The Steps to Economic Freedom

Christopher Lingle is a visiting professor of economics, ESEADE at Universidad Francisco Marroquín in Guatemala.

Many Latin American countries suffered for decades under a form of homegrown despotism. The accompanying repression of political liberties left a legacy of far-reaching state intervention, widespread corruption, persistently high rates of poverty, and slow economic growth.

Emerging market economies elsewhere can learn from the experience of some of these Latin American countries. Many are replacing state-led, protectionist models of development with systems that allow greater individual freedom along with open-market economies. Trends evident in both Chile and Mexico indicate that expanded economic freedom can be beneficial in promoting modern democracies that offer greater support for civil liberties.

More recently, economic liberalization in Mexico contributed to the momentum toward political liberalization and the peaceful transition from a single-party regime. Earlier, the “Chilean economic model” included an extensive and sustained commitment to free markets. Much of Chile’s success occurred because workers became owners of financial capital. The worker-capitalists joined a growing middle class and benefited from increased economic openness and the wide dispersal of payoffs of this free-market model.

Indeed, Chile’s experience provides evidence that expanded economic freedom can contribute to higher growth. Its rate of economic growth averaged 7 percent annually from 1984 to 1998. At the same time, there was a reduction in the proportion of people living in poverty from 45 percent in 1987 to around 22 percent in 1998. These combined results help set the stage for the introduction of liberal democracy and the rule of law.

Sustaining high growth requires deep-reaching economic reforms. At the heart of Chile’s reform was the depoliticization of economic and commercial life. This included the removal of state-sanctioned privileges for monopoly producers, while minimizing special favors for cronies and supporters of the leadership.

As part of the process, Chile also underwent thoroughgoing tax reform along with radical deregulation of economic activities and strict control over monetary policy along the lines followed by New Zealand. Perhaps most important, Chile led the world as an innovator in privatizing its public pension program. The principal advantage of such privatization is that the closing of a state-run system removes a tool that is often abused for political purposes.

In 1981, Chilean workers were allowed to choose between a private scheme and the existing state-run system. At present, 94 percent of workers have chosen the private system in which workers can place their retirement savings into their own accounts, which are privately managed by competing firms. The rest have chosen to remain in the state-run system that has maintained the level of benefits to current retirees. All new entrants in the labor force are required to go directly into the private system. At least ten other countries have adopted some or most of the elements of Chile’s pension reform.

An advantage to allowing private investment for retirement savings is that it can help restore trust in and encourage deeper development of a country’s domestic financial sector. This is because private investment firms can invest in highly competitive global index funds. Allowing pension funds to flow abroad freely provides foreign and domestic investors with greater confidence to undertake risk. As the domestic financial sector becomes liberalized, it can be integrated into the international system, allowing all citizens to have access to the savings of the rest of the world.

Overhauling Tax Policy

A radical overhaul of tax policy is an important step in weakening the political grip over the economy. For example, payroll taxes could be cut or eliminated. Lower tax rates that are applied in a nondiscriminatory manner will encourage job creation, investment, and a more transparent business sector because firms will have less incentive to avoid taxes. In those circumstances, lending operations of foreign and domestic banks can expand owing to improved assessment of the financial conditions of potential borrowers. In turn, this will encourage capital formation that would increase the growth potential of the economy.

There should be a removal of government-sanctioned monopolies that receive various forms of protection. Subsidies should also be eliminated since they obscure transparency in accounting practices and involve high social costs arising from sustaining inefficient business enterprises. Such policies interfere with the ability of financial systems to guide savings to productive investments that encourage growth. Because public-sector firms are seldom allowed to become bankrupt, they hold resources captive that should be released to a more efficient use.

Privatization can bring an end to government monopolies, but they should not be replaced by private-sector monopolies. Widespread deregulation should accompany privatization so that free entry by domestic and foreign firms into all segments of the economy can create competitive conditions for better engagement with the global economy. At the same time, this competition would encourage changes in accounting standards and legal practices to meet international standards. It is also likely that greater exposure to contract negotiations may alter cultural attitudes about market activities that require an increased sense of trust in strangers.

Finally, a more stable currency would increase security and growth while providing a greater resilience against external shocks to the economy. Those countries plagued by inflation (or deflation) should undergo fundamental monetary reform. Since this may take a long time, an alternative is to replace the domestic currency with one that already has a reliable reputation, such as the dollar or the euro. This would allow a reduction in interest rates and provide security to foreign and domestic investors. By enhancing the ability to make financial plans for the future, long-term credit markets would be able to emerge.

Such radical reforms can be more readily resisted when countries face crisis and hardship. The most vigorous opposition can be expected from those who will lose their privileges. However, support for reform will be stronger if government-sanctioned privileges are eliminated equally for all groups.

Citizens and public officials must realize that expanding individual freedom is the best step toward sustainable development. In the end, whether a country enjoys prosperity or suffers from poverty is a matter of political choice.