57751 WO R K IN G PAP E R N O .52 Chile's Growth and Development: Leadership, PolicyMaking Process, Policies, and Results Klaus Schmidt-Hebbel WORKING PAPER NO. 52 Chile's Growth and Development: Leadership, PolicyMaking Process, Policies, and Results Klaus SchmidtHebbel © 2009 The International Bank for Reconstruction and Development / The World Bank On behalf of the Commission on Growth and Development 1818 H Street NW Washington, DC 20433 Telephone: 2024731000 Internet: www.worldbank.org www.growthcommission.org Email: info@worldbank.org contactinfo@growthcommission.org All rights reserved 1 2 3 4 5 11 10 09 08 This working paper is a product of the Commission on Growth and Development, which is sponsored by the following organizations: Australian Agency for International Development (AusAID) Dutch Ministry of Foreign Affairs Swedish International Development Cooperation Agency (SIDA) U.K. Department of International Development (DFID) The William and Flora Hewlett Foundation The World Bank Group The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the sponsoring organizations or the governments they represent. The sponsoring organizations do not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the sponsoring organizations concerning the legal status of any territory or the endorsement or acceptance of such boundaries. All queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 2025222422; email: pubrights@worldbank.org. Cover design: Naylor Design About the Series The Commission on Growth and Development led by Nobel Laureate Mike Spence was established in April 2006 as a response to two insights. First, poverty cannot be reduced in isolation from economic growth--an observation that has been overlooked in the thinking and strategies of many practitioners. Second, there is growing awareness that knowledge about economic growth is much less definitive than commonly thought. Consequently, the Commission's mandate is to "take stock of the state of theoretical and empirical knowledge on economic growth with a view to drawing implications for policy for the current and next generation of policy makers." To help explore the state of knowledge, the Commission invited leading academics and policy makers from developing and industrialized countries to explore and discuss economic issues it thought relevant for growth and development, including controversial ideas. Thematic papers assessed knowledge and highlighted ongoing debates in areas such as monetary and fiscal policies, climate change, and equity and growth. Additionally, 25 country case studies were commissioned to explore the dynamics of growth and change in the context of specific countries. Working papers in this series were presented and reviewed at Commission workshops, which were held in 2007­08 in Washington, D.C., New York City, and New Haven, Connecticut. Each paper benefited from comments by workshop participants, including academics, policy makers, development practitioners, representatives of bilateral and multilateral institutions, and Commission members. The working papers, and all thematic papers and case studies written as contributions to the work of the Commission, were made possible by support from the Australian Agency for International Development (AusAID), the Dutch Ministry of Foreign Affairs, the Swedish International Development Cooperation Agency (SIDA), the U.K. Department of International Development (DFID), the William and Flora Hewlett Foundation, and the World Bank Group. The working paper series was produced under the general guidance of Mike Spence and Danny Leipziger, Chair and Vice Chair of the Commission, and the Commission's Secretariat, which is based in the Poverty Reduction and Economic Management Network of the World Bank. Papers in this series represent the independent view of the authors. Chile's Growth and Development iii Acknowledgments This paper was prepared for the Commission on Growth and Development. I thank César Calderón, Homi Kharas, Michael Spence, Roberto Zaga, and participants at the Commission's Workshop on Country Case Studies in Washington, DC for valuable discussions and comments. I also thank Mauricio Calani and Mauricio Larraín for proficient assistance. The views expressed in this paper are solely mine and do not necessarily correspond to those of the Commission on Growth and Development or the Central Bank of Chile. iv Klaus Schmidt-Hebbel Abstract This paper analyzes the relations between leadership, the policymaking process, policies and institutions, and development results in Chile. It starts with a stylized model for the dynamics of development that derives a Kuznetstype relation between growth and distribution of income, determined by the quality of leadership, the policymaking process, institutions, and policies. This framework is applied to Chile, identifying the features of the policymaking process and leadership that allowed for continuation of growthenhancing reform, with a stronger focus on equity goals, since the transition to democracy. As a result of three decades of reforms, Chile has recorded a quantum leap in economic growth, which is traced down to specific reforms. Yet Chile's equity experience is much more mixed: poverty has declined massively but income remains highly concentrated, a likely result of shortcomings in the quality of education and in labor markets. The paper reviews the major risks to the country's future development pace and points out the main reform challenges faced by policy makers. Ten lessons from Chile's experience close the paper. Chile's Growth and Development v Contents About the Series ............................................................................................................. iii Acknowledgments ..........................................................................................................iv Abstract .............................................................................................................................v 1. Introduction ..................................................................................................................9 2. A Framework for the Role of Leadership, the PolicyMaking Process, Institutions, and Policies in Shaping Growth and Equity .................................10 3. Leadership, PolicyMaking Process, and Reforms in Chile .................................22 4. Chile's Development Results: Growth and Equity ...............................................31 5. Current Risks and Challenges to Chile's Future Development...........................40 6. Ten Lessons from Chile's Experience......................................................................43 7. Concluding Remarks .................................................................................................44 References ....................................................................................................................... 46 Chile's Growth and Development vii Chile's Growth and Development: Leadership, PolicyMaking Process, Policies, and Results Klaus SchmidtHebbel 1 1. Introduction Chile's development experience reflects some idiosyncratic features, including growthenhancing reforms adopted by an autocratic government, a smooth political transition to democracy, and continuation of reforms under democracy with a stronger focus on equity goals. However, Chile's case shares sufficient common elements with other developing countries to offer valuable insights on the links between politics, policies, and development results. Therefore the objective of this study is to assess the relations between leadership, the policy making process, policies and institutions, and development results in Chile. Section 2 spells out a general framework for the dynamics of growth and equity, determined by the features and the quality of political leadership, the policymaking process, institutions, and policies. Section 3 applies the latter model to Chile, assessing the exercise of leadership and the features of the policymaking process under democracy, and reviewing the reforms of institutions and policies under autocracy and democracy. Section 4 reviews Chile's growth and equity performance. It focuses on the GDP growth record, its proximate causes and deeper policy determinants, and revisits the country's growth and distribution dynamics using the framework spelled out in section 2. 1 Klaus SchmidtHebbel has been a Chief Economist and Head of the Economics Department at OECD since September 2008. He spent the previous 12 years as Chief of Economic Research at the Central Bank of Chile. Before that he was Principal Economist in the Research Department of the World Bank. Since 2004 Mr. SchmidtHebbel has been Full Professor of Economics at the Catholic University of Chile. In 2007­08 he was President of the Chilean Economic Association. He has worked closely with international organizations (IMF, World Bank, Asian Development Bank, UNESCO, UN, IPRI, AERC, and others), central banks (New Zealand, Peru, Argentina, Uruguay, Egypt, Indonesia, Malaysia, Mexico, Costa Rica), governments, and universities, providing key policy advice on a wide array of topics ranging from macroeconomics and growth policies, to pension systems and capital market reforms, institutional organization, and policy design. Mr. SchmidtHebbel has been widely published in the field of macroeconomics, monetary policy, international finance, economic growth, and development. Chile's Growth and Development 9 The key development risks and reform challenges faced by Chile are discussed in section 5. Ten lessons from Chile's experience, based on the previous sections, are derived in section 6. The paper closes with concluding remarks. 2. A Framework for the Role of Leadership, the PolicyMaking Process, Institutions, and Policies in Shaping Growth and Equity Policy Hierarchy, Development, and Democracy I start by distinguishing between three levels of the institutional/policy hierarchy: political institutions, economic institutions, and economic policies. This distinction is helpful in analyzing subsequently the links between a society's institutional/policy hierarchy and a society's main achievements: development and democracy. The three levels of the hierarchy are closely related to the new institutional development economics, as reflected for example in Acemoglu, Johnson, and Robinson (2001, 2002, 2005) and Rodrik, Subramanian, and Trebbi (2002). At the most basic level of the institutional/policy hierarchy are political institutions, comprised by legal and social organizations, laws, and regulations that define national values and individual rights, state organization, government functions, and the balance of power. Examples of political institutions include constitutions, laws and regulations, and state and government bodies. Economic institutions are at a second level. They are comprised by constitutional principles and regulations that influence privatesector behavior and decisions, and by government institutions that take economic decisions and/or regulate and supervise private markets and agents. Economic institutions are derived from or embedded in political institutions. Examples of economic institutions are the central bank charter and organization, tax codes, electric utility regulation and supervision, and social insurance laws. At the hierarchy's third level are economic policies: the regimes and policy principles that shape and limit the contents and daily exercise of economic decisions by government authorities. They are based on, and conform to, economic and political institutions. Examples of economic policies include the choice of exchangerate regime, price controls, and transfer programs to poor families. Institutions and policies shape the two fundamental outcomes in a society: development and democracy. Development is defined here in a narrow sense, being reflected in a society's average income (or consumption) level and equity. Equity reflects a combination of the distribution of income (or wealth or consumption) among all members of a society, their opportunities for material 10 Klaus Schmidt-Hebbel progress, and the number of members of society afflicted by poverty. The latter definition of development--reflecting income and equity indicators--represents a widely accepted function of a society's material welfare and its distribution, but is different from even wider measures of ultimate happiness achieved by the members of a society.2 This study focuses on the latter, more limited concept of development. Following conventional usage, democracy is defined here as a form of government that combines three essential, interdependent principles: the presence of institutions and procedures through which citizens can express effective preferences about alternative policies and leaders, the existence of institutionalized constraints on the exercise of power by the executive, and the guarantee of civil liberties to all citizens in their daily lives and in acts of political participation (from the Polity IV Project; see Marshall and Jaggers 2004).3 Political institutions, as key pillars of the organizational structure of a society, shape the form of government (democracy) and determine both economic institutions and economic policies (diagram 1). Diagram 1: Relation between Institutional/Policy Hierarchy and Results Institutional Development Economics (Acemoglu et al. 2001, 2002) Economic Institutions Washington Consensus (Williamson 1990) and its amendments (Rodrik 2005) Political Economic Institutions Policies Development: - Growth - Equity (Przeworski et al. 2000) Democracy 2 A small but growing economics literature focuses on the measurement and determinants of happiness, including Morawetz (1977), Di Tella et al. (2001), and FerreriCarbonell and Frijters (2004). 3 Other aspects of plural democracy, such as the rule of law, systems of checks and balances, and freedom of the press, are means to, or specific manifestations of, these general principles. Chile's Growth and Development 11 Economic institutions, by shaping economic policies, have a major impact on development (growth and equity). The new institutional development economics underscores the importance of economic institutions for achieving higher growth, in contrast to previous views (i.e. the Washington Consensus, see Williamson, 1990) that focused more narrowly on economic policies and their reforms trigger for growth. Rodrik (2005) warns against the temptation of policy makers to map firstorder (universal) economic principles into unique policy packages, instead recommending careful consideration of local opportunities and constraints in the design of policies and institutions. Development and democracy interact positively (e.g., Przeworski et al., 2000). The dual challenge of development and democracy is to trigger sustainable reforms of political and economic institutions to break the vicious circle of underdevelopment and autocracy, in order to start a virtuous and sustainable path of high growth, improving equity, and broadbased political participation. Leadership, Policy-Making Process, Institutions and Policies The preceding framework scratches only at the surface of the links between institutions, policies, democracy, and growth. We have to dig deeper for a better understanding of the processes governing the relations between policy inputs and outcomes. This requires identifying more closely the roles and relations of three key aspects of policies: leadership, the policymaking process, and reforms of institutions and policies. Leadership (L)--both political and economic leadership--is the ability of authority to initiate and sustain institutions and policies (IP) in support of development and democracy. L entails initiating and reforming IP in a way that translates into an effective policymaking process (PMP). Leaders are shaped--that is, the quality of leadership is shaped--by: institutional and political constraints (i.e., constraints on corruption) rules of the PMP interests and goals of groups or parties represented by the leaders incentive structure faced by leaders efficiency of the state economic and political results (elections and other expressions of political legitimacy). The PMP comprises the ways and stages in the conduct of policies and the reforms of IP by the political leadership. The PMP is determined by following politicalinstitutional factors: democratic organization of government government system electoral system and resulting party system 12 Klaus Schmidt-Hebbel state efficiency: government bureaucracy, judiciary (independence, efficiency), parliament (auditing and control). The PMP is also shaped by social norms and implicit institutions and rules that characterize the political culture and social capital of a country. However, because they are difficult to define and measure, it is hard to identify causal relationships from these "soft" features to PMP. I follow the political economy literature based on repeated games (Spiller and Tommasi 2003, applied by Aninat et al. 2006 to Chile) in identifying six features of the PMP that contribute to attaining cooperative outcomes among the main players (government and opposition, as well as other actors): (i) high degree of shared interests and views (consensus) among players (ii) small immediate benefits from reneging on agreements (iii) small number of decision makers (iv) repeated interaction among decision makers (repeated game) (v) easy observation of deviations from agreedupon behavior (vi) availability of credible enforcement mechanisms. Now let's turn to institutions and policies. The reform of IP--designing and putting in place effective IP--is key for development. Yet underdevelopment itself is often a hindrance to reform. Therefore the main triggers of adoption of programs of IP reform are: domestic political crises or changes (ends of war, new governments) and domestic economic crises, and/or foreign triggers, including foreign aid conditionality, political or economic association with other countries, changes in international conditions (i.e., major international trade or financial shocks), and demonstration effects of internationally successful policies (policy learning). Sustainable reforms of IP go through the following stages: negotiation among main actors and affected groups institutional or policy design experimentation fullscale implementation corrections ensuring longterm sustainability. Reforms could result in failure or reversal because of one or several of the following factors: bad technical design negative interaction with lack of reform in other areas (a form of bad design) poor implementation Chile's Growth and Development 13 lack of democratic legitimacy and political sustainability (done under autocracy; benefit minorities) reform reversal due to growing influence of reform losers (which could be few but powerful). On the other hand, the likelihood of reform success and sustainability is raised by one or several of the following conditions: strong influence of technocrats in reform design reforms represent interests of majorities (i.e., the "representative consumer") if politically required, reforms allow for compensation of losers reforms are enacted democratically reforms are shaped by a PMP that favors cooperative outcomes. The main features of reforms of IP are reform strength or depth (shallow or partial versus deep or comprehensive), speed (gradualism versus cold turkey), timing (when), and sequencing (in relation to other reforms). A significant analytical literature has developed since the 1970s on the latter reform features, focusing on positive and normative (welfare) aspects of reforms, as well as on their political economy. Most of the latter literature focuses on particular reforms (like macroeconomic stabilization, pensionsystem reform, or antipoverty programs) or on partial aspects of comprehensive reform programs (e.g., sequencing of trade and financial liberalization, speed of macro stabilization). Not many sturdy inferences can be derived from the latter literature, due to its largely partial and restrictive focus.4 The latter is largely unavoidable due to the complexity and countryspecificity of reforms. Among the exceptions to the latter conclusion are a few lessons on optimal reform sequencing.5 More recently, Hausmann, Rodrik, and Velasco (2005) have developed a framework of "growth diagnostics" that complements Rodrik's (2005) "growth strategies." Their novel approach focuses on deriving a country's key policy priorities from identifying the most binding constraints on economic activity. While their framework is based on an explicit generalequilibrium model that embeds economic and political constraints, its practical application is untested yet. 4 Sturzenegger and Tommasi (1998), Agénor and Montiel (1999), and Agénor (2004) review the positive economics and the political economy literature on reform gradualism and sequencing. My reading of the latter reviews is that specific conclusions yielded by the analytical models on reform speed and sequencing are highly modeldependent. Results are hard to generalize because the underlying models assume specific forms of initial and/or nonremovable distortions. Often the models abstract from generalequilibrium features and from interactions between positive economics and politicaleconomy aspects. Finally, most models abstract from countryspecific conditions that shape reforms in the real world. 5 One general conclusion is that macroeconomic stabilization should not come after sector and microeconomic reforms, and that trade liberalization should precede financial liberalization (Agénor and Montiel 1999; Agénor 2004). 14 Klaus Schmidt-Hebbel My inference from the world experience and literature on IP reforms since the 1970s is that effective leadership and the quality of the policymaking process are more important for successful adoption of better IP than reform features like optimal timing, speed, or sequencing of reforms. Timing, speed, and sequencing should not be finetuned. As long as good L and PMP are in place, and reform capacity and willingness are not strained beyond their limits, the sooner, the quicker, and the more good reforms of IP are designed, executed, and followed through, the larger will be their development impact.6 Now we turn to the complex relations between reform efforts (or the quality of IP) and development results (growth and equity). While there has been analytical and empirical progress in better understanding the latter relations, they are still largely a black box. Among the many possible reasons, I selectively list some of them next: lack of deep macroeconomic foundations that link IP to economic outcomes (particularly true for "soft" institutions, like transparent government, central bank independence, or bankruptcy legislation) feedback effects from results to IP (e.g., bad economic results may trigger election losses or, if political institutions are weak, to coups d'etat, leading to further changes in IP) nonlinearities and threshold effects between IP and results; critical mass of political will/capability, leadership, human resources in government required for effective reform (e.g., between IP and growth, between IP and democracy) nonmonotonicities between economic results (e.g., between equity and growth: the Kuznets curve) path dependence (initial conditions matter both for IP and their reforms, and for economic results) multiple equilibria (similar initial conditions can lead to widely different development paths, depending on particular components of IP and exogenous shocks (good luck, neighborhood, and demonstration effects) interaction effects between institutions and policies in different areas: key to consider by governments at reform design and implementation stages interaction effects between institutions and policies in different areas: key in estimation of results (e.g., growing empirical evidence for growth performance). 6 Hausmann et al. (2005) contradict this conclusion, arguing that "Do as much as you can, as best you can" is faulty in its logic because of secondbest arguments (not every reform is welfare improving, given other distortions) and because of the differential welfare impact of different reforms. However, secondbest measures of reforms are hard to consider in practice (and should not be used in practice, as suggested by Hausmann et al.) and differential welfare impacts of reforms--considering adequately their positive economic and political costs--are also very hard to come by in practice. Chile's Growth and Development 15 Without forgetting about the latter difficulties, diagram 2 makes an attempt to depict the complex relations between IP and economic and political results. It represents the key role of L, PMP, and the conditions for attaining cooperative outcomes, as a result of the quality of IP, with feedback effects from the quality of leadership. Social norms and the political culture of a society also shape the PMP and the leaders' own interests and incentives, conditioned by the efficiency of the state, also affect the quality of leadership. The PMP determines the contents and quality of policies and reforms of IP, and the latter impinge on economic and political outcomes. Good IP lead to good outcomes, with positive feedback for political stability. In contrast, badly designed, implemented, or enforced IP lead to bad results. The latter are rejected by the population, leading to electoral rejection and a democratic change in government if political institutions are strong and democracy is entrenched. When political institutions are weak, bad results may lead to political crises, armed domestic conflict, and violent overturn of government, in turn leading to further change in L, PMP, and IP. Hence the challenge of development and democracy is to get societies on a virtuous path of improved L, PMP, and IP, leading to high growth, better equity, and a stronger democracy. Diagram 2: Leadership, Policy-Making Process, Reforms, and Results Interests/Incentives of Leaders Efficiency of State Leadership Elections Coups d'Etat Policies Policy- Political and Reforms Economic and Making institutions of Institutions Political Results Process and Policies Determinants of Social Norms Cooperative Outcomes Political Culture 16 Klaus Schmidt-Hebbel 2.3 A Simple Dynamic Model of Growth, Distribution, IP, L, and PMP In this section I present a simple stylized model for the dynamic relation between the quality of institutions and policies (IP), leadership (L), and the policy making process (PMP) in determining the growth of a society's average level of income (or output) and the change in a measure of society's distribution of income among its members. Per capita GDP growth ( y ) is specified as a function of y, the current level of per capita GDP; d, a measure of income distribution; and X, a vector of relevant growth determinants: y f ( y , d , X ,..) (1) (+) (+) or (-) Sign depends on quality of IPy, Ly and PMPy (+) or (-) (+): Growth divergence Sign depends on quality of (-) : Growth convergence IPd, Ld and PMPd The change in income distribution ( d ) is specified as a function of y, d, and Z; a vector of relevant determinants of a better income distribution: d g ( y , d , Z ,..) (2) (+) (+) or (-) Sign depends on quality of IPd, Ld and PMPd where IP is a vector of measures of the quality of institutions and policies, comprised by three subvectors: IP = [IPy, IPd, IP0], L is a vector of measures of the quality of leadership, comprised by three subvectors: L = [Ly, Ld, L0], and PMP is a vector of measures of the quality of the policymaking process, comprised by three subvectors: PMP = [PMPy, PMPd, PMP0]. The three subvectors in each vector represent sets of key determinants of the sign of the corresponding partial derivatives. The subvectors denoted by super index y comprise variables within IP, L, and PMP that are key in determining the sign of the influence of income levels on growth (equation 1). The subvectors denoted by superindex d comprise variables that are key in determining the sign of the influence of the level of distribution on growth (equation 1), as well as the signs of the influence of both y and d in the change of income distribution (equation 2). Chile's Growth and Development 17 High levels of quality of incomerelevant institutions and policies (IPy), leadership (Ly), and policymaking process (PMPy) contribute to high growth and hence, growth convergence to the international income frontier. In the latter case, the partial derivative of GDP growth to the GDP level is positive. By contrast, low levels of quality of the latter three sets of variables lead to growth stagnation or low growth--"divergence, big time" (Pritchett 1997). In this case, the partial derivative of GDP growth to the GDP level is positive. Similar arguments apply to the role of the quality of distributionrelevant IPd, Ld, and PMPd in determining the corresponding partial derivatives. There are many combinations for the dynamics of income growth and income distribution changes, depending on the signs of the corresponding partial derivatives, determined by the levels of the incomerelated and distribution related components of IP, L, and PMP. Here I focus only on three possible combinations, selected for their relevance for the international development and growth experience, and for Chile's case discussed below. The first case (Case A, depicted in figure 1) reflects a low income and equity trap, determined by the low quality of IP, L, and PMP, reflected in the corresponding partial derivatives of the growth and distribution equations summarized in figure 1. The steadystate equilibrium represents economies trapped at low income levels. Any deviation from the stationary equilibrium will lead to either oscillatory dynamics around the steadystate equilibrium or a diverging (explosive or implosive) path for GDP and distribution. Figure 1: Simple Dynamic Model--Case A: Low Income and Low Equity Trap · d =0 d · y = f ( y, d , X ,...) (+) (-) (+) · y=0 · d = g ( y, d , Z ,...) (+) (-) (+) y 18 Klaus Schmidt-Hebbel Figure 2: Simple Dynamic Model--Case B: Development Path of High Growth (Growth Convergence) and Deteriorating Distribution · d =0 d · y = f ( y, d , X ,...) (-) (-) (+ ) · · y=0 d = g ( y, d , Z ,...) (+) (-) (+) y Case B (figure 2) reflects stable development dynamics that are consistent with growth convergence and deteriorating (improving) income distribution when income is below (above) the steadystate equilibrium. Growth convergence (the negative partial derivate of GDP growth to GDP levels in the growth equation) is caused by the better quality of IPy, Ly, and PMPy, in comparison to the lowincome and distribution trap of Case A. Case C (figure 3) reflects a second scenario of stable development dynamics, which now are consistent with growth convergence and improving (deteriorating) income distribution when income is below (above) the steady state equilibrium. The latter distribution dynamics (the negative partial derivative of the change in distribution to the GDP level) are caused by the better quality of IPd, Ld, and PMPd, in comparison to the two preceding cases. Now let's combine the three preceding cases into one development story that is coherent with the Kuznets (1955) interpretation of a nonmonotonic (quadratic) relation between per capita income levels and the distribution of income.7 7 Several explanations have been provided for an inverted Ushaped relation between inequality and income, including the development transition from agriculture to manufacturing (Kuznets 1955), the existence of European settlers, and the transition from subsistence agriculture to commodity exports and to manufacturing (Easterly 1993). However, the evidence on the existence of the Kuznets curve is disputed. For example, Barrios and Strobl (2005) provide supportive evidence while Anand and Kanbur (1993), Adams and Page (2003), and Kustepeli (2006) reject the existence of an inverted U curve in crosscountry data. Results seem to be dependent on the country sample, methodology, choice of inequality measure, and the time horizon selected in empirical work. Chile's Growth and Development 19 Figure 3: Simple Dynamic Model--Case C: Development Path of High Growth (Growth Convergence) and Improving Distribution · d =0 d · · y=0 y = f ( y, d , X ,...) (-) (-) (+) · d = g ( y, d , Z ,...) (-) (-) (+) y Figure 4 embeds the dynamics of cases A, B, and C. Case A reflects those countries that are trapped at low levels of income and income distribution, as a result of the very poor quality of their institutions, policies, leadership, and policymaking process. With improving IP, L, and PMP, low and middleincome countries that are on a growthconvergencebutdistributiondeteriorating dynamic equilibrium move along the D1­D2 dynamic path toward a steadystate equilibrium that is consistent with case B. Finally, middleincome countries that are on a growthconvergenceanddistributionimproving dynamic equilibrium move along the D3­D4 dynamic path toward a steadystate equilibrium that is consistent with case C. The latter stationary equilibrium is depicted in figure 4 as consistent with the highincome and gooddistribution condition that characterizes industrial countries. Figure 4: Full Development Path: Shifting Dynamics from Case A to B and C D4 d · D1 ( y = 0) C d · D2 D3 (d = 0) A · (d = 0) C · · ( y = 0) B d tra ( y = 0) A · (d = 0) C y tra y y Notes: Shift from Dynamics B to Dynamics C caused by improving IP-L-MP that shifts and rotates steady-state equilibrium conditions. D1­D2­D3­D4 is the Kuznets curve. But other development paths that contradict the Kuznets curve are possible (e.g., Anand and Kanbur, 1993) 20 Klaus Schmidt-Hebbel The shift from the dynamics of case B to those of case C is caused by better IP, L, and PMP conditions, beyond a threshold level. In other words, when the quality of IP, L, and PMP attain a certain level, growth convergence continues but income distribution, instead of deteriorating, starts to improve, taking middleincome countries on a virtuous development path. The latter is coherent with the Kuznets' view of development, reflected by the shift in dynamics embedded in the full D1--D2--D3--D4 development path. Finally consider a simple exercise of comparative dynamics that affects the world's growth and income distribution levels and dynamics. The ongoing integration of China and India into the world economy doubles the world's supply of unskilled labor, depressing the world's unskilled wages and raising the returns on skilled labor and capital (Freeman 1995, 2005). This leads to a deterioration in the world's average level of distribution and a higher average level of world income, both in the short term and in the very long term. The corresponding downwardright shift in the Kuznets curve is depicted in figure 5 as a shift in the D1­D2­D3­D4 development dynamics, leading to a new developedcountry stationary equilibrium of higher GDP ( y1 > y 0 ) and worsened distribution ( d 1 < d 0 ). The shortterm impact goes in the same direction, as suggested by recent world evidence. Figure 5: Comparative Dynamics of Development Paths altered by China and India's Integration into the World Economy (Freedman 2005) d D4 d0 D1 D4 D2 D3 D1 D2 D3 y Source: Freedman 2005. Note: South-east shifts of dynamic paths show worsened distribution, improved temporary growth, and permanently higher income levels. Chile's Growth and Development 21 3. Leadership, PolicyMaking Process, and Reforms in Chile In this section I apply part of the framework presented in section 2 to Chile, assessing the features and quality of leadership, policymaking process, institutions, and policies, as well as their links. This requires distinguishing between two very different periods: autocracy and democracy, briefly reviewed below. The subsequent analysis focuses largely on Chile's development under democracy, because leadership and the policymaking process under autocracy are unique to that regime and hence devoid of lessons for the future.8 Autocracy and Democracy The period of autocracy or dictatorship (1973­90) started with a military coup against the Allende government. Its initial conditions were characterized by deep political and economic crisis. The military regime introduced profound changes in institutions and policies, many geared at consolidating the new political regime, while others aimed at a radical overhaul of economic institutions and policies. Structural changes in the economic sphere embodied a revolutionary shift toward a deregulated and openmarket economy based on private ownership, away from a highly regulated closed economy dominated by state property and government control. The reforms adopted during the 1970s and 1980s aimed primarily at attaining macroeconomic stabilization and high growth, with a moderate focus on poverty alleviation and showing little concern for the distribution of income and wealth. The exercise of dictatorship implied that the PMP under autocracy encountered few constraints, with little need of negotiation and consensus building. Political opposition was suppressed by legal means and largescale violation of human rights. Economic leadership was exercised without the constraints imposed by democracy, making adoption of deep reforms of institutions and policies easier, but at the risk of major blunders and biases in the reform process. Examples of the latter were the policy mistakes that led to the 1982­83 recession and a bias in reform benefits toward the governing elite (reflected for example in the way privatization of stateowned enterprises was conducted). However, macroeconomic stabilization and structural reforms adopted during autocracy were largely geared at raising income growth of the "representative citizen," laying the foundations for Chile's highgrowth path attained since the mid1980s. This achievement stands in stark contrast to most other contemporary autocratic regimes in Latin America and Africa, which say little about growthenhancing reforms of institutions and policies. 8 Aninat et al. (2006) and Chumacero et al. (2006) present very valuable assessments of Chile's politics, reforms, and results. 22 Klaus Schmidt-Hebbel Due to its autocratic context and origin, the sustainability of reforms-- beyond the military regime--was far from assured. In fact, due to the lack of democratic context and legitimacy, the deep reforms of economic institutions and policies represented a highly risky strategy, prone to the likelihood of major reform reversal after transition to democracy. The latter transition from military autocracy to democracy took place in 1990, under exceptionally favorable conditions that contributed to its smoothness and success. Autocracy allowed an endogenous transition to democracy, complying with its own rules of electoral rules of the game. The centerleft opposition to dictatorship accepted the latter rules and formed the broadbased Concertación coalition. The historic moment of transition was marked by the collapse of communism and the Soviet Union, contributing to the shift of thought of socialists toward socialdemocratic positions and formation of the Concertación. Finally, the reforms adopted by the military government were starting to bear fruit, contributing to their legitimization and acceptation by the incoming democratic government. The first and subsequent Concertación governments had two fundamental goals. Their main political objective has been the removal of autocracy's constitutional constraints on full democracy, which has been largely attained by a sequence of legal reforms, the last one enacted in 2005. The Concertación's initial and ongoing socioeconomic objective is to lay the ground of a development path of high growth with improving equity. The accent on growth led to continuation and deepening of many growthenhancing reforms that were adopted under autocracy. However, the focus on equity implies a significant departure change from autocracy, as a response to the extensive poverty and unequal income distribution observed around 1990. The dual focus on growth and equity, shaped by the interests of the Concertación's electoral base, marks the reforms of economic institutions and policies enacted since 1990. Leadership and the Policy-Making Process under Democracy The quality and performance of Chile's political leadership under democracy are largely determined by the following legal and political constraints and traditions: Enforcement of institutional and political constraints imposed on abuse and corruption. There is generally low tolerance of the polity to abuse and corruption at the highest government levels. However, corruption tends to be observed at some of the lower and more decentralized levels of government. Rules of the PMP. Chile has a highly legalistic approach to the PMP in the tradition of the French legal system, with strong weight attached to formal procedures enshrined by law. Interests and goals of government coalition in power. With a strong emphasis on coalition programs and longterm holding of power, the Chile's Growth and Development 23 Concertación coalition has a longerterm political horizon than parties or coalitions centered around strong charismatic leaders. Incentive structure faced by leaders. Political reputation tends to dominate financial returns from holding power at high government levels, attracting able leaders that are paid only moderate wages. Central government bureaucracy efficiency. On average (but with a significant dispersion) the bureaucracy of the central government is well trained and provides relatively efficient services to both the leadership and the general public. Sensitivity to economic and political results. Leadership is significantly influenced by economic and political performance (including opinion polls and elections), yet avoiding populism most of the time. Chile's policymaking process under democracy is determined by the following politicalinstitutional factors: Democratic organization of government. With the return to democracy, Chile attained a high level of democratic rule, which was further improved in subsequent years (table 1). Political leadership is strongly bound by the constitutional rules of the game. Strong presidential system. The government system is rooted in a presidential system with strong executive dominance in the policy making process, reflected in government veto points and government initiative in several domains of lawmaking. State organization. Chile has a unitary (nonfederal) state organization that endows the central government with all relevant decisionmaking powers regarding regional policies. Binominal electoral system. Chile's "twopastthepost" electoral system results in a stable party system dominated by two party coalitions (the government Concertación coalition and the opposition Alianza coalition), avoiding the veto powers of small parties outside the two coalitions. State effectiveness/efficiency. Adjusted for the country's income level, Chile's state and government powers and functions display reasonably high levels of efficiency (see below). Negotiations and policy agreements. The policymaking process relies frequently on government negotiation and policy agreements with the opposition, responding to both constitutional constraints and the need of policymaking legitimacy.9 9 This was particularly the case until 2005, when the opposition controlled parliament due to constitutional constraints inherited from autocratic rule. With the 2005 constitutional change, the government coalition controls parliament, reducing the latter's need for attaining lawmaking agreements with the opposition. 24 Klaus Schmidt-Hebbel Table 1: Chile's Position in World Ranking of Macro and Institutional Development Indicators, 2006 Highest ranked emerging Position of Number of Index country Chile countries Source Competitiveness Chile 27 125 The Global Competitiveness Report Ease of doing business Lithuania 28 175 Doing Business--The World Bank Group Quality of institutions Chile 11 30 World Bank Rule of law Chile 12 30 World Bank Macroeconomic Algeria 6 125 World Economic management Forum Banking system strength Chile 9 30 Based on Moody's Financial Strength Ranking Contribution of monetary Chile 1 61 Institute for policy to macroeconomic Management performance Development Corporate tax rate Hungary 3 30 Price Waterhouse Coopers Labor market rigidity Brazil 18 21 Heckman and Pagés (2003) Following Spiller and Tommasi (2003), I identify next the main features of Chile's PMP that contribute to attaining cooperative outcomes: a high degree of shared interests and views (consensus) among players, as a result of: ­ collective memory of the costly highconflict period (1969­88) ­ large, unprecedented influence of professional economists in politics and in policy design and implementation small immediate benefits to the government of the opposition obtained from reneging on agreements small number of decision makers: two large coalitions and diminished role of other actors (armed forces, trade unions, Catholic Church, business associations) repeated interaction among key decision makers (repeated games based on reputation) deviations from agreedupon behavior are easily observed, due to increasing role of transparency of political agreements existence of credible enforcement mechanisms. Chile's Growth and Development 25 Reforms of Institutions and Policies Reforms under autocracy took place under very different conditions than under democracy, for the reasons that were spelled out above. Yet it is revealing to review the main domestic and foreign triggers of reforms that were adopted during the full reform period, starting in 1973: (i) Domestic factors: · major 1970­73 political/economic crisis (1973 hyperinflation--see figure 6) and 1973 coup d'etat crisis: leads to comprehensive programs of macroeconomic stabilization and structural reforms · 1990 return to democracy: continuation of economic reforms and stronger focus on equity goals · moderate political crisis in early 2000s triggered by corruption scandals: leads to negotiated program of reform of the state. (ii) Foreign factors: · recurring external crises in the 1970s and 1980s trigger domestic crises and subsequent reforms (e.g., persistent loss in terms of trade since 1975--see figure 7; strong cycles in capital inflows) · since the 1980s: demonstration effects of successful reform and growth experiences in the United Kingdom (1980s), East Asia (since the 1980s), Central and Eastern Europe (since the 1990s), and small OECD countries (including Finland, Ireland, and New Zealand). Figure 6: Inflation Rate/(1+Inflation Rate), 1961­2006 1 0.9 0.8 Inflation/(1+Inflation) 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 Year Source: Central Bank of Chile. 26 Klaus Schmidt-Hebbel Figure 7: Terms of Trade 250 200 Terms of trade 150 100 50 0 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 Years Source: Central Bank of Chile. The stages of Chile's reforms of institutions and policies during democracy display the following features: The first stage of preparation of large reforms under the current Bachelet administration has been entrusted to special presidential commissions responsible for preparing reports with background analysis and specific technical recommendations about the contents of the reforms. The latter commissions (listed in section 5 below) are comprised by a variable number of sector specialists, economists, and interestgroup representatives; some commissions have issued public documents with substantial and detailed recommendations. The second stage of preparation of reforms is at the cabinet level, involving technical commissions under the responsibility of one or several ministers. Government negotiation of reforms with the opposition is highly variable, depending on the needs of parliamentary votes and political legitimacy. Government negotiation with negatively affected groups (reform losers) is highly variable, ranging from nil (example: privatization of public enterprises in the 1990s) to moderate (example: freetrade agreements), and to very large (teachers' union representatives in 2006 Education Reform Commission; workers' vetoes to 2007 public port privatization). Chile's Growth and Development 27 There is generally no or little compensation of reform losers (one exception: workers of state coal mines closed down were significantly compensated for job losses in the late 1990s). Institutional or policy design of reforms is heavily influenced by technocrats in general and economists in particular. For example, the latter are highly represented in the presidential reform commissions of the current Bachelet administration. Reform experimentation ranges from nil to very little. For example, there are very few cases of experimentation of new social policies in small communities and pilot cases. Full reform implementation is generally well executed and accords with reform blueprints. A major exception is the badly implemented (and designed) 2007 Santiago public transport plan. Corrections and finetuning of complex reforms are introduced frequently, ranging from design to implementation (examples: pension system reforms and electric utility pricing and regulation). Longterm reform sustainability is generally ensured by good design, ability to introduce corrections, and political legitimacy of reforms. Chile's success in reforming economic institutions and policies has been the result of the following features: Chile has been and is at the world design and implementation frontier in many reform areas (e.g. pension systems, publicprivate partnerships, freetrade agreements, inflation targeting, fiscal policy rules--see figures 8 and 9). Figure 8: Monetary Policy Regime: Monetary Policy and Inflation under Inflation Targeting, 1990­2007 28 Inflation target (range or point) 23 Annual inflation Real monetary policy rate 18 Percent 13 8 3 ­2 1990 1992 1994 1996 1998 2000 2002 2004 2006 Year Source: Central Bank of Chile. 28 Klaus Schmidt-Hebbel Figure 9: Fiscal Policy Regime: Actual and Structural Fiscal Balance, and Sovereign Risk Premium, 1996­2006 8 250 Obs. Fiscal Balance Structural Fiscal Balance 6 Country Risk 200 4 % GDP 150 B.P. 2 100 0 50 -2 -4 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year Source: Author's calculation based on data of Ministry of Finance. Radical economic reforms undertaken under autocracy were legitimized and often improved upon under democracy. Subsequent reforms under democracy are legitimized by democratic implementation. Reform design generally represents the interests of majorities (or the "representative consumer"). Positive interaction and threshold effects that reforms in complementary areas have obtained (as discussed below). Low likelihood of reform reversal due to weak influence of reform blockers/losers. Large national consensus on reform needs (e.g. candidates' programs in 2005 presidential elections were largely shaped and written by economists). Policies and institutions are perfected by learning from mistakes (e.g. financial reforms and the role of bank regulation and supervision, exchangerate regimes). Competent bureaucracy (in some key government institutions) support effective reform implementation. Publicenterprise privatization and publicprivate partnerships are complemented with government regulation and supervision in new areas (e.g., pensions, infrastructure concessions). Rules versus discretion: Chilean reforms tend to favor adoption of rules and regulations, limiting the scope for government discretion (e.g., monetary, fiscal, and exchangerate policies; government pricing, regulation, and supervision of private firms in natural monopolies). Chile's Growth and Development 29 Regarding reform features--including reform depth, speed, timing, and gradualism--Chile's experience since the 1970s points toward three conclusions: (i) Reforms have often been deep and broad in scope, and cutting across different reform areas. According to a measure of structural reform progress in different areas, many reforms took place in the late 1970s, were somewhat reversed in the early 1980s, and have continued at a more moderate pace since the mid1980s to date (figure 10). Deep and broad reforms have included macroeconomic policy reforms (leading to high levels of macroeconomic stability and credibility; figures 8 and 9), domestic financial and capitalmarket reforms, international trade and financial reforms (leading to free and full integration into the world economy; figures 11 and 12), and pension system reform, among others. (ii) Many reforms have been very gradualist. For example, Chile adopted the most gradualist inflation stabilization experience in world history: it took 28 years to reduce inflation from 1,000 percent in 1973 to 3 percent in 2001. Regarding trade openness, import tariffs were reduced from a 100 percent average tariff rates in 1974 to a flat 11 percent in 1991 to an average 2 percent in 2007 (the average of a flat 6 percent for nonFTA imports and 0 percent of FTA imports). (iii) Little attention has been paid by reforming governments to optimal timing and optimal sequencing of reforms. Reforms were adopted because of conviction of political leadership, taking into account their perceived reform support and the restrictions and features of the policymaking process that were discussed above. Figure 2: Structural Reform Index, 1960­2005 0.8 0.7 Structural reforms index 0.6 0.5 0.4 0.3 0.2 0.1 0 0 05 3 6 9 2 5 78 81 84 87 90 96 99 02 93 6 6 6 6 7 7 19 19 19 19 19 19 19 19 19 19 19 20 20 19 19 19 Year Source: Author's calculation extending Lora et al., IDB. 30 Klaus Schmidt-Hebbel Figure 11: Trade Openness (Trade Share in GDP, 1970­2005) 120 Asian emerging countries 100 80 Chile Percent 60 Latin World American countries 40 Developed countries 20 0 1970 1975 1980 1985 1990 1995 2000 2005 Year Source: World Bank and IMF. Note: Measured as the sum of exports and imports in percent of GDP. Figure 12: Financial Openness, 1970­2004 140 Chile 120 100 Percent 80 Developed countries 60 Latin American countries 40 Other emerging 20 countries Asian emerging countries 0 1970 1975 1980 1985 1990 1995 2000 Year Source: Lane and Milesi-Ferretti (2006) and IMF. Note: Measured as the sum of the stocks of external assets and liabilities of foreign direct investment and portfolio investment in percent of GDP. 4. Chile's Development Results: Growth and Equity This section reviews Chile's growth and equity performance. It focuses on the GDP growth record, its proximate causes, and deeper policy determinants. Then the mixed performance of equity is revised, mentioning some of its likely determinants. Finally, Chile's growth and distribution dynamics are revisited, making use of the framework developed in section 2. Chile's Growth and Development 31 Growth As a result of the reforms started in the 1970s, Chile made a quantum leap in its growth performance. After an average annual per capita GDP growth of 1.5 percent per year during the 180 years since its independence (1810­1990), per capita growth rose to 4.1 percent in 1991­2005 (while the world recorded average annual per capita GDP growth of 1.4 percent in 1991­2005) (figure 13). Chile's accelerated growth path reduced its relative income gap with industrial countries and put it at a distance with most developing economies, except the highgrowing East Asian economies (figure 14). In comparison to its own history, Chile's improvement in the first moment of growth was matched by an improvement in the second moment, as growth volatility fell after 1990 to its lowest level recorded since the early nineteenth century (figure 15). The standard deviation of per capita GDP growth declined from 6.6 percent in 1810­1990 to 3.1 percent in 1991­2005. What is behind Chile's growth spurt? Conventional growthaccounting exercises focus on the proximate sources of growth: capital, labor, and total factor productivity (TFP). Fuentes, Larraín, and SchmidtHebbel (2006) show that the growth gains recorded since 1990 have been due to larger capital investment and aggregate efficiency gains reflected in higher TFP growth (figure 16).10 Figure 13: Four Stages in Chile's Historical GDP Dynamics Relative to Six Selected Countries: 1820­2005 3.0 II 2.5 III IV 2.0 I Percent 1.5 1.0 0.5 0.0 1820 1840 1860 1880 1900 1920 1940 1960 1980 2005 Year Australia Spain Japan Mexico United Kingdom United States Source: Author's calculation based on data of Diaz et al. (2003), IMF, and Central Bank of Chile. Note: Based on per capita GDP levels expressed at PPP-based exchange rates. 10 The three periods 1960­73, 1974­89, and 1990­2005 were selected by Fuentes, Larraín, and SchmidtHebbel (2006) because they reflect similar businesscycle conditions as the breaking points (years 1973­74 and 1989­90) exhibit relatively low unemployment rates. Hence average growth and factor accumulation rates in each period are relatively unbiased by cyclical growth. 32 Klaus Schmidt-Hebbel Figure 14: Per Capita GDP and GDP Growth in Chile and Major World Regions, 1980­2005 Per capita GDP (US$ PPP), several periods, several regions Region 1980­85 1986­90 1991­95 1996­2000 2001­05 Chile 2,928 4,173 6,275 8,524 10,821 EAP 760 1,287 2,134 3,292 4,915 OECD 11,831 16,610 21,127 25,627 30,833 LAC 3,989 4,799 5,701 6,752 7,689 UMI 5,237 6,433 6,863 7,840 9,831 World 3,458 4,628 5,677 6,878 8,502 GDP per capita growth, several periods, several regions 10 8 6 Percent 4 2 0 Chile EAP OECD LAC UMI World ­2 1980­85 1986­90 1991­95 1996­2000 2001­05 Source: Author's calculation based on data of IMF and Central Bank of Chile Figure 15: Average per capita Chilean GDP Growth Level and Volatility by Decades 7 18 Average Volatility 6 16 14 5 12 Average 4 Volatility 10 3 8 6 2 4 1 2 0 0 10 20 18 0 40 18 0 60 70 18 0 90 19 0 10 20 19 0 40 19 0 60 70 80 00 0 6 3 5 8 0 3 5 20 199 ­0 18 18 18 18 18 18 19 19 19 19 19 19 Year Source: Author's calculation based on data of Diaz et al. (2003). Chile's Growth and Development 33 Figure 16: GDP Growth Decomposition, 1961­2005 6 5 Capital Employment TFP 4 Percent 3 2 1 0 ­1 1960­73 1974­89 1990­2005 ­2 Source: Fuentes, Larraín, and Schmidt-Hebbel (2006). Note: Capital and labor adjusted for hours and wages, full sample periods, and subperiods. The latter growth decomposition also shows that average efficiency payoffs from the 1973­89 reforms were on average nil during the later period, materializing with a substantial time lag, since 1990. Splitting the 1990­2005 performance into two reveals very different subperiods (figure 17). GDP growth declines from an average 7 percent in 1990­ 97 to only 3.5 percent in 1998­2005. While the absolute contribution of capital investment remains high during the latter subperiod, TFP growth declines by half and employment levels declines. This reflects the fact that the massive deterioration in growth and its determinants observed since 1998 has a large cyclical component. In fact, more recent figures for 2004­07 (5.4 percent average estimated GDP growth) point toward a significant recovery of growth, employment, and TFP. Yet it is highly uncertain how much of the growth decline since the late 1990s is due to cyclical conditions and how much comes from lower trend growth--an issue to which I will come back below. Figure 17: GDP Growth Decomposition, 1990­97 and 1998­2005 8 7 Capital Employment TFP 6 5 Percent 4 3 2 1 0 ­1 1990­97 1998­2005 Source: Fuentes, Larraín and Schmidt-Hebbel (2006). Note: Capital adjusted for utilization (energy consumption) and labor adjusted for hours and wages. 34 Klaus Schmidt-Hebbel Table 2: Institutional and Policy Determinants of Growth Changes between 1981­85 and 1996­2000 in Chile and Major World Regions Latin East Industrial Policy Variable Chile America Asia Countries Economic growth Actual change 3.57 2.94 -0.21 1.37 Projected change 3.76 2.65 1.42 0.94 Convergence Initial GDP per capita -0.19 0 -0.2 -0.09 Human capital 0.47 0.4 0.47 0.42 Structural policies Private credit -0.11 -0.11 -0.29 -0.25 Institutions index 0.94 0.5 0.32 0.01 Government expenditure 0.78 0.35 0.32 0.04 Stabilization policies Inflation rate 0.55 0.9 0.07 0.3 RER overvaluation 0.35 -0.01 -0.03 -0.46 Openness policies Trade openness 0.45 0.42 0.51 0.42 Financial openness 0.67 0.38 0.52 0.8 External shocks Terms of trade changes 0.11 0.09 0.02 0.01 Changes in the period -0.27 -0.27 -0.27 -0.27 Source: Calderón and Fuentes (2006). Now let's turn to the contribution of deeper growth determinants, those that are behind higher growth of reproducible factors of production (physical and human capital) and higher efficiency gains. Using crosscountry growth regressions that highlight the contribution of institutions and policies to growth, Calderón and Fuentes (2006) contrast Chile's 3.6 percent average annual growth gain between 1981­85 and 1996­2000 to that observed in major world regions and identify its largest determinants (table 3). The major factors behind Chile's growth rise are improvements in institutions (contributing 0.9 percent), trade and financial opening (1.1 percent), macroeconomic stabilization (0.9 percent), the lower ratio of government spending to GDP (0.8 percent), and human capital accumulation (0.5 percent). In comparison to other regions, the role of better institutions and macroeconomic stabilization in raising growth is particularly large in Chile. Focusing on the determinants of TFP growth in Chile during a longer time horizon (1963­2005), Fuentes, Larraín, and SchmidtHebbel (2006) identify the massive improvement in institutions and policies (measured by the structural reform index measured depicted in figure 10) as explaining much more than 100 percent of the improvement in TFP growth during the last four decades (table 4). The latter improvement much more than offsets the very negative effect of the major termsoftrade loss suffered by Chile during the same time span. Chile's Growth and Development 35 Table 3: Decomposition of Annual TFP Growth, 1963­2005 Measure 1* Measure 2* Average annual TFP growth Actual 0.75% 0.46% Predicted 0.75% 0.70% Contribution of cyclical variables Terms-of-trade loss or gain -1.89% -0.95% Real exchange rate devaluation or appreciation 0.10% 0.08% Contribution of better policies and institutions Improvement in macroeconomic instability 0.00% -0.10% Improvement in structural reforms 2.54% 1.66% Improvement in civil liberties 0.00% 0.00% Improvement in policy complementarity 0.00% 0.03% Source: Fuentes, Larraín, and Schmidt-Hebbel (2006). * Capital and labor adjusted for hours and wage-based labor quality. ** Capital adjusted for utilization (energy consumption) and labor adjusted for (hours and wage-based labor quality). Hence there is significant statistical evidence that better institutions and policies--brought by the reforms started in the mid1970s and continuing to date--are the main driving factor behind Chile's quantum leap in GDP (and TFP) growth. Gallego and Loayza (2002), using a somewhat different methodology, complement the latter results. They estimate that about 1 percent of Chile's growth acceleration can be explained by reform threshold effects and interactions of progress in different institutional and policy reform areas. This result underscores the importance of Chile's experience in advancing in different reform areas, ranging from legal and economic institutions to macroeconomic stabilization, and from sector reforms to improved social programs. Which is a reasonable estimate for Chile's potential (or trend) GDP growth rate? Chile's actual average annual GDP growth, during the recent cyclically balanced period that extends from 1990 to 2007, has been 5.4 percent, equivalent to a 4.2 percent annual average per capita GDP growth. However, as an unobservable stochastic variable, potential growth cannot be measured--it can only be inferred from empirical estimates and simulations. Current estimates for potential or trend GDP growth are close to 5 percent (SchmidtHebbel 2006). The latter figure is confirmed by the most recent estimates of the independent panel of experts consulted by the Ministry of Finance for the 2008 budget for the structural budget surplus rule (Ministry of Finance 2007). The panel's median estimate for the mediumterm (2008­12) GDP growth projection is a flat annual 5 percent. 36 Klaus Schmidt-Hebbel Equity Chile's equity experience is much more mixed than its growth record. On the positive side is the massive and systematic reduction in poverty levels. The population share living in poverty (extreme poverty) has declined from 28 percent (17 percent) in 1987 to 11 percent (3 percent) in 2006--a twodecade poverty reduction that is matched by only a few other development cases (table 5). On the negative side is income distribution. Household survey data show that income is highly concentrated in Chile and the relative income distribution remains largely unchanged between 1990 and 2003 (tables 6 and 7). The same survey data indicate that consumption expenditure levels have become somewhat more equal across households. The last survey (for 2006) shows an improvement in income (and consumption) distribution, reflected by a significant reduction in the aggregate income Gini coefficient from 0.57 to 0.54. However, it is obviously too early to infer if the latter improvement marks the start of a trend improvement or reflects a single outlier of a generally stagnating distribution in Chile. In contrast to income distribution, Chile is internationally well positioned in qualityoflife and humandevelopment indicators. This reflects the major progress in the incidence of poverty. For example, whereas child malnutrition was considered a major public health concern in Chile during the 1960s, child obesity--particularly among low and middleincome groups--is considered a public health epidemic in Chile today (Mardones 2006). Regarding government's social and antipoverty programs--including general and targeted social government spending and transfer programs--they have helped in reducing poverty but have had little impact on overall income distribution in Chile. The tax system does also not alter much the pretax distribution of income (Engel et al. 1999). Poverty has declined largely because of high growth, less because of government programs (which is consistent with Eyzaguirre and Larrañaga 1991). Table 4: Population Share Living in Poverty in Chile, 1987­2006 (%) Year Poverty Extreme Poverty Total 1987 27.7 17.4 45.1 1990 25.6 13.0 38.6 1992 23.8 9.0 32.8 1994 20.1 7.6 27.7 1996 17.5 5.7 23.2 1998 16.0 5.6 21.6 2000 14.6 5.6 20.2 2003 14.0 4.7 18.7 2006 10.5 3.2 13.7 Source: Ministry of Planning and Cooperation (MIDEPLAN) based on the National Characterization Socio- economic Survey (CASEN) 2006 household survey. Note: Expansion factor calculated on 2002 census. Chile's Growth and Development 37 Table 5: Evolution of Income Distribution across Deciles in Chile, 1990­2006 Decile 1990 1992 1994 1996 1998 2000 2003 2006 I 1.4 1.5 1.4 1.3 1.2 1.3 1.2 1.2 II 2.7 2.8 2.7 2.6 2.5 2.7 2.7 2.9 III 3.6 3.7 3.5 3.5 3.5 3.6 3.6 3.9 IV 4.5 4.7 4.5 4.5 4.5 4.5 4.7 4.9 V 5.4 5.6 5.6 5.4 5.3 5.7 5.4 5.6 VI 6.9 6.6 6.4 6.3 6.4 6.2 6.6 7.0 VII 7.7 8.1 8.1 8.2 8.3 7.9 8.2 8.7 VIII 10.4 10.5 10.6 11.1 11.0 10.4 10.7 11.1 IX 15.2 14.8 15.4 15.4 16.0 15.1 15.3 16.0 X 42.2 41.8 41.8 41.8 41.4 42.7 41.5 38.6 Total 100 100 100 100 100 100 100 100 Source: MIDEPLAN based on CASEN household survey. Table 6: Income Distribution Indexes in Chile, 1990­2006 Ratio 1990 1992 1994 1996 1998 2000 2003 2006 10/10 30.1 27.9 29.9 32.2 34.5 32.8 34.6 31.3 20/20 14 13.2 14 14.8 15.6 14.4 14.5 13.1 10/40 3.5 3.3 3.5 3.5 3.5 3.5 3.4 3 Gini coefficient 0.57 0.56 0.57 0.57 0.58 0.58 0.57 0.54 Source: MIDEPLAN based on CASEN household survey. Note: Ratios (x/y) represent the share in country's wealth of the x% richest compared to the y% poorest. Why is income so unequally distributed in Chile? Beyond ultimate historical and sociocultural factors, some studies have identified Chile's labormarket features that contribute to the high concentration of income and wealth. They include the low quality of education (Contreras 1999), a high average unemployment (Larrañaga 2001), and a low female labor force participation (Larrañaga 2001). Dynamics of Growth and Income Distribution in Chile Now I turn back to the relation between average income levels and income distribution and the dynamics between growth and distribution. First I consider Chile's position in the world distribution of per capita GDP and income concentration (measured by the Gini coefficient) in the 1990s (using available UNWIDER data; figure 18). The crosscountry data allows estimation of a non monotonic relation between both variables that is consistent with the Kuznets hypothesis. Against this curve, Chile is a clear outlier. Considering its GDP level, Chile's Gini coefficient is some 15 percent higher than that of a country that conforms to the Kuznets relation. 38 Klaus Schmidt-Hebbel Figure 18: Cross-Country Relation between World Income Distribution (Gini Coefficient) and Per Capita GDP, 1990s 0.8 0.7 0.6 GINI coefficient CHL 0.5 0.4 0.3 0.2 0.1 0.0 GDP per capita Source: Author's calculation based on UN-WIDER World Income Inequality Database (2000). For the time dimension, I now use Chilean income distribution data for a longer time horizon (1960­97) from the University of Chile Employment Survey. This data is less reliable than the 1990­2006 data from the CASEN survey. However, it provides a useful first approximation to the evolution of income distribution from the 1960s through the 1990s. Combining the latter data as a distribution indicator (the inverse of the Gini coefficient) with per capita GDP data allows depiction of their relation during the last four decades in Chile (figure 19). The data suggests that income distribution deteriorated significantly after the mid1970s, with a partial recovery during the 1990s. Yet during the 1990s the Gini coefficient (an average 53 percent) was still significantly higher than during 1960­75 (an average 46 percent). Figure 19: Income Gini Coefficient and Per Capita GDP in Chile, 1960­97 2.40 Inverse of GINI coefficient 2.20 1960s 1990s 2.00 1.80 1.60 1,000 2,000 3,000 4,000 5,000 Per-capita GDP (constant 2000 US$) Source: Author's calculation based on data of Central Bank of Chile and Employment Survey of University of Chile. Chile's Growth and Development 39 The relation between income distribution and per capita GDP show in figure 19 seems to suggest that Chile's timeseries experience is consistent with a Kuznets curve. While this reading of the data is tempting, one should bear in mind that the 1960­97 income distribution data has drawbacks, the sample period includes significant recession periods in the 1970s and 1980s that lower the distribution indicator (the Gini coefficient is countercyclical), and a decade of post1997 data is excluded (including the last 2006 survey that shows an improvement in income distribution). Having the latter limitations in mind, now I apply the simple dynamic framework for growth and distribution spelled out in section 2 to interpret Chile's experience in the light of the latter model. With potential GDP growth at around 5 percent and a stagnating (or somewhat improving) level of high income concentration, Chile may be at some point between D2 and D3 along its growth distribution path depicted in figure 20. Therefore the country is probably at a juncture where the quality of policymaking, leadership, institutions, and policies could enable it to jump on a dynamic path of improving distribution and high growth. In terms of figure 20, Chile's development challenge is to get on the D3­ D4 train. 5. Current Risks and Challenges to Chile's Future Development In the following, I identify the key risks to Chile's future development path and review reform challenges in key areas, faced by the current Bachelet administration and by future governments. Figure 20: Chile's Distribution-Growth Dynamics d D4 · d ( y = 0) C D1 · D2 (d = 0) A D3 · (d = 0) C · d tra ( y = 0) B · ( y = 0) A · (d = 0) C y tra y y 40 Klaus Schmidt-Hebbel Risks Chile faces two major risks in its attempt to catch the development train. One is related to growth, the other to equity. As discussed above, current and mediumterm potential growth has been estimated at 5 percent for Chile. Future growth projections are generally unreliable, as they are based on recent performance or simple assumptions that are often inadequate for assessing future performance. In the case of Chile, the highgrowth period has not been sufficiently extended, with the country relapsing to its historic growth of circa 3 percent. Reversion to the mean has been indeed the fate of most growth spurts observed in the world (Rodrik 2005). Chile could only be an exception to growth reversion if it continues adopting and extending growthenhancing institutions and policies, and if it goes on improving the quality of its leadership and policymaking institutions. The second risk faced by Chile is continuing stagnation of income and wealth distribution at current high levels of concentration, with little extension of the current set of limited opportunities to overcome poverty or nearpoverty. This adverse scenario is bad for the welfare of the poor, for social and political stability, and for growth. Chile's current economic condition--and in particular the government's exceptional financial condition, reflected in an estimated cumulative 40 percent rise in real government spending during 2004­08-- represents a unique opportunity for designing and implementing social programs focused at extending the opportunity set of the lowerincome population. This raises a related risk: adoption of social policies and government programs that contribute to alleviate poverty and reduce income concentration, but at the cost of imposing major distortions that lower growth. There is a large world experience of wellintended but badly designed social policies--ranging from traditional unemployment benefits to many government transfer programs--that lead to growth stagnation and, in the end, little improvement of poverty and income distribution. Hence, Chile should be particularly careful in identifying potentially stiff tradeoffs between efficiency and equity in the design or reform of social policies. Reform Challenges Having in mind the latter risks, the country faces significant reform challenges to improve both growth and equity prospects. Many of these challenges are tackled by the current Bachelet administration, reflected in proposals worked out by special government commissions, legislative projects submitted to and discussed by parliament, and correction of preceding reforms. The main challenges are in the following areas: Education. The low quality of primary and secondary education in Chile is a major hindrance to higher growth and improved income distribution. The 2006 Education Reform Commission presented a large Chile's Growth and Development 41 and heterogeneous menu of reform proposals, currently evaluated by the government and parliament. Pension system. In order to tackle the main problems of the current pension system (low coverage, low firstpillar benefits, and lack of competition in the pension service industry), the 2006 Pension Reform Commission developed a significant reform proposal. Based on the latter report, the government presented a pension reform package to parliament, which is likely to be approved, with amendments, in 2007­08. Innovation, research, and development. To address Chile's weaknesses in innovation, research, and development (low private spending on research and development, inadequate government incentives and programs, weak innovation and research activities and output), the 2006­07 Innovation Commission is developing a comprehensive reform strategy that is likely to be translated in more government spending on innovation, a revamping of government programs, and improved incentives for the private sector in 2008­09. Labor markets. Chile's labor market laws and regulations reflect a mixed picture of partial flexibility and incomplete worker protection. Inefficient distortions (high firing costs, constraints on part.time and overtime employment) coexist with insufficient protection of lowskilled labor (weak to moderate collective bargaining strength of unions, low unemployment insurance benefits and little government support of low income families). The recently formed Equity Commission faces a very stiff tradeoff between efficiency and equity in designing its future proposals to improve labor markets and reduce poverty. State and government reform. After the 2003 government reform (that improved transparency and competition in hiring and remunerating government service managers), an additional government transparency law is likely to be enacted by parliament in 2007. Yet efficiency of central, municipal, and decentralized government services is low to moderate on average, and exhibits large dispersion across different services and government levels. Public enterprises operate in many areas where government productive activity exhibits little comparative advantage. Corruption at decentralized lower levels of government, and in public enterprises, is certainly not absent. Therefore a wideranging reform of government services and enterprises (including broad privatization) should be high on Chile's reform agenda. Control of crime and violence. Like most countries, Chile faces escalating crime and violence. While high growth and improved equity are likely to reduce crime and violence, a revamped government policy of sticks and carrots is required to stem the rise in crime that taxes investment and growth, and affects very adversely the welfare of the people, particularly the poor. 42 Klaus Schmidt-Hebbel Improving on previous reforms. Key sectors have been reformed recently but require--due to inadequate reform design and implementation--further adjustments, which in fact are considered or under implementation by the current administration. The new universal health program started by the previous administration (Plan Auge) requires major improvements in implementation. The energy sector (after Argentine natural gas cuts and the rise in international oil prices) requires better incentives for an expansion of the private supply of traditional and new energy sources. Finally, Santiago's new public transport plan--a basket case of bad design and implementation-- requires a major redesign. 6. Ten Lessons from Chile's Experience I derive ten lessons from the assessment of Chile's development experience carried out in preceding sections. (i) Recent crosscountry research and Chile's own experience has shown that development success is not only determined by good economic policies but is fundamentally a result of welldesigned and managed economic and political institutions that provide the foundation for good policies. (ii) However, digging deeper reveals that the links from institutions and policies to development are mediated by good leadership and a stable policymaking process (PMP). (iii) Good leadership, PMP, and institutions/policies are key in moving countries from stagnant development traps to strong dynamics of growth convergence and improved equity. (iv) Good leadership is promoted by closely aligned individual and political incentives, welldesigned political institutions that promote transparency and accountability (minimizing corruption), a stable PMP, and a moderately efficient state bureaucracy. (v) Chile's PMP is determined by democracy, a strong presidential system, a binominal electoral system, and six major factors that contribute to attain cooperative political outcomes between the two dominant party coalitions. (vi) Reforms of institutions and policies--triggered by political and economic crises during autocracy and by the return to democracy in 1990--have been and are broad, deep, and sustained, with a strong focus on growth and, since 1990, an added focus on equity. (vii) Economic growth, based on investment and efficiency gains due to reforms, has increased significantly. Chile's Growth and Development 43 (viii) Poverty has declined massively but income and wealth concentration has remained very high. (ix) Chile's main current risks are a relapse to lower growth and lack of progress in equity improvement. A related risk is adopting social policies and government programs that contribute to alleviate poverty and reduce income concentration, but at the cost of imposing major distortions that reduce growth. (x) Therefore Chile's main challenge lies in a careful design, negotiation, and implementation of institutional and policy changes for future growth and equity gains that complement each other, avoiding stiff growthequity tradeoffs. All this requires further hard work by Chile's leaders and technocrats, who face the right incentives provided by strong institutions, an effective PMP, and democracy. 7. Concluding Remarks I have reviewed in this paper the relations between leadership, the policy making process, policies and institutions, and development results in Chile. As an organizing framework, I have sketched a model for the dynamics of growth and distribution--two key dimensions of development. A Kuznetstype dynamic relation between growth and distribution can be traced to changes in the quality of L, PMP, and I. Chile has been lucky in two dimensions. First, the autocratic government (1973­1990)--notwithstanding its massive humanright violations--adopted growthenhancing reforms of IP and permitted an endogenous, smooth transition to democracy. Second, the centerleft coalition government that has governed Chile since 1990 has largely continued growthsupporting reforms, complemented by a stronger emphasis on poverty reduction and improved equity. Yet luck has been complemented by hard work. The quality of leadership and the policymaking process is relatively high in Chile, considering the country's level of development. This can be traced to several constitutional and political constraints, features, and traditions that shape the behavior of leaders and the policymaking process. As a result of the growthenhancing reforms of economic institutions and policies since 1973, the improved political institutions since the return to democracy, a modern policymaking process, and strong political leadership, Chile has recorded a quantum rise in economic growth and reduced income volatility during the last two decades. Chile's equity experience is much more mixed than its growth record. On the positive side is the massive, systematic reduction in poverty--but on the 44 Klaus Schmidt-Hebbel negative side is Chile's highly concentrated income distribution. The latter is likely a reflection of education and labormarket features that contribute to high concentration, including the low quality of education, high average unemployment, and low female labor force participation. Chile faces two major risks in its attempt to catch the development train. One is a relapse from recent and current high growth to its historically low growth rate. The second is continuing stagnation of income distribution and equity. Both risks are bicausally related. The higher is longterm growth, the better are the prospects for defeating poverty and improving income distribution. And the better is income distribution and the lower is poverty, the larger will be investment and growth. Realizing the latter virtuous cycle of growth and equity puts the onus on Chile's political leaders. They have to motivate careful design, negotiation, and implementation of institutional and policy changes for future growth and equity gains that complement each other, avoiding stiff growthequity tradeoffs. Chile's Growth and Development 45 References Adams, R.H., Jr., and J. Page (2003). "Poverty, Inequality, and Growth in Selected Middle East and North Africa Countries: 1980­2000." World Development 31(12): 2027­48. Agénor, PR. and P.J. Montiel (1999). Development Macroeconomics. Princeton University Press: Princeton, New Jersey. Agénor, PR. (2004). The Economics of Adjustment and Growth, Second Edition. Harvard University Press: Cambridge, Massachusetts. Anand, S., and S.M.R. Kanbur (1993). "Inequality and Development: A Critique." Journal of Development Economics, 41(1): 1943 Aninat, C., J. Landregan, P. Navia, and J. Vial (2006). "Political Institutions, Policymaking Processes and Policy Outcomes in Chile." InterAmerican Development Bank Working Paper No. 521. Acemoglu, D. (2003). "A Historical Approach to Assessing the Role of Institutions in Economic Development." Finance and Development 40(2), June. Acemoglu, D., S. Johnson, and J. Robinson (2001). "The Colonial Origins of Comparative Development: An Empirical Investigation." American Economic Review 91 (December): 1369­1401. ------ (2002). "Reversal of Fortune: Geography and Institutions in the Making of the Modern World Income Distribution." Quarterly Journal of Economics CXVII (November): 1231­94. ------ (2005). "Institutions as a Fundamental Cause of LongRun Growth." In P. Aghion and S.N. Durlauf, eds., Handbook of Economic Growth Vol. 1A. Amsterdam: NorthHolland. Acemoglu, D., and J. Robinson (2000). "Why Did the West Extend the Franchise? Democracy, Inequality, and Growth in Historical Perspective." Quarterly Journal of Economics 115: 1167­99. Barrios, S., and E. Strobl (2005). "The Dynamics of Regional Inequalities." European Economy Economic Papers No. 229. European Commission DirectorateGeneral for Economic and Financial Affairs, Brussels. Calderón, César and Rodrigo Fuentes (2006). "Complementarities between Institutions and Openness in Economic Development: Evidence for a Panel of Countries." Cuadernos de Economía (Latin American Journal of Economics) 43(127): 49­80. Instituto de Economía. Pontificia Universidad Católica de Chile. 46 Klaus Schmidt-Hebbel Chumacero, R., R. Fuentes, R. Lüders, and J. Vial (2006). "Understanding Chilean Reforms." In J. Fanelli, ed., Understanding Market Reforms in Latin America. Palgrave Macmillan. Collier, D., and S. Levitsky (1997). "Democracy with Adjectives: Conceptual Innovation in Comparative Research." World Politics 49(3): 430­51. Contreras, D. (1999). "Distribución del ingreso en Chile. Nueve hechos y algunos mitos." Perspectivas. 2(2). Cowan, K., and J. De Gregorio (1996). "Distribución y pobreza en Chile: ¿Estamos mal? ¿Ha habido progresos? ¿Hemos retrocedido?" Estudios Públicos 64: 26­56. Díaz, J., R. Lüders, and G. Wagner (2003). "La República en Cifras: Chile 1810­ 2000." Manuscript. Catholic University of Chile. Di Tella, R, R.J MacCulloch, and A.J. Oswald (2001). "Preferences over Inflation and Unemployment: Evidence from Surveys of Happiness." American Economic Review 91: 335­41. Easterly, W. (2003). "A Tale of Two Kuznets Curves: Inequality in the Old and New Globalizations." Paper for NBER PreConference on Globalization and Inequality, Cambridge MA, October. Engel, E., A. Galetovic, and C.E. Raddatz (1999). "Taxes and Income Distribution in Chile: Some Unpleasant Redistributive Arithmetic." Journal of Development Economics 59(1): 155­92. Eyzaguirre, N., and O. Larrañaga (1991). "Macroeconomía de las operaciones cuasifiscales." Serie Política Fiscal 21. Santiago, Chile: Economic Commission for Latin America and the Caribbean. FerreriCarbonell and P. Frijters (2004). "How Important is Methodology for the Estimates of the Determinants of Happiness?" The Economic Journal 114 (July): 641­59. Freeman, R. (1995). "Are Your Wages Set in Beijing?" Journal of Economic Perspectives 9(3): 15­32. ------ (2005). "China, India and the Doubling of the Global Labor Force: Who Pays the Price of Globalization?" The Globalist, June. Fuentes R., M. Larraín, and K. SchmidtHebbel (2006). "Sources of Growth and Behavior of TFP in Chile." Cuadernos de Economía 43(127): 113­142. Gallego, F., and N. Loayza (2002). "The Golden Period for Growth in Chile. Explanations and Forecasts." In N. Loayza and R. Soto, eds., Economic Growth: Sources, Trends and Cycles. Santiago: Banco Central de Chile. Hausmann, R., D. Rodrik, and A. Velasco (2005). "Growth Diagnostics." Manuscript. John F. Kennedy School of Government, Harvard University. Chile's Growth and Development 47 Heckman, James, and Carmen Pagés (2003). "Law and Employment: Lessons from Latin America and the Caribbean." NBER Working Papers 10129. National Bureau of Economic Research, Cambridge, MA. Kustepeli, Y. (2006). "Income Inequality, Growth, and the Enlargement of the European Union." Emerging Markets Finance and Trade 42(6): 77­88. Kuznets, S. (1955). "Economic Growth and Income Inequality." American Economic Review 45(1): 1­28. Lane, P., and G.M. MilesiFerreti (2006) "Exchange Rates and External Adjustment: Does Financial Globalization Matter?" The Institute for International Integration Studies Discussion Paper Series No. 129. Larrañaga, O. (2001). "Distribución de Ingresos en Chile: 1958--2001." Documento de Trabajo No. 178, Departamento de Economía, Universidad de Chile. Lora, E. (2001). "Structural Reforms in Latin America: What Has Been Reformed and How to Measure It." Interamerican Development Bank Working Paper No. 466. Mardones, Cristián (2006). "Impacto de la Percepción de la Calidad del Aire sobre el Precio de las Viviendas en ConcepciónTalcahuano, Chile." Cuadernos de Economía (Latin American Journal of Economics) 43(128): 301­330. Instituto de Economía. Pontificia Universidad Católica de Chile. Ministry of Finance (2007). "Acta Resultados del Comité Consultivo del PIB Tendencial." Santiago, Chile. Morawetz, D. (1977). "Income Distribution and SelfRated Happiness: Some Empirical Evidence." Economic Journal 87: 511­22. Marshall, M.G., and K. Jaggers (2004) "Political Regime Characteristics and Transitions, 1800­2002." Polity IV Project. University of Maryland. Pritchett, L. (1997). "Divergence, Big Time." Journal of Economic Perspectives 11(3): 3­17. Przeworski, A., M. E. Alvarez, J. Cheibub, and F. Limongi (2000). Democracy and Development: Political Institutions and WellBeing in the World, 1950­1990. Cambridge, UK: Cambridge University Press. Rodrik, D. (2005). "Growth Strategies." In P. Aghion and S.N. Durlauf, eds., Handbook of Economic Growth Vol. 1A. Amsterdam: NorthHolland. Rodrick, D., A. Subramaninan, and F. Trebbi (2002). "Institutions Rule: The Primacy of Institutions over Geography and Integration in Economic Development." NBER Working Paper No. 9305. SchmidtHebbel, K. (2006). "Chile's Economic Growth." Cuadernos de Economía 43(127): 5­48. 48 Klaus Schmidt-Hebbel Spiller, P., and M. Tommasi (2003). "The Institutional Foundation of Public Policy: A Transactions Approach with Application to Argentina." Journal of Law, Economics and Organization 19(2): 281­306. Sturzenegger, F., and M. Tommasi (1998) "Introduction." In F. Sturzenegger and M. Tommasi, eds. The Political Economy of Reform. Cambridge, Massachusetts: The MIT Press. Williamson, J. (1990). "What Washington Means by Policy Reform." In John Williamson, ed., Latin American Adjustment: How Much Has Happened? Washington, D.C.: Institute for International Economics. Chile's Growth and Development 49 Eco-Audit Environmental Benefits Statement The Commission on Growth and Development is committed to preserving endangered forests and natural resources. The World Bank's Office of the Publisher has chosen to print these Working Papers on 100 percent postconsumer recycled paper, processed chlorine free, in accordance with the recommended standards for paper usage set by Green Press Initiative--a nonprofit program supporting publishers in using fiber that is not sourced from endangered forests. For more information, visit www.greenpressinitiative.org. The printing of all the Working Papers in this Series on recycled paper saved the following: Trees* Solid Waste Water Net Greenhouse Gases Total Energy 48 2,247 17,500 4,216 33 mil. *40 inches in height and 6­8 Pounds Gallons Pounds CO2 Equivalent BTUs inches in diameter The Commission on Growth and Development Working Paper Series 43. Private Infrastructure in Developing Countries: Lessons from Recent Experience, by José A. Gómez-Ibáñez, January 2009 44. From Financieristic to Real Macroeconomics: Seeking Development Convergence in Emerging Ecomnomies, by Ricardo French-Davis, January 2009 45. Setting Up a Modern Macroeconomic-Policy Framework in Brazil, 1993­2004, by Rogério L. F. Werneck, January 2009 46. Real Exchange Rates, Saving, and Growth: Is There a Link?, by Peter J. Montiel and Luis Servén, January 2009 47. Avenues for Export Diversification: Issues for Low-Income Countries, by Paul Brenton, Richard Newfarmer, and Peter Walkenhorst, February 2009 48. Macroeconomic Policy: Does it Matter for Growth? The Role of Volatility, by Antonio Fatás and Ilian Mihov, February 2009 49. Current Debates on Infrastructure Policy, by Antonio Estache and Marianne Fay, February 2009 50. Explaining China's Development and Reforms, by Bert Hofman and Jingliang Wu, February 2009 51. Growth Challenges for Latin America: What Has Happened, Why, and How To Reform The Reforms, by Ricardo Ffrench-Davis, March 2009 52. Chile's Growth and Development: Leadership, Policy-Making Process, Policies, and Results, by Klaus Schmidt-Hebbel, April 2009 Forthcoming Papers in the Series: Investment Efficiency and the Distribution of Wealth, by Abhijit V. Banerjee (April 2009) Africa's Growth Turnaround: From Fewer Mistakes to Sustained Growth, by John Page (April 2009) Electronic copies of the working papers in this series are available online at www.growthcommission.org. They can also be requested by sending an e-mail to contactinfo@growthcommission.org. T his paper analyzes the relations between leadership, the policy-making process, policies and institutions, and development results in Chile. It starts with a stylized model for the dynamics of development that derives a Kuznets- Commission on Growth and Development type relation between growth and distribution of income, determined by the Montek Ahluwalia Edmar Bacha quality of leadership, the policy-making process, institutions, and policies. This Dr. Boediono framework is applied to Chile, identifying the features of the policy-making Lord John Browne process and leadership that allowed for continuation of growth-enhancing reform, Kemal Dervis ¸ with a stronger focus on equity goals, since the transition to democracy. As a Alejandro Foxley result of three decades of reforms, Chile has recorded a quantum leap in economic Goh Chok Tong growth, which is traced down to specific reforms. Yet Chile's equity experience is Han Duck-soo much more mixed: poverty has declined massively but income remains highly Danuta Hübner concentrated, a likely result of shortcomings in the quality of education and in Carin Jämtin labor markets. The paper reviews the major risks to the country's future Pedro-Pablo Kuczynski development pace and points out the main reform challenges faced by policy Danny Leipziger, Vice Chair makers. Ten lessons from Chile's experience close the paper.. Trevor Manuel Mahmoud Mohieldin Klaus Schmidt-Hebbel, Chief Economist, OECD Ngozi N. Okonjo-Iweala Robert Rubin Robert Solow Michael Spence, Chair Sir K. Dwight Venner Hiroshi Watanabe Ernesto Zedillo Zhou Xiaochuan The mandate of the Commission on Growth and Development is to gather the best understanding there is about the policies and strategies that underlie rapid economic growth and poverty reduction. The Commission's audience is the leaders of developing countries. The Commission is supported by the governments of Australia, Sweden, the Netherlands, and United Kingdom, The William and Flora Hewlett Foundation, and The World Bank Group. www.growthcommission.org contactinfo@growthcommission.org