Wednesday, June 12, 2013

Ignoring Milton's advice in Chile II

In the May 1993 American Economic Review is an article by Arnold Harberger, Secrets of Success: A Handful of Heroes.  In which, he praises many of his former students--Sergio de Castro, Hernan Buchi, especially--for the role they played in restoring economic prosperity to Chile after the deposition of the Allende administration.  He likens their plan for doing that, popularly known as El Ladrillo (The Brick), to The Federalist Papers.  

No doubt they are deserving of a great deal of praise for things like reducing tariffs, from in some cases 100%, down eventually to a uniform 10%, or restoring nationalized businesses to private ownership.
However, one of their tactical moves--pegging the Chilean Escudo to the U.S. Dollar--later famously exploded in their faces. Harberger thinks it was a particularly ingenious policy...taking advantage of the fact that large quantities of Chilean debt, mostly of private banks but also of the Central Bank, were selling in New York at a substantial (e.g., 40 percent or so) discount.

Harberger explains that arbitrageurs were buying this debt in New York in dollars, then exchanging it at 100% face value for Chilean currency or Chilean denominated debt at the issuing banks. Which had the effect of destabilizing the foreign exchange market. So the Central Bank captured those arbitrage profits for itself by auctioning off the right to repatriate the debt every two weeks or so.

Which is at least an explanation of why the Chicago Boys (who many people erroneously think were controlled by Milton Friedman) enacted a policy that was decidedly non-Friedmanian--who always advocated freely floating exchange rates. It allowed them to get away with locking in Chile's monetary policy to America's.  Which was fine for awhile, and helped to finally tame Chile's inflation, as even in the late 70s the rate of inflation in America was far lower than in Chile.

Unfortunately, when Paul Volcker, aided by newly inaugurated President Ronald Reagan's acquiescence, slammed on the monetary brakes in January 1981, the ensuing recession was transmitted to Chile.  With far worse consequences there than in America.  Consequences that justifiably cost Sergio de Castro his position as Finance Minister.

Given the disaster from this episode, it is even more miraculous that Pinochet continued with his free market policies throughout the remainder of his reign.  Which eventually ended democratically when Allende lost a plebiscite and agreed to relinquish his power.

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