Chile’s unraveling: Unregulated capitalism or ponderous government?

For more than a month, Chile has been engulfed in protests and violence, and the end is not in sight. The unrest is typically attributed to income inequality caused by “excessive free markets.” That diagnosis is wrong and will induce a response that will make matters worse.

The facts are inconsistent with the excessive free market narrative reported in the international press. Chile has been governed by left-leaning presidents, two of them socialists, for 23 of the past 29 years. Less than 10 percent of Chileans live in poverty today, compared to almost 50 percent in the early 1990s. Chilean income inequality has been falling for the past 20 years, and is now at a historical low.

There is a gap in Chile, but it is not between “the haves” and the “have nots.” It is between the promises of governments over the past two decades, the resulting expectations of Chile’s new middle class and the capacity of the Chilean economy and government to actually deliver on them.

Since the election of 1999, every presidential candidate, left or right, promised that Chileans would reach the standard of living of a European country, with its attendant welfare state, within a perennially moving next decade. The promise always verged on false advertising; tripling per capita GDP to Western European levels, and building their social infrastructures, would have been a herculean task even under ideal circumstances. The circumstances of the Chilean economy were, however, far from ideal: Total factor productivity (TFP, the amount of additional economic output that is not accounted for by additional labor and capital) has fallen almost every year since 2005, and TFP today is at the same level as in 1999.  

Chileans could believe the promises of politicians because they mistook a copper boom for a permanent acceleration in the growth of wages, government spending and GDP. Chile is the world’s leading exporter of copper, accounting for one-quarter of world output, and copper prices climbed seven-fold 1999 to 2011. Since 2011, they have gradually fallen, such that they are currently 40 percent below their 2011 peak. Chileans are now confronted by the gap between the promises of politicians and the dismal performance of their economy.

Underneath that dismal performance is the overregulation of the private economy by a ponderous government. Chilean businesses must obtain endless permits, one-by-one, from a long list of uncoordinated government agencies. A large project must navigate the maze for five to 10 years in order to get regulatory approval, and then, even after obtaining it, may still be rejected by a discretionary political decision or a judicial ruling about a small procedural point. California-style, urban growth restrictions raise the cost of housing and also drive up the ground rents that any retailer must factor into the prices charged to consumers. The tax code is a nightmare. In 2014, the government introduced a sweeping reform, to tax a corporation’s retained profits according to the marginal tax rates of each of its shareholders. It proved completely unworkable. But the solution was to replace it with a complicated system in which firms choose among two methods of taxation that accountants still struggle to understand.

At the same time, Chilean governments and politicians have ignored their core task, public services. Eighty percent of Chileans receive medical care from a public health system whose bureaucratic organization has not changed in three decades, and delivers staggeringly long wait times. When the first cohort of the government-mandated, private pension system (essentially a compulsory 401K plan introduced for all new workers in 1980) began to retire in 2015, they found that their monthly pension benefits were about one third of their last salary. 

The problem, which has been known for decades, is that rigid labor laws make hiring expensive, such that at any one time roughly one-third of the labor force works in low-paid self-employment or in off-the-books jobs in small, “informal” firms that stay small to elude regulations and labor law. These workers do not receive a paycheck from which contributions can be deducted, and so every worker contributes to the pension system for only 20 years on average.

Public education is of abysmal quality; many Chilean children fail to learn to read and write competently. The government’s response was a 2015 reform among whose features was the requirement that private schools that accepted per pupil public subsidies (the Chilean version of an education voucher) had to purchase the real estate where they operated. The cruel cynicism of this law cannot be understated: School choice was essentially restricted to high-income households; the schools educating middle- and low-income children were forced to buy real estate made expensive by restrictions on urban growth or close their doors. 

Small wonder that people are protesting in the streets. Alas, the misdiagnosis of what ails Chile has caused most everyone – international pundits and middle class Chileans alike – to push for more regulation, weaker property rights, higher taxes and increased government spending. That will not enlarge economic surplus by incentivizing the private investment necessary for productivity and income growth necessary for redistribution. Those hoping for a better life for Chile’s fledging middle class will be disappointed.

Alexander Galetovic is a senior fellow at the Universidad Adolfo Ibáñez in Santiago and a research fellow at the Hoover Institution. Stephen Haber is professor of political science at Stanford University and a senior fellow at the Hoover Institution.