Critics blame socialist President Ricardo Lagos for the economy’s crisis of confidence.
By Deepak Gopinath
March 2001
Institutional Investor Magazine
Critics blame socialist President Ricardo Lagos for the economy’s crisis of confidence. But could his “reforms” be what Chile’s free-market miracle needs to sustain it?
La Moneda presidential palace in Santiago, a squat, gray-and-white monolith with bars on the windows, has long been a forbidding symbol of General Augusto Pinochet’s oppressive dictatorship. Chileans have a vivid image of La Moneda burning during the Pinochet-led military coup that toppled socialist president Salvador Allende in 1973.
So it was highly symbolic that, as one of his initial acts, Ricardo Lagos, Chile’s first socialist president since Allende, threw open the palace gates so that Chileans could wander the grounds and attempt to make their peace with the Pinochet era. But as Lagos himself is discovering to his frustration, Chile’s past exerts an inordinate sway over its present.
For a start, Pinochet, now 85, remains very much a presence on the political scene 12 years after his departure from office: Maneuvering over his legal fate has polarized the country. Nor is Lagos finding it easy to tinker with Pinochet’s free-market legacy. As harsh as the former dictator’s regime was, he embraced the Hayekian doctrine of unfettered competition that ushered in Chile’s “free-market miracle,” some two decades of extraordinary economic success.
Now Lagos must contend with critics not only from the staunchly conservative Chilean business community but also from within his center-left coalition as he seeks to overhaul what he believes to be outmoded tax and labor laws and - even more ambitiously - struggles to engineer a postmiracle miracle to allow Chile’s economy to go on prospering in an information-driven global economy. As Lagos put it in a frank interview with Institutional Investor (see box), “Our big challenge is finding the new wine or salmon for the next decade.” These products and natural resources now overwhelmingly dominate Chile’s exports. Copper alone accounts for 40 percent of Chile’s exports and 10 percent of its GDP.
But before he can succeed as a visionary, Lagos must prove that he is a competent economic steward, and he has yet to do that to the satisfaction of Chileans. Chile’s economy presents a study in paradox. GDP growth in 2000 was a sturdy 5.4 percent, with just 4.5 percent inflation, and government predictions are for more of the same this year. The Chilean government calculates that it will run a 1 percent budget surplus this year, and Chile is the only country in South America with an investment-grade rating from Standard & Poor’s.
Lagos has sought to foster foreign investment by lifting Chile’s encaje system of tight capital controls and, in particular, the burdensome requirement that investors keep their money in the country for at least one year. Moreover, the president is in discussions with the U.S. over a free-trade agreement, in a practical affirmation of his commitment to Chile’s basic free-market philosophy. “We have the highest growth in Latin America,” Lagos proclaims. “Chile is one of the best-performing emerging markets.”
And yet Chileans are anxious about their economic well-being, and that is hampering growth. “Domestic demand is flat. The labor-intensive construction sector is paralyzed, and people didn’t expect income to fall [because of a recession in 1999]. Consumers are shocked, scared stiff about losing jobs or not being able to maintain living standards,” asserts former finance minister Alejandro Foxley, a Partido Demócrata Cristiano senator who is a member of Lagos’s coalition but also a sometime political opponent. “The president’s message is not getting across. The government is finding it difficult to get the economy going again because of [sluggish] domestic demand.”
A January Gallup poll found that some 81 percent of Chileans are bracing for harder times. “There is a discrepancy between the mood and the economic numbers,” notes Graham Stock, an economist with J.P. Morgan Chase & Co. “The economy is growing strongly, exports are very competitive. I don’t see major challenges for the economy. Lack of confidence locally is the problem.”
Some of the malaise may be traceable to the fact that Chileans have been spoiled by success. Until the economy declined a modest 1.1 percent in 1999, largely in response to diminished demand for copper and other key exports as a result of the Asian crisis, Chile had enjoyed good GDP gains every year since 1982. In the ‘90s, growth averaged 7 percent a year, unemployment was generally held to 5 percent or lower, and GDP per capita doubled.
Now Chileans have been rattled by their first recession in two decades and by unemployment that stubbornly persists at more than 8 percent, despite the rebound in GDP growth. Members of the country’s comparatively large middle class, worried for their jobs, aren’t helping matters by saving more and spending less, damping demand just when it is needed to spur job creation. Meanwhile, foreign direct investment has fallen off, local bank lending is flat, and capital markets are shrinking.
Lagos finds himself in an unenviable - and ironic - position. Although he largely inherited the 1999 recession from the administration of Christian Democrat Eduardo Frei, Chileans have seemingly become so accustomed to good times that they have been quick to blame Lagos for their predicament. “Most people are disappointed with the Lagos government because expectations were very high,” says Ricardo Israel, a political science professor at the Universidad de Chile in Santiago. “The government had a majority in Congress, and people recognized that Lagos was brilliant, a leader of stature.”
Indeed, Lagos, 63, entered office with impressive credentials. A lawyer, he earned a Ph.D. in economics from Duke University and taught the subject in the U.S. before eventually becoming chancellor of the Universidad de Chile. As a minister of public works in post-Pinochet Christian Democratic governments, he presided over privatization of Chile’s highways. Although Lagos fled Chile following Allende’s ouster, he returned in the mid-1980s as an outspoken opponent of the Pinochet regime.
But from the start of his six-year term in March 2000, Lagos has not had an easy time of it. Nor has he helped his own cause. First, he campaigned on a platform of doing more to help the poor - one quarter of Chile’s 15 million citizens - but received an unexpectedly narrow mandate. He defeated a surprisingly strong conservative opponent, Joaquín Lavín, in the regular election by just 31,000 votes, forcing a runoff that Lagos won by fewer than 200,000 votes out of some 10 million cast.
As a socialist, he has had to contend with the strong suspicions of the business community and the conservative opposition. Although Lagos’s Partido Socialista de Chile has been a member of the center-left ConcertacÁon de los Partidos de la Democracia coalition that has run the country on the market-economy model since 1990, his promise of greater government spending on health care, education and housing caused uneasiness on the right.
On the equally tumultuous political front, Lagos has had to delicately balance Chileans’ desire for justice in the Pinochet case with the need to placate the military. As if this weren’t challenge enough, the president has struggled - not altogether successfully - to hold together his own undisciplined coalition. In October’s municipal elections, Concertacon lost important posts to the conservatives, and next December’s national elections could erode Concertacíon’s majority in the legislature. Lagos has also been frustrated in his efforts to overhaul the country’s Pinochet-era constitution.
Some of Lagos’s wounds are self-inflicted. During the election campaign, he pledged to create 200,000 new jobs. They have yet to materialize. Chile’s recent growth has come largely in the export sector, which is not especially labor-intensive. Jorge Schaulsohn, a lawyer who frequently speaks for the business community, observes: “Because [he] raised the red flag of unemployment, people are scared. The government created a litmus test for itself that it cannot meet.”
Compounding the public’s unease, Lagos proposed labor and tax reforms that have proved to be nearly as confusing as they are controversial. Late last year he introduced balanced and relatively uncontroversial labor law reforms. Among the proposals were the introduction of unemployment insurance and the strengthening of workers’ rights to organize, but the reforms would also grant increased flexibility to employers to hire and fire.
But then, apparently in response to prodding by coalition members, Lagos expanded his agenda to embrace two provisions bitterly opposed by business. One would allow for collective bargaining across industries, and the other would prevent employers from hiring temporary workers during strikes.
The reaction was swift condemnation from virtually all quarters. “This is a bad idea because we are export-oriented and service-oriented,” says Schaulsohn. Lagos’s own coalition allies also mobilized against the plan. “I don’t think it is consistent to say that we will embrace globalization but have legislation from the 1940s,” says Christian Democrat Foxley, who is leading a group of senators in opposing the more radical measures, which remained on the table as of late February.
Lagos’s campaign against tax evasion also provoked an uproar. It’s no secret that many of Chile’s wealthy skirt the country’s high personal income taxes (up to 45 percent) by forming dummy corporations that are taxed at the 15 percent corporate rate. As many as one quarter of all Chilean taxpayers are estimated to evade some taxes. But opponents of Lagos’s proposal to crack down on tax loopholes argue that it is really a tax hike in disguise and that it would chiefly hurt the small businesses that employ most Chileans.
For his part, Lagos insists that his labor and tax measures are fair and also economically sound and that the business community’s criticism is essentially ideological. “What I am trying to have is a modern country,” he says. “All I am trying to do is have the kind of legislation that is normal in a developed country, no more than that.” Nevertheless, many feel that the measures could have been handled better. “Ideally,” says Foxley, “the government should have proposed the labor and tax reforms when the economy had [fully] recovered.”
Some of the mistrust between business and government no doubt derives from the administration’s failure to clearly signal its intentions. Unfortunately for Lagos, disputes within the contentious Concertacíon complicate his policymaking efforts. “There is no clear congressional agenda,” says political scientist Israel. “There is a lot of infighting, with ministers saying different things.” By the standards of many in the coalition, Lagos as a classically trained economist is too much the pragmatist. The leader of the Christian Democrats, the largest party in the coalition, has actually called for the repudiation of Chile’s entire free-market approach.
Moreover, with legislative elections coming up, the Christian Democrats and the other coalition members will be seeking to differentiate themselves in a bid for votes. The glue that has always bound the coalition together has been opposition to Pinochet. But now that the former dictator has been arrested and indicted, a united front can no longer be taken for granted. Lagos must supply the cohesion. Says Heinrich Lessau, head of research at Santander Investment Chile: “Lagos is the brightest president we have had in a long time - he has vision, but has so far not been able to transmit it to the coalition. It is likely that Lagos will be able to reach consensus with the right-wing opposition. The key issue is to solve uncertainty as soon as possible.” Adds Foxley, “We require strong leadership from Lagos.”
Underlying the debate about Lagos’s leadership is the fundamental question of what Chile’s economy will look like in ten years. Can Santiago rely solely on the private sector to prepare a natural-resource-dependent country like Chile for the rigors and the opportunities of the new global economy? Foxley, for one, would like to see Chile adopt an industrial policy geared to the digital age. Lagos himself traveled to Silicon Valley in December to pitch Chile as a congenial home for high technology. The trip has yet to result in any firm investment commitments.
But undertaking it was entirely in keeping with Lagos’s wish to counteract Chileans’ preoccupation with the Pinochet era and its putative economic security in a world that is changing fast. Lagos declares of his mandate for his six-year term, “I was elected not to administer what happened in the past, but to write the new lines of the future.”
Finding the ‘new wine or salmon’
Chilean President Ricardo Lagos was once best known as perhaps the bravest and most outspoken opponent of Augusto Pinochet. In a famous television appearance just before the national plebiscite in 1988 that led to Pinochet’s ouster, Lagos jabbed his finger at the camera as though speaking directly to the dictator and delivered a caustic critique of his regime.
A socialist and an agnostic in a conservative, Catholic country, Lagos, 63, traveled a long and circuitous road to La Moneda, the presidential palace. Designated by Salvador Allende to be Chile’s ambassador to Moscow, Lagos fled Chile after Pinochet overthrew the socialist president in a 1973 coup. Before returning in the mid-1980s, the Duke University-trained economist taught at the University of North Carolina and worked as an economist for the United Nations. In the 1990s Lagos served as minister of education and of public works in post-Pinochet administrations. Attesting to his refusal to be bound by socialist orthodoxy, he won plaudits for privatizing Chile’s highway system.
Lagos discussed his plans for Chile’s future with Institutional Investor Senior Writer Deepak Gopinath.
Institutional Investor: Chile’s luster as Latin America’s model free-market economy appears to be fading. Investment and consumer confidence are both down, while unemployment remains high despite recovery.
Lagos: It is difficult to understand what’s happening in Chile if you don’t consider what’s going on on the world stage. We suffered during the Asian crisis because of a decline in commodity prices, but we had a fast recovery. Last year we had growth of about 5.5 percent, which is not bad by world standards, and this year we are going to have similar growth.
It is true that foreign investment is not coming to Latin America other than to Mexico and Brazil. But this has nothing to do with Chile’s economy; it is simply a matter of [the country’s] size - that’s my impression. Nevertheless, quite a large amount of money is still coming to Chile just to buy assets here. This represents confidence in Chile even though it does not represent a net increase in investment.
According to polls, people are afraid to spend because they are worried about job security. How do you improve consumer confidence?
They see that people, especially in small and medium-size companies, are losing their jobs. That is why we are introducing insurance for the unemployed as a way to increase consumer confidence. Our economy overheated in ’97 and ’98, and then the question was how do we cool the economy. We probably cooled it too much.
Despite renewed growth in 2000, unemployment remains stuck at more than 8 percent.
That is very important. Recovery means introducing more efficiency in labor productivity. Industrial production increased 6 percent last year, while industrial employment declined 3 percent. Thus labor productivity increased - which is fine. The question is, What we are going to do with regard to unemployment? But I think we are going in the right direction.
When do you see employment picking up again?
That will come primarily through new areas of the economy. We are very good in terms of education - 11 to 12 years of schooling on average for our kids - and we have quite a nice technological infrastructure for telecommunications. When banks like [Spain’s] Santander Central Hispano plan to have part of their back-office operations in Chile, this is good news. We may see this as an area of new jobs in the future. It will require a lot of investment in on-the-job training.
Is Chile at risk of being passed over by the global economy because of its small size?
Last year Chile was one of the four emerging countries that had the highest growth rates. So I am quite confident, even though we have only 15 million people. It is a small market, but countries like Finland have shown the way.
Second, Chile is an extremely open economy. Almost 50 percent of our GDP comes from trade. We have already paid the price of opening the economy so much, and therefore we are in a position to participate in specific niches in the world economy.
Our big challenge is finding Chile’s new wine or salmon for the next decade. We are second to Norway in salmon exports, and we are very good at producing and exporting wine. Now what are going to be the new salmon and wine? That is the question for Chile.
Will it be back-office operations, customer service call centers and the like?
We would like to put some of our bets on that. And the other area would be transforming our forestry products into furniture exports, like the Swedes and the Italians.
Your labor reforms have provoked controversy. Why reduce employers’ flexibility when other countries are increasing it to remain competitive?
We are trying to introduce what would be considered normal worker rights anywhere in the world to promote strong labor unions. Because strong unions can introduce labor flexibility. [German Chancellor Gerhard] Schröder was able to introduce important tax reductions in Germany, and one of the champions of that reduction was the leader of the trade union movement. When you don’t have [a strong labor union movement], workers and unions would ask for legislation that makes it impossible to dismiss workers. They would want jobs to be created by law, which is nonsense.
What I am trying to do is to have better trade unions, flexible labor legislation and some kind of negotiations to make sure that the benefits of industrial productivity increases like the one we had last year can also be transferred to workers. In other words, if we are going to have growth, I want to make sure that it reaches all the sectors, including labor. But I am not in favor of labor that is not flexible. That is nonsense in today’s world. That is nonsense in a country that is as open as Chile. You have to be able to dismiss workers. What I don’t want is the dismissing of workers because they want to have a trade union.
Why did you add collective bargaining across industries and a prohibition on companies’ hiring replacement workers during strikes to your original labor reforms?
Those things are normal in any labor legislation in any modern country in the world. If you have those things, you make sure that some of the increases in productivity are transferred to workers.
Why do Chilean businesspeople complain that your administration is difficult to work with and that uncertainty about economic policy is making it hard for them to invest?
The problem in this country is that [the business community] thinks that it is impossible to change anything. And I say, ‘Look my friend, you know what the rate of tax evasion in Chile is - 25 percent.’ Developed countries have no more than 10 to 15 percent. I have two options: increase taxes or fight evasion. I say it is unfair for those businesses that pay taxes to compete with those that don’t pay. Lots of complaints.
I have made my goals very clear. We are going to have growth, and we have growth. We are going to have fiscal discipline, and we have fiscal discipline. We have an autonomous central bank because we have fiscal discipline. And finally, I want to have changes in legislation appropriate to a modern country, and this is in the area of labor and taxes. I agree we have very high taxes on a per capita income basis, and if it is necessary, we are going to reduce that.
Finance Minister Nicolas Eyzaguirre recently said that business opposition to your administration is ideological.
It is.
So how are you trying to reach out to businesspeople?
I talk with them often. My only complaint is that what they tell me in private they don’t say in public. During the campaign I said I wanted to recover $800 million in taxes. My [conservative] opponent said $800 million is too little, and that he was going to recover $1 billion. I thought that [my tax-reform] bill was going to be approved unanimously. But it has not been approved by my opponents in Congress.
Recently, the head of the Partido Dem¢crata Cristiano, the biggest party in your coalition, called for a move away from the free-market model. What are you doing to make sure that everyone speaks with one voice?
There has been discussion, as there is in any democratic country, but the major lines are in complete agreement. Nobody would question the role of the market, nobody would question the kind of fiscal responsibility that we have, nobody has questioned the autonomy of the central bank. There is discussion within the coalition about reducing taxes - is this the right moment? That is normal in a democracy, and I don’t think that represents very disruptive ways to perceive things.
There is a perception that the Christian Democrats are looking to leave the coalition.
I’m not sure that’s the case. Ten years ago it was exactly the same question: Are you going to be able to work together in the same cabinet? Here we have a coalition, and we are working together.
During your campaign you said that you would reform the constitution. You had a chance last year to achieve limited reform by eliminating the provision that ex-presidents like Pinochet are senators for life. Why didn’t this move forward?
Reform of the constitution is essential to aid political transition. This constitution was rejected in the 1988 plebiscite when Chileans said no to the continuation of General Pinochet in power. Since then the majority of Chileans have consistently voted for the coalition, which thinks it is essential to introduce changes in the constitution. Now we have a substantial majority, but we do not have a [sufficient] majority to change the constitution. We do not have a very democratic electoral system. I want a Congress elected by democratic means. And if I have a majority, I want to have a majority in Congress. I don’t want to change only this institution of designated senators; I want to change the whole thing. Let’s be serious [about reform].
How would you like to see the Pinochet situation resolved, given how polarizing it has been for Chilean society?
I would like to think that it is possible that all violations of human rights, Pinochet’s case included, can soon be part of our history and not part of our political agenda. I know that this is difficult to accomplish. Nevertheless, I think I was elected not to administer what happened in the past but to write the new lines of the future, and this is what I feel is going to be important for my administration.
Most of what can be accomplished is going to be decided by the tribunal, and this is why the most important part of my [year] in office has been that the [tribunal] has been working. Probably a year ago, if you had told me that Mr. Pinochet was going to be prosecuted, that the military was going to acknowledge what happened with many of those who disappeared, and that Chile is going to remain quiet, peaceful, I would say that’s wonderful. And this is what has happened in the past year.
When you decided to start negotiations with the U.S. on entering Nafta, you antagonized some Mercosur members, primarily Brazil. Why push forward on the U.S. front as opposed to Mercosur?
Since the beginning of my administration, I have emphasized that foreign policy has to be done from the region, and therefore Mercosur is extremely important as an instrument for foreign policy. Mercosur is the place where we are going to have some convergences of our economic, educational and labor policies. It is political.
But Mercosur is also a customs union. That’s a problem. It has tariffs of 14 percent; we have tariffs of 9 percent. Mercosur must make a decision as to when our tariffs are going to be similar. You cannot ask me to raise my tariff. Therefore when the U.S. decided that it was time to have negotiations with Chile on free trade, I said, ‘Yes, I accept.’ I did not say anything different from what Chile has been saying during the past ten years.
Do you expect progress on free trade even if the Bush administration doesn’t get fast-track negotiating authority for Chile?
We have had some contact with the new administration, and I am confident [of progress on trade], since the Bush administration is trying to push for the Free Trade Agreement of the Americas. President Bush has explained that the administration sees what can be accomplished with Chile as a signal to the rest of Latin America. Therefore we would like to see how far we can advance before Quebec [and the Summit of the Americas] in April.
What do you see as Chile’s role in Latin America?
I would like to see a world in which you are going to have major blocs, where you are going to have some kind of free-trade association in the hemisphere. Because the U.S. is so big, the Latin American countries will have to present some common views in particular areas. That is the only way to be heard on the world stage.
At the Asia Pacific Economic Cooperation summit, you called for business to look at ways of regulating and monitoring capital flows. What are your views on a new international financial architecture?
What you have now are the Bretton Woods agreements, and it is very clear that they are old-fashioned; they are for another world. And when you have a small country like ours and are successful, then you have tremendous inflows of foreign capital, which is very good. But then suddenly it can go out, causing problems. How are we going to be able to manage that? It is better to face the problems, otherwise we will face the same problems we had in the past.
Do you feel that the financial architecture debate has shifted to the back burner?
To some extent. The major Latin American countries, Mexico first, Brazil second and now Argentina, all suddenly required intervention. That’s fine with me. It is very important to do that kind of operation, but they were all prompted by some kind of panic.
You have said that you want a market economy but not a market society. What does that mean?
I want our economy to reflect the market. But I don’t want a market society. Because a market society means that only a few can afford services like education or health care. Society has to be organized in such a way that everybody can reach those services. If you have a society where education or health care is given on market terms, then only those who can pay are going to be educated or treated in the hospital. That’s the difference between a market economy and a market society.
