Chile: how free trade debilitated a nation

“It is a very common clever device that when anyone has attained the summit of greatness, he kicks away the ladder by which he has climbed up, in order to deprive others of the means of climbing up after him. In this lies the secret of the cosmopolitan doctrine of Adam Smith.”      

Friedrich List (1916) [1]

“Life, liberty and property.”

Locke (1689)

When the Founding Fathers of America drafted the Declaration of Independence, they set forth “life, liberty and the pursuit of happiness” as humankind’s inalienable rights. From this humane and democratic foundation spruced a government that fostered its nation’s infant industries, and implemented policies that prioritised domestic economic development.

Yet, after World War 2, American economic thinking started to emulate List’s quote. The prestigious Chicago school of Economics, a school of thought that preaches free market, free trade and laissez-faire economics to always deliver the best outcomes, rose to the forefront of global economic thinking. Their desire to convert the world to their free-market doctrine led to unilateral meddling in other countries’ governments and policies – and the disastrous effects of their dogma are still felt in Chile today.

In the 1940’s, most Latin American governments and economists wanted to replicate the economic development of the United States and Britain through industrialisation. [2] However, the American government associated state-sponsored industry and manufacturing with communist sentiment, and instead urged South American countries to export food, minerals, and other primary materials. [3] The cited reason was the Ricardian doctrine of comparative advantage and mutually beneficial trade, whereas in reality, free trade crippled the infant manufacturing industries of Latin America.

Los Chicago Boys

The irony of Chicagoan economics is palpable, considering that it was protectionist policies and state involvement that established the dominant economic status of America. Nonetheless, this did not deter them from derailing Chile’s economy. In the late 1940s, Theodore Schultz, the chairman of the Chicago economics department, decided that education in free market economics would be how Chile, along with the rest of Latin America, would raise themselves from poverty. Consequently, in 1956, Chilean students from Santiago’s Universidad Catolica arrived in Chicago, and began studying under Arnold Harberger.

In the classroom, Chicagoan professors dissected Latin America economies and policies, and pointed out how market forces and free trade can drastically improve outcomes. Despite seeing relatively little of Friedman, these impressionable Chilean economists became stout monetarists. Upon returning to Chile, their ideas found no utility until the 1970s, but the seed of free market economics was already planted in the country’s most prominent economics departments.

Personally, I find it amusing that these Chicagoan economists compared themselves to doctors, willing to treat anyone in need. However, where real doctors seek the consent of their patients, Chicagoan economists and the Chicago boys did not. They persuaded Pinochet – one man, and the whole country was subject to the yoke of free trade. Indeed, Locke’s quote, in which “property” replaces “pursuit of happiness”, begins to prevail in American foreign policy beginning in the latter half of the 20th century.    

An Alternative View on Free Trade

In contrast to Ricardo’s model of trade, consider the following dependency theory trade model proposed by Argentinian economist Raul Prebisch. A discrete 2 period model will be used to illustrate the effects of free trade. Country A specialises in manufacturing cars, a luxury good; Country B specialises in growing fruit, a basic good. Some assumptions that reflect reality are that the income elasticities of cars and fruit are very different; in particular, as income increases, demand for cars will increase by a lot more than demand for fruit.

In period 1 both countries may engage in mutually beneficial trade. At the end of this period, the real income of both countries has increased per comparative advantage. Before trade begins in period 2, due to the income elasticities, the increase in demand for cars is greater than that for fruit.

A mathematical description may shed more light on this situation. Assuming consumers are utility-maximising, the marginal rate of substitution of cars for fruit should equal the price ratio of the two goods when trade has ceased. At the end of period 2, the marginal utility for cars increases, and marginal utility for fruit decreases. As a result, the price of cars relative to fruit increases.

Since both demand for cars and the price of cars have increased, Country B must now export more fruit through further specialisation. Whilst there may be scope for technological innovation to deliver increases in output, extending this model into an infinite number of periods highlights a clear result: Country B will need to produce more and more fruit to trade for less and less cars; real wealth in Country B declines rapidly in contrast to Country A.

This means the gap between rich and poor economies would only increase over time. For Chile, a country that was blessed with natural resources, free trade has destabilised and stumped its prosperity for decades to come.

History as it happened

In the 1970 Chilean presidential election, the socialist Salvador Allende claimed a narrow victory, and immediately enacted large-scale expansionary fiscal policy. This was quickly followed by a sharp rise in inflation, and civil unrest followed.Under then President Nixon’s orders, the CIA followed orders to “make the economy scream” and sent a clear message – that America wanted a new government. [4] Sure enough, the Chilean military seized power in 1973 under Augusto Pinochet.

However, as a military man, Pinochet was not inclined to let the market control their economy. Yet, as the population continued to struggle, the Chicago Boys seized the day, and in March 1975, paid for Friedman and Harberger to travel to Chile. [5] Their one-on-one session with Pinochet proved enough to subject the entire country to Friedman’s “shock treatment”. It entails a sharp reduction in money supply, which necessitates a sharp reduction in government spending. [6] Although Pinochet was warned about the pain the shock would cause, Friedman also assured him that it would be fleeting. [7] However, official unemployment figures remained above 10% for the rest of the 1970s, while inequality also rose.[8]

Further accompanying the economic downturn were the devastating effects on education and free speech caused by the Chicago boys. Sergei de Castro, a Chicago boy who served as economics and finance minister, himself testified that the policies implemented by Pinochet required an authoritarian regime. [9] Such an authoritarian regime crushed dissent overtly. Orlando Letelier, Chile’s ambassador to the United Nations, was assassinated in 1976 after writing about the brutality of Pinochet’s policies. [10] Moreover, Pinochet overhauled the economic education system in Chile by purging economic faculties of non-Chicagoan economists and professors. He also installed the Chicago Boys in all the important economic and financial roles in government.

Yet interestingly, for all the supposed benefits the “shock treatment”, no truly democratic country has come close to imitating such policy. Friedrich Hayek, founder of the free-market Mont Pelerin Society, wrote to Margaret Thatcher in 1982 to follow Chile’s lead, and was confronted with the response “in Britain, … with the need for a high degree of consent, some of the measures adopted in Chile are quite unacceptable.” [11]

Consequences of Free Trade for Chile

In examining Chile’s economic growth in the 20th century, it is prudent to compare it to another country: Taiwan. Although in 1950, Taiwan’s economy was only about one quarter of Chile’s, its ability to industrialise through state-sponsored competition and innovation allowed it to achieve rapid economic development. To illustrate Taiwan’s economic development in contrast to that of Chile’s, consider Tables 1 and 2.

Table 1: Per Capita Real GDP (PPP with US Dollars 1990) [12], [13]
 1950196019731992
Chile3,8274,3045,0287,238
Taiwan9221,2563,66911,590
US9,57311,19314,85421,558
Taiwan / Chile (%)24.129.273.0160.1
Chile / US (%)40.038.535.133.6
Taiwan / US (%)9.611.2224.753.8
Table 2: Per capita GDP growth [14]
 ChileEast Asia[1]
1960-19692.24.7
1970-19791.25.4
1980-19891.34.5
1990-19994.84.0

One reason for the difference in growth rates is that Taiwan installed engineers to oversee its economic policy. The mastermind amongst these engineers was K. Y. Yin, who had an insightful approach in fostering industry. Using an ecological metaphor, he advised the government that they should plant the seeds and nurse the sprouts, but ensure the trees grow up in the market.[15]

Another reason is that Taiwan managed to resist the doctrine of free-market economics. Although Taiwan received huge amounts of non-military aid from the United States, Yin never succumbed to the pressure of Chicagoan thought. Instead, he continued a policy of protection against imports in order to shield domestic industry from price competition.[16] Eventually, once the infant industries matured into sustainable entities, Taiwan gradually reduced the degree of protectionism and became integrated into the world economy.

Furthermore, this ensured that economic growth was shared by all evenly. Since Taiwan’s fiscal policy throughout the 1950s-1990s was moderate, this equality was not achieved through redistribution; instead, through building up small shareholders and then investing heavily in research education, Taiwan raised the living quality of all its inhabitants.

From this narrative, there are two lessons to be learnt about economic development. Firstly, beware List’s proverbial ladder, and do not be led astray; always think critically about the advice you are given and see if it applies in your unique circumstance. Secondly, and more importantly, economic growth and equality is not always a trade-off – effective policy can deliver the win-win that benefits everyone.


[1] Includes China, Hong Kong, Taiwan, Indonesia, Korea, Malaysia, Philippines, Singapore, and Thailand

References

[1] List, F. (1916). The National System of Political Economy. Pearson Longman.

[2] Valdes, J., G. (1995). Pinochet’s Economists: The Chicago School of Economist in Chile. Cambridge University Press.

[3] Ibid.

[4] Appelbaum, B. (2019). The Economists’ Hour: How the False Prophets of Free Markets Fractured Our Society. Little, Brown and Company.

[5] Ibid.

[6] Ibid.

[7] Ibid.

[8] Ibid.

[9] Fuentes, C. & Valdeavellano, R. (Directors). Fuentes, C., Valdeavellano, R. & Mladinic, H. (Producers). (2015). Chicago Boys [Film].

[10] Kornbluh, P. (2004). The Pinochet File: A Declassified Dossier on Atrocity and Accountability. New Press.

[11] Margaret Thatcher Foundation. (2021). Large Scale Document Archive. https://www.margaretthatcher.org/.

[12] Maddison, A. (1995). Monitoring the World Economy 1820-1992. Organisation for Economic.

[13] De Gregorio, J. (2004). Economic Growth in Chile: Evidence, Sources and Prospects. Working Papers Central Bank of Chile, 298.

[14] Ibid.

[15] Chang, CL. & Robin, S. (2012). Knowledge Sourcing and Firm Performance in an Industrialising Economy: The Case of Taiwan (1992 – 2003). Empir Econ, 42. 947 – 986.

[16] The Economists’ Hour