoming increasingly thin, helped the process.
In the meantime, new deposits were discovered in the far south,
where, although the coal is of lesser calorific quality, the mines are easier
to exploit, and therefore extraction costs are lower. It was a special case,
because a serious effort was made to integrate coal into the general
mining system. Since in fact the most important assets were controlled
by Corfo, it was necessary to find investors who were not only interested

Hernn Bchi 73
in exploiting this resource, but who also believed in the stability of the
policies announced by the authorities.
Of course, the market cannot fix everything overnight, and enabling
and liberalizing markets is no easy task. In fact, the task is still
incomplete. The end of the story has yet to be written. There are still
issues pending, for instance, in the electricity sector. The government has
an important task ahead, not only to make the development of the
economy viable, but also to reinforce the credibility of the associated
institutional framework.
There has been significant backsliding in this area. Beginning in the
late nineties, the government began intervening unnecessarily in the price
system and in electric contracts. These interventions, still unresolved, are
at the root of the problems that the country faces today, which are
exacerbated by the ill-conceived interventions in the Argentine natural
gas market and by the global rise in the price of oil.

Forestry
The development of forestry during the military government is a very
good example of how implementation of the right policies allows a
countrys comparative advantages to emerge. Law Decree 701, issued
during the first years of the military government, set up a forestation
subsidy that was important in helping the development of the sector.
However, the key factor was the comparative advantage that the country
enjoyed in its forest industry, but that had been repressed by state
regulation. The subsidy was based on compensating for the difference
between the amount received by a private enterprise and the amount
received by the government, vis--vis the decision whether or not to
reforest. The level of public assets committed to this program was
sufficiently low as to make it justifiable as an incentive to employment.
Several of the arguments that initially surrounded the development of
policies in this sector can still be heard today in other countries. Was

74 The Real Modernizations


exporting logs acceptable? Should the government have required the
export of products with greater added value?
At the end of the day, confidence in the greatest possible
liberalization and in the market resolved these dilemmas. The market
performed extraordinarily well and there were periods during which
more than 100,000 hectares were planted in a year. The added-value
dynamics gradually prevailed, unaided by governmentsawmills, pulp
mills, paper manufacturing plants, and lumber mills thrived.
In some countries, the exportation of raw wood is forbidden. For
example, Paraguay has issued regulations to this effect. The rationale
behind such export bans is to favor the development of domestic
industry, but this mechanismwhich can be legitimate in certain
contexts as a means to promote industrializationis just as misguided as
is imposing high tariffs.
The impatience expressed by many people at seeing faster
development of the countrys basic industries than in newer, value-added
industries, such as the computer manufacturing plants they would like to
see in Rancagua or Chilo, stems from serious misunderstandings. How
does one determine nowadays what a basic industry is? Where is more
technology applied: in manufacturing athletic shoes or auto parts, or in
hiring teams of scientists to determine which pine species are the most
suitable for foresting a region? The evidence is irrefutable. When all is
said and done, a country that exports only lumber can be just as
technologically advanced as a country that exports paper or forestderived chemical products.
It is the market and entrepreneursthrough thousands of everyday
individual decisionsthat determine the routes to development. This is
what Chile did, and everything indicates that it was done well.
The charge that forestry policies did not adequately safeguard the
integrity of the countrys forests is unfair. Unfair because these resources
were previously exploited indiscriminately. Unfair because thanks to the
military governments policies, Chile actually began reforesting at an
impressive rate and recovering land that was suffering erosion. Unfair

Hernn Bchi 75
because, within the existing budget constraints, the administration did an
excellent job in the national parks through the National Forestry
Corporation (Conaf). Unfair because in order to protect the native forest
effectively, adequate incentives needed to be created. If citizens or the
government want to create forest reserves, there is nothing stopping
them, but naturally they must pay for them. Peoples appreciation of the
native forest should not work to the detriment of property rights.
Unfortunately, today the environmental movement has provided a
new home for opponents of the free market. Environmental protection
itself is a laudable goal, and there are people who have been advancing it
honestly for years. The world of nature is, by the way, one that I know
well, and few people can teach me anything in this area. I mention this
because these days too many recent converts to environmentalism appear
to have shifted from red to green with suspicious ease. These are
advocates of formulas that have failed in every place that they have been
tried, and who see in environmental ideology their last chance to gain
power in order to impose central planning. The Rio Earth Summit
(1992) was a sorry spectacle in this regard. When faced with evidence of
the planets environmental degradation, the last thing the environmental
experts will propose is to implement rules, regulations, and
mechanisms to make ecological recovery compatible with the market.
The same standards that were raised by the Chilean government in many
areascreating clear property rights and deregulating wiselycould be
used today to gain ground in this area, which has been beset by state
control and statist rhetoric. In this field, socialism has also been a failure:
environmental problems in the former Eastern bloc are far more serious
than those in the West. By the same token, it is not true that development
is the main culprit behind ecological degradation. Ultimately, the
problem turns up whenever incentives are distorted. It makes no sense
for environmental activists to ask for more state intervention to protect
the araucaria (monkey puzzle tree, national tree of Chile) or the pud
(South American deer), while turning a blind eye to the serious
environmental problems in Santiago and Valparaiso, which are derived

76 The Real Modernizations


from the poor sewage system and related to underdevelopment. State
enterprises or the treasury itself, it must be said, were responsible for
these problems.
Environmental protection is the area in which some of the most
serious institutional backsliding has occurred during the nineties and the
beginning of this century. We are all concerned about the environment,
but it is unreasonable that environmental protection should be at the
expense of prosperity. There is no worse environmental disaster than
poverty. The most polluted countries on the planet are, invariably, poor.
Today, a movement is gaining ground in Chile that sees development as
the problem. This movement focuses only on the possible negative
externalities of economic growthwhether real or imaginedwhile
ignoring the increased well-being and countless other benefits of
progressvia increased employment and improvements in health and
education. Unfortunately, the global discourse on this issue is not very
helpful. If we are unable to set up mechanisms that are more balanced,
respect private property, and be less prone to irresponsible demagogy,
the future of the country will be very much threatened.

Water Management
Government action in water management was guided by the same
principles as in forestry: to create solid property rights, not on the water
itself but on its use, and to make it feasible by all means at our disposal
for the market to operate in an orderly way.
The regulations issued made the distinction between consumptive
rights and non-consumptive rights. Consumptive rights apply to water
that is consumed and is therefore permanently extracted from the natural
water supply. Non-consumptive rights apply to water that is used but is
then returned to its source, in the way that hydroelectric plants function,
for example.

Hernn Bchi 77
The water issue suffered at the time from the same inertia that
hindered the development of mining. It faced the same arguments: that
water should be a public good that belongs to everyone, and one that the
state should be in charge of administering. Such rhetoric leads only to
squandering and underuse of resources. Where is the benefit for a farmer
who installs drip irrigation if he cannot then sell the water that he would
save with this system to a third party?
A full understanding of free market principles and mechanisms was
not easy to introduce in this field, either. Introducing these principles was
hard work, so much so that in 1992 the Chamber of Deputies reverted
reforms. These changes became law during President Lagoss
administration. The law establishes that the right to use water lapses if it
is not exercised for a five-year period. This cause for lapse seems
reasonable, but it reflects the same kind of motivation that in darker
times led to expropriations, whenever some government official
considered that the land was not being properly exploited. Again, the
same old story: the cause for lapse is based on the belief that government
officials know better than the market. This hubris has been proven a
failure the world over. Why would a government officials reasons
benefit the community more? If someone is not exercising his right of
use, it is because he is waiting for a better opportunity, which may
ultimately benefit the community more.
The debate on the use of water is relevant in many parts of the world.
In Mexico, several reforms were carried out in this area during the
nineties. In California, during the drought just before winter 1992, the
debate on local water rights did not even consider the private ownerships
of the rights to exploit this resource. The outcome of collective water
rights schemes is waste of water and a lack of incentives to invest. For
example, farmers end up sowing alfalfa, which uses up great amounts of
water, and discarding crops that could optimize the resource. The facts
are undeniable. The problem will persist until the market is allowed to
function. For this to happen, a full acknowledgment of property rights

78 The Real Modernizations


and of the rules is essential. That is the bottom line, even if in many
fields private property remains anathema to some.
The military government itself did not refer to property rights
directly. It referred to property of a concession, not to property of the
mine. It referred to property of water use rights, not property of water
itself. This reticence was absurd. Property is by far the best system for
safeguarding the social utility and correct allocation of resources. In
areas with strong institutional roots and a stronger tradition in favor of
privatization, this is widely accepted. But it is resisted in areas in which
the state has stronger influence. The less tradition, the greater the state
control. The electromagnetic spectrum, which was discovered at the end
of the nineteenth century, is illustrative. In this field, the only option
considered is the concession system. The state owns everything and only
grants concessions for use for a time and conditionally.

Fishing
In the fishing sector, the military government met only partial success.
The market was set in motion, products were diversified, a climate of
great competitiveness prevailed, and fishing companies took advantage
of liberalization to expand their business internationally. They exported
sea products in various forms for approximately $1.3 billion in 1992,
compared to only $15 million in 1973. Butand herein lies the
problemproperty rights were never satisfactorily defined. When goods
are relatively abundant, this may not cause serious problems. But when
the resources are at risk of depletionas is the case with some fish
speciesthe problem can become very serious.
I am convinced that if the government had found a way to define
fishing property clearly and solidly, the country would not have had to
ban fishing of abalone, due to overexploitation. The Fishing Law issued
during the final years of the military regimeand modified, after much
debate by the following governmentwas a belated attempt to amend

Hernn Bchi 79
the omission, but it was far from perfect and did not address the real
problem.
It is true that it property rights of fishing resources are a difficult
concept to convey. However, the Spanish conquistadores found it even
harder to define property rights over the waters of the Mapocho River, as
currents change constantly, and yet they finally managed to do so. The
challenge still stands. A system based on bans leads to distortions and
overexploitation. As soon as the ban is lifted, everyone rushes to extract
as much as possible before anyone else does. From overinvestment in
larger boats to industrial capture technologies, this is a very dangerous
and destructive zero-sum game. What I win, others losewhat others
win, I lose.
If the military government was only partially successful in defining
property rights in fishing, it was not only because this was a complex
task, but because a major mistake was made. The first efforts did not
acknowledge the participation and preference of those who were already
engaged in the fishing industry and had a track record to show for it.
When property rights are first defined in an area where they did not
previously exist, it is important to assign some value to the experience
and expertise of those already in the business. One cannot start from
scratch, and a basic sense of justice should make one wary of any statute
that treats someone who has been in the business for many years the
same way that it treats a newcomer. This was not fair, and it made
political consensus more difficult, thwarting better and more modern
regulations.

Telecommunications
The greatest difficulty in this area was setting the market in motion. One
would think that the challenge was relatively simple, having
accomplished what we did in the electricity sector. But here the issue is
more complex, because the country had fallen behind in this areaits

80 The Real Modernizations


technology was obsolete and its equipment antiquated. If the sector was
known for anything, it was for excessive regulations, prohibitions, and
cross-subsidies. This was the price that the country paid for state
interventionthrough price control policiesand for the Allende
governments nationalizations, which left Chile a laggard in the
technological development of telephony and telecommunications,
looking on while the developed world raced ahead.
There was another political problem of telecommunications being
considered as an area of high strategic national security value. Making all
parties interested in the sector including the militaryunderstand that
it was preferable, in terms of the countrys sovereignty, to have
telecommunications that were good, free, and modern rather than bad,
obsolete, and state controlled, was not a straightforward, instantaneous
process.
Although visualizing property rights in this sector was not that
difficult, the fact is that very little was done. In the case of cable
communication, things seem relatively simple. Introducing property
rights is harder, although not impossible, for communications requiring
use of the electromagnetic spectrum, as in television and radio
broadcasting. I have no doubt that as soon as the government auctions off
the spectrum to private ownersproperty right includedthe
technology required to split those bands into three, four, or even twenty
frequencies will appear, and the net asset value of that right will
multiply. But as long as property rights are not recognized in this field
everywhere, not just in Chilethere will be little incentive for such
innovation.
Television, which is privately run in most of Latin America, was
born in Chile under a state or para-state control modelthrough
universities that receive public fundsand only in very recent years has
it incorporated private participation. In truth, its programsgive or take
a couple of local idiosyncrasiesare hardly different from programs in
the rest of the region. In radio, on the other hand, the country has always

Hernn Bchi 81
had a strong private industry. Chile appears to be one of the countries
with the widest variety in radio programming, especially on FM.
The
basic
instruments
used
to
modernize
Chilean
telecommunications were the rates system and the regulations regarding
interconnection. These regulations succeeded in breaking the vicious
circle that made every natural monopoly into a legal monopoly. This
logic was the key step to liberalize the sector, open the telephone market,
create competition between companies, and, above all, recover the legal
concept of easements, which enabled a company interested in providing
services to use another companys infrastructure.
The problems arising from competition and from the overlap of
companies in the same geographic area are not easy to solve. It is much
simpler to have just one company. But I am convinced that competition
works even through simple presence. The governments role is to make
sure that the market works despite the difficulties involved. A natural
monopoly need not necessarily become a legal monopoly. On the
contrary, competition, even if only potential, should be the policy
makers main concern. The effort is absolutely worthwhile. The
incentives to deliver good service at lower costs are incomparably greater
in a market scenario.
In Chile, the telephone system used to be very inefficient. Waiting
lists to get a line installed were as long as the phone book. Just the fact
that the telephone market needed to be opened describes the absurdity of
the situation. If the state phone company had worked well, installing
telephone lines should have imposed practically no costs on consumers,
since companies profit from the use of the lines, not from any inability to
cover the demand.
There was constant pressure on the government to back out of all of
this. Until 1993, CTC and Entelone company delivered local telephone
service and the other long-distance serviceeach refused to let the other
compete on its own turf. This made no sense; multi-carrier technology
allows multiple long-distance providers to operate simultaneously. It is
up to users to choose the supplier that they prefer. Companies have no

82 The Real Modernizations


right to make the choice for them. It must be noted, however, that the
method and timing chosen to do this created a series of difficulties.
The modernization of telecommunicationsthe restructuring of rates
and dismantling of subsidies, both overt and hidden, paved the way for
the privatization of the telephone system. It was a pioneering move in
Latin America, which speaks highly of the military government, not only
because of the content of the policy, but because of the strategic
implications that it had for the military. It required great political will.
Privatization was unavoidable, because considerable investment was
needed and the state was in no condition to provide it.
At one point, it looked as though the entire privatization effort could
fall apart, because CTC was awarded to the Australian group headed by
the Australian entrepreneur Allan Bond. Not only was his offer the best,
but it also promised new investment, instead of external debt promissory
notes. The problem was that Bond, who founded his empire on credit, hit
hard times internationally and had to liquidate his investment in Chile.
Fortunately, the whole affair did not entail major consequences for Chile.
During the time that the group ran the company, a huge investment
program to modernize the sector and increase the number of lines was
launched. Getting a phone line was no longer a nightmare. Subsequently,
Telefnica Espaola, the runner-up in the bidding, took control of CTC.
On this foundation, Chile became the leader of cellular telephone
development in the region.

Transportation
In all areassea, land, local, long-haul, freight, and passenger
transport was an overregulated sector in which the state had accumulated
an increasing amount of power, led by bureaucrats who thought they
knew how to safeguard the interests of the public better than the market.
There was another problem: the constant pressure from transport unions
for more power. Fortunately, since the notion of property was quite a bit

Hernn Bchi 83
stronger here than in other fields, the governments first concern was to
get the market to function. Ports were the only area in which private
property was unheard of.
After selling the assets of the State Public Transport Company
(Empresa de Transportes Colectivos del Estado) in the governments
early days, and repeatedly postponing the total privatization of the State
Railway Company (Empresa de Ferrocarriles del Estado)which was
finally never carried through, perhaps because Chiles geography makes
railways less critical than in other placesthe task consisted of revising
regulations to make them market friendly. This was not hard to do,
because fortunately the sector was quite competitive by nature. However,
convincing the unions that competition, which they feared, would benefit
everyone in the long run was more difficult. Few union leaders could
understand that public transport working with competitive prices would
not be the end of the world. Older people remembered a time when
Chiles government had come very close to collapsing as a result of a
rise in the public transport fare to one chaucha (a 20 cent coin, in the old
peso currency).
In the end, competition worked. It worked well in freight transport
and in long-distance passenger transport. Local public transit, while not
optimal and inferior in quality compared to that of developed countries,
saw definite improvements in relation to what it had been twenty years
before. I say this because today there are those who cite deregulation of
public transport in Santiago as proof of the failure of free market
policies. One needs to have traveled on a bus the way most Chileans did
in the sixties and seventies in order to know what a disaster the system
was back then. The experience was almost degradingan obsolete and
inadequate bus fleet, vehicles that were dangerous to travel in,
insufficient routes, infrequent scheduling, terrible service. I have no
patience with nostalgia for the past in this area. I, like most Chileans,
experienced the public transport disaster firsthand. I spent all of my
youth hanging on to the steps of buses trying to get to school and later to
the university on time.

84 The Real Modernizations


What the military government did not do, admittedly, was to bring
the market into the use of urban space. Santiago is a city afflicted by
traffic jams. The military government made no serious effort to improve
the traffic situation. This was partly due to political pressure, and partly
because the logical way to have gone about this was to start with private
vehicles, then move on to taxis, and finally on to public transport,
following a scale based on social utility.
In the last few years, the Concertacin government decided to
improve public transport, by intervening in individual decisions
expressed through the markets. The outcome was Transantiago, a
recently launched public transport system that establishes that the
governmentnot the marketwill design urban bus routes. In addition
to burying the small private transport companies that served the public
years ago, and requiring millions in state investment in infrastructure, the
project has been disastrous and has not managed to satisfy peoples basic
transport needs. Workers, who often wait for hours to get to their jobs,
are the worst hit by this statist experiment.
On the maritime front, deregulation overcame difficult obstacles.
Often, monopolies are external, determined by treaties that impose
various freight restrictions. But nevertheless, the government reduced
their room for action to a minimum. Various adjustments were made in
order to establish competition in as many areas as possible. This was
done with consideration of the position of those in the sector who argued
that their real competition was with the rest of the world, but never to the
point of allowing monopolies that might eventually prevent our cargo
from leaving our ports. In the past, both imports and exports had to
follow a strict cargo reservation system and could only operate with
Chilean companies. That is no longer the case, although they must
comply with certain procedures, which to a certain extent are a
compromise with global reality. Shipping is affected by protectionism
and overly strict regulations the world over. In any case, cabotage
remained restricted to national companies.

Hernn Bchi 85
The most important problem that the military government met in
ports was labor related, and it translated into very high rates and anticompetitive regulations. For example, the rates system resulted in a
situation in which it made no difference to a ship owner whether he used
his own ships crane boom or that of the port to load and unload cargo. I
first discovered this absurdity when I joined the government in 1975. The
ship owners chose to use the port cranes, which were obviously
insufficient to serve all of the ships within an adequate time frame. This
circumstance created an urgent need to invest in equipment; I remember
how vehemently government port officials demanded it. The sector was
riddled with distortions of this kind. Behind each such distortion there
were always favors being handed out to the detriment of the majority,
while benefiting a specific person or group. Showing great resolve, a
government team headed by Miguel Kast ended the labor monopoly in
the ports and incorporated the port labor system into the one for all
Chilean workers.
Despite all of the reforms introduced in the sector, despite all the
improvements achieved in operations, considering that trade increased
five-fold in this period, and in spite of the important reforms introduced
in the sectors labor legislationa subject that will be taken up later
onthe military government was unable to create property rights or
privatize state-run ports. This final step was simply not taken.
Air transport went through a similar process as that of maritime
shipping, which in addition coincided with deregulation in the sector.
Industrial property and intellectual property faced a similar situation,
but in these areas the conflicts tended to be fewer and less intense
compared to those in other sectors. Consequently, the governments
critical mission was to deregulate. Quotas purported to prevent industry
overcapacity were scrapped. Chilean industrial legislation was overrun
with socialistic laws and regulations, many dating from the thirties. The
content of the regulations was openly interventionist, and it was my
responsibility, as sub secretary of Economy, to take advantage of the
passing of several miscellaneous laws and to advance toward their being

86 The Real Modernizations


revoked. Otherwise, the multi-target laws that were absolutely
instrumental would still be in force today, given the chance to eliminate
them without provoking too much political resistance. Those regulations
were potentially dangerous. In unscrupulous hands, they could have been
a death sentence for Chilean industry.
When the economy was centrally planned, when almost all prices
were controlled by the state, when the authorities decided who could
import and who could not, when the state owned countless enterprises,
the Economy Ministry was a colossal source of power. All of this was
dismantled, beginning with the unconscionable prerogatives bestowed on
the Industry and Commerce Office (Dirinco), the agency in charge of
price control, and with the complicated regulations that strangled foreign
trade. Some criticized the government for not having an industrial policy,
but that criticism could not have been more mistaken. Everything that the
government did in this area was geared toward a different industrial
policy, one that was non-interventionist and designed with a view to
exploiting the countrys comparative advantages. In my long personal
experience in the pharmaceutical, capital goods and transport equipment
areas, among many others, careful, painstaking effort was made in all of
them to keep either the tax system or the tariff system from preventing
the development of activities at which Chilean businesses could excel.
This was not coarse work. It involved much fine-tuning. It was not
just a question of eliminating controls, but also of correcting distortions.
These included, for example, the tax regulation that made it more
profitable for a businessman to import a machine than to buy the
technology needed to build it in Chile, or the tax rebates on supplies and
capital goods for exporting manufacturers who bought from local
suppliers. These support industries are very important. Underestimating
them is a mistake, because such carelessness can transform a welldevised industrial policy into an anti-industrial policy with obstructive,
harmful implications. From my point of view, they are a necessary
complement to the industrial development framework, which tariff and
exchange policies that favor opening-up provide naturally.

Hernn Bchi 87
Government Reform
On reviewing the modernizations introduced into the states
provision of infrastructure and public works, the importance of having a
system by which to evaluate public investment projects stands out. The
military government, through Odeplan, in collaboration with the
Economics Faculty of the Universidad Catlica and especially with
professor Ernesto Fontaine, created a complete system for the economic
evaluation of projects that, because they were financed and run by the
government, were not subject to the automatic profitability control that
surrounds private projects.
Thousands of government officials, from a wide range of agencies,
were trained in project preparation and evaluation techniques. This was
done so successfully that to this day it is not the governments
specialized agency that evaluates projects, but the officials of the public
institutions who themselves facilitated the investments, with Odeplan
acting solely as inspector and regulator. This model has been transferred
to other Latin American countries through state-financed courses run by
the Universidad Catlica and through the work of international entities
like the United Nations Development Program and the Latin American
Institute for Economic and Social Planning, which finance the training of
public officials from various countries in these techniques, with the
participation of Chilean consultants. A framework for private financing
of public infrastructure projects exists in Chile today, thanks to the
approval of a concessions lawa positive move made by President
Aylwins government that emerged from this task.
In this same area, regionalization, which began through studies
carried out by the State Administrative Reform Commission
(CONARA), was an important step toward decentralizing government
activities. This brought people closer to governing institutions by
creating regional governments. An essential complement to this was the
redefinition of the role of municipalities, which were provided with
greater financial resources at the expense of central government, to

88 The Real Modernizations


enable them to carry out the new tasks assigned to them. In addition, the
decentralization in health and education farther down the road would
hand them new responsibilities and new resources.
But the reform of the state went even farther. It is a huge task that is
never done. Multiple administrative reforms were carried out in all
sectors. They affected diverse areas, from tax administration to the civil
registry system, from defense and security to certain aspects of justice
administration, from the management of public enterprises to the way in
which state assets were made available to the private sector during the
privatization process. In some areas, such as justice, the task has only
just begun, but that does not make the efforts already made any less
remarkable. A complete account that adequately acknowledges the
contributions made by all of those who took part in Chiles government
reform process requires a whole book.

CHAPTER FIVE

Work, Capital and Freedom


Each of the reforms carried out during the countrys modernization phase
were part of a program whose goal was to lead Chile toward
development through a market economy. But these reforms also arose
out of opportunities, circumstances, and special situations that no one
could foresee.
Just as in the lives of individuals, there is a time for each initiative
and each experience. Little is gained by attempting to do things ahead of
their time. On the other hand, it is hard to make up for things not done at
the right time when it is too late.
In this respect, circumstances have a huge influence. Could there
have been reform in the former Soviet bloc before Lech Walesa in
Poland, and others in the rest of Eastern Europe denounced their leaders
as not representing their interestsif those governments had not faced
international pressure? Could property rights have been established in
mining if the Constitution had been slightly less biased toward the state
on this issue? Was this not, in fact, the factor that created a general
awareness among government officials that the situation was
unsustainable over time? Would modernization of the ports have been
possible had freight and landing costs not reached the unmanageable
levels that they did, bottlenecking the external opening-up policy?
It is therefore not so strange that the government should have
achieved sustained modernizations, starting out from the points
previously described. Every reform has its time, and it is up to policy
makers to perceive when this time has arrived. This is what overly
conservative and bureaucratic governments never notice, because they
are unduly averse to change and innovation.

90 Work, Capital and Freedom


The Labor Market
Airplanes remain airborne because they reach a certain speed. If they
lose enough velocity, they fall out of the air. This is one of the first
lessons that pilots in training learn. However, when an aircraft loses
speed and altitude, peoples natural instinct is to try to lift the plane,
putting all their effort into getting it to climb. This reaction is
catastrophic, because if the plane is falling steadily, what one actually
needs to do is not try to lift it, but make it fall even harder so that the
increased speed allows it to recover lost altitude quickly. Needless to say,
this requires having some margin for action. If there is none because the
plane is too low, perhaps the best that one can do is to say a quick prayer
while looking for a spot to make an emergency landingat that point,
the pilots life is in Gods hands more than in his own. This lesson
should be mandatory not only for aviators, but also for social and
political leaders, especially in the field of labor.
Many labor leaders believe that wages will rise higher the more they
battle against employers. This is like the pilot who, when his airplane is
in free fall, tries to point it toward the skywhen he is not even certain
where the sky actually isas if this were enough to stop the fall. It is just
as misguided as the belief that wages can be improved as much as one
wants with the backing of a generous law coupled with strict
enforcement. Some honestly believe that workers are better off
renouncing their individual freedom in order to negotiate en bloc and
face employers from a much stronger position.
None of this is true, however. Confrontational war with a company
yields not better, but worse wages. Real wage increases come about not
because of laws mandating them but from increased worker productivity.
It is highly improbable that a worker will win anything by resigning his
freedom. In fact, there is a good chance that he will lose, because salaries
negotiated by a union will tend to reflect the companys mean
productivity, which means that all those above this level will have to

Hernn Bchi 91
settle for less. This is the best way to kill any incentive to improve and
the best way to neutralize the motivation for individual creativity.
The dogmas of trade unionismthe unity of workers against
employers at all costs, the loss of individual freedom for the benefit of
the group, and the maximization of the political power of labor unions to
improve their negotiating capacityderive from a combination of errors,
distortions and myths. Nearly all of those who shaped labor legislation
during the twentieth century have subscribed to these grave errors to
varying degrees. It is no accident that these distortions are cultivated with
devotion by Marxism.
Truth lies precisely in the opposite direction. Workers will do well
only if the company does well, if the economy is growing, and if new
work opportunities arise on a permanent basis.
For this to happen, freedom and flexibility are fundamental. Without
freedom and flexibility, economic growth is impossible. The security and
stability that people seek will yield to stagnation and instability when
those goals are sought through coercive and collectivist means. The
attempt to nail down the wheel of fortune only leads to nailing the
country down to economic prostration and poverty.
This being the case, what labor legislation must safeguard is the
freedom and flexibility to adapt to changes in the market, since this is the
waythe only wayin which workers interests are effectively
protected. It has been proven that measures whose primary goal is to give
workers greater stability always end up harming them.
Labor legislation should be limited to fulfilling the objective to
which all laws adhere: to preserve as much as possible of the tradition,
the natural sense, and common practice of social and economic activities,
while establishing mechanisms to address future conflicts that may arise.
This is what sets the path for progress. The laws themselves need not be
progressive, only functional and fair. The energy that drives progress
comes from the people, not the laws.
Regulations that undermine job mobility or make it mandatory to
belong to a certain union are completely counterproductive, both for the

92 Work, Capital and Freedom


workers and for the union organization. Freedom of association should
be a non-negotiable principle in the world of labor policy. The union
may represent its members in good standing, but only insofar as they
have adhered freely to it, rationally weighing the freedom of action that
they give up against the material benefits that they can gain. In this
aspect, nominal freedom is not enough. In several Latin American
countries, the law stipulates that admission to and membership in a union
are free decisions to be made by each worker. But what good are such
laws if, for example, access to company pension programs and other
benefits remain tied to union structures? In many countries in the region,
freedom of association remains an illusion, because of the collusion of
politically powerful union and business leaders.
Compulsory unionization is harmful, both to economic performance
and social welfare. In the American experience, which is often invoked
in favor of openly interventionist labor laws, economic growth has
shifted from the states that are overregulated in labor matters to those in
which there is greater freedom in this field. A federal country can afford
this and ultimately has this escape valve. It is true that in some American
states a large part of labor legislation is permeated by inflexibility, but
these states should not be considered a model for anybody. The outcome
of these experiences many times lies in that, despite the regulations,
those states have managed to succeed because of the dynamism of a
federal economy, with the scarcity of labor like what happened in
European countries for an extended period or for other reasons
unrelated to labor legislation.
Reform of the Chilean labor market was carried out based on three
principles: full freedom to work, ample freedom of association, and
collective negotiation within the company. Union leaders resisted the
three principles vehemently, because all three threatened their political
power. There was also a threat of an international boycott in 1978, which
would have meant, among other things, the refusal of port workers
around the world to load or unload merchandise to and from Chile. In the

Hernn Bchi 93
long run, this threat benefited the government, inasmuch as it made the
need to liberalize the labor market more urgent.
The effect of the extensive labor reforms introduced into legislation
was soon felt in the marketindividual work contracts, collective
contracts, trade unions, use of contractors and subcontractors, collective
bargaining, and the right to strikewere secured. However this was done
at company level and without restricting the employers right to continue
operating his company with third parties if necessary. Until 1973,
employment in Chile grew basically as a function of the growth of the
public sector. The economic liberalization launched in 1974 marked the
beginning of change in the nature of the workforce. Later changes
brought about by the liberalization of the labor market were beyond what
anybody could have imagined. Chile, at the time that I left for the United
States for my post-graduate studies, was a rigid country, where the only
major employer was the state, and university-educated professionals
positions were virtually guaranteed. In the country I had helped to
change, these things already belonged to the past by the time I returned.
Another problem was caused by the 19821984 debt crisis, which
led to high unemployment throughout Latin America. Wages fell as well.
But in the medium term, they fell less in Chile than in Mexico and other
countries in the region. Contrary to what some demagogic critics
suggested, the situation had not been brought on by liberalization. By
1985, when the opposition held that Chile would not be able to leave
two-digit unemployment behind, the facts quickly proved them wrong.
By 1989, the country had a 5 percent unemployment rate. This recovery
would never have taken place under rigid socialistic labor legislation.
The stubbornness of the opposition on this matter was enormous.
When, as a presidential candidate in 1989, I put forward the goal of
creating a million jobs in four years, my opponents said there would not
be enough Chileans to fill those jobs. Between 1985 and 1989 an average
of 239,000 jobs were created annually, which was unprecedented at the
time. One million new jobs in four years were certainly achievable.
However, plenty of people remain out of work, and there are thousands

94 Work, Capital and Freedom


of Chileans who should be joining the ranks of the labor force. The
countrys

active

working

populationcurrently

around

35

percentneeds to continue to grow in the coming years until it


represents at least 45 percent of the population. Greater flexibility and
vision are still needed in order to advance in this direction. What matters
is not just the people who are working today, but also those who could
join the labor force in the future. Rather than set up obstacles that
interfere with employment in export agriculture, which is largely
temporary, ways should be found to enable more peoplemainly women
and young peopleto participate in these tasks, in order to bolster the
countrys competitiveness. Why not, for example, consider a change in
school holidays to suit local needs?
Within the labor reforms accomplished during the military regime,
the ports reformcarried out by Miguel Kastwas critically important.
A monopoly of scandalous measure had prevailed for years in this staterun infrastructure, favoring workers who were licensed to work in ports.
The conditions and benefits that they had obtained were so favorable that
many actually hired other people to do their work for a fraction of their
wages, which was still an attractive option to them. There were
exceptions, of course, but not enough to alter the big picture, because the
overall situation was undoubtedly scandalous. It was enabled by state
control, since the ports belonged to the state, and by the economys
apparent insensitivity to the costs of this absurd labor structure.
Essentially, the people who paid the cost of these labor privileges were
the farmers and agricultural workers whose products became much
harder and costlier to export because they could not negotiate with the
port workers. The negotiation was done by the shipping agent, who in
turn passed on the costs to the exporter or importer. The costs were so
high that it was impossible for ports to work a third shift, which meant
that a third of the countrys port capacity remained idle.
This was the situation in Chile, and it is a situation that still exists in
many other countries. This is why the ports reform issue should be on the
agenda of all governments committed to economic liberalization. Above

Hernn Bchi 95
and beyond the content of the political decision, the dismantling of union
privileges in Chiles shipping industry included compensation for those
affected. This cost the country around $50 million, but the expense was
worth it. However, the matter did not end there. Old habits die hard, and
so many privileges remain entrenched today.
After moving in one direction for decades, turning in the opposite
direction is not easy. It is not easy to internalize that yesterdays truths
and core concepts were mistaken. I remember a question asked by a
Chilean labor lawyer to a government official in Hong Kong during a
visit by a Chilean government and business mission to that country in the
late seventies. They showed us impressive evidence of the economys
dynamism, and the lawyer asked, Yes, thats all very well, but what is
the minimum wage and where are the laws protecting workers? The
official, without batting an eyelid, answered with another question: Do
you want us to suffer unemployment? With the enormous amount of
Chinese immigrants that we have annually, and the terrible poverty
conditions in which they come to our country, our challenge is to expand
employment, not obstruct it.
Even though I cannot help but believe that many union leaders will
eventually come around, I am not particularly optimistic regarding the
future of labor reform in Chile. The foundations have already been
undermined in some fields; for example, today it is possible to have
sector-side collective bargaining, which in a small and open economy
such as that of Chile can be very damaging.
On the other hand, some projects presented in Congress during the
Concertacin government give cause for apprehension, as do the actions
of labor authorities, based on certain potentially damaging administrative
interpretations. Unfortunately, the tendency to grant by law benefits that
only economic growth can provide remains deeply ingrained in the
countrys political class. Today, pressure groups remain very powerful
and have extraordinarily effective weaponstheir organizational
capacity and the public perception of them as representatives of the
downtrodden, which is far from true.

96 Work, Capital and Freedom


Against the labor leader who knows only how to maneuver his
people politically, a new, kind labor leader is often at a disadvantage. It
is difficult to get the rank and file to understand that conditions have
changed and that wages depend not on ideological slogans, but on
training, increased work productivity, expertise, and the contributions
that workers as a whole make to the company.
However, the evolution of industrial activityits increasing degree
of technological specializationis transforming work throughout the
world into an increasingly individualized experience. Collectivist labor
systems are on the way out. This explains the decline of unionism
worldwide. Companies do not maintain collectivist relationships with
their workers. Therefore, the times have bypassed the old union models
that are supported by the Marxist idea of class struggle. In the new
scenario, the companys relationship with its people is increasingly
sensitive to the individual skills, professionalism, character, and
motivation of each individual.
The sole aim of the liberalization of the labor market was to open it
up to the responsible decisions of individuals. Finally, the direct
agreements made between workers and managers began to matter and to
influence the inner workings of companies, the natural space for labor
relations to play out. Both parties became independent, free agents.
Collectivist labor arrangements fell, and relationships evolved from rigid
to flexible.
If this change was important socially because it took labor
relationships to an individual level, economically it was critical. Chile
would not have been able to become what it is with the privileges and
rigidities that used to prevail in this field. The reforms invested Chilean
companies with a competitive spirit. This is precisely what an open
economy impliesopenness, plurality, competition, non-discrimination,
and freedom of choice in the widest sense.
The inflexibilities, artificial barriers, safeguards, and privileges not
only limited the freedom to contract and the freedom to work, but also
became breeding grounds for inefficiency and lagging productivity. This

Hernn Bchi 97
concept was very hard to advance politically, because it meant
transferring power from the union leadership to the people, while it also
involved dismantling the false social gains obtained at the cost of
inequities and disadvantages imposed on the least powerful and the
poorest.
Labor reform vindicated the freedom to work in a comprehensive
sense. The changes in labor legislation were complemented with
resolutions to further freedom of association and to do away with
mandatory association as a requirement for employment, giving shape to
a set of regulations appropriate to a truly free society and a truly open
economy. The right to work was reinforced by eliminating the number of
registrations, identification cards, and licenses established by political
pressure over the course of many years. The task was neither simple nor
well understood, but it benefited millions who found a job. The
backsliding in this area, which has occurred gradually throughout the
nineties and this decade, partly explains the reduced dynamism in the
Chilean economy after 1997. This is why, in spite of economic growth,
the proportion of the population that is active in the labor force has not
increased as it would have if the pro-employment vision had been
sustained. This has serious negative consequences, especially for the
younger, lower-income population and for women.

Pension Reform
The pension reform, launched in 1980, is related to both labor reform on
the one hand, and to the capital market on the other. In Chile, the pension
system had so drastically severed the connection between work and
benefits that retirement contributions had become a tax on work. In some
cases, contributions were as high as 60 percent of wages.1 In theory, this
correlation gap should have advanced the social welfare goal of
1

Cheyre, Hernn. La Previsin en Chile: Ayer y hoy.

98 Work, Capital and Freedom


benefiting those in greatest need, but that was not what happened. The
workers in the worst situation were precisely the poorest, and were also
the Social Security Service contributors. These workers represented 65
percent of the contributors and, while other groups were entitled to retire
at 42, the workers who performed the heaviest physical tasks could not
retire until they were 65and in addition received a sum that was below
the taxable income2.
The people who benefited the most were those with the greatest
political clout, beginning withno surprise heremembers of Congress.
The inequity of the system, in addition to shameful discriminations and
privileges, showed up also in terms of a financial shortfall, which meant
an inequity between generations. A consequence of this was a sustained
increase in pension contributions, reaching 60 percent of a workers
income in the case of private employees, with very serious consequences
on the level of formal employment.
The military government decided to tackle the matter at its roots, and
started out by correcting the most obvious deficiencies, inequities, and
distortions. This preliminary cleanup was necessary in order to
reorganize the system as much as possible and neutralize the pressure of
organized groups attempting to obtain privileges, a race in which
everyone took part, even while aware that it was materially impossible
for everybody to succeed.
Even though the pension provision situation was similar to that in the
rest of Latin America, in Chile things had reached an apex in terms of
state control, irrationality, and injustice. The system was unsustainable
owing to the number and the magnitude of perverse incentives that it
contained. These incentives yielded effectsunderstated income tax
returns, constant pressure to obtain benefits at the expense of others,
depletion of the systems technical reserves on homes sold to a lucky
few, long-term plans with no readjustment clausethat would ultimately
lead the system to ruin. For each pensioner there were only two-and-a2

Lus Larran. Soluciones Privadas a Problemas Pblicos, p. 16.

Hernn Bchi 99
half active workers. This ration, combined with other deficiencies in the
system, inevitably meant that the vast majority of workers were retiring
on very low pensions. In a population whose life expectancy was
increasing, there were ever fewer active workers financing each
beneficiarys pension. While in 1995 there were 12.2 active workers for
every pensioner, in 1979 only 2.5 active workers financed each
pensioner.3
Politically, that may have been the hardest part of pension reform,
because what people thought of as the root of the crisisthe miserable
level of pensionswas not really the root but the consequence of the
problem, and therefore very difficult to solve for current pensioners. To
begin with, it had nothing to do with a pension reform, because pension
reform simply means devising a system free of perverse incentives that
could jeopardize it in the future. To fix problems in the old system,
policy makers have no room for action outside the political and tax
expenditure decisions they make, based on the tax resources generated
by economic growth.
In addition to discouraging saving and considerably raising the cost
of labor, the old pension system also weakened the private measures that
people would take to anticipate possible emergencies and times of need.
In the end, the magnitude of pension contributions reduced workers
savings capacity even more, and the system ended up nationalizing most
private savings. But the problem did not end there, because everything
was set up for the state to transform those savings into spending.
The route chosen by the military government to carry out the pension
reform had three major elements.
The first consisted in introducing some rationality into the old
system. For example, equitable age requirements for retirement were
established and privileges were eliminated. A case in point are the
pensions known as perseguidoras (chasers), which granted some lucky

Estudio de la Reforma Previsional: Previsin Social Chilena

100 Work, Capital and Freedom


pensioners the income and the adjustments corresponding to his former
position, as if he were still actively employed.
In exchange, all retirees gained a permanent, general adjustability
mechanism, which had previously been lacking, and which restored the
purchasing power of pensions when inflation exceeded a certain range. A
decade after the reforms implementation, the numbers confirmed that
the new pension system paid a higher average pension than did the old
system. The relative factors were 1.4 in old-age pensions, 2.2 in
disability pensions, 1.5 in widows pensions, and 1.4 in orphans
pensions.4
It is ironic that precisely the same government that to this day is
attacked for not having granted a 10.6 percent adjustment in
1985which by the way nobody received, neither the public sector nor
the military nor any other sector, and which the same government later
compensated for with automatic adjustments for the poorest
pensionerswas the one that created the automatic adjustment system
for retirement pensions in Chile. This system did not exist before then. It
was created, not by any one of the governments that made shallow
promises about redistributing wealth, or that proclaimed themselves
saviors of the poor. It was created by the military government. So it is
asinine that the same political factions that wreaked havoc with pensions
and whose inflationary policies relegated the vast majority of Chilean
pensioners to minimum pension levels should continue to present
themselves as advocates of pensioners. Not only did they never defend
the pension system, but they were responsible for the miserable state in
which it ended up.
I remember an especially unpleasant incident just before the 1989
presidential campaign. I was on a bicycle and was accosted by an elderly
retired man who reproached me for his problem with that 10.6 percent
readjustment. He had just argued with his wife, he said, over money. He
looked not only irritable but also bitter. But he refused to listen to reason.
4

Boletn Estadstico Mensual S.A.F.P.

Hernn Bchi 101


He hardly even let me speak. An impoverished old age can be a very sad
experience, which the old Chilean pension system imparted with no
compassion whatsoever. It was not the government during the eighties
that was to blame for the situation, but rather its predecessors.
The second component involved the government gradually reducing
the tax on work that was implicit in pension contributions. Benefits were
no longer financed by pension funds but by general tax revenues from
the national government. Employment benefited from these changes.
Naturally, in order to make them, first the tax and collection systems had
to be improved and government spending cut.
The third element arrived at the comprehensive solution: a top-tobottom structural overhaul of the pension system. The governments first
victory was its ability to separate benefits for old age, disability, and
family group survival from the rest of the social security program
including health, workmans compensation, welfare, death benefits, and
personal loans. Mixing different systemsfor example, using pension
funds to finance health benefits or to provide workers with credit to buy
their own homescan lead to nothing good.
The new pension system, with freedom as its guiding principle, is
founded on the individual responsibility of each worker, reflected in his
own savings capacity and his own individual account, and in the private
administration of the funds by properly regulated companies, known in
Chile as AFPs. At the time, banks were expressly barred from managing
pension funds for reasons related to their vulnerability in the early
eighties.
Initially the investment portfolios managed by the AFPs were
restricted by wariness toward the management of pensions by private
companies. However, over time, the investment of pension funds in the
more firmly consolidated companies stock was authorized. Therefore, in
the long run, the increase in the price of stock benefited all of the Chilean
workers, through high returns on their retirement funds. Currently, the
AFPs are authorized to invest abroadwith certain limitationsboth in
stock and in other financial products.

102 Work, Capital and Freedom


The system, on the other hand, provides a social safety net. The state
supports it by guaranteeing to supplement workers savings in order that
pension holders who have not managed to accumulate sufficient
resources in their accounts but comply with certain basic requisites
concerning years of contribution, will collect a minimum pension at
least. This minimum pension is completely unrelated to the pension
granted by the State to pensionless elderly people on the verge of
indigence.
The system provides adequate incentives for exercising individual
responsibility. If a person wants to retire before reaching the required
age60 for women and 65 for menhe or she will need to save up
more money. If his job involves heavy labor, the worker can make
arrangements with his employer for a higher pension contribution. Also,
individual pensioners are entitled to choose the AFP that provides them
the best terms and service. Competition between institutions is a key
factor to ensure that they aim at greater efficiency in their administration
of the funds.
On the whole, the new system redirects decisions that until then had
been political into the individual sphere, which was precisely one of its
objectives.
As a Russian economist who was visiting Chile some time ago
pointed out to me, in a perfectly libertarian society, there would be no
need for a government-imposed retirement system, since there would be
no reason for the state to interfere in peoples private decisions. How he
or she wants to face old age would be up to each individual. Some may
prefer to start from a very early age and save much more than 10 percent
of their monthly income. Others might be less apprehensive about the
future. There may be a point in this argument, but not within current
political reality. Today, for better or worse, people have already removed
these matters from their realm of decision and believe that creating a
good retirement system is a government responsibility. This is an
undeniable political fact that every government must deal with. Things

Hernn Bchi 103


may be different in the future, but in the meantime, utopian libertarian
scenarios are bound to remain just that.
The military government did not impose reform by force. Granted,
the law creating the new system was enacted in the same way that all
laws were generated during that period, but joining the system was
voluntary. It must be noted that the incentive to transition into the new
system was very strongnamely through an increase in liquid salary
owing to the changes in retirement contributions and a bonus that
recognized the contributions made into the old system. The efficiency of
the new system made these things possible.
With the reform, the government completed its efforts to reduce
pension contributions in the old system to a reasonable level, at which
they were no longer a tax but an equitable contribution in relation to the
benefits that they guaranteed. Besides, in both the old system and the
new, contributions were now paid from the workers wages, and to this
end, gross remunerations were increased. The cost for the employer,
however, was still basically the same. The change was important in
allowing the worker to feel that it was his own money that he was saving.
The interesting thing about the reform is that, in addition to
introducing efficiency, rationality, and justice in an area sensitive to a
societys welfare, it also helped create a substantial private capital
market.
The system, as noted, became more flexible over time. At the
beginning, the range of investment options for pension funds was very
limited. Later on, these options became more varied. During his whole
working life, the worker saves into his AFP individual accountwhich
he can transfer from one company to another as often as he wants to
and at the end, among other alternatives, he can opt for a lifelong annuity
to be paid by an insurance company. Management by insurers was
suggested early on, but the idea was dropped, mainly because the scope
of this participation is not the same in a compulsory savings system as it
is in a retirement system. It seemed crucial to safeguard peoples

104 Work, Capital and Freedom


freedom, anticipating that hasty decisions made while they were young
could be very costly in their old age.
In countries in which private and compulsory pension funds already
exist, initiating a reform similar to the one carried out in Chile may of
course create some complications. But it is not hard to visualize good
formulas for adjustment and coexistence in terms of each countrys
circumstances. This is what countries such as Mexico, Argentina, and
Peru did in the nineties.
The Chilean pension reform has completely fulfilled its objective,
especially regarding incentives, which today are well structured. The
fears that pension funds would become easy prey to rapacious capitalists
were completely laid to rest. In the case of embezzlement, there is no
comparison between the new system and the old, which was a constant
source of scandal and allowed fraudsters ample leeway for impunity.
Doing away with the tax on work revitalized employment. In addition,
the system created an ample market for savings, close to 35 percent of
GDP in 1993. It is true that the Central Bank, for macroeconomic
reasons, absorbs a significant part of these resources, but the difference is
that it now absorbs them in a competitive system. The issuing institution
must now compete for these resources.
The foundations of the system are perfectly applicable in any
country, as long as the role of individual responsibility is recognized and
as long as the retirement system remains independent of politics. Every
nation can adjust the system to its own circumstances and development
level, but the basic structure is universally valid.
Strangely enough, certain institutions, such as the International
Monetary Fund (IMF), were somewhat skeptical of the Chilean pension
reform. It is to be expected that the implementation of a reform this size
will generate a greater fiscal deficit. In effect, when workers transfer
their funds to the private sector, the Treasury loses part of its income,
which was anathema for the IMF. The real problem arises when the long
term is not considered, and when the truly important variable is not taken
into account: that domestic saving should not drop, so therefore

Hernn Bchi 105


incentives should be created to make it increase. This can be achieved
through increased private savings, even at the expense of somewhat
greater fiscal deficit, because the treasury can still resort to the capital
market to obtain the resources that it forfeits.
Chiles decision was different. The idea was to modernize the
savings market and privatize itthat is, to make it responsive to the
individual decisions. At the same time, to maintain and even improve the
level of domestic saving, the level of government spending was cut. In
economic terms, what the Chilean government did was to create private
savings and to fully neutralize the increase in the fiscal deficit by
restricting state expenditure. The purpose behind this was to increase
private domestic saving. Depending on the specific situation of the
economies adopting this strategy, the compensation that was necessary in
Chile may not be necessary or may be only partly necessary elsewhere.
The military and the security services were not incorporated into the
new system. The reform always met opposition from the military, mainly
for two reasons. The first is that military institutions need to operate
under strict secrecy, because they are exposed to special risksincluding
combatand have different promotion and retirement systems. It is true
that their situation is not the same as that of civilians, but there is nothing
to stop the development of adequate mechanisms that would ensure that
the system could handle these particular circumstances. For example,
there is nothing to prevent the creation of a special bonus to supplement
the funds of someone who retires early from the military. The second
reason, which was the one that led to deciding against further attempts at
persuasion on this issue, was related to certain barriers of distrust that
added to the pressure from multilateral lending organizations against
generating a larger deficit. In retrospect, this imbalance was handled
well, but it seemed advisable at the time to be prudent in the face of
uncertainty and to take all of the necessary precautions to avoid
exacerbating the potential conflicts. In the end, the military continued to
operate within the old system and to that degree, they are today more

106 Work, Capital and Freedom


vulnerable to governments political decisions than is the reformed
sector.
The effects of the pension system reform are still developing. Within
the next two or three decades, the structure of Chilean social expenditure
should vary substantially. The country will have greater leeway to
allocate resources to the needier sectors. Because the pensions from the
old system, which today are by far the largest item in the countrys social
spending budget, will gradually disappear. There will always be
pressures from retirees, but they will not be as important or as urgent as
they are today.
The pension reform, led by Labor Minister Jos Piera who had
previously led labor law reform, was not conceived with the idea of
building a rigid, fixed structure. The reform was intended as the starting
point of a modernization process that would be open over time to
successive developments. Full development of the pension system will
take time. It behooves the government to gradually adjust it to the
development of the domestic capital market and to its increasing
integration into the international market. There is still much to be done
toward achieving this, while consistently preserving the basics of this
important modernization. The day may come when individual
responsibility will be so deeply rooted in the population that, as the
Russian economist believed, compulsory pension provision will no
longer make sense. Unfortunately, since 2006, proposals have been
introduced that would undermine the very heart of the system of
incentives for retirement savings. Should these ever be adopted, they will
create long-lasting harm down the road.

The Capital Market


The capital market plays a crucial role in the allocation of the economys
resources. It transfers savings into investment and enables the flow of
many peoples capital into large-scale financing programs.

Hernn Bchi 107


For obvious reasons, both roles have traditionally been very dear to
the political class. The capital market, like the labor market, can be a
huge source of power that socialists firmly believe should be controlled
by the state. They mistrust individual freedom, assuming that individual
interest is at odds with the common good, and instead place their faith in
political leaders.
It is no coincidence that one of the Allende governments first tasks
was to impose state control over banks (nor is it a coincidence, incredible
though it may seem today that the nationalization of the banking system
in France was one of earliest decisions made by Francois Mitterrands
government, 19811995).
Expropriation and nationalization are not the only ways to control
the banking system. Government can also yoke it though onerous
regulations or by nationalizing savings. This had happened in Chile long
before Allende came to power. Savings existed, but they were not
private. Banks existed, but they were little more than cashier windows
for the Central Bank. The issuing institution granted them financial
backing and instructed them on where to allocate resources and what
interest rates to apply. More often than not, these rates would be negative
in real terms.
Inflation, on the other hand, also obstructed any possibility of
developing a significant capital market. This is the problem that many
Latin American countries with a long history of monetary instability are
facing today. High inflation rates are the death of any capital market, and
there are only three ways to fix the problem: by eliminating inflation
entirely, with people being convinced that this has been achieved;
through indexation, as Chile did; or by full dollarization, as Argentina
did under Finance Minister Domingo Cavallo, and as other countries,
such as Peru, have also done.
To rebuild the Chilean capital market, the government acted on three
fronts. It privatized everything that the socialist government had
managed to expropriate or control, thus reestablishing clear property
rights in the financial sector. It shifted control of savings from

108 Work, Capital and Freedom


predominantly public to predominantly private. Finally, it encouraged
competition by amending regulations that restricted financial institutions
operational spheres to absurdly narrow extremes, which prevented
financial institutions from attracting investment in a competitive manner,
from paying and charging real interest rates, and from allocating credit
based on risk and profitability.
The deregulation of the Chilean financial sector ran parallel to the
implementation of new modernizing regulations, and comprised several
stages.
The initial stage involved complete liberalization, and there were
even some informal financial companies in operation. The first
monetization of the economy took place during these years. People who
previously bought a car or an apartment as a way of protecting their
savings from inflation now took their money to the bank in order to be
paid interest and readjustments. However, in 1975 and 1976, the crisis in
Sinap became unsustainable. Sinap was the National Savings and Loan
system whose structure was similar to the Savings and Loans system in
the United States, which had enjoyed the monopoly of readjustable fund
raising, then lost it, encountering subsequent liquidity problems. These
institutions offered long-term home loans, but operated on short-term
investments. The fall of the Banco Osorno, in 1978, was another such
incident. And so the sector continued until January 13, 1983, when in the
middle of the debt crisis, the state liquidated or intervened into a large
part of the banking system in order to protect depositors.
This period has been subjected to many criticismsincluding lax
regulation, extremely high interest rates, deficient controls, and
institutions inadequate capacity to adapt to the changing economic
conditions. At the same time, other events were taking place within the
capital market during those years. The rules for the insurance industry
and for corporations were also changing. The stock market was already
operating under new guidelines and, toward the end of this period, AFPs
were beginning to function. There were several reforms underway
simultaneously.

Hernn Bchi 109


The second stage took place during the debt crisis, between 1983 and
1985, when many observers would have concluded, in view of the
intervention into a large part of the banking system, that reform had
failed.
The third stage began in 1986, when the country gradually found its
way to a capital market whose degree of development was comparable to
that in industrialized countries, as shown in the increase in financial
liabilities expressed as a percentage of GDP from 60.3 percent in 1983 to
94.4 percent in 1988. It was also shown in the level and stability of real
interest rates and in the increased length in average loan periods (the
long-term debt in 1983 represented 59 percent of the total debt; in 1991
this percentage had increased to 69).
It is true that the military governments experience in financial
matters took its toll. But after the early stumbles and falls, the mistakes
and corrections, a capital market that had not existed before was finally
openeda capital market whose development had been prevented by the
political class that had appropriated its power. I do not want to go into a
lengthy interpretation at this point of the difficulties in and the price paid
for the restructuring process. Getting all the pieces of the puzzle into
place was a long and arduous task. Transferring domestic savings to the
capital market was very difficult. Several countries in the region are now
taking their first steps in this direction and with this experience as an
example, it is to be hoped that they will be able to make quicker progress
than Chile did.
If at the end of the day the system worked well, it was because three
factors converged simultaneously: institutions were properly regulated;
operational rules and procedures were properly grounded in the market;
and peoples savings were channeled through the financial market, which
was also a key factor in the pension reform. Only when these three
factors converged did Chile achieve a relatively stable market,
reasonable interest rates, and wider operational horizons.

110 Work, Capital and Freedom


A Diagnosis on the 1983 Crisis
My personal observations and diagnoses regarding the crisis that the
Chilean financial system went through are very different from the views
prevailing in nearly all circles of opinion. I do not believe that the 1983
crisis was mainly a consequence only of lax regulation or of lack of
control. Before the debacle, it was common knowledge around the world
that banks were granting interconnected loans. In some countries, such as
Germany and Japan, this had posed no major problem. It caused
difficulties in Chile, because the external crisis was too strong and there
came a point when the solution could only be political. Hence the
intervention, to protect not bank shareholderswho ended up losing
everythingbut depositors, especially checking account holders. One
way out would have been, following the interventions, to declare the
banks bankruptcy. Leaving aside the fact that rules regulating
bankruptcy were weak and inadequate, this would have meant
exacerbating the economic crisis even further. Once this option was
discarded, public fundsfrom CORFOwere used to capitalize the
institutions in order to sell the stock to private investors, with special
incentives. Why the incentives? Because losses were only partially
capitalized. The portfolio resale program was set up to eliminate the
burden of unproductive assets. Through this program, the Central Bank
bought troubled assets from banks, under the condition that they would
buy them back later on. In essence, a special tax on banks was set up,
until the time that they had returned the backing received from the
Central Bankagain, not to benefit shareholders, but to answer to
checking account holders and creditors.
Politically speaking, capitalizing the total sum that was needed at the
time was very difficult. How were the banks to be sold afterward? In all
probability, an institution that had been capitalized at 100 would sell for
less than 50, in which case, it seemed more tolerable that the bank should
sell portfolio worth 60, that it should capitalize 40 and then be sold off at

Hernn Bchi 111


that value or slightly less. Also, the exact loss in each specific case was
not really clear.
Generally speaking, I have always thought that the main problem
with financial systems is that they do not make it sufficiently clear what
is to be done when institutions go bankrupt. This is a fact. And it is also a
fact that banks in small countries tend to go bankrupt more frequently
than in larger countries, because small countries often have more
pronounced and more frequent ups and downs. Economic adjustments
make equity capital adjustments inevitable. When things are going well
this is not a problem, but when the economy slows down problems arise:
peoples net worth diminishes, and debtors cannot make their payments.
The structure of banks with small assets and large liabilities is very
vulnerable. What happens when debtors fail to pay and depositors want
their money back? This is a problem in all countries.
The dilemma becomes even more complicated because all financial
systems tend to confuse a business that is to a large extent risk related
granting loanswith the function of providing means of payment within
an economy. The issue is made more complicated by the overlap
between these two roles. I do not think that a greater or lesser degree of
control would solve the problem completely. The root of the problem is
that no financial system can endure a really serious crisis unless the laws
specify that in these cases people will not be able to recover their
deposits in full. The laws much also provide a practical mechanism to
make this happen, without this resulting in many wages and bills going
unpaid in many companies for a long period of time.
Would it have been possible to force the institutions that had been
intervened into in 1983 into bankruptcy? Was Chiles legal system equal
to the task of sharing out losses between the banks creditors, with a
reasonable degree of equity? Was the economy adequately equipped to
restrain or to obstruct means of payment indefinitely in the way that
bankruptcy does? The answer was clearly no.
Later, an effort was made to establish legal mechanisms regulating
these issues, while the new Law of Banks was being discussed. Besides

112 Work, Capital and Freedom


optimizing controls, systems were added to ensure a certain degree of
separation between operations pertaining to the banking business itself
mediating resources, granting loans, and taking in savings and
operations connected solely to the handling of payment methods within
the banking systemmainly checking accounts.
Chile has legislation in force related to this issue, which is an
important factor in crisis contingency. To me, the worst scenario would
be for the government to not have a legal system that would make sure
that if crisis struck again, the losses would be paid by whoever was
responsible for them, and to have to intervene once again in order to
answer to checking account holders. The regulations to address this now
exist, not just for the banking system but also for mutual funds, insurance
companies, and the financial sector in general. But the fact that they exist
is not enough. They need to be in operation, they need to be
rememberedcrisis drill exercises need to be carried out, to make sure
that the system is properly responsive to and familiarized with existing
mechanisms. I would like to be certain that this is being done. Today, not
all deposits are guaranteed to the same extent. Depositors need to be
aware of this and responsibly assess the risks they are taking.
I think that, ultimately, financial systems are not flexible enough to
make equity capital adjustmentssooner or later, they become an
unmanageable source of loss of confidence and instability for the state.
The German and Japanese financial systems can probably afford to be
less flexible, because their economies are very powerful and very stable.
Crises are less recurrent and less dramatic, but even so, they have still
caused problems.
As for lessons, there were several that Chile learned from its
financial crisis. As I pointed out earlier, regulations for insurance
companies and other intermediate agents in the capital market now
contemplate the possibility of companies going bankrupt. The law
provides a solution that is not necessarily traumatic and protects users, on
the one hand, from the uncertainty associated with any bankruptcy, and
the state, on the other, from having to assume the burden of heavy losses.

Hernn Bchi 113


In the case of insurers, these regulations are crucial because pensions are
at stake.
There is, one might say, something epic about the creation of the
Chilean capital market. The country went through with the venture and
achieved its objective. It opened up a space in which institutions in the
financial sector can operate relatively freely. Practices that made it
possible to work with different maturities were forged, a matter in which
the inflation adjusted unit of account (unidad de fomento) as an indexed
currency played a fundamental role. Savings became a part of the
market. The pension system reform and the experience of popular
capitalism created an ownership society. This whole process shaped a
very complex and enriching reality. In early 1993, the Central Bank set
up a tender for twenty-year promissory notes. A true victory, this would
have been unthinkable in the old Chile. Today it is easy to see that the
Chilean financial modernization went far beyond the question of whether
control over the banking system failed or not. Relative to the crux of the
matter, this argument is almost incidental.
Having said this, it should not be inferred from this that financial
reform focused only on the banking system. Albeit less dramatically, the
development of spheres of activity for other financial market actors
corporations, insurers, mutual funds, foreign investment funds, stock
marketsfollowed their own paths to prosperity. In these sectors, too,
the scope of liquidations and of bankruptcy was properly defined. In
short, it was the convergence of reforms from different fronts that shaped
a capital market whose standard, considering the size and the degree of
development of the Chilean economy, is practically unequalled.

Hernn Bchi 115


CHAPTER SIX

Opting for Human Capital


In the realm of social policy, the Chilean experience leaves absolutely no
doubt that development is the only way to improve living standards for
the most vulnerable members of society. This point is crucial. To argue
that growth is at odds with the redistribution of resources is not only
wrongheaded; it is a leftover of discarded ideologies. Economic growth
has never precluded an equitable distribution, and furthermore, the only
sustainable and reasonable path to redistribution is through growth. In
general, comprehensive solutions to the most acute social problems
minimum sustenance for families, medical care for the indigent, decent
homes in outlying villagesrequire economic growth. Equitable
distribution can only become a reality in the context of economic
development. The age-old conflict between growth and equality was
therefore completely pointless.
Perhaps because this concept was so clear to the military
government, its social policies were closely coordinated with its
economic policies. The economic team, in this case headed by the
economist Miguel Kast, spent long, sleepless hours designing the social
policies that would effectively end the vicious circle of poverty in Chile.
The first steps were taken through Odeplan in collaboration with the
Economics Faculty of the Universidad Catlica, where Sergio Molina
(later to become President Patricio Aylwins Odeplan minister) took part
by drawing up the Extreme Poverty Map, which determined for the first
time that 21 percent of Chiles population in 19701,916,000
Chileanslived in extreme poverty. There was much talk about poverty
in Chile, but no government had ever made any serious effort to describe
or study the problem in order to determine where the poor were to be
found and what were their most pressing needs. It was discovered, for
example, that over 40 percent of children from poor families did not
attend school, despite the fact that the country had had tuition-free

116 Opting for Human Capital


education for a long time. This and other such data led to the creation of
social programs designed to address the real needs of the poor. Before
then, it had been common for the assistance from social programs to
reach the middle classes, but not the poorest. The reason for this was
that, generally, the old programs focused on wage workers, who were not
among the poorest.
Many of the social programs in education, health, and other areas
designed to benefit the poorest were developed through Odeplan. The
professionals who worked there also took part in the free-market
economic reforms. There was consequently no divorce between the
economic team and the social programs, as is often the case in many
governments in Latin America. During the debt crisis, when people
began to look on Odeplan with some mistrust as the source of
government teams promoting the economic reforms, social work moved
to a new organization created for that purpose. Under the leadership of
the outstanding sociologist Patricia Matte, the Social Development and
Assistance Bureau, subordinate to Office of the President, continued to
work effectively toward directing state social assistance to the countrys
poorest.
This experience also confirmed that all of the sociological,
economic, and intellectual exercises carried out during the sixties to
allegedly prove that a small segment of the population controlled a huge
percentage of the countrys wealth, or that a very small number of
landowners controlled 80 to 90 percent of the countrys arable land, were
deceptive and led nowhere ... except to socialism. The only thing this
kind of research achieved was to mislead people into thinking that
problems could be solved by seizing wealth from these minorities and
distributing it among everybody else. Nothing could be farther from the
truth. These calculations were terribly precarious technically. Their true
purpose was to show that the small elite groups were hijacking the
countrys wealth, to keep it all to themselves and not share it with
anybody. The fact that these people were running companies and

Hernn Bchi 117


farmsproductive enterprises that invested and grew, where thousands
of people worked and earned their livingwas never taken into account.
It is precisely because of this close correlation between growth and
redistribution that social policies that go against growth cannot be
healthy. At the very least, they need to do no harm to growth. For
example, a program that involves setting up very low interest rates in
order to create easy loan terms will not only not benefit the poorest, but
will depress savings and drive investors out of the country; the poorest
will lose out and, naturally, so will the country. A better alternativein
keeping with the same examplewould be to establish a program to
subsidize the purchase of houses, financed through general taxes such as
a VAT, because the distorting effects will be considerably less. Any tax
interferes with the economic process, it is true. No tax is harmless. A
VAT, for example, affects consumption and encourages tax evasion. But
a VAT at least, because of its higher degree of neutrality, has the
advantage of not encouraging the consumption of noodles at the expense
of bread. Neither does it force a company into vertical integration or into
carrying out activities for which it has no competitive advantage.
Therefore, social policies that interfere with, restrict, or obstruct
economic development can only lead to disaster and ultimately will harm
the people whom they are intended to benefit. Relevant examples
abound: unrealistic minimum wages, preferential exchange rates for
certain products, politically fixed prices for wheat and bread, and an
assortment of price controls.
The second point is related to a delicate issue that we have already
outlined in regard to the social work carried out through Odeplan. Often,
owing to political pressure, the benefits of social programs do not reach
the poorest. By definition, the basic purpose of all of these programs is to
help the poor. It is worth keeping in mind that this was Allendes
intention when his government promised university education for all.
What could be better than a young person from an underprivileged
background making it to the university? But what happened?
Universities began to use up 40 percent of education expenditure, even

118 Opting for Human Capital


though universities are not where the countrys poorest were to be found.
Whom did free university for all ultimately benefit? Certainly not the
poor, except for a few isolated individuals who reached the university
level and who were already relegated to achieving only a basic education
because of access to minimal resources. In the end, the beneficiaries
were those who got tuition-free education even though they were in
comparatively better social conditions to pay for it.
The third important point is that social programs should include
gradual measures to incentivize individual effort to encourage people to
take responsibility for their own destinies. Nothing is more tragic than
social programs that foster dependence or the growth of a pliable, rentseeking client constituency. The goal should be for the poor to someday
no longer be poor.
The fourth point is a word of caution: although it is usually
government that designs social programs, implements them, and
determines their content, ideally these programs should not be
administrated or operated by the government. If, for example, the State
wants to provide more and better opportunities in education, then it
should subsidize good quality elementary and secondary schools, even if
they are privately run. But it should not make the mistake of
monopolizing the school administration.
It is no coincidence that the principles displayed in these four
observations should elicit very little enthusiasm from the political class,
because they reduce its power. A politician always has more to gain from
favoring not the neediest but whoever shouts the loudest and controls the
most votes. I was almost killed by students from the Universidad de
Concepcin a few days before the 1988 plebiscite, but that would not
have happened with students from an elementary school in a working
class neighborhood. Usually the sectors that are better organized
politically are not the poor.
There is a perverse feedback effect between certain bad political
habits and the cycles of dependency and poverty. This is the case at
many levels. Education ministries in Latin America have long been a

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kind of public relations service for the teachers unions. The truly
important decisions that they make do not cater to the contents of
educational plans; they cater to wage increases every two or three years
due to inflation, or to issues that took up most of the ministers time and
energyissues which, while important, should not be the only ones or
the priorities in an education policy.
The government was harshly criticized during the seventies and
eighties for its alleged social insensitivity and social policies that were
supposedly inadequate to the problems that they were meant to address.
There is no doubt that the government prioritized growth. To do so was a
question of social responsibility. But even as it defined this priority, it
also defined the boundaries for a field of action for supporting programs
to develop human capital as well as welfare programsto provide basic
assistance to people who could no longer fend for themselves. That was
indispensable, for it was development that set people free from the
captivity of sickness, ignorance, and poverty.
On both of these fronts welfare programs and programs to develop
human capitalthe Chilean government showed impressive results and
numbers. The accusation that the government was insensitive because it
reduced university budgets is, therefore, nonsense. That was not an
oversight. It was a deliberate decision based on social spending priorities
and was made at a time when resources were very scarce.
Meanwhile an addition problem was the fact that assets had become
scarcer as a consequence of the external crisis. When the topic of the
number of poor people in Chile comes up, people forget what happened
with the number of poor people in Latin America. It is because Chile
pursued the economic policies that it did, from which the country,
unfortunately, has strayed in recent years. Otherwise, the number would
still be increasing, as in fact it is in many other countries in the region.
In terms of schooling, libraries, basic literacy, elementary education
coverage, child nutrition and mortality, care for pregnant mothers,
morbidity rate, medical care, and other indicatorsincluding UN
indicatorsChile experienced an authentic social revolution and became

120 Opting for Human Capital


one of the top ten nations in the world in terms of social achievements
between 1975 and 1990.

Housing and the Market


The military governments achievements in housing were governed
by sensitivity and social reality. The key decision was to allow the
market to operate at its full potential by withdrawing the state from the
direct administration of housing programs. At this level too, government
action had been disastrous. When the new government took over in 1973,
approximately ten independent agencies connected to the government
through the housing ministry directly carried out projects, building roads
and houses and employing over 50,000 workers. There was an incredible
number of projectsplanned, interrupted, underway, abandoned, taken
over, or half finished. It was the usual chaos.
While the middle and wealthier classes received state subsidies, there
was no policy aimed at solving the housing problems of the poor. This
did not become evident until 1974, after the extreme poverty map was
drawn up.
In the context of free interest rates and of a developed capital market,
among other factors, housing policies began to subsidize buyers and
became an example for targeted social spending. For the first time in a
long time, state resources allocated to housing actually mainly reached
the needier groups, rather than the groups with greater pressure power.
The housing subsidies system achieved a good balance between
individual and family savings, and state aid, enabling a greater number of
Chileans to become owners.
For the sectors with no savings capacity, on the other hand, basic
social housing programs were a good solution within the existing
economic limitations. The idea was to de-bureaucratize the system as
much as possible and to give increasing decision-making power to
municipalities in the allocation of houses. In matters like these, local

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governments generally make better informed decisions than does the
central government.
One of the most recurrent accusations made against the military
government was that the development agency (unidad de fomento),
specifically the readjustability system applied on mortgage loans, was
responsible for the impoverishment of the middle class between 1975
and 1985. Therefore, it is worth analyzing in detail the plight of many
homeowners who were unable to make their mortgage payments and
whose homes were auctioned off by the banks.
At the core of the problem was the debt crisis that hit the country
between 1982 and 1984, which made Chile and all of the countries in the
region objectively poorer.
A second factor involves a basic concept of justice. Justice is served
when a person buying a home pays what it is really worth, within a
certain time limit. Adjustable rate loans, which are beneficial to a
fortunate few, are disastrous to society as a whole, because it deincentivizes saving and the accumulation of housing resources, thus
harming families that do not own a home. In theory at least, one of the
benefits provided by the Private Employees Fund, an institution
belonging to the old pension system, was the granting of home loans at a
nominal interest rate below inflation. This was very convenient for the
debtor, who was practically being handed a gift when inflation rates were
high. The problem was that only 1 percent of the Funds contributors
received this benefit, and in most cases, they were selected because of
connections and influence rather than because of actual need.
A third factor in the analysis leads to the recognition that in Chile the
indexation mechanisms made it possible to restructure the housing and
capital markets, but they jeopardized a vast sector of the population that
had contracted long-term debt to purchase homes during the boom,
before the 19821984 debt crisis. Some people had bought houses that
they could not afford, and to make things worse, in some cases the debts
involved both the mortgage and a second shorter-term loan that had been
taken out to make the down payment. While the economy was growing,

122 Opting for Human Capital


there was no problem. But things fell apart with the first setbacks caused
by the crisisincome contraction and unemploymentwhich created a
delicate and protracted social problem.
The best rebuttal to the criticisms made against the housing policy,
and especially against the UF (unidad de fomento) as a readjustability
mechanism, is the fact that the country has continued to operategive or
take a few adjustmentswithin the same framework. Successive
Concertacin governmentseven though they had more resources
available to themhave not been able to come up with anything truly
new in this area.
Santiago, which used to be full of shantytowns with no running
water or electricity, gradually changed. Anybody who has driven through
the city thirty years ago and then again today can see the difference,
although there is still much to be done. Between 1970 and 1992,
according to census data, 1/4 million rural families acquired decent
housing. This is unprecedented in Chilean history.

Education
The government, in its approach to reforming education, recognized two
levels from the outset. One comprised preschool, elementary, and
secondary education, which the vast majority of the population goes
through. The other involved higher education, which only a very small
percentage of the population attains.
Establishing priorities was easy and required little thought. Yet many
still cannot forgive the military government for turning its back on the
university-for-all utopia. Perhaps the reason why they cannot forgive the
government is that it revealed the fact that most of the education budget
was being spent on minority populationsand in very uncompetitive
conditions, to boot. Higher education circles still exerted the greatest
pressure on the education budget, even though it comprised only
minority segments of the population.

Hernn Bchi 123


The government policy for the allocation of fiscal resources to the
university system was to steer it toward a financing structure that would
be less direct and less dependent on fiscal decisions to create incentives
for competition and quality. The idea, on the one hand, was to gradually
equip universities, using their own assets. On the other hand, special
funds were created, or strengthened, to support university programs in a
more competitive frameworkincluding a science and technology fund,
money contributions based on better results, and student loan programs.
The objective was to detach the state from the university systems
requirements, as far as this could be done. It was reasonable to think that
these resources, added to students contributions, would allow
universities to finance themselves and reduce their dependency on the
state education budget.
Some critics decried the concept of paid and self-financed
universities as unfair, because it allegedly excludes the lower classes
from university education. This meant that a loan and scholarship system
needed to be set up in order to overcome this barrier. However, not all
college degrees guarantee an income that will be sufficient for a graduate
to cover adjustable loan installments. This means then that the
government will have to direct its efforts to awarding education grants
for disciplines, if and when they are deemed socially valuable.
The governments favorite verb in education-related issues was to
target. Adequate targeting of social spending is a must, for the sake both
of efficiency and civic responsibility, and in consideration of the
principle of equal opportunities. The undertaking took years, and it is not
finished: for example, a student loans system was never properly
consolidated. Pressure to turn back in this area was extremely strong. I
would have liked, for example, to consolidate an endowment-type
system, with rotating funds managed by the universities themselves, to
finance the loan and scholarship systems. Such a system would provide a
sounder operating structure and produce greater commitment from the
universities both in the allocation of resources to studentsresources
that are supposedly recoverableand in the creation of new degree

124 Opting for Human Capital


programs. It would have disadvantages, certainly, because it would not
allow transfers from one university to another, but it is better in many
ways. Other policies do nothing but prompt students and university
administrators to gang up against the government. The competitive funds
solution also proved innovative in the areas of scientific research and
cultural creation, where it was actually possible to consolidate systems of
work that were later used by the successor government.
The challenge in this area, in any case, was to channel resources to
the needier sectors, which were not in higher education. But an effort
was made to link higher education to a properly oriented system of
incentives, grounded on basic principles: that students should be aware
of and, if at all possible, assume the cost of their education; that there
should be some degree of competition in the allocation of resources for
research; that having a university degree should not necessarily obligate
the state to provide the graduate with a job; and that there should be
some kind of incentive to promote quality.
This idea of incentives was the goal behind what some people called
la marraqueta (loaf of bread), a fiscal contribution made to universities
based on their success in attracting students with the highest scores on
academic aptitude tests. It is a good idea, but it needs perfecting. The
important thing is not just rewarding the universities that draw the best
first-year students; it is also important for the schools to make sure that
these students stay on and eventually graduate.
In a way, which is yet to be analyzed in depth, the Chilean
modernization process weakened the universities role as cultural arbiters
and as the critical conscience of the nation, to use an expression in
vogue during the sixties. Indeed, several universities faded into the
background. Others, on the other hand, which were more receptive to the
value of academic quality, increased their prestige. What happened was
that, as a result of de-bureaucratization, society itself became more
receptive to knowledge, but less enthusiastic about professional degrees.
The correlation between education and development became more
complex. Professional diplomas were no longer seen as evidence or as

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public employees ticket to a highly respected albeit ill-paid position in
the community. The society and economy became more sensitive to
skills that did not necessarily need to be certified by a university degree.
In short, there was greater social mobility. The country of old, which was
scared to death of competition, was gradually left behind. In essence, that
conservative, hierarchical, bureaucratic, and somewhat provincial social
structurethe liberal professions at its apexthat had been so typical
of the country for many years, began to fade.
Another priority in higher education was private universitieswhich
were looked down on at first, but have in several cases become more
prestigious than many traditional universitiesand initiatives aimed at
diversifying alternatives for post-secondary, non-university training. This
resulted in the burgeoning of technical and vocational schools. The idea
was to open this field in as transparent a way as possible to the individual
responsibility of students and the private initiative of schools. There is a
tendency to underestimate the quality of the instruction that these
institutions provide; however, strictly speaking, only those who sign up
for this training are qualified to judge whether it is useful or not. People
are perfectly capable of discerning what their own needs are. They do not
need tutors for this, as some state-control advocates believe. Neither is
there any need for planners to make projections and forecast the exact
number of technicians or professionals that the country will need in ten
or twenty years time. Although they are valuable as reference points and
should be made available to young people for their consideration, these
estimates are almost always speculative and should not interfere in
peoples decisions. If someone, knowing that there is an oversupply of
professionals in a certain specialization area, insists on registering for
and assuming the costs of that same degree, he or she has every right to
do so.
In the field of preschool, elementary, and secondary education, the
government had to confront the commitments made by the two preceding
administrations. The law stated that everyone should receive an
education, but what the law mandates is one thing; having the

126 Opting for Human Capital


administrative and financial means to do it is quite another. Frei
Montalvas government (19641970) had extended basic education from
six to eight years. After that, Allende promised university for all.
However, the numbers reflected a very different reality. By 1970, the
average Chilean had 4.5 years of schooling. In addition, 43 percent of
school-age children living in extreme poverty did not attend school.1
The governments experience in this area proved interesting, because
it was faced with the task of carrying out the promises made by other
administrations. In fact, during the military governments term in office,
indicators gave evidence of spectacular improvements. In secondary
education, the rate of schooling increased from 37.4 percent in 1970 to
52 percent in 1980 and 74.8 percent in 1988.2 The average years of
schooling in Chile practically doubled, reaching 8.7 in 1987.
That was not all. The governments greatest triumph in this area was
its ability to make the distinction between its orienting and regulating
roledefining curricular contents and standardsand its financing and
administrative roles.
The first role belonged exclusively to the state, whose responsibility
it was to define a basic curriculum that met wide social approval, by its
respecting the nations identity and values. The risk at this point is to try
to put the cart before the horse by using education to change or
manipulate the societys values. The government that took office in 1990
has done quite a bit of this kind of social engineering. The idea of
including human rights in the basic curriculum requirements points in
this direction. The initiative seems worthy of consideration from the
perspective of civics, but only insofar as it does not go beyond the
consensus within Chilean society as to when, how and why such issues
arose. Many people will argue that the origin of the serious problems that
the country lived through in this area lies in socialism, in the
Machiavellian political morality that it fostered through its rejection of
democracy and bourgeois institutionalism and its efforts to reshape
1
2

Extreme Poverty Map, Odepln, U Catlica, 1974.


Chile Central Bank, Social and Economic Indicators, 1960, 1988.

Hernn Bchi 127


society by means of political coercion, by force or through the use of
legal loopholes. That being the case, would this mean that the basic
curriculum should include lessons on the failure of socialism throughout
the world?
Having established that the governments role in education was
mainly to set curriculum content and standards, a system of financing
laws was also enacted. The focus was now on the students, rather than on
the schools. Consequently, financing consisted in providing schools with
a subvention for each child in the school. This was an important and
unprecedented step forward. It was the first time that central government,
the proprietor of schools that had always been financed according to a
traditional government budget, introduced the principle of
decentralization and competition in the sector. As soon as school
administrators realized that in order to receive more resources they
would need more students, the stage was set for municipalities to take
over the administration of the schools and for new private schools to
open. Very peculiar things happened as a result of this liberalization.
Some municipalities resisted the idea of new private schools opening, for
fear of the competition to which they would be exposed.
This conflict, in any case, still has not been resolved. There is an
abundance of news stories on the excesses, fraud, abuse, and
irregularities that have taken place in private schools. Strangely,
irregularities in the state sector do not receive the same kind of attention.
Yet, in spite of so much scandal and so many attempts to discredit
private schools, thousands upon thousands of parents still prefer privately
run schools for their childrens education. According to national
Education Quality Measurement System (Simce) tests, achievement
levels in private schools are higher than in schools under municipal
administrationand people had become aware of this even before the
test results had been published. I remember, in the early eighties,
speaking to a man selling dusters and brooms at the door of a
supermarket, who told me that he worked, among other things, in order
to be able to send his children to a state-subsidized school in which

128 Opting for Human Capital


parents were asked to pay a monthly fee collected by the parents
association. He was glad to do it and knew that he was making a good
investment toward his familys future.
In the case of technical and vocational education, these schools were
transferred to private companies. On the wholethere are always
exceptionsit was a satisfactory experience, but I tend to think that this
kind of education needs careful and fundamental rethinking. The idea
that young people should master some trade skills by the time they
complete their schooling, in order to enter the workforce early and with a
head start, is attractive, but it involves considerable risks for two reasons.
First, the equipment required to provide this type of education is very
expensive. Second, the trades that are taught are highly vulnerable to
obsolescence. Technological change is accelerating and it is highly
improbable that schools will manage to stay ahead of it. The only way to
close this gap is to strengthen the links between schools and businesses,
but determining how to make this connection enriching for both parties is
not easy.
The decentralization of education was accomplished quite creatively.
The biggest problem that it faced was that its progress was affected by
the economic crisis during the eighties. This made it impossible to
increase subventions as much as initially planned. The objective was to
substantially improve the quality of education and ensure a smooth
transition, because the transfer of state schools to municipalities or to
private operators would necessarily entail replacing less competent
teachers with better qualified staff. The political problem that would
ensue was foreseeable, but the government believed that other teachers
and the community at large would appreciate the improvement that this
change would bring about for everyone, and that this would neutralize
the conflict.
However, this did not happen. In teachers perceptions, the change
would always be associated with layoffs, uncertainty, and economic
restrictions that were as great as or greater than before. The effect that
the crisis had on the deterioration of the situation was completely

Hernn Bchi 129


ignored. The truth of the matter is that no more progress was made. One
unrealized goal was to entrust the administration of municipal schools to
organizations made up of teachers or of parents and trustees, in order to
decentralize the system even further. Also on the agenda was the idea of
moving toward a system that would integrate, in addition to the state
subvention, contributions from parents themselves, if and when the
populations real income began to improve.
The task, therefore, went unfinished. Although the process succeeded
in engaging municipalities in the development of education, it did not
take root, mainly because subventions remained too small. The
backsliding after 1990 demonstrates that the system is still vulnerable to
statist pressures. That backsliding has been largely caused by the
restoration of direct allocations to schools run by municipalities, which
meant discarding the subsidy-per-student financing system. That is a sure
way to increase schools dependency on the discretionary decisions made
by the central government and to distort the competition between
municipal and state-subsidized schools.
Among other initiatives, the decentralization process in education
included a general instrument for assessmenta nationwide test,
strongly resisted by the same teachers union leaders who rejected
municipalization in the name of quality in educationthat is intended to
help guide parents decisions and their involvement in their childrens
education. To the extent that the results of these tests are publicly
released and published, the system will have incorporated a key measure
for competitiveness and selection.
On another level, the modernization of education also opened up
ways to deliver food to the student body more productively and
efficiently. These ancillary services were outsourced to private
companies operating according to previously determined guidelines,
which identify schools in the poorest areas as well as the most vulnerable
ages in children. These and other initiatives in this area contributed
substantially to the human capital development efforts carried out by the
government between 1973 and 1990.

130 Opting for Human Capital


It is always possible to turn back, and in fact this is what successive
Concertacin governments have done. For example, universities are once
again favored, to the detriment of preschool, elementary, and secondary
education, as the trend in government education spending seems to
indicate. The idea that the infrastructure of state schools should be
financed through direct resource allocations and not through a
subvention per student is gradually becoming accepted. This entails a
form of discrimination against private schoolswhich still achieve better
results. The modifications made to the Teachers Statute to a certain
extent involved the government in the issue of teachers wages again.
Centralization has reared its head once more. Another issue that has been
called into question, creating strong nationwide controversy, is whether
private schools that receive a subvention from the government should be
non-profit organizations, which is the politically convenient way of
rejecting free enterprise in this area for fear of the comparison of results,
among other things. While the total education budget has increased by 29
percent between 1990 and 1993, subsidies made to devolved schools
have increased only by 8.8 percent. On the other hand, expenditure on
staff in this ministry has increased by 44 percent in this same period,
without this reflecting an improvement in the quality of education.

Health Freedom
At the time changes were made in the cabinet in 1980, the stage had been
set for me to be named Undersecretary of Health. At the last minute,
however, the President let me know that he would prefer that I assume
the position of Undersecretary of Economy. The following year, exactly
the opposite happened: I thought I would be staying on at Economy, but
at the last minute, the President asked me to take over as Undersecretary
of Health. This move was actually decisive in my survival in the
government, since I did not belong to any of the teams that were blamed
for the 19821984 crisis. I was working elsewhere at the time. What had

Hernn Bchi 131


appeared to be a position that would force me into the spotlight, because
at the time health was the most controversial sector, turned out to be a
refuge in the midst of an economic storm.
If the field of education is complex, the field of health is even more
so. In education, at least it is possible to get society to agree on the
standards and the minimum curriculum requirements that elementary and
secondary school students should comply with or master. Establishing
the range of health care that a person should receive is much more
difficult. The difficulty lies in the fact that no one aspires to anything less
than top quality, yet no system can guarantee that level of care for
everybody.
The other controversial point in this area is that, when human lives
are at stake, any standard that one defines as satisfactory or reasonable
can be highly controversial. The reason is simple, but there is quite a bit
of demagogy surrounding all this. Any standard implies leaving some
people without coverage, which entails a question of life and deathand
therefore a huge political and ethical problem. In fact, there is not a
single health care system that does not put human life on the line in its
everyday decisions.
This harsh and undeniable reality is the reason why all state health
care systems, to some degree, avoid the dilemma and prefer to face it
indirectly. They prefer to offer the highest standards, letting the
fulfillment of their promise be contingent on their ability to actually
deliver them. Rationing is not explicit, yet it is made manifest in delays,
postponements, and waiting lists and other rationing practices. The state
system will be successful to the extent that it manages to line sick people
up in a queue without their ever realizing it.
The situation is different in private health care systems. The limits
are set right from the start. A company, after setting a higher fee for
higher risk candidates, will be able to control its costs by setting limits on
the expenses incurred through a given illness or service, or even by not
covering some illnesses. This refusal will no doubt lead to conflict.
However, once interpretation-related issues are out of the wayfor

132 Opting for Human Capital


better or worse from the patients perspectivethat is the end of the
discussion and it is quite clear what the beneficiary is and is not entitled
to.
There tends to be quite a bit of hypocrisy involved in the discussion
of this topic. People become indignant when a private company denies
coverage for some clinical treatment or recovery program and claim that
it is unfair to leave someone unprotected in such a predicament. Hence,
many people infer that it is more convenient to have a health care system
that will grant everyone the same coverage. But those critics fail to
understand that this does not do away with the problems. In fact, they
will exist all the same, because a one-size-fits-all system will still have to
ration its services through queues or waiting lists. The difference is that
in one case, the decision is controversial and transparent; in the other it is
not controversial but it is obscured and opaque because it depends,
ultimately, on each patients luckgood or badwith the medical
bureaucracy.
Now then, it stands to reason that endless comparisons between one
system and the other are pointless, insofar as they obscure the truly
important issuesthat people should feel motivated to look after their
health and lead a healthy lifestyle; that reality should not be disguised in
the name of a deceptive egalitarian ideal; and that the system should not
hide its limitations or shortcomings, allowing everyone to keep them in
mind when making decisions on how to maximize their own well-being.
In short, that the fees paid by the users of the health care system should
be precisely thatfees for a serviceand not a tax.
The military government had to sort out several questions before
arriving at the health care system that it finally adopted. Should
assistance be public, private, or a combination of the two? Should care be
comprehensive or differentiated by specialty, as it is in insurance
coverage? But perhaps the most important decision was whether to favor
primary care or more complex health care services.
Chiles infant mortality rate in 1973 was 68 per 1,000that is, 68
out of every 1,000 children died within the first year. This was a high

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rate even by Latin American standards, so it is paradoxical that medicine
schools in Chile were prestigious and received many students from other
Latin American countries in which public health issues were better
addressed. The explanation is that at certain stages of development,
public health problems are not related mainly to medical care in hospitals
or other sophisticated institutions, but to the provision of basic sanitary
infrastructure and of primary care in rural areas. Thus, once again the
military government faced a decision and, in my opinion, made the right
choice in deciding to favor the weakest, namely, the children of poor
families. This also implied a decision regarding resources, which led to
the strengthening of primary care through rural clinics and doctors
offices that were built or reinforced throughout Chile, and supplemented
with diverse special programs designed for vulnerable groups, such as
mothers and children. PNAC, the supplementary nutrition program, was
one of these programs. As a result, Chile today has one of the lowest
infant mortality rates in Latin America. This means that approximately
30,000 children a year survive, in circumstances in which they formerly
would have died before their first birthday. The infant mortality rate in
2006 was 7.8 per 1,000.
The health care system was organized along the following criteria:
The state guarantees a minimum provision of health care for all of
the population. The public system covers everyone, regardless of
whether they have health insurance or not, and whether they are
employed or not. Traditionally, this systems coverage has been
very broad.
Workers must be responsible for their health and are required to
belong to a health care system.
The public system is financed by direct contributions from the state
and through the contributions made by the workers in the system.
The workers contribution is set at a percentage of salary, with a
certain taxable maximum limit. This percentage is in itself a
mistake, because low-wage workerswho fall ill as often as or
more often than workers who are better paiddo not cover their

134 Opting for Human Capital


costs. Yet, however flawed, there seems to be no other solution
available, at least from a political standpoint.
The system makes every provision to allow people who want to
migrate from the state system to the private system to do so. In turn,
private providers are also given maximum flexibility conditions
within which to operate. The most obvious candidates to transfer
between systems were, of course, higher income groups, which
caused some consternation among people who believed that highincome people migrating out of the system would be depriving the
system of resources. Those who felt this way essentially thought of
the health care contribution as a taxwhich it was never intended
to be. Those critics also ignored the fact that having the wealthy
stay on in the public system does more damage to the poor in the
long run, because the wealthy add to the congestion of the system
and have greater political clout to be able to jump the queue for
medical care and to direct the system toward satisfying their own
needs. In fact, the most expensive treatments in the public system,
which required a co-payment, were given to higher income people.
Within the health care institution regulations, the provisions made
to ensure a smooth transition between systems included new
opportunities for private providers to participate in the health care
market, provided that they could guarantee compliance with the
commitments they made to their users, mainly through reserve
requirement regulations. In time (not at the outset), some measures
were taken to shift health care contracts toward open-ended or
lifetime agreements, with a view to gradually generate contracts that
could encompass different life cycles.
Another important feature that made the system viable was the
states commitment to provide supplementary support for the public
system, based on the consideration that it would be the lower income
workers, whose contributions were not enough to cover costs, who would
remain in this system. This was done through state payments from the
general fund.

Hernn Bchi 135


One proposal that was never carried outalthough it had been part
of the original planwas to create a supplementary subsidy, equivalent
to what the state spent on each beneficiary and along the lines of what
had been done in education, it order to allow people with lower incomes
to also be able to migrate to the private system.
What thwarted this last step? Basically, it was the impossibility of
finding viable policiesboth administrative and operationalthat could
effectively decentralize the system. Transferring a school to a
municipality or to a private educational organization is not very
difficultstudents continue attending the same schoolbut the health
care system is more complex and more interconnected. People do not
always go to see the same doctor. They go from their primary care
physician to the hospital, and from there they might be referred to
specialist or group of doctors for further evaluation, and then to another
hospital. All of this is complicated.
One hypothesis was that, by granting this subsidy, a large number of
people in the public system would transfer to the private system. This
would mean that from then on, public clinics and hospitals would charge
a fee for the care they provided, financed by the government subsidy.
Undoubtedly, this would not be easy. But there was an additional
problem: the supplementary subsidy would, in any case, ultimately entail
a substantial increase in health care spending. The reason is simple:
assuming that a significant part of the public health care system
beneficiariessay, one third or one halftransferred to the private
system, taking their subsidy with them, it seemed highly improbable that
an equivalent reduction could be made in the public systems
expenditures. In all probability, spending would remain at the same level,
but the system would be providing care for atheoretically
substantially smaller number of people, albeit in better health condition.
Taking on this increased cost may perhaps be worthwhile, for the sake of
decentralizing the health care sector, but in the eighties, resource
restrictions were dramatic enough to postpone the implementation of this
proposal. At the time, public expenditure was affected by increased

136 Opting for Human Capital


costs, caused by the pension system reform and by educational
decentralization, and adding a new pressure front would have been
irresponsible.
To that extent then, modernization did not go all the way and
therefore remained unfinished. Two major difficulties complicated the
effort, one political, the other financial. The financial solution is
absolutely feasible. The challenge boils down to encouraging workers to
join a health care institution, to which end the state would supplement
their contributions up to a certain limit.
It is reasonable to expect that putting this operational structure into
effect in the health care sector would require a reasonable transition
period, and that it would generate certain costs that are inevitable in any
learning process. What the government plans is one thing and what
actually happens when the measures are carried out is another. The
normal approach in this field is to work with estimates and to sort out
thousands of unforeseen details. For instance, the military government
had initially set the health care contribution at 4 percent of a workers
taxable salary, but soon realized that it had fallen short. The percentage
was later increased to 7 percent.
Alongside this reorganization, the government carried out many
other initiatives in the health care sector. The state health care system
was reorganized, moving from a centralized model to a decentralized
model. The municipalization process was not always as comprehensive
as it had been in education, although it was partially implemented
through primary care and rural clinics. Here, too, municipalization gave
rise to conflicts, because the tendency in the Health Ministry was to
finance these services through municipal corporations and to increasingly
reduce the resources assigned to them. Of course it is easy to argue,
citing these problems that municipalization is a bad idea and that it does
not address peoples needs. That controversy has still not been resolved.
The fact of the matter is that more sophisticated hospitals remained
in the state system, which did succeed in eliminating the differences that
existed in the past, when there had been one healthcare plan for white

Hernn Bchi 137


collar employees and another for blue collar employees (National Health
Care). The hospitals managed by the central government were then
administered by local governments.
I know that the military governments health care policies have been
criticized very harshly. Yet people often miss the central point of the
debatethey miss the forest for the trees. In this controversy, the
government needs to have a clear idea as to how much money can be
spent in this area and how it can be spent most efficiently. What the
government responsible for modernization in Chile tried to do was to
give people more freedom so that they could decide how much to spend
and how they wanted to spend it.
Obviously, keeping a sense of proportion in all of this is important.
The shortcomings in the public health care system are often compared
with those in highly developed countries. This type of comparison makes
no sense. Per capita health care spending in the United States is
approximately equal to or higher than the per capita income of Chile. In
order to have a similar system, Chileans would need to spend practically
all of the countrys GDP on health care alone, which is, of course,
impossible.
Health policy is such a complex issue that even as the system
improves, new needs and demands arise in the process. When authorities,
for example, shift emphasis to prioritize the early detection of a certain
illness, many sufferers who otherwise would have died from the illness
are made aware of it and thus seek medical treatment. Although in the
long run, prevention preempts future demand, in the short term it almost
always generates greater demand for care and more people lining up in
the queue.
It bears repeating that the most important effort made by the military
government centered on social expenditure on health care. This effort
favored, above all, preventions and care for the neediest and most
vulnerable groups in society. The program to reduce mother and infant
mortality included protective measures for pregnant women, special
nutrition for children in their first year, distribution of milk and

138 Opting for Human Capital


nutritional supplements, vaccinations, and other medical assistance.
Many such programs were developed, opening new opportunities for
state action. Through these initiativesin conjunction with basic
sanitation policies in towns and villages and development programs for
rural communitiesChilean society began to incorporate commitments
to long-term health care strategies. Essentially, it was about choosing for
the people, which did not always coincide with what its potential
beneficiaries wanted. But this is where the state comes in, since it can to
a certain degree force individual decisions in the interest of the common
good. For example, a mother might prefer to not have her child
vaccinated for fear that he will contract the illness that the vaccine
prevents. The risk is plausible, albeit remote. That is where the state
comes in and mandates vaccination to be compulsory. The risk of a child
contracting a disease and even dying may still exist, but the state
assumes the risk of one child dying versus thousands, hundreds of
thousands, being saved. This is what the government and its authorities
need to be involved innot in how much doctors should be paid.
Chile was extremely efficient in fulfilling some of its objectives.
Many health indicators showed spectacular improvement. Chiles infant
mortality rate, which had not been among the lowest in the region,
dropped into the lower ranges. It could be argued that in Cuba it is even
lower, but it must be kept in mind that in 1958, in Batistas time, the
island already had one of the lowest infant mortality rates in Latin
America. In any case, mortality and morbidity levels drew very close to
those in developed countries. Several illnesses were successfully
eradicated, but the situation regarding typhus and hepatitis is still
precarious. Both are related to deficiencies in sewage treatment by state
enterprises responsible for this service.
Bearing in mind that on health-related matters, nobody settles for
less than optimal quality, and given that technological development
contributes to making medicine increasingly specialized and costly, this
is one area where it is very easy for the state to become bogged down.
The solution to this increasing tension is not for the state to spend more,

Hernn Bchi 139


because this leads to destructive distortions, but rather to have people
assume more responsibility in this area, in line with rises in income. It is
part of the logic of development that health issues will constitute an ever
higher proportion of spending. And it is a historical fact that countries in
which the state has made increased spending commitments end up in
trouble, because the degree of public satisfaction does not increase in
proportion to the increase in spending, and because public systems
contain pernicious incentives that impair efficiencyincluding that of
the controlling political system.
The experience of the Concertacin governments is telling. Thanks
to the growth generated on the foundations of a healthy economy, more
resources have become available to the system, which now cater to a
smaller number of beneficiaries. But, in spite of this, the overall
perception is that medical care has not improved, and some of the
governments major internal political crises have been precisely in this
area. In my view, the reforms introduced by these governments have
only succeeded in creating more confusion and less efficiency in the
structure of the system.

There Was More to the Social Safety Net


In addition to the reforms in housing, education, and health care
described above, the government took other measures to strengthen the
structure of the social safety netwhich fall outside the scope of this
discussionencompassing such areas as assisting homeless children,
supplementing the income of the unemployed, and providing custody for
abandoned children. It also covers areas such as providing pension
assistance to people with no access to pension coverage, providing a
uniform subsidy for poor families and temporary workers, and many
other programs intended to cover basic needs, without undermining the
foundations of social and economic development. Each one of these
programs has its own history, its own conflicts and tensions, and its own

140 Opting for Human Capital


heroes. The effort was so comprehensive and complete, that eighteen
years after the end of the military government, it is still the basic support
framework for the neediest in Chile today.

CHAPTER SEVEN

Reform Becomes Law


The Chilean economic reform process involved not only multiple sector
reforms, but also a serious attempt to modify the criteria by which the
public would assess policies, and to educate society. This intention
which would have scandalized F.A. Hayek, a sworn enemy of
government intervention in intellectual matterswas never articulated in
terms of the social engineering that the author of The Road to Serfdom so
feared. The military regime helped transform Chiles political culture and
led a true revolution in its social and economic institutions, in the
orientation of its development, and in peoples perceptions. But it was a
different kind of revolution because it was accomplished in the name of
freedom. This revolution was carried out not in order to build wallsas
many revolutions did in the twentieth centurybut to tear them down.
The changes also affected the combination of regulations,
institutions, and customs, starting with the Constitution itself, that
determine both how a society works and how its government is to be
structured. The governments aim was to give economic liberalization
proper backing at the highest institutional level and to lay the
foundations for a democracy based on checks and balances that would
have good prospects for stability over time.
My perspective on this point is rather unorthodox. I believe that the
proper conclusion to a reform process is popular acceptance of the
reforms, independently of what is written in legal texts and
constitutionswhich tend to be worse the more detailed and full of
regulations that they are, anyway. Excessive meticulousness in these
matters is often indicative of a lack of consensus.
For this reason also, it would be a mistake to analyze the Chilean
process only in light of the military governments construction of the
new institutional superstructure. In fact, this task marked a culmination
of an accomplishment rather than a starting point. This speaks well of the
authorities of that time. One of the most baleful features of Latin

142 Reform Becomes Law


American politics is the persistent belief that reality can be changed by
simply changing the laws and that a countrys greatness is not forged
through work, through education, and through peoples creativity, but
through drawing up a constitution.

Perverse Legislation
It is often the case with laws and regulations that the intended meaning
of the laws at the time that they were drafted is not always the sense that
prevails when they are applied. I had the chance to follow a series of
trials closelyon agrarian reform, on pension system issues, among
other mattersand was very often surprised by the courts interpretation
of regulations whose meaning, at least to me, seemed unequivocal. But
clearly they were open to other interpretations.
Although I have always understood that legislating meant
establishing the rules of the game so that everyone knew where they
stood in the future, it became very clear to me early on that to politicians
and legislators redistributing wealth today, it presents a more appealing
option for gaining voter support. For example, in the case of legislators
working on a rental contracts law, the incentive to set a maximum rent or
to freeze rental payments nowand earn renters approvalis much
stronger than it is to lay down guidelines for future rental contracts. The
problem with this behavior is that these regulations become a hindrance
to the people who hope to make a reasonable profit out of buying houses
and renting them, and consequently reduce the supply of this service,
which means that rental properties in the future will be fewer and more
expensive. It is, of course, a perverse incentive, which in a way
explainsespecially in the case of laws regulating economic issuesthe
gradual intrusion of legislation into areas that previously had been left to
the parties involved.
If legislators were made to forget the present and look toward the
future, their perspective would necessarily change. No one would want to

Hernn Bchi 143


promote a misguided labor law if he knew beforehand that it would hurt
employment in the future. Legislators tend to write faulty laws because
they think it will benefit people who are working today. They either
neglect or underestimate the effect that such a law will have on people
who will need jobs tomorrow.
On the other hand, laws and constitutions will be ineffectual if their
text contradicts the prevalent perceptions and beliefs of a society. Were
that to happen, courts would end up interpreting regulations in order to
suit the preferences and priorities of the society in question.
In times of prevalent belief in state control, then, no pro-market
legislation will ever be strong enough. Therefore, the goal should not be
to pass laws in favor of the private sector. This may be useful, but what
is truly worthwhile is to convince the greater society that the market
advances the common good better than does state interventionism.
Even so, drawing up the 1980 Constitution was an important
milestone in the military regimes reform process. The governments
resolve to submit to regulations of a higher order had been made clear
through the passing of constitutional acts between January and
September 1976, and through diverse general legal regulations.
The Constitution represented a serious effort to provide a backbone,
within a greater institutional framework, for the reforms that the regime
had implemented or intended to implement in the countrys political,
social, and economic institutions.

Simple Truths and General Principles


Personally, I feel disappointed by our inability to draw up a Constitution
that was simpler and less regulation-oriented than the 1980 Constitution.
Its major faults are its neglect of principles and excess of detail,
especially on the regulation of economic matters. I am not sure to what
extent such meticulousness works as an effective barrier against distorted
interpretations of the regulations. There will always be loopholes, and a

144 Reform Becomes Law


Constitution that has been drawn up with the obsession of closing them,
come what may, is off to a bad start.
It is important to note that by 1973, our countrys institutional
framework had been broken not by a coup, but by a long series of small
transgressions that eroded and undermined the rule of law. It was a long
process that started well before Allendes government. However, Allende
took it to its logical conclusionto such an extreme, that the Minister of
Justice proclaimed that the revolution would keep within the boundaries
of the law as long as the law did not attempt to curb the revolution.
Meanwhile, the general secretary of the governing party publicly
congratulated the workers who would not submit to a legal order.
Perhaps we lacked the courage to present the country with a
constitution that would reflect only basic principles, in as distilled a form
as possible. We lacked confidence that thisa handful of simple truths
and very general principlescould provide the foundation and a set of
guideposts for the entire institutional structure. As a consequence of the
traumatic experience in 19701973, the government feared the creation
of loopholes (resquicios), but we failed to keep in mind that these would
arise anyway, because the political manipulation of institutions and
regulations is ultimately unavoidable.
For example, the rule establishing that the Central Bank cannot
finance the Treasury seems to be, in principle, a good guarantee against
uncontrolled monetary expansion, which as we know always leads to
inflation. But what about the National Bank? Can it or can it not make
loans to the Treasury? And if not to the Treasury, can it make loans to a
state enterprise? And what about Corfo (Chilean Economic Development
Agency), which was created in 1939? In each of these cases, it is
possible to come up with numerous legal gimmicks that, while not
betraying the letter of the Constitution, would be going against the civic
principles that inspired it.

Hernn Bchi 145


Other Times
At the time that the government tried to build an institutional framework
for the economy that would be consistent with the reformsboth those
already carried out or on the agendathe intellectual climate and public
opinion were very different from what they are today. Even in the
eighties, the social market economy was a project still in its
developmental stages. Its scope was still very much open to debate even
within the government.
The most revealing testament to the internal contradictions of that
time is the Constitution itself. Skimming through it is enough to discover
that several of its ordinances reflect contradictory orientations. Although
it is openly statist on mining issues, it could not be more committed to
the market economy when it comes to outlining property rights. The
Constitution would probably have been even more biased toward state
control had it been drawn up after the 19821984 crisis. After all, 1978
1980 were bonanza years for the country. The economy, diverse
worrying symptoms notwithstanding, was flourishing.
In Chile, expropriation is out of the question except by law, with
compensation to be paid in cash. This Constitution leaves no room for
another wave of forced dispossession similar to the one brought about by
the agrarian reform. Now there are different loopholes: for example, the
municipal zoning ordinances entail serious restrictions on property
rights, and the same is true, to an ever increasing extent, in the process
for environmental approval of projects.
The Constitutions most important contribution is perhaps its ample
and vigorous recognition of economic freedoms. Behind this lies the idea
that individual rights and political rights that are normally recognized by
a constitution become a dead letter if they do not go hand in hand with
economic rights.
This correlation is essential. Anyone who studies socialism will
understand why this ideology makes a distinction between formal and
real liberties. Socialist criticism of bourgeois democracies makes a lot

146 Reform Becomes Law


of noise about the proliferation of formal rights in constitutions when
there are people in those democracies who are undernourished because
they do not have enough to eat.
Socialism has always been adroit at confusing the ends with the
means. The objective behind any institutional legislation is to make it
possible for people to fulfill their needs. Obviously, a constitution cannot
guarantee fulfillment of those needs, although many constitutionsas a
result of pressure from socialist factions, no doubtin addition to
personal, political, and economic freedoms, guarantee so-called social
rights, such as the right to eat, the right to social security, the right to a
job, the right to pleasant summer holidays, and so on. This reflects huge
misconceptions. What a constitution can guarantee is opportunity, not
concrete results.
The Chilean Constitution is not immune to these distortions. Parts of
it feature idealistic or programmatic statements. In almost all of its
articles, the tension between the liberal positions and dirigiste positions
is evident. These tensions are often dealt with by including exceptions in
one direction and then the otherwhich are not few. The resulting
amount of detail undermines the quality of the laws. The wording of the
great constitutional principles should have been much simpler and
briefernot enough constitution, too many rulesbut perhaps this was
the best we could have done.

Isolated Observations
One of the most long-lasting contributions made by the Constitution on
the economic plane is undoubtedly the cash compensation, in the absence
of an agreement between the parties, in cases of expropriation. This
obligation was also in force under the old 1925 Constitution, but the
indemnity could be paid in installments subject to undefined adjustability
mechanisms. In a country with the rates of inflation that Chile had, this
would make a mockery of the payment.

Hernn Bchi 147


On education, labor, and health issues as well, solutions provided by
the Constitution were also rather hybrid. On reading the text, for
example, one might wonder to what extent the municipalization of
education complies with the constitutional requirement that the state
finance a system of basic, compulsory, tuition-free education. Under this
prescription, would it ever be possible to transfer municipalized schools
to be managed by organizations comprising of teachers or parents, as
some of us had envisioned? Would it be possible for parentswhen a
rise in their wages made it feasibleto also start paying toward
financing schools? How meaningful would an explicit reference to basic
education be in a hundred years time?
In many of the constitutional regulations, it is possible to discern
traces of the traditional distrust that our legislation has always had of
customary practicea distrust that may be rooted in the Spanish colonial
legacy. In Chile, contrary to the legal tradition in Anglo-Saxon countries,
the law comes first and, supposedly, customary practice will follow.
Supposedly, if the constitution guarantees the right to health or to
education, then the problem has been solved: all Chileans will
automatically have good health and an education because the state says
so.
The Constitution recognized the importance of private property to a
social market economy. However, it made a clear distinction between
property rights and the right to property. The former would protect those
who already owned property; the latter those who hoped to one day own
property. The result, however, was an overly long property rights law.
Perhaps it would have sufficed to include a short statement to the effect
that the constitution recognizes private property rights, period. It should
be incumbent on other laws to establish the scope of this principle in
mining, waters, telecommunications, intellectual and industrial property,
and other areas. The mere fact that the Constitution included so much
detail speaks volumes of the internal tensions that prevailed.
A few safeguards were adopted on issues related to public
enterprises. Certain requirements were set upmainly qualified quorum

148 Reform Becomes Law


lawsregarding the States participation in business activities,
establishing that these would be subject to common legislation applicable
to private individuals.
The debate over the Central Banks independence proved interesting.
Apart from guaranteeing the issuing institutions independence, the
Constitution limited its operations severely. In fact, it can now only
operate with financial institutions, both public and private, but cannot
purchase documents issued by the state or finance public spending as it
used to do. The Constitution envisaged this institution fulfilling a
technical role, since that was the only way that it could function as the
backbone of monetary policy. But it was a long process. The
Constitution stating that the Central Bank is independent is not enough to
make this a reality. It gradually became a reality because the military
government created opportunities for the development of a capital
market in Chile. Without this market, the Central Bank would never have
been able to leave behind its role as a direct lender to the Treasury and to
specific industries. The Central Bank had basically been a fiscal policy
agent. Its autonomy was realized during the later years of the military
government, after a political agreement had been reached, taking
representatives of the opposition on board as counselors. This fact is
important because it shows how autonomy was legitimized. Otherwise,
the banks autonomy would still be questioned today. With independence
realized, it was essential that the Bank act independently and confine its
activities to its basic task: currency stability.
I am inclined to believe that, given the existing problems and the
countrys perceptions at the time, the 1980 Constitution was the best one
possible. At least the pivotal definitions of economic institutional
organization were taken seriously. At least we left behind the endless
discussion of whether the Constitution should allow the president to run
for reelectionwhich at times completely overtakes any constitutional
debate in Latin America to the detriment of important provisions that
will have a significant effect on the country.

Hernn Bchi 149


Several aspects in the 1980 Constitution are essential and have been
dealt with reasonably well. For instance, time has shown that the twoparty electoral system that it incorporates has benefited political stability.
Fortunately, it has so far survived the attempts at modification promoted
by the political convenience and fashion. The rules on budgeting and on
presidential authority on this matter have resulted in a favorable regime
of fiscal discipline that has put a check on the tendency toward arbitrary
and inefficient allocation of state resources.
But there is no doubt that countries are not defined by their
constitutions. Some, even, are what they are in spite of them. And others
fall far short of the high-minded constitutional prose laid down by their
national leaders.

Hernn Bchi 151


CHAPTER EIGHT

Times of Crisis
The eighties began with a world in upheaval. In the United States,
Ronald Reagan was launching his conservative revolution and was to
find his strongest ally in Margaret Thatcher.
Chile, in turn, was experiencing an economic boom. Growth rates
were close to 8 percent, real wages were up 9 percent, and everything
seemed to confirm that General Pinochet had made the right decision in
1973 when he adopted the principles of economic liberalization
articulated in El Ladrillo. The countrys first shopping mall and first
private university were both about to open, and the private health care
system institutions were beginning to operate.
Storm clouds began to gather on the economic horizon in 1981.
Pressure on the exchange rate, which had been frozen at 39 pesos to the
dollar in mid-1979, was strong, because during two consecutive years,
inflationthough it was decreasinghad caused domestic production
costs to increase. In this context, exporters returns were becoming less
and less attractive.
Many Latin American economies have gone through this
predicament. Applying exchange policy as an instrument toward
stabilization is more common than people in Chile thinkexamples
include Argentina during President Carlos Menem and Minister
Domingo Cavallos time, and Mexico during President Carlos Salinas de
Gortaris time in office. In both countries, the exchange rate was used as
an anchor mechanism to slow inflationary momentum (although that was
in the context of the early nineties, not the late seventies).
In 1981, in any case, debate over the exchange rate gathered
momentum in Chile. Nobody could say that there was no awareness of
the behavior of this crucial economic variable, or that it was not being
analyzed.

152 Times of Crisis


There are two aspects of the economic situation at the time that
should be kept in mind. One is that 1981 was atypical: it was the only
year since 1975 in which Chiles export volume did not increase. The
other is that foreign borrowing had never been as high in Chile as during
that year.
Nonetheless, there was significant growth both in 1980 and in 1981.
It is true that the rhythm of activity began to slow during the second half
of 1981, but before that, the economy behaved relatively well.

Dollar Inflows
The economic situation that the country faced in 1982 was less
reassuring. That year was marked by strong and intense debateboth
within and outside the governmentover the advisability of devaluating
against the dollar, which was being kept at 39 pesos, or reducing salaries
directly. The crisis hit rock bottom when the decision was made to
devaluate by 18 percent.
On the one hand, there were evidently problems in the private sector,
especially for commodities, because the government was resorting to the
exchange rate to stabilize the economy. The idea was to eradicate
inflation, and this is not easy, especially in a country in which wages are
adjusted by inflation. On the other hand, the government was working in
the context of a large amount of foreign investment that did not go into
the Treasurythe Treasury actually had a surplusbut into the private
sector, especially the financial sector. The authorities did not foresee any
major problem with this because, in the event of credit flow coming to an
end, the problem would be between foreign and domestic private parties.
As it turned out, the situation was not that easy. The problem of
stabilizing the financial system in order for it to be able to answer to
depositors was not a matter of importance to private individuals only; it
concerned the state as well. Therefore, when credit inflows came to an
end in 1982, the problem, which had been private, became public. The

Hernn Bchi 153


situation was even more difficult because at the time, the financial
system did not feature legal mechanisms enabling the adjustment of
potential imbalances by prorating losses between depositors.

What Went Wrong?


There is ample room to attempt to explain this episode. One proffered
explanation maintains that the problem would not have become as
serious as it did had there been fewer loans between banks or through
interrelated companies, and that the situation would not have arisen had
the country been able to resort to more efficient mechanisms to control
the financial system.
Although the Superintendence for Banks and Financial Institutions in
time did become more efficient, it was only halfway there at the time.
The country had already been through one banking crisis in 1978. But
the fact that private economic actors went into debt the way that they did
was not clearly perceived as a problem. Why should an organization
structure that worked quite well for the German and Japanese financial
systems, where the banks own enterprises, be unacceptable in Chile?
The main diagnostic error was to think that it would be possible to
keep the state out of the problem that was developing. Private parties
were unable to make the changes that the situation demanded, because
they were not equipped to do so and because there were no laws or
regulations stipulating how to cope with this contingency. Essentially,
bankruptcy in the banking context was not clearly defined.
The other element of the crisis was economic rigidity. When foreign
investment stopped flowing in, the logical reaction would have been for
the economy to change relative prices. With a fixed dollar, this would
necessarily have meant reducing internal prices, especially wages. In
theory, this would have solved the crisis, but in practice, prices were
fairly inflexible downward, and wages particularly so. Politically, wage
reduction was too high a hurdle to jump, even for the military

154 Times of Crisis


government, which today many people regard as headstrong and
determined. In fact, the government did not even come close to imposing
wage reductions of the magnitude that the economy required. Ironically,
a decision so avoided and postponed, so feared and exorcised, was
finally forced by circumstances anyway, when the economy adjusted on
its ownbetween 1982 and 1984, wages fell by 10.7 percent in real
terms. This was an important component in the adjustment. The other
component was paid for by an increase in unemployment, which in 1984
climbed to approximately 23.5 percent of the workforce, if we include
among the unemployed the people working in emergency employment
programs created by the government. In any case, although these
numbers seem astounding, this was the experience of many Latin
American countries labor markets, if we look at the combination of
wages and unemployment that prevailed during those years.
It is unlikely that the economy would have adjusted unaided, without
the 1982 devaluation, which took care of generating inflation, reducing
the purchasing power of wages, and changing the structure of relative
prices. In Chile, the wage system was indexed and the collective
bargaining law set the previous contracts wage level and adjusted for
inflation, as the floor for new union contracts. It could not have been
more inflexible. The government in turn reproduced these same
dynamics in its own wage policies and in the labor law that applied to
non-union private sector employees. In fact, in order to make the
adjustment via devaluation effective, the convergence of a pronounced
recession and legal changes making labor indexation more flexible was a
necessary precondition.

Two Factors
The two main factors that explain the Chilean crisis are, first, a very
strong external shock and, second, the interaction of this external shock
with the fixed exchange rate mechanism. When Mexican Minister of the

Hernn Bchi 155


Treasury Jess Silva Herzog called the banks in New York to let them
know that his country would be unable to pay them and would default,
all of Latin America was dragged into the hardships of the decade of the
debt crisis, which became known as the lost decade.
The external situation became especially grim. The Mexican default
coincided with the effects of the policies that U.S. Federal Reserve
Chairman Paul Volcker had implemented in order to curb the inflation
rate inherited from President Jimmy Carters administration (1977
1981), during which inflation had reached a yearly 11 percent rate. As a
result, interest rates during President Ronald Reagans time soared to
unforeseen levels: between 16 percent and 17 percent for nominal rates,
between 4 percent and 5 percent for real rates.
In addition to this, there was the fall in terms of trade to consider.
They had deteriorated between 1970 and 1980, but the decline between
1980 and 1985 made the situation even more dramatic.
There can be no doubt that the external shock was underestimated in
Chile in 1982. Critics of the official policies hardly took it into account
as a variable in their analyses. The authorities, in turn, never could have
imagined the depth and duration of the crisis.
In the end, events turned out to be much more serious than had been
indicated by either the diagnoses made by economists, the criticism from
government opponents, or the governments own working assumptions.
Latin American countries fell one by one, victims of the violent
international recession. The situation made evident the fact that the
Chilean contraction was a consequence not just of the fixed exchange
rate system, as critics maintained. The change in the external variable
was crucial. Latin American countries, each with different policies, were
just as affected as Chile was, if not more so.
No doubt, the delay in the decision to make the exchange rate more
flexible was a problem, especially given the new external conditions. But
it was not the whole problem, as some suggested. It was evidentone
had to be blind not to recognize thisthat Chilean exports had been
losing competitiveness. This was disturbing, given the countrys

156 Times of Crisis


development strategy, even though the conditions required by the
exchange rate as an instrument were being adequately complied with.
The situation was in itself serious without the external shock, but the
external crisis intensified the problem. Perhaps it might have been
possible, once inflationary momentum had been arrested, to correct the
exchange rate lag through other instruments within the system, or by
means of milder traumas than the ones that were finally applied to check
the external crisis. But something had to be done. The imbalance would
not correct itself. Furthermore, the way to development is through export
competitiveness. If it is a question of erring on any one side, a high
exchange rate and an undervalued currency are by far preferable to an
exchange structure that makes exporting unviable.
Using the exchange rate to stabilize the economy is a legitimate
policy and can be very effective in certain contexts. This strategy proved
useful to Argentine Finance Minister Cavallo in controlling rampant
inflation in 1991, at a time when his country had been through several
shocks. This is what happened in Chile. The exchange rate lag could
perhaps have been overcome, but not the lag in conjunction with the debt
crisis and international recession. That was too much.

Unanswered Questions
The Chilean economic crisis during those years raises many questions.
How was it that the authorities did not react in time? Why did the
measures to face the emergency take so long to implement? On the other
hand, it is only fair to recognize that there was no easy way out.
Devaluation, which seemed such a sensible measure and was finally
adopted, entailed huge costs. The rise in the exchange rate made the
situation of debtors in the financial system more critical and brought to
question the health of practically the entire banking system.
That there was no easy way out was made very clear not only in
Chile, but throughout Latin America, and violently so. Chilean GDP fell

Hernn Bchi 157


by a whopping 14.1 percent in 1982. However, in retrospect, Chile
reacted better in the end than did any other country in the region,
especially in comparison to Mexico, Peru, and Argentina. Between 1981
and 1992, Chiles per capita growth was the highest in Latin America,
according to CEPAL data higher even than Colombias, even though
that country largely escaped the debt crisis. The only exceptions were a
few small countries in the Caribbean.
Handling the situation was extremely difficult as the economic crisis
threatened to turn into a major political crisis. For example, between
1982 and 1984, Chile had five treasury ministersSergio de Castro,
Sergio de la Cuadra, Rolf Lders, Carlos Cceres, and Luis Escobar. I
was appointed in February 1985.
As controversial and painful as it was, devaluation did at least fulfill
its basic objective: it made it possible to change relative prices. The
crisis, on the other hand, made it possible to modify the law that indexed
workers wages, making the Chilean labor market more flexible.
The final point here is that in Chiles experience, two factors
converged that were impossible to resist in conjunction: a major external
shock and a fixed exchange rate as a weapon against the inflationary
trend, in an economy where there was strong indexation, not only by law,
but in practice and by popular custom.
I do not think it would have been possible at the time to stabilize the
economy via nominal wages. This option is not part of our economic
policy toolbox and has not been internalized either by the authorities or
by workers.

A Rift in the Team


Aside from its huge economic costs, the crisis introduced a serious
rupture in the liberal consciousness of the team of professionals and
economists on which the government had relied to plan the countrys
economic transformation. The climate of great unity, the certainty of

158 Times of Crisis


having taken the right path, and the collaboration of previous years
yielded to an atmosphere of struggle, conflict, and ill feeling. This could
not have come at a worse time, given the situation that the country and
the government were going through. The administration was pushing for
substantive reforms that required not only imagination and hard work but
also deep personal commitment, in order to carry them through.
Politically, the government was sailing through rough waters, and
these divisions did not help face criticism from detractors. The
newspaper El Mercurio, through its editorials, questioned the path taken
by the government economists, arguing that things were being handled
with the clumsiness of the inexperienced. Political opposition also
became more intense. National protest days began to occur, and
eventually turned into massive anti-government demonstrations.
On April 22, 1982, Minister of the Treasure, Sergio de Castroone
of the main promoters of the reforms from the outset of the
governmentresigned. The crisis, the shattering of consensus, and the
course of events were crushing blows to the Chilean reform project. The
decision to devaluate was taken by General Pinochet at the same time
that he refused to reduce nominal wages.
It is possible that in the handling of the crisis, many people saw signs
of intellectual arrogance that may have contributed to a hardening in
positions. But it is important to recognize that the economic authorities
were in a very difficult position. Any evidence of doubt or hesitation
would inevitably have worked against the economic teams efforts, so
political sensitivity was a luxury that we could not afford. The fixed
exchange-rate policy is precisely a no-regrets policy that requires mental
toughness in order to implement it.
If things had happened the way they do in textbooks or in laboratory
experiments, there first would have been an automatic unaided
adjustment in wages and internal relative prices. Second, private debts
would have been transformed into private equity, and foreign creditor
banks would have capitalized the loans that they had made to their clients
in Chilemost of them in the financial sector. Third, depositors in some

Hernn Bchi 159


troubled banks would have had to assume the loss of varying proportions
of their credit balance.
None of this happened, however. The first point was very difficult,
and the country was not ready to carry it through. As for the second and
third points, there was no clear system of regulations establishing the
mechanism by which equity adjustments were to be made effective.
Some of these points began to take shape, in fact, when indexation was
made more flexible, especially after 1985, as a result of the changes
introduced in financial market legislation. However, the direct equity
adjustment in 1982 was confined to the owners of the unstable banks,
because they had lost practically everything.
In practice, foreign bankers also lost. They ended up selling Chilean
external debt promissory notes substantially below their nominal values,
which ended up benefiting the country to a great extent. However, this
process was not immediate. It took time and did not take definite shape
until 1985.
To sum it up, the change in relative prices was never as significant as
an automatic adjustment would have required. Besides, the proposal to
pass a law to reduce wages by a percentage that would not have
exceeded 10 percent eventually yielded to a law that reduced only a
small fraction of the higher wages in public administration. In view of
the magnitude of the imbalances at stake, this was insignificant and,
inevitably, the problem exploded in the form of a recession. Some critics
argue that the devaluation merely added fuel to the flames of recession
but that in fact the recession was coming anyway; it had been gathering
force during all of 1981 and became visible at the beginning of 1982.
External conditions rendered it inevitable.
In Chile, the outcome of the eighties crisis was especially bitter:
devaluation, recession, and state intervention into the financial system.
Aside from this, the state had to take responsibility for the debts
contracted by private parties. This was for the purpose of answering not
to bank ownersas has often been claimedbut rather to depositors and
creditors.

160 Times of Crisis


Fatal Convergence
Many were the factors that converged in 1982, in Chiles second worst
economic crisis of the twentieth century. The economic authorities were
stuck in a fixed exchange-rate policy. Nobody could predict how long or
how intense the crisis would be. The regime lacked the political ability to
provide relief through wages. The legal system was imprecise and rather
ineffective as a means to induce the equity adjustments that the crisis
called for. There was also a misguided perception that the indebtedness
of the private sector did not concern the public sector. In addition to this,
one more factor failed: the solidity of the financial system and of the
Chilean private sector in general. It is true that the private sector had
grown in comparison to its situation in 1973, but this expansion had
taken place through debt. There was little capital in Chile. The
decapitalization of the private sector after decades of interventionism and
of the Allende period of outright Marxism was real. It took years to
overcome this problem, which exacted a heavy price during the crisis.
Debts are always too inflexible to cope with times of crisis.
Undercapitalization in economies trying to transition from socialism
to a market economy is a serious problem, because there can be no free
economy when the private sectors equity situation is unstable.
Transition from one system to the other, as Eastern European countries
discovered, requires mechanisms and incentives to strengthen the private
sector, and this can only happen via reduced taxes or via direct equity
transfers. Such transfers could take place via privatizations through
popular capitalism, the sale of enterprises to their employees at favorable
prices, or the voucher system that was used in the Czech Republic and in
Russia.
Despite the intensity of the crisis in Chile, the country showed an
amazing capacity for recovery. The countrys trade deficit in 1981 had
become a surplus by 1983. This transformation involved almost a 15
percent GDP movement, which is significant. Now, the downsides in this
situation were the dramatic fall in GDP, increased unemployment, and

Hernn Bchi 161


reduced wagesalthough some sectors such as Codelco, where wages
were not reduced, escaped the fall that affected even the salaries of
central government staff and the military. This means that the reduction
was necessarily steeper in other areas, to compensate for the privileged
few who went through the crisis unscathed.
The crisis also changed the fiscal situation, which prior to the crisis
had shown a surplus. Clearly, if there was one thing that could not be
done to address the new needs and spending, it was to raise taxes.
Increasing the tax burden on a depressed private sector would have made
things worse. Therefore, there was no choice but to cut spending and
adjust public sector wages and the government agency budgets, applying
an adjustment factor below the rate of inflation.

The Governments Actions on Other Economic Agents


The accusation that some of the means the government used to overcome
the crisis were arbitraryespecially the intervention into the bankswill
always linger. Why were some debtors affected while others were not?
Why were depositors helped? Why was the assistance offered to some
people not offered to others?
These are legitimate questions, but so are the priorities that guided
the actions of the government. The government decided not to help the
owners of the banks, but did help debtors, especially small and medium
debtors, through mechanisms such as a preferential dollar exchange rate,
successive renegotiations, refinancing operations with the Central Bank,
and de-dollarization, among others.
In practice, the question of who could be rescued and who could not
depended on how extensive these mechanisms were and on each groups
credit position. Ultimately, the groups and the banks that fell were the
ones that had assumed greater obligations in a risky bet. If things went
well, they stood to gain a great deal, both through the bank and through
the company that had received the money. If the system locked down,

162 Times of Crisis


their only hope was that the problem would be so massive that in one
way or another the government would come to their rescue. But this did
not happen and these groups disappeared. Later, in 1984, several
economic groups made that same gamble and things turned out well for
them, because the country was doing well, but there was a radical
difference this time: the assets on which they were gambling were
mainly their own, not those of other people. The government had
changed its strategy to make this possible. Taxes were modified, and a
series of measures enabled greater capitalization of the private sector.
The outcome of the crisis was not only painful and dramatic, but
paradoxical: after six or seven years of a social market economy, the
banking system and a significant part of the private sector in Chile
returned to the state. The country perceived this development in two
conflicting ways: while the market purists thought that state intervention
had gone too far, the opposition held that it had not gone far enough and
that money was being given away to the bankers.
The truth was at neither of these extremes. Intervention was not
spurred by a dogmatic eagerness to vindictively liquidate the private
sector, as some people maintained, and neither were bankers favored.
Depositors and savers were favored foremost, with small debtors second.
This explains the entry of new investors and owners into the banking
industry, even in the case of institutions into which intervention was not
a factor.
Would it have been possible to negotiate with the economic groups
of enterprises that fell into bankruptcy? In other words, was there an
intermediate solution, more assertive than doing nothing but less drastic
than intervention? Of course it was not up to the state to present the
solution. The government always expected greater negotiating potential
from the main economic groups, especially with their foreign creditors;
however, they lacked this potential, and they failed in this. Perhaps they
did not even consider the possibility, but the securitization of debts by
foreign banks would have been not only a solution for the country, it
would also have meant the salvation of the banks. Paradoxically, this was

Hernn Bchi 163


considered to a great extent several days later, when the crisis was over.
It was too late, of course.
Today, some people argue that all of these companies and banks
could have gotten back on their feet had they been given time. That is
true, in view of the development of the Chilean economy since 1984. But
what would have happened if the country had not recovered? Recovery
at that point was not guaranteedit was actually so uncertain that
foreign banks were prepared to take losses of up to 40 percent and 50
percent of their credit, in an effort to liquidate Chilean external debt
promissory notes.
Everyone lost out in the crisisthe government, bankers, workers,
businessmen, pensioners, and foreign banks. Strictly speaking, nobody
won. What did happen later was that recovery in some activities was
swifter than in others. During the second half of the eighties, there was
great mobility. A large number of small and medium-sized businesses
expanded. Those in a better position were able to capitalize on the
benefits of recovery more advantageously.

Reflections from a Distance


My own experience at the time of the crisis was unique. I lived through
the culmination of the process, not within the economic policy
community, but as Undersecretary of Health. After this, I moved to the
National Planning Bureau (Odeplan) and later to the Superintendence for
Banks and Financial Institutions. In a sense, this saved me; in another
way, it tied me inexorably to the appointment awaiting me farther ahead.
In the Health Ministry, I never felt involved with or committed to either
the unshakeable truth of the fixed exchange rate or the harsh criticism
directed at De Castro at the time.
In retrospect, the crisis was a time of great conflicts and crucial
decisions. The country came to within a short step of abandoning the
social market economy for good. Had it turned back on the experience

164 Times of Crisis


then, historys verdict would have been that the model had failed and
was therefore abandoned. Where would we be now? In Brazils situation
in 1992? Facing the same problems as Venezuela in 1993? Would we be
looking for a Chilean version of Menem or Salinas de Gortari? Going
even farther, where would Latin America stand now? Would the
Mexican, Argentine, or Peruvian experiences have occurred, if not for
the Chilean experience? Would it have been possible if the country had
only gone halfway?
The year 1983 marked the peak of political risk for the market-based
development model in Chile. There were several cabinet changes, each
new minister having to face a tough and thankless task, until the
appointment of Minister Escobar Cerda. He clearly belonged to a
different school of economic thought, but the merit of his tenure was the
confirmation of the fact that there were no easy and painless solutions to
the problem. The country began to recover in 1984, but it was clear to
everyone, given the trend reflected in the indicators, that the recovery
would be short lived. That year, the balance of payments current account
deficit increased by $1 billion. So short lived did the recovery turn out to
be that the Minister, at the end of his short term in office, had to
devaluate once again and increase tariffs.
This experience proved useful when I was appointed Minister of the
Treasury. There were no easy solutions. Therefore, the task the country
needed to undertake was to retake the initiative on behalf of a free
economy, which required perseverance and hard work. It was not a
question of moving just one economic variable. All of the variables had
to be dealt with simultaneously and in coordination in order to put the
country back on the path of sustained and sustainable development.

CHAPTER NINE

How to Get the Country Back on Its


Feet
The year 1984 in Chile proved that solving the economic crisis that the
country was going through was not easy and that the tough times were
not simply a consequence of the former economic teams obstinacy. Nor
was it a question, as many people believed, of the need for greater skills
in negotiating with the International Monetary Fund. It is true that for a
few months, public opinion was that things were improving. There was,
in fact, a certain degree of relief and greater growth, but the downside
was the worsening external crisis at a moment in which the world
showed absolutely no interest in financing Chile or Latin America, and in
which the prices of our products were falling. This situation could later
generate significant inflation as well, if the economy was not stabilized
quickly and soundly. Greater growth translated into successive increases
in imports at a pace that was unsustainable in the long term, as evidenced
by the fact that the current account deficit was taking on dangerous
proportions.
Minister Luis Escobar Cerdas objective in devaluating by
approximately 24 percent and raising tariffs from 20 to 35 percent in
September 1984 was to reduce domestic spending, moderate peoples
consumption, and reorient the economy toward exports. But these
measures also meant that real wages had to be restrained; otherwise the
economy would once again be caught up in the inflationary spiral caused
by continuous movements of both exchange rates and wages.
This was the situation at the end of 1984. Things were not going well
for the country, and during the latter months of the year, rumors of a new
cabinet change began to circulate. After many years, I had decided to
take a long family vacation, especially to spend time with my oldest
daughter who would soon be leaving childhood behind to become an
adolescent; this would probably be the last holiday that I would be able
to spend with her. But the President, just as I was beginning my vacation,

166 How to Get the Country Back on His Feet


announced a cabinet change that was to be made at the beginning of
February, which was rather late, given his habit of making cabinet
changes at the end of the year. In short, this announcement obliged me to
cut short the trip I had planned and postponed several times as I had
come to occupy different positions: Undersecretary of Economy,
Undersecretary of Health, Directing Minister of Odeplan, and, finally,
Superintendent for Banks and Financial Institutions. In fact, I had to be
tracked down in a place in the south of Chile by the Carabineros
(Chilean national police), who took me immediately to La Moneda by
Air Force plane for an interview with General Pinochet.
On February 12, the President confirmed my appointment as
Minister of the Treasury. It was not the most optimistic of times.
Different proposals to solve the crisis all seemed to have been exhausted.
Almost two and a half years had passed since economic indicators had
begun to decline and, after all this time, the country was still very
disoriented. Some colleagues on whom I called to share the work ahead
have reminded me that at the time they joined the team, they knew that
the work presented to them would be very interesting, but also very
precarious in terms of job security. The high turnover of officials who
had preceded us in the economic policy team led us to place bets, only
half jokingly, as to how long we would last in our positions. The average
bet was of about two months.

The Diagnosis
The challenge that I faced was complex and the responsibility enormous.
We had made great progress in matters related to structural reforms. We
had transformed the economy into something entirely new. We were also
facing a new social situation, and were making significant reforms to
help the poor. But, in the short term, we faced a major crisis, the end of
which no one in Latin America could foresee. The Chilean economys
terms of trade continued to deteriorate. The numbers for 1985 show

Hernn Bchi 167


Chiles terms of trade at dramatically low levels. In October 1984, the
price of copper fell to 57 U.S. cents per pound.
There was another, more serious problem: the gradual divorce of the
government from the social market economy model. The Minister of the
Treasury and his teams work, to all intents and purposes, renounced the
development model that the government had embarked on in 1973. Many
felt that the strategy had failed and therefore should be abandoned. The
government had placed its bets on expansionary and protectionist
measures that would help improvement in the long run. The challenge in
front of me was to a great extent political: to prove that this path led
nowhere, that any recovery it may achieve would be ephemeral in the
best of cases. In short, I needed to persuade the country of the need for a
drastic change that would mean a renewed commitment to economic
freedom, liberalization, and the market.
I was convinced that the structural policies implemented by the
government were the right ones. The problem that the economy was
experiencing was a consequence of the loss of wealth caused by the
decline in terms of trade, which had translated into an even greater loss
in well-being as a result of foreign banks refusal to continue granting
Chile credit to the extent that they had done in previous years. Peoples
difficulty in accepting and facing the new situation made things worse.
The right thing to do, from my point of view, was to strengthen
structural policies, reinforcing the economys orientation toward exports.
In view of the shortage of foreign capital, this was more pressing than
ever before. The debt-to-product ratio reached its highest historic level in
1985, at 114.1 percent. Interest rates at the time were excessivethe
180-day LIBOR rate was 13.4 percent in 1982 and 11.2 percent in
1985and the poorer the country became in dollar terms, the greater its
foreign obligations became.
Regarding support of exporters, the devaluation implemented by
Minister Escobar in September was certainly useful. But it would only be
useful insofar as it was not eroded by rises in either government spending
or nominal wages, both which proved unlikely due to existing pressures.

168 How to Get the Country Back on His Feet


The situation was different in the case of the tariff hike, which took
tariffs to 35 percent and headed precisely in the opposite direction as
what the country needed. A protected economy always exports less, but
lowering this barrier involved greater fiscal discipline, since tariffs are
politically expedient tax for the Treasury.
The other critical problem that needed to be dealt with at the time
concerned the rate of investment, which the crisis had reduced
drastically. It was barely 13.6 percent in 1984; clearly, in the long term,
this level of investment would lead the country to a dead end. The task
was to determine how to increase this level quickly, but this time without
foreign capital, at least in the medium term, since banks had stopped
lending to Chile. A steep rise in domestic savings2.7 percent in
1984was therefore required. In achieving this end, fiscal savings were
key.

A Weak, Broken-Down Engine


There remained a more serious problem. The crisis had destroyed the
private sector, so building it back up was crucial, as we considered it the
true engine of development. It was a strange time because the situation,
after several years of market reforms, was somewhat similar to the
situation in Eastern Europe, since a good number of enterprises and a
significant part of the banking industry were run by the state, to which
they had returned when faced with bankruptcy. Clearly, until the private
sector was consolidated, the country stood little chance of getting off the
ground. The challenge was not to take it back to its pre-crisis situation,
but to make it much stronger. This meant moving on quickly to the
privatization of the major public enterprises.

Hernn Bchi 169


The External Debt
Among the tasks aimed at solving the truly pressing problems
concerning unemployment and income in Chile, the handling of the
external debt was extremely important. The debt was a constant source of
pressure on the economy. The opposition maintained that the strategies
that Alan Garca was implementing in Peru at the time were what this
situation called for. The more moderate opposition endorsed the policies
applied by Raul Alfonsn in Argentina. They called for outright war
against foreign banks. Garcas announcement that Peru would pay only
for up to 10 percent of its exports was hailed as a model of economic
inventiveness and political courage. In the end, the amount Chile finally
paid was not far from this percentage, but it was paid in the context of
systematic and orderly negotiations that helped increase our exports and
our manufacturing. At the time, however, we were criticized for our
alleged political meekness. That criticism would not stand up to scrutiny
today.
The negotiation of the external debt was an extremely interesting
experience for me. It gave me the chance to work with important world
economic leaderssuch as U.S. Federal Reserve Chairman Paul
Volcker, U.S. Secretary of the Treasury James Baker, and his successor,
Nicholas Brady. In addition, I worked with Bundesbank President
Helmut Schlesinger as well as French chief Jean-Claude Trichet, who is
now President of the European Central Bank, and with several leaders of
private banks. This was all in a context of great uncertainty in the world
economy, caused by the repercussions of the debt crisis. In that context,
we Chileans were able to devise and put into practice solutions that
would also prove useful to many other countries trying to overcome the
global debt crisis. Specifically, this involved debt-equity swaps, which
were first set forth in chapter XIX of the Central Bank Regulations
Compendium, and restructuring of payment schedules with our creditors.
Chile was the first country to apply the Baker plan, before James Baker
translated it into a concrete proposal, and came up with a Brady plan

170 How to Get the Country Back on His Feet


before Nicholas Brady. However, what comes seems so simple when
described in one paragraph was not that simple at all. The myriad
difficulties and anxieties caused by delays in the approval of the first
structural adjustment loan from the World Bank, due largely to political
considerations, seem trivial today, but at the time they were nighinsurmountable hurdles. The creditor banks were not easy to deal with
either. At one point, I even decided to travel to Antarctica for a few days,
as a way of getting a reprieve from a negotiation that I found
exasperating. The decision helped meliterallyboth to cool down the
talks and to better fulfill my role as a member of the Antarctic Politics
Commission. It also gave me time to go over existing budgetary
problems.
The rationale behind this effort was not to adjust macroeconomic
figures on paper. It was to solve the tremendous problems that people
were living throughmainly unemploymentthat would never be
solved unless Chile managed to set itself on a stable growth rate that not
only would bring bread today but would also thwart the risk of hunger
tomorrow.

To Grow, but in Stability


What we were trying to do was to get back on the path of stable growth,
with stability as the top priority. A spectacular growth rate one year
would be worth nothing if the following year the economy contracted
again. That was the only way we would be able to eliminate the dire
unemployment situation. It must be kept in mind that at the time, a large
segment of the opposition held that the problem was unsolvable. The two
state emergency employment programsthe minimum employment
program (PEM) and the unemployed heads of household program
(POJH)at one point comprised 500,000 workers, which in a workforce
just under 4 million people was a huge proportion. Alongside these
numbers, we faced the reality of a 20 percent open unemployment,

Hernn Bchi 171


including people employed by the central government through social
programs, taking the percentage of population affected by the lack of
work close to 30 percent. Our main priority was to create jobs, leaving
improvement in wages to be dealt with later. The oppositions prognosis
maintained that the economy would need over twenty years to overcome
the scourge of unemployment.
Put in these terms, the recovery program seems a simple matter. In
fact, theoretically it is, but it is easier said than done. The difficulty lies
in handling several interrelated variables. Talking about implementing a
fiscal austerity policy is easy, but actually doing so becomes very
complicated in areas such as health or education at a time when, because
of the crisis, society is highly vulnerable both economically and
politically. The political situation in 1985 and 1986 was still very
difficult. Street protests, which began soon after the onset of the crisis,
had not only become widespread, but had turned into a ritual whose
routine nature did nothing to detract from its violence. The tension and
the level of confrontation increased, month after month. I remember
venturing out on the streets in a neighborhood where one of the most
violent protests had taken place the day before, trying to go unnoticed, to
see the damage for myself. This underscored for me the extent of the
crisis and strengthened my resolve to work toward overcoming it.
The last straw for my administration was the violent earthquake in
March 1985. Damage in the central region was extensive; a significant
part of Chile was literally razed to the ground. It was a terrible
experience but, in a way, it forced the country to face up to reality. The
level of government spending prior to 1984 could no longer be
maintained. Agreements that had been signed by Minister Escobar before
I took over, regarding budget increaseswhich were already unfeasible
before the earthquakebecame impossible to fulfill. A closer watch
needed to be kept on government spending, even though after the
earthquake the whole country set its eyes on what the state would do to
help overcome the emergency in the areas and regions that had been
worst hit.

172 How to Get the Country Back on His Feet


The disaster helped make people aware that there was no other way
out but through hard work and austerity, which entailed moderating
wages and cutting government spending. It was in this context that the
10.6 percent adjustment on pensions was not applied, as it should have
been according to the automatic readjustment mechanism that General
Pinochets own government had set up in favor of retirees. It was a tough
time; wages in Chile were not being increased at all, so at the time this
decision was made, there was no other choice.
The government, showing great resolve, adopted a policy that
affected pensions in the defense sector more than in any other. In the
case of higher pensions, the loss was substantial. This was not done out
of some masochist compulsion: times called for more than just patching
things up. Drastic decisions were necessary. Countries that avoided such
decisions caused more harm to their needier populations in the long run.
In Peru, Argentina, and Brazil, the problem was much more critical, and
those countries to this day cannot offer any hope of recovery to their
most disadvantaged citizens. Between 1980 and 1987, real wages in civil
service and defense underwent a sharp and sustained decline. Much the
same thing happened in the private sector. It is worth noting that workers
at public enterprises, many of whom did not apply the adjustment or
applied it in a milder version, fared quite a bit better.
Government spending, which had reached 30.7 percent of GDP in
1984, was reduced to 20.6 percent in 1989. Fiscal policy was
fundamental in creating opportunities for export in backing a high real
exchange rate and in promoting increased domestic saving. The latter
increased from 2.1 percent of GDP in 1982 to 17.2 percent in 1989.
During that same period, investment rose from 11.3 percent of GDP to
20.3 percent. The real exchange rate increased by 80 percent between
1980 and 1988. Without an austerity policy, the government would never
have been able to carry through measures such as the tariff reduction.
Without lower tariffs, a high exchange rate would have been impossible
and exporters would not have been able to recover to the extent that they
did.

Hernn Bchi 173


The decision to reduce exports costs translated into numerous other
measures during this period: rebates on or assistance for VAT payments
for exporters; incorporation of the construction sector into the VAT in
order to facilitate investment; elimination of all export taxes; and further
tariff reductions. Tariff reductions were always resisted, both by some
people in government, because it reduced revenues, and by the business
community, which feared greater competition from imports.
Every one of these reforms involved a struggle. In fact, the last tariff
reduction was carried through only after Chile had been removed from
the Generalized System of Preferences, due to political pressure. Success
makes consensus easier: this was clearly reflected in the fact that in
1991, Patricio Aylwins Christian Democrat government reduced tariffs
once again, after a unanimous vote in Congress.

The Authority of Detail


The process of restoring business confidence was slow. The most
depressing year was 1985. The specter of the previous years increasing
balance of payments deficit, which included a current account deficit
of11 percent of GDP, lingered over Chile. The dramatic fall in terms of
trade, an earthquake in the central region, street protestswherever one
turned, the situation seemed to be a disaster. Things began to improve
slowly, but never by chance. Behind every measure and every decision
there was a systematic effort to apply a balanced approach to the
achievement of many objectivesto restore confidence, encourage
recovery, appease public opinion, convince government ministers of the
unfeasibility of increased expenditure, uphold General Pinochets
commitment to the strategy that we were following, and neutralize the
oppositions criticisms.
I think I managed to survive so many problems and so much pressure
during this period because I had detailed knowledge of the governments
institutional structure, which allowed me gain the trust of the health

174 How to Get the Country Back on His Feet


minister one day, of the manager of a public enterprise the next, and then
of the education or defense ministers. I had the advantage of having been
involved in practically every area of government. Setting modesty aside,
the one thing that no one could tell me was: Youre new, so you dont
know what Im talking about. In fact, I knew quite a bit from the years
that I had already spent working in different fields within the
government. I doubt that I would have been able to privatize state
companies without the knowledge that I had about the problems in the
companies that we wanted to transfer to private ownership, about earlier
privatizations in the seventies, and about the difficulties faced by banks
that had been intervened into. I had to combine and coordinate thousands
of decisions and detailswhile facing over 10 percent of the workforce
on minimum employment plans (which were supposed to be temporary)
and a large number of unemployed. The challenge lay not only in
maintaining these special programs, but in thinking of ways to dismantle
them when things improved. Memories lingered of past crises in which,
in an effort to bring down unemployment, the government agencies had
taken on employees on a temporary basis but then never let them go. In
this task, the support of other economic policy agencies was essential.
Minister of Economy Modesto Collados (19841985) understood from
the outset that the path we were suggesting was the right one, and his
decision to take the risk and commit to it was important to future
accomplishments. Later, Juan Carlos Dlano and Manuel Concha, in the
same ministry, gave their valuable support, as did all other economic
policy officials.
Until 1984, many people believed that Chiles problem was mainly
due to the external debt, which they believed could be addressed through
what was known as a good negotiation with the IMF. My
administration quickly put aside this perception, because the problem lay
not with the IMF. The problem was ours. When a business is in a
difficult situation because its operations are becoming unsustainable, its
main challenge lies not in getting more funds or an extension on
financing. The challenge is to sort out the enterprise, in order to achieve

Hernn Bchi 175


a positive cash flow, increase its products market appeal, and improve
its competitive position. Within this perspective, endless renegotiation of
debt schedules made no sense unless the country corrected its own
imbalances and dysfunctional structures.
The effort to attain stable growth was subject to the condition of
keeping inflation within ranges that were reasonable in the Chilean
context. Our aim was never a one-digit figure. The goal was to achieve
growth that could be sustained over time and to reduce inflation as much
as possible, although not eliminate itthat would come later. Our
indexation was not just formal, but psychological, and the need to raise
the exchange rate made this almost impossible.

The Tools of Recovery


The Treasury played an important central role in strengthening the export
sector and in maintaining an attractive exchange rate. Its handling of tax
revenue, tariff changes, and pension system reform were key instruments
in the recovery of savings levels and in the recapitalization of the private
sector. The tariff changes and pension system reform had remarkable
exponential effects. In just a few years, domestic saving jumped from 3
percent to 18 percent of GDP. This proved once again that, in the long
run, the socialist compulsion to levy taxes on businesses hurts the poor
even more than it hurts the businesses themselves. The higher taxes are,
the more limited is the private sectors reinvestment capacity and the
fewer are the jobs that businesses can create. This debate is far from
over, and it continues not only in Chile but in many other countries as
well. The one thing this debate needs to avoid is the pitfall of short
termism, which is usually reflected in the question: Why reduce taxes
if the economy is working well? The situation cannot be evaluated
based on one years results. It needs a wider perspective. Any growth
process will generate increased savings capacity, but when development
objectives are ambitious, these savings will in all likelihood not suffice

176 How to Get the Country Back on His Feet


and more will be required. It is then, looking a little bit beyond next
week, that the importance of lower taxes becomes evident. The signals
and incentives that citizens perceive will strongly influence their
behaviorsaving vs. consuming, working harder vs. sitting back, and
state support.
Several measures proved to have a crucial role in strengthening
private investment, from the fine-tuning of detailssuch as of the
mechanism for collecting VAT on construction projectsto the
resumption of financial activity with the rest of the world, privatization,
taxes, and the mechanisms devised to attract foreign investment through
debt conversion operations. The latter, in addition to helping reduce the
countrys external obligations, also helped to put Chile back on the
global investment map.
We consistently adhered to the imperative of safeguarding foreign
investment. This was clearly a way to escape the debt crisis. We
systematically refused to submit to pressure from various constituencies,
including the IMF, to include maturities and returns on foreign
investment on the list of items to be negotiated with foreign banks. We
thought this was a dangerous thing to do. We even increased our
advantages for foreign investment in order to attract more investors,
especially those interested in strengthening our economys export
capacity.

The Road to Privatization


Politically, the most critical issue in my administration was perhaps the
restructuring and strengthening of the private sector. The very idea
roused indignant reactions from many people. Why build up the private
sector when the whole country had just witnessed its fall? they would
argue. In the eyes of many critics, the private sector appeared to be the
main culprit. Looking beyond those resentments, to whom could these
corporations, which had been driven into state hands by bankruptcy and

Hernn Bchi 177


had become known as the peculiar sector (rea rara) of the economy,
possibly be sold?
To whom could the major state enterprises such as the phone
company or the electric utilities be sold? The privatization strategy
applied to the peculiar sector enterprises this time was different from
that applied in the seventies. The objective was not to sell, but to build
indeed, rebuilda solid private sector, through capital flows and through
stocks. This had to be done, as had been clear to me since the late
seventies. That was the reason why I considered it so important for
individuals savings to go through the capitals marketwhich made the
pension system reform feasibleand for the government to reduce the
tax burden on businesses. Who could ever conceive of a social market
economy with a chronically weak and battered private sector?
The strategy for restructuring sought to increase capital flow through
the pension system reform and the tax reform. Since their taxes had been
reduced, businesses either increased their level of investment or directed
their savings into either the financial market or retiring debt. It also
sought to increase stock ownership through the mechanisms that allowed
nondiscretionary stock transfers, such as popular capitalism, labor
capitalism, and advantages granted to public employees and to large
groups of people. The idea was to make stock ownership accessible to
relatively large groups of peoplepublic administration officials,
workers from the privatized enterprises, small saversusing nonconventional procedures such as the use of retirement compensations and
reduction of personal taxes if they bought stocks.
The privatization process also attracted foreign investors who came
in through the door that had been opened by chapter XIX of the
Compendium of Foreign Exchange Regulations. These foreign investors
converted external debt into capital. The process also attracted the
domestic entrepreneurship that had managed to overcome the crisis.
Interesting combinations began to develop, and each case was different.
The privatization of the Bank of Chilegiven its tradition and what it
representedfollowed the guidelines to reduce the concentration of

178 How to Get the Country Back on His Feet


property ownership. We believed that foreign banks would show interest
in the Banco de Santiago, but this did not happen, and the same
procedures were applied to its sale. In the case of Banco Concepcin, the
solution adopted involved the workers, through an agreement with the
National Mining Society. The negotiation concerning the Banco
Internacional involved Israeli investors. In the cases of the Santa Mara
and AFP Provida, popular capitalism was combined with foreign
investment from Aetna and Bankers Trust, respectively. In all of these
cases, the challenge lay in privatizing within a competitive environment.
In Mexico, for example, it is true that the banking system was privatized,
but during the initial phase, it maintained some significant obstacles to
foreign competition. In Argentina, telephone companies were granted a
period of legal monopoly. In the Chilean privatizations, monopoly was
not part of the negotiation.
Copec, a fuel distributor and cellulose exporter, and a peculiar
sector member, was taken over by the Angelini group through
successive share purchases. CCU, a brewery, was taken over by a private
entrepreneur, Andrnico Luksic. It was interesting to see the ways in
which domestic investors attracted foreign partners for these projects.
This was how investors from New Zealand came into Copec. Later
CMPC, another paper and cellulose company, interested the Fletcher
group, another Kiwi concern. Luksic also attracted German investors.
In the end, not everyone profited to the same extent from these
changes. In fact, investors ran considerable risks, which was the reason
why, initially, administrators of the pension funds were barred from
taking part in the process. Had they been allowed to do so, any losses of
workers assets at the outset of a new private system would have been
politically disastrous. Pension funds would be allowed into privatization
later, and then gradually.
When the storm had subsided, some critics portrayed the
privatization process as a carve-up, but it was nothing of the sort. Over
time, people came to believe that the popular capitalism shares had been
given away, because the shares obtained excellent returns as companies

Hernn Bchi 179


and banks recovered. But, just as things went well, they could have gone
awry. There was no try-before-you-buy policy in privatization.
The privatization of the large state consortia, such as steel,
telephones, and electric utilities, came later and was gradual. The
makeup of the Chilean economy had changed markedly. The financial
sector had been stabilized. Interest rates, for the first time in over a
decade, had dropped to normal levels. But privatization faced restrictions
and real problemsto begin with, because of the size of companies that
were hard to incorporate into a private sector that had only just begun to
recover. In addition, when it came to obtaining credit and foreign
investment, the global financial community still perceived Latin America
as a high-risk region. In fact, in some other countries privatizations,
such as those of Argentina and Peru many years later, there would not
have been enough bidders had it not been for the presence of the
Chileans.
One option was to say that conditions were not ripe for the
privatization of these consortia and that this had to wait. However, that
meant keeping key sectors stagnant. Faced with this alternative,
launching the sale of the main electric utility, Endesa, and other
companies in the electricity sector, including the telephone company and
the steel company CAP, among several others, was infinitely preferable.
By doing so, Chile ultimately benefited from a cycle of spectacular
growth, which extracted it from the mire of debt and enabled it to lead
Latin America in economic recovery. A large part of Endesas assets
came under the control of public employees through pension funds or
through an advance payment on their retirement annuity. The phone
companys capitalization was increased by investment from the
Australian business group led by Alan Bond, who at one point controlled
40 percent of the company. Bonds foreign investments later hit hard
times, but the investment that he brought to Chile launched the take-off
of investment in telephony, which was later taken over by Telefnica
Espaola, the company that bought the Australian consortiums shares.
As for the steel company, domestic investors, the workers themselves,

180 How to Get the Country Back on His Feet


and a Swiss business group entered the scene. Each companys
privatization was a separate case and each was difficult to carry through,
but the dynamism that the process generated made it all worthwhile.
However, many tasks were left pending. The oil refineries were not
privatized (Argentina would later take the lead in this field). The mining
unions situation became complicated, and the National Mining
Company (Enami) remained antiquated. Banco del Estado remained
untouched, after a reasonable attempt to privatize it, giving workers
ample participation through dispersed ownership, failed.
This process involved the work of a large team that included both
veterans and newcomers; economists, civil servants, and military
officers; and academics and practitioners, young and old.
If one were to assess the work carried out, the emphasis would surely
have to be on the notion of pragmatism. The task set aside ideologies and
preconceived notions. In fact, it can even be said that the general ideas
put into practice were few and simple. The details, however, were many
and complex, which is probably why I felt so comfortable carrying it out.
I consider myself to be detail oriented. I strongly believe that highsounding statements mean little if they are not grounded in reality. The
mere description of how the debt equity swaps were implemented is
overwhelming. The process seemed never-ending. The creditor banks
originally opposed our plan, because the debt renegotiation contracts
prevented us from carrying out the swaps and prevented the sale of state
assets. After long negotiations, they accepted the plan, but that was not to
be the end of our problems, which were just beginning. How could we
guarantee that the different promissory notes would receive equitable
treatment? How would we decide on the order in which to accept them?
How would we meet the challenge to increase competitivity, as the
Japanese did? Details, simply details, but the issue was crucial. Chile
reduced its debt level substantially through this process. Banks that got
rid of their promissory notes immediately made a bad deal; the more
patient ones did better. However, the banks that transformed their debt

Hernn Bchi 181


into direct investment, effecting the operation themselves, made out the
best.

Outcomes
In the end, our efforts led to a vigorous economic recovery and a healthy
growth trend that lasted nearly a decade.
The structure of government expenditures changed. Although they
now represent only 20 percentnot 30 percentof GDP, actual
revenues are much greater because there has been spectacular GDP
growth.
The improvement in employment was remarkable. At the end of
1989, unemployment stood at 5 percent and emergency jobs programs
had completely disappeared. Social spending, on the other hand, was
increasing at an unprecedented rate, even as the government began the
twin processes of decentralization and regionalization in this area. The
flexibility introduced by the labor laws passed in the early eighties was
vital in improving the employment situation. As foreseen, the recovery of
the purchasing power of wages held back until 1988, but it finally
showed, and since then real wages have shown sustained improvement. It
became clear that nothing has more damaging consequences for workers
than inflexibility. Chile actually needs to go much farther still. Our
workforcearound 35 percent of the populationneeds to grow. Rates
of workforce participation in developed countries are higher. Achieving
that requires greater labor market flexibility.
Exporters response was equally encouraging. Between 1985 and
1989, Chilean exports jumped from $3.8 billion to $8.1 billion. The
projects involving greater production capacity were in the mining, fruit,
forestry, and fishing sectors.
What the country experienced starting in 1985 was not a boom, but a
process of orderly and gradual recovery. It was a healthy process,
grounded in the improvement of savings and investment rates. Without

182 How to Get the Country Back on His Feet


this, recovery would have been illusory. In short, manna never rained
down from heaven, but things did improve consistently and gradually.
By 1989, the private sector had changed completely. New players
appeared on the economic scene. Emerging enterprises became
increasingly important, in addition to those that were already established.
Not only had businesses wounds scarred, but Chilean companies were
now ready for far greater development.
The government was also extremely successful in stabilization
inflation, which, although it was not reduced to international levels, was
kept under control and came close to disappearing.
By 1989, the country had successfully completed its structural
reforms. Chile had not only extracted itself from the rut that it had been
in, but had also cleared a path for development for many years to come.
Personally, I found this process doubly encouraging for two reasons.
First, a successful development strategy, which the country had almost
given up on between 1983 and 1984, was salvaged. Second, having
started out as a simple pawn, I came to the later stages of the reform
process holding responsibility and authority over the countrys social and
economic policy making and development. I found additional
satisfaction in seeing new government officials who had criticized the
model when they had been in opposition now applying it with no major
changes. In all honesty, I think that they have done so less imaginatively,
yet have been rewarded with greater praise, but such is lifewhat really
matters is improving the lot of the poor, not personal recognition.
Never think of yourself, I said to myself when I sat down at the
Treasury Ministers desk for the first time. I think I have been loyal to
that commitment. I never changed my government car. I did not even
dare move the desk from the place where my predecessor had left it. In
the public sector, one owns nothing. And in the ministries, the day-to-day
hassle or ones exhausting schedule are not what really matter. What
matters is the contribution that one can make for the country. In this case,
we left hope for the futurenot only for Chile, but also for other
developing countries (including other Latin American countries) whose

Hernn Bchi 183


economic reform processes would have been much harder to achieve had
our experience been cut short.

Hernn Bchi 185


CHAPTER TEN

After the Battle


Now is a good time to reflect on issues that were critical in Chile and that
have also appeared in other countries whose economies are moving from
a state control regime to a liberal model, facing serious stabilization and
balance of payments problems in the process. Addressing these problems
requires, above all, long-term stable growthand, one would hope, the
greatest possible growth. The content of this chapter may seem too
technical to some readers, but I think that the questions it raises come up
frequently in every economic liberalization process.
In any case, beyond the conclusions recorded here, my firmest
recommendation to those in a position to carry out market reforms is to
avoid delay. In the end, the time available to economic policy makers is
always short. The task is so vast that there will always be challenges left
unresolved, but the important thing is to leave lasting solutions for as
many of the countrys challenges as possible. I know of many people
who were part of the government and did not make full use of the time
that they hadthey do not say as much, but their regret is easy to see.
The opportunities to modernize, to liberalize, and to clear paths to
development come around only once. The following conclusions and
suggestions should be read in this spirit:
1. There are no easy ways out. This may be the most important
lesson from the Chilean economic experience, and is drawn from diverse
situations that the country went through during its modernization
process. Chile had long suffered from chronic inflation, and was on the
verge of hyperinflation during Allendes time. Inflation was later brought
under control, but it was never eradicated, not even when the behavior of
prices seemed very stable and when the peso was pegged to the dollar, as
it was in 1980 and 1981.
The price that the country paid to moderate the rise in prices was
high in terms of lost competitiveness by exporters and manufacturers as

186 After the Battle


well as other adverse effects. Unfortunately, the debt crisis struck in
1982, and this experience was cut short over the next few years.
Although inflation was kept under control, eliminating it was not a
priority in the face of the urgent need to get development back on course.
Once the debt crisis had been overcome in the late eighties, it became
possible to make eliminating inflation a priority once again. However,
this was interrupted by a change in government. In the meantime, the
total indexation in the capital market, by means of the UF, made it
possible to live with a moderate level of inflation, while at the same time
developing an increasingly sophisticated financial sector. It should be
pointed out that the indexation of financial operations does not
necessarily lead to the indexation of the goods market or the labor
market. The degree of difficulty in eradicating inflation will depend on
the degree of segmentation achieved in these markets. Interestingly,
other Latin American countries, rather than resort to indexation, have
decided to dollarize their financial sectors, which has allowed them to
develop a more complex financial market. In any case, it is important to
keep in mind that it is not easy to leave instability behind. Once
instability rears its head, correcting it always translates into slower
growth (which can lead to recession and depression) or into clear
deterioration vis--vis the external sector. Sometimes both effects occur
simultaneously. When this deterioration is only partial, a relatively good
external situation can be very helpful. In Minister Cavallos time,
Argentina provides a good example of a stabilization program sustained
by the external sector. The same thing happened in Mexico in the early
nineties. In both cases, the effort made during the eighties had corrected
the critical external imbalances, and, in Argentina, this had generated a
significant commercial surplus. However, this changed quickly when
exchange policies were used as stabilization instruments, because this
generated increasing trade deficits. The challenge was to maintain price
stability and reverse the loss in competitiveness, setting into motion
growth based on investment and exports. When the first edition of this
book was written in 1993, these challenges were as yet unresolved in

Hernn Bchi 187


both Argentina and Mexico, and their subsequent outcomes have both
been dramatic, albeit different.
When inflationary instability combines with a serious external
disequilibriumas in Chile in 1974 or Peru in 1990the situation is
more severe, and the margin for action is much narrower. Correcting
these disorders can be very difficult unless there is financing for a
gradual adjustment in external accounts. Unfortunately, except in some
special cases, this option is not available at the height of a crisis.
2. Stability is its own reward. This belief used to be less widespread
than it is today. The CEPAL development model, which had taken such
deep roots in Latin America, for many years accepted that, in view of the
costs of instability, a small amount of inflation was not in itself a bad
thing, provided that other economic indicators were sound. The hit-andmiss economic policy approach that Brazil had followed since the late
seventies reflects a blatant disregard for stability and illustrates many
governments cavalier attitude toward inflation. They disregard the fact
that when a crisis hits, chronic instability becomes explosive. During the
sixties, Brazil and South Korea both stood poised for spectacular growth.
One need simply see where each of these countries stands now. South
Korea paid attention to inflation. Brazil, unfortunately, did not.
3. There are three key tools. In order to achieve stability,
governments can resort to three basic instruments linked to monetary,
fiscal, and exchange policy, respectively. Hundreds of theoretical models
provide guidelines on how to address instability. Some emphasize the
exchange rateraising it almost to gold standard statusand give
monetary policy a passive role. Others advocate a more active monetary
policy. Chile adopted several alternatives. In 1974, and after the first
devaluations and efforts toward a single exchange rate, a managed
exchange rate policy was adopted. Monetary policy was designed around
inflation targets, and the currency was revalued against the dollar in
order to maintain a real net parity, which was adjusted according to the
balance of payments situation. Later a pre-announced dollar table was set
up, and finally, in 1979, the exchange rate became fixed. It remained so

188 After the Battle


until 1982, when monetary policy became passive, as reserves exceeded
the money in circulation in the economy. Between 1982 and 1985, the
country went through times of great confusion, including a brief period
during which the dollar was free. After 1985, the economy went back to
a policy similar to the one applied during the governments early years,
with monetary and exchange targets that were consistent with an
inflation range of 10 percent to 20 percent and with a real exchange rate.
Personally, I think that in these matters, flexibility was an important
principle that was applied during my tenure. This is not to say that what
was done during those years should be applied in all situations. Once the
crisis has been overcome, eradication of inflation would need to become
a priority. Other alternatives may become appropriate, as has been the
case in some countries that have reimposed a fixed exchange rate. It is
difficult to establish general rules. What works in one case may not in
another. At times, a fixed exchange rate is unfeasible. At times, setting
targets may not work, because it is very difficult to predict how the
demand for money will develop. Underlying the alternatives in the
management of monetary and exchange policies is fiscal policy, which is
always decisive in a stabilization process.
4. Highly developed capital markets provide valuable help. Almost
always, at the outset of a stabilization and reform process, the margin of
action in monetary policy is very limited. Central banks are often very
restricted in their functions, because they are obliged to finance state
enterprises and the Treasury, and because of a lack of capital markets in
which to make long-term investments (sometimes not even short-term
investments). Because of these things, it is difficult for them to carry out
an active monetary policy with any degree of certainty. When capital
markets do exist, the Central Bank faces a less complex task; it has some
margin in which to neutralize the expansions that the Treasury may
create in order to fulfill the commitments required of it through issuing
of bonds. Without this, the margin for action is smaller or inexistent.
These markets are unlikely to exist when, in the period prior to the
reforms, the only capital market institutions to be found are the banks,

Hernn Bchi 189


and these operate practically as cashier windows for the Central Bank, as
was the case in Chile. In this context, the combination of necessarily
strict monetary policies, exchange rate uncertainty, erratic expectations
regarding future inflation, certain sectors protection from the restrictions
through preferential credit, and falling domestic savings due to the crisis
result in exorbitant real interest rates. Chile went through that process.
The normalization of interest rates to ranges compatible with
international rates was not achieved until 1986. By then the Chilean
economy had developed a capital market that enjoyed a considerable
degree of independence and sophistication, and many of the issues
affecting the interest rate had been addressed. Mexico, Argentina, Brazil,
Peru, and many other countries went through similar situations involving
inordinately high interest rates. Moreover, Brazil, to a certain extent, was
still feeling the effect of this phenomenon in 2007.
Changes in monetary policy should be done with great care, because
of the inflationary effects that they could create, and because exorbitant
interest rates almost inevitably cause defaults by debtors, putting strain
on the financial system. Chile also lived through this experience. This is
the type of experience that shows that economic policy making is as
much an art as a science.
5. Fiscal policy is a key factor, both during stabilization and in
subsequent stages. Fiscal stability is neither a whim nor an accident. A
treasury that spends above its revenue level is a destabilizing factor that
is very difficult to neutralize in economies resembling those in Latin
America. Developed countries such as the United States, Germany, or
Italy can afford to have significant fiscal deficits without this
immediately having an inflationary effect, because they can resort to
highly developed capital markets for financing, and because their overall
economies are much more stable. The long-term effect of a fall in
savings, investment, and growth certainly leaves its mark, and this is part
of the controversy going on in some countries today.
But when instability is evident and chronic, and capital markets are
not yet fully developed, fiscal policy becomes a key factor for both the

190 After the Battle


long and short term. This was a constant in Chile. Public deficits during
the seventies, which exceeded 20 percent of GDP, began decreasing
gradually. At the beginning of 1980, the country already had a strong
surplus. The crisis temporarily put an end to this affluence, which
reappeared in 1986, when the country once again showed a surplus.
Between 1984 and 1990, government spending fell from 30 percent of
GDP to 20 percent, and proved decisive in the increase in domestic
saving, which rose from 2 percent to 17 percent of GDP. On the other
hand, the fiscal situation can also highlight an important trend. An
overspending treasury can be dangerous in the long term even when
there is a current surplus. The important goal is not a one-time balance
such as can be caused by a rise in commodity prices, an increase in tariff
revenue after an import boom, or new borrowingbut rather a longlasting, sustainable balance between revenues and spending. Financing
the treasury through an onerous tax burden is not the answer either.
Higher taxes mean reduced incentives for growth and investment, and
reduced investment means less future development, which is the worst
thing that can happen to a country. My experience in this matter is that
sound fiscal policy is essential both in containing inflation and in
achieving adequate levels of savings, investment, and competitiveness.
6. The external sector is not to be fooled with. Chiles case proves
the effectiveness of development strategies based on export growth. As
far as I know, no country has reached development in modern times in
any other way. A key variable within these strategies is the real exchange
rate. As I have already pointed out, I am of the belief that going
overboard is preferable to falling short. However, a high real exchange
rate, which requires real measures, should not to be confused with a high
nominal exchange rate, which can lead to nominal rises and inflation.
The development of exports needs an exchange rate that is favorable not
only today, but also over the long term. Otherwise, it is unlikely that the
exchange policy will be able to incentivize the investment needed to
generate growth.

Hernn Bchi 191


Undoubtedly, the exchange rate is not the only necessary factor;
rather, it must be part of an ensemble of micro and macroeconomic
policies geared toward improving competitivenessincluding lowering
or eliminating export taxes, liberalizing overregulated sectors that have
exporting potential, and providing support for entry into foreign markets.
On the other hand, there is talk these days of the world moving
toward the configuration of large, outwardly closed trading blocs, and
rumors that countries that do not succeed in joining one of these blocs
will not fare at all well. This prediction has some very respectable
advocates, but I do not subscribe to it. On the contrary, I believe that the
world, for the most part, is moving in the direction not of protectionism
but of freer trade. There may be backsliding as some countries and
markets close up, and there may be whole industries that need to be
retooled, but essentially the opportunities that open up always outnumber
the ones that close down. In fact, the rate at which international trade has
increased exceeds the rate of world product growth. Countries in Eastern
Europe, the former Soviet Union, and China, among others, have opened
up to trade. Besides, the only choice for small developing economies
Latin America, for instance, represents roughly 5 percent of GWPis to
take the opportunities that the world offers. Locking the region into this 5
percent sharethat is, ignoring the opportunities of 95 percent of
GWPhas proved a losing strategy for Latin America.
7. Overly rigid positions can be damaging. In setting economic
policy, a certain degree of flexibility is not only desirable, but also
necessary. The important thing is to have clear objectives. We must not
turn things upside down and let the instruments of economic policy
become ends unto themselves, because this can generate many
distortions and very few benefits. Complete understanding of the
circumstances of each sector is extremely useful; theoretical concepts
must go hand in hand with a thorough knowledge of concrete reality in
order to yield optimal results. Theories on tax rates do no good if one is
not familiar with the rules of accountancy that affect those rates. For
example, when tax rates in different countries are compared, if the real

192 After the Battle


effect of these rates in view of depreciation regulations or exemptions is
not allowed, the comparison will have a basic flaw. The same applies in
all areas of policy. This is the source of my appreciation for a detailed
understanding of real-world circumstances, to ensure flexibility in action.
8. Reasons for and against indexation. In the absence of indexation
mechanisms, persistent inflation becomes a serious obstacle to the
development of sustainable capital markets, which are indispensable for
investment and growth. The predicament for countries such as
Venezuela, where stability yielded to several years of double-digit
inflations, is more serious than we can imagine. Mexico and all of
Central America had enjoyed considerable price stability in the past, but
since the eighties they have had to live with high rates of inflation that
they have still not erased. The risk in indexing capital markets is that,
although it eliminates the problem of inflationary uncertainty, indexation
can spread to the market for goods or to the negotiation of wages,
making the economy more rigid and difficult to stabilize. In addition,
there must be credibility in the index chosen. Some countries have fallen
back on dollar indexation, a dollarization that is almost natural in Peru
and elsewhere in Central America, or is the result of a strategy, as it was
in Argentina. Dollarization, while it can solve the problem of reduced
credibility in local currency, can have negative effects if there happen to
be strong modifications in terms of trade, since this would rule out the
option of solving the problem by simply adjusting the exchange rate.
This is a serious problem to which I believe there are no alternatives
outside the ones described: paying the price of uncertainty, indexation, or
dollarization. Chile generated a general mechanism for indexation, which
I think has been positive for the country and can be a useful model for
other countries.
9. The important thing is to persevere. A countrys economic
transformation is not a one-shot undertaking. It requires many struggles.
During the endeavor, there will always be setbacks, be they internal, in
which case policy makers have a certain say, or external, in which case
they have practically none. In every liberalization process one must

Hernn Bchi 193


expect to go through some dark and difficult moments. But the important
thing is to send out the right signals to the economy, protect the weakest
while assuming the costs of reform, and keep on track, maintaining
resolve. This ingredient is essential. Little is achieved without faith and
conviction.

Hernn Bchi 195


CHAPTER ELEVEN

The Model Endures


Even at the beginning of the nineties, in spite of the winds that were
sweeping the world at the time, there were setbacks around the world.
Uruguayan voters, for example, rejected in a referendum a privatization
program designed to bring the economy up to modern standards. Why
this rejection? Was the crisis not strong enough to make a majority of
Uruguayans sensitive to the need for the discipline of a reduced role for
the state? Was the referendum not properly set up? Did political leaders
not explain the advantages of privatization clearly enough? Does this
mean that Uruguay chose to fall behind from that point on?
It is not easy for leaders and political parties that have condemned
pro-market policies in the past to later embrace them. Many prejudices
and reservations still endure, in spite of the markets capacity to raise
living standards, especially for the poorest.
Many are the specters that cause large sectors of public opinion to
mistrust the market. It is not easy to accept reality when utopias come
crashing down overnight. Development is not about simply transferring
wealth; it is about creating it, and certain political factions lack the
intellectual repertoire required to meet that challenge. In recent years,
Bolivia, Ecuador, and Venezuela have gone back to talking about
redistribution, abandoning the goal of wealth creation, and have
destroyed existing wealth in the process.
Even now, many people think of the market economy as being about
selfishness, consumerism, and the poor becoming poorer. This
perception is demonstrably false. In this context, during the nineties,
whether Augusto Pinochets democratically elected successor would
uphold the economic model or overturn the measures taken over the
previous seventeen years, taking the country back to the days when the
state took a predominant role was a valid question.

196 The Model Endures


On March 11, 1990, Christian Democrat Patricio Aylwin won the
presidency with 55 percent of the vote, leading the transition to
democracy. He was backed by the Coalition of Parties for Democracy
(Concertacin de Partidos para la Democracia)a coalition that drew
together several left-wing parties, all opposed to the economic
liberalization model. In fact, several Concertacin members had actually
worked in close collaboration with Salvador Allendes government.
President Aylwin himself had stated that he thought the market was
cruel, and later, in an interview in a Brazilian newspaper, said that the
new Chilean pension system was not completely just, but was probably
realistic in that it takes account of human nature. The notion of an open
economy makes some sectors in the country so uncomfortable that, in
late 2007, members of the Christian Democratic Party were still
questioning the free market model and holding it responsible for poverty
in Chile.
At that time, during the nineties, wondering how much these statist
and retrogressive visions would influence the future of the economy was
a valid concern. Was this to be the beginning of a major shift? Would the
new government be able to address social demands by handing out
money at the expense of fiscal discipline? Would we move backwards
again, toward populist policies that would plunge us back into the
poverty of the sixties? At the time that Aylwin took office, these
questions were yet to be answered and generated uncertainty in many
people. The only certainties in 1990 were that Chile was beginning a
period of sustained growth, and that there was a 21 percent inflation rate
and a 6 percent unemployment rate.

The Guidelines Are Preserved


President Aylwin governed with an opposition that, although it did not
have a majority, had significant representation in National Congress.
This opposition was resolute in blunting changes that threatened to

Hernn Bchi 197


dismantle the economic model. Moreover, in several areas, the reforms
that had been launched in previous years were carried on. This not only
prevented us from backsliding, but made it possible for Chile to continue
growing for several years.
The free trade agreements signed with the United States (2004), the
European Union (2003), China (2005), and many other countries are the
last links in a chain that began to be forged in 1973, when the country
opted for opening its economy to the world. Minister of the Treasury
Alejandro Foxley himself (19901994) described the path taken by the
Christian Democrat government thus: It was necessary to open up the
economy more, reducing country risk and negotiating trade agreements.
We needed to take further steps in the international reach of Chilean
companies.1 There is no doubt that this would not have been possible
had the economic liberalization not been launched seventeen years
before, or if it had been upended during the crisis in the eighties. The
same thing happened with foreign private investment: in 1990, it was
among the highest of the previous twenty years, and 26 percent higher
than the previous year. This was made possible by the guarantees
established in the mining law for this type of investment.
Also along these lines, the Central Banks independence, which was
put into effect in 1990, just after Patricio Aylwins government had
begun, was fundamental. In addition to establishing the Banks
independence, the 1980 Constitution restricted the loans made by the
Central Bank to the financial sector. One of the main objectives of this
measure was to control inflation. Thus, Chile managed in fifteen years to
reduce inflation from approximately 30 percent to the current annual 4.8
percent, patiently going through the process of building up trust as well
as institutions. The Constitution also restricted government spending.
Moreover, creating a state enterprise now requires passing a law to that
effect, under special quorum conditions.

Alejandro Foxley. La Economa Poltica de la Transicin, p. 7.

198 The Model Endures


The list of examples of reforms that took shape during the second
half of the eighties, and were behind the important advances made in the
two subsequent decades, is very long. Actually, behind the control of
inflation after the nineties stand not only a revived Central Bank, but also
a new regime of fiscal discipline at the Treasury and at state enterprises,
and the creation of a strong financial market. Building all of this took a
long time, mainly because of the initial chaotic situation. At the
beginning of the present decade, President Lagos inaugurated several
new modern highways in Santiago and throughout the country. Few
people realized that this would have been unthinkable without the
convergence of many of the changes implemented in the eighties.
Financing for all of these projects comes from a financial market that
was strengthened by the 1980 pension reform. Decreased poverty and
improved social indicators after 1990 have gone hand in hand both with
the economic growth enabled by the previous changeswhich
unfortunately have not been reinforced as vigorously as they initially
wereand with the social policies designed between 1970 and 1980,
which involved a lot of hard work. Undoubtedly, changes have been
introduced that have accumulated over time, sometimes with negative
effects; on the whole, however, the guidelines have been upheld long
enough for them to bear fruit.
Which factors were decisive when it came to upholding the model?
Looking back to try to identify the lessons that could be useful in other
reform processes, I find two aspectsone, temporal, the other spatial
that stand out as essential.
In the first place, the changes must be comprehensive and go deep
enough to make them enduring. In Latin America, there have been
numerous attempts at economic reform, but the policies did not go deep
enough to make them lasting. Argentina is a case in point. That country,
which started off on a strong privatization plan, after a while centered its
economic reform on a fixed exchange rate, with a convertibility law
establishing that one peso would be equivalent to one dollar. Instead of
advancing toward comprehensive reforms, the Argentine government

Hernn Bchi 199


made the mistake of turning the exchange policy into the centerpiece of
reform, which paved the way to failure. By trying to address the
weakness of the countrys political institutions through the convertibility
law, the Argentine government was left with the convertibility law as the
only enduring legacy of the whole reform process.
The second essential factor for transforming an economy is for
reforms to be comprehensive in encompassing as many areas as possible,
in order for professionals and experts in areas as diverse as education and
health to all work in conjunction toward the same goal. As in all major
change, the success of the reforms does not depend on one single person,
but on the joint efforts of a large number of men and women working
toward the same end.

Two Minds
Although it has maintained the countrys macroeconomic stability, the
coalition that has governed Chile since 1990 has exhibited a conflict
between two opposing worldviews, in effect two mindsone pragmatic,
the other ideological. This conflict has prevented the swift, decisive
action required in order to make further progress in the reforms that the
country needed. As well as curbing the progress needed to uphold
growth, Concertacins ideological mind has brought into the debate a
constant questioning of the pillars of the free market, which has ended up
shifting economic policy in the wrong direction. For many public figures
in the country, the entrepreneur is an enemy to be distrusted and whose
work therefore must be hampered with obstacles, taxes, and mandates.
So, entrepreneurs who want to start a new business today face everincreasing costs, energy shortages, and an increasing number of
regulations that increase their costs and make all aspects of running a
business more complicated. Fortunately, there are voices within the
Concertacin that have expressed concern about this trend.

200 The Model Endures


The proposals for more labor regulationswhen what the country
needs is more flexibilityand for higher minimum wages are misguided.
In the modern world, there is more and more labor flexibility, as more
people work from home or on a part-time basis. As for minimum wages,
surveys show that the work situation of the poorestof those who are
employedis precarious, because their jobs are temporary, part time, or
informal. In fact, a nationwide social indicator survey indicates that they
earn less than the minimum wage, confirming that this type of regulation
is ineffective.
In the mid-eighties, a harmonious labor institutional framework that
favored competitiveness was finally achieved. After this came a ten-year
period, between 1985 and 1995, in which workers wages increased at a
7 percent annual average rate, taking into account the increase in
employment. This performance is unprecedented in the countrys history.
Unfortunately, the situation was affected by a gradual deterioration in the
legal framework, resulting in greater adherence to a confrontational
worldview, which caused this rate to drop to just 4 percent between 1995
and 2005. Difficulties in finding employment are still critical for lowincome young people and for many women. If this spiraling trend
continues, it would not come as a surprise if we were to find, in ten
years time, that workers as a whole have been the most harmed.
It might relieve our consciences to say that we want better wages for
everybody. However, imposing on others what they should doturning
a blind eye on the evidence confirming that these impositions curtail
progress, employment, and the future of the pooris unethical. What we
desperately need are policies that will accelerate growth and create jobs.
Chile has adopted these in the past, and there is no reason why it cannot
do so again.
The mark of the ideological vision of some Concertacin factions
also crops up in the debate on education. Instead of tackling the problem
of quality in education and why it has not improvedeven as education
spending has tripled in recent yearsthe focus has jumped to issues of
equality. Some claim that the goal of equality would be better served

Hernn Bchi 201


through direct state provision of education. Others aim at much stronger
control of subsidized schools based on the fact that they receive public
money, ignoring the fact that the goal of the subsidies is to use the
peoples own money to make sure that they get an education.
Parents must have as great a freedom as possible to choose their
childrens education. The state has no right to impose any one school on
them. We must not forget the lessons of the past, when almost all schools
were state run and inequity was huge.
There has been no progress in investment issues either. Getting an
investment project approved is becoming increasingly difficult, which
has curbed investment growth. We seem to have forgotten that just as
investment may have negative externalities, it has positives ones too, and
many of them.
Regarding pension reform, although the system has room for
improvement and should work toward raising its share of population
covered and increasing competitiveness in order to reduce costs, the
answer does not lie in greater state intervention. Proposals such as
creating a state-run AFP, or private pension fund managers, or granting
benefits that are not directly correlated to individual income, are
misguided.
It is vital that Concertacins pragmatic mindthe one that sets
ideological visions asideretake the economic reins of the country. We
cannot miss the opportunities that globalization has to offer. We must
allow the poor to achieve the prosperity that they deserve. It is to be
hoped that the recent dialogue between the government and the
opposition on topics such as education and equity will lead to a more
practical and less partisan approach.
The worst thing for the country would be for the ideological mind to
prevail, and for misguided policies to become legitimized. Today, we
answer to an ideological or demagogical viewpoint. At the present, antiglobalization voices, which are becoming ever stronger in the region,
seem to reflect that regrettable tendency.

202 The Model Endures


Part of the Culture
Transforming a countrys economy involves understanding that reforms
must not be directed at any specific group, political party, or individual,
but rather at all citizens. When this concept has been internalized by
citizens and policy makers, it becomes imperative to carry on with the
necessary reforms, rather than take them apart in an ideologically
charged debate. Ideally, good policies should be a part of a countrys
culture.
A 2007 survey revealed that three decades after the liberal reforms
were launched, 55 percent of the Chilean population supports the market
economy model. In the 1834 age group, this support is even greater.
The survey also shows that this support cuts across political affiliations,
from right to left.2
For those of us who helped tackle the challenge of implementing the
basic principles of economic liberalism, this is an important triumph for
the country, whose population today believes in an economy that is based
on individual effort.
However, Chile has not yet taken the last step. I believe that Chileans
have not incorporated into their culture all of the elements necessary for
the countrys development. They have accepted some of them, but not
all.
In my opinion, the concept of opening up to the global economy and
being part of a globalized world has been accepted. Unlike in other
countries in the region, which have gone down different routes, in Chile
there is practically no political space for nationalistic or populist
proposals, or for advancing extreme ideologies. The same is true of
macroeconomic stability. Most people recognize the importance of
controlling inflation and of balancing fiscal accounts.
It is also necessary to shape a culture that will favor growth.
Learning to value entrepreneurship is essential. Countries that value,

National Survey, La Tercera Survey Center, October 2007

Hernn Bchi 203


admire, and encourage their entrepreneurs have made huge strides in
becoming competitive internationally. This is precisely where we have
failed. We need to understand that local companies that decide to go
global face ferocious international competition. To burden them with
more taxes and regulations is clearly the quickest way back to
underdevelopment. I think a socialist tendency still persists, which
ascribes success to the government when the country grows, and blames
entrepreneurs for declines in growth and employment. A persisting
demagogy keeps repeating that the fate of workers can change by simply
passing a law, when it is no secret that only a dynamic economy can
create more and better jobs.
Another error that prevails in our countrys culture is the belief that
more regulations are the only way to protect consumers. The experience
of other countries proves that precisely the opposite is true. Fewer
regulations translate into more competition, which ultimately benefits the
consumer by offering more products at lower costs.

Two Post-1990 Periods


Based on the countrys growth rate, two post-1990 periods can be
defined since the beginning of the Concertacin governments.
During the first, between 1990 and 1997, the country experienced a
7.2 percent growth rate, which surpassed the 3.4 percent world average.
In 1990, President Aylwins economic team believed that they were
facing an overheated economy and likely inflationary outbreak. This was
not their only diagnostic error. They also thought that the debt crisis had
not been overcome and that the country would have trouble accessing
external financing. But the country paid a price, which translated into a
year of lost growth because of this error in diagnosisalthough this
probably reaped the benefit of everyone better understanding and
accepting the bases of economic policy.

204 The Model Endures


Since then, when free market policies prevailed, Chiles growth rate
exceeded the world average. During this period, no doubt encouraged by
the previous economic reforms, the countrys first free trade agreements
were signed and efforts became focused on opening markets for exports.
The results are in plain view.
However, during 19982007, when the world average growth rate
was barely 5 percent and the price of copper was high (toward the end of
the period), the average national growth rate slowed down to 3.9 percent.
The world in 2007 seemed about to complete a five-year cycle of
continuous growth, the likes of which had not been seen in decades, but
this bonanza was not seen in Chile. The reason for the slowing of the
growth rate lies in the ideological mind of the Concertacin
governments, when it has prevailed over its pragmatic counterpart. When
this happens, it destroys incentives to hire and to invest. The source of
progress is private enterprise, so when it becomes more difficult for
businesses to operate, the country finds it harder to get ahead in an
increasingly competitive world. The negative effects of misguided
policies are slow in showing up, but they accumulate, and in the end they
curb progress. The effects of economic policies, good and bad, take
longer to be felt than is generally recognized, and they extend far beyond
politicians time horizons. Rarely are the effects felt immediately, as in
the case of Transantiago. In pensions, for example, the mistakes that we
make today will be felt by the next generation. Slowly at first, but more
markedly later, misguided decisions, guided by the ideological mind of
the Concertacin governments, have begun to accumulate. By now, the
obstacles to employment, saving, and investment are such that the
dynamic Chile that was once an example of growth and progress for the
poor is now a thing of the past.
During 2006, economic growth estimates gradually declined.
Paradoxically, while this was happening, external conditions were
improving beyond all expectations. The price of copper was almost $4
per pound, while pulp for paper products, fishmeal, and many of our
products were thriving.

Hernn Bchi 205


Reduced growth during this period coincides with a persistent drop
in ranking in global indices measuring competitiveness and transparency.
The World Economic Forum competitiveness report ranks the countrys
performance in innovation 45th out of 131 countries. The trend repeats in
transparency and technological advancement.
For quite some time, external conditions have been very favorable
for our country. However, the population has not perceived
corresponding improvement. This is not because entrepreneurs or the
businesses lack the will or the ability to channel the positive effects to
everyone. The real beneficiary this time is the government, which
receives the revenues from copper, directly or indirectly. Private
companies put up with the higher costs, energy shortages, and
increasingly burdensome rules that make all aspects of doing business
more densely regulated, more costly, and more complicated. Luck has
helped the government. Today, the moral responsibility of the countrys
leaders is to determine how to put it to good use in order to promote
growth, increase employment, and thus overcome poverty.

The Inertia Is Over


Despite the legacy of the military governmentor rather as evidence of
its strengthin social policy, the government that took over in 1990
showed little competence in creating new programs. Despite the
resources available to it and which, thanks to the growth rate, become
more abundant every year, the initiatives turned out by the cabinet
ministries in recent years leave much to be desired.
The achievements of recent years are nothing compared to the
military governments efforts to restructure all of the countrys social
programs in order to build up a comprehensive and consistent social
safety net. The same government that proved capable of coming up with
answers and reforming the economy and society to benefit the poorest is

206 The Model Endures


still denounced as insensitive. Winning the policy battle does not
necessarily mean winning the battle for perception.
If Concertacin had been able to maintain the 7.9 percent growth
rate attained between 1987 and 1996 for another ten years, the poor
could have become 40 percent wealthier. The importance of this fact
extends beyond its economic value. Eradicating poverty is a profoundly
human issue. But the average growth over the last ten years has been
only 3.9 percent. The innovative reforms begun in the eighties were not
followed through with the same determination and imagination, and that
is the real cause of our more modest performance.
I am convinced that Chile has a great opportunity today to
accomplish growth-enhancing reforms. It is true that the government
coalition, due to its ideological bent, has difficulty in making progress on
the issues of employment, investment, and regulation. But fortunately,
the country has resources with which to implement policies that promote
prosperity, while compensating for theoretical negative effects (which
may not be real, but worry some of the current authorities nevertheless).
All opportunities to introduce the right reforms must be seized. Even
if their consequences seem trivial, they could lead to increased long-term
benefits.
Although it is difficult to say this, I believe there is cause for
optimism. The lengthy period of time during which Chileans have
experienced a free market economy system has allowed them to
appreciate the advantages of progress, or at least get a closer look at
them. This is especially important for young people. People who have
tried to convince them that it is possible to take shortcutsthat
individual responsibility and a job well done are not the main ingredients
of successhave lost credibility. Solutions based on greater state
intervention and social engineering, such as the public transport reform
in Santiago, have been spectacular failures. The evidence is
overwhelming; one just needs to look at neighboring countries. Peru is,
economically speaking, making better progress than Chile, paradoxically
under the leadership of Alan Garcia, who today openly admits that he

Hernn Bchi 207


was wrong. Fortunately, on the other hand, our country does not have a
strong Chavista discourse based on the squandering of Venezuelas oil
riches that can be perceived like an antagonistic model to our own.
That is why, although the countrys political situation today is
disappointing to those who would like to speed up the creation of wealth
and jobs, there is light at the end of the tunnel. If the pragmatic mind of
the coalition government joins the members of the opposition who
uphold and value the spirit of free enterprise, and together they help
build a new and thriving Chile born from the reforms, then the last step
toward development would not prove that difficult. The foundations
required to make rapid progress remain firmly rooted in the countrys
economic institutions. However, as noted before, taking this step will
demand not only clear ideas, but also committed people to carry through
the details of the task. The key to success lies in motivating them and
providing them with the space that they need.