(Fig 1.1) Inflation Rate of ChileIt was in 1975, Milton Friedman, an American economist, in his letter to Pinochet laid out what he thought Chile’s economic policies should be. To stabilize inflation, he suggested reduction of government deficit and a commitment by the government, that it will no longer finance government spending by creating money, which was taken care of, thanks to Chicago Boys & Pinochet. Also, he suggested free-floating exchange rates but Pinochet government in 1979 decided to peg the exchange rate at 39 pesos to the US dollar because Pinochet administration was more committed to anti-inflation policy and this somewhat anti-free market decision placed an effective ceiling on any inflation Chile was to suffer and also provided the benefit of a stable currency in the minds of foreign investors who were considering sending their funds to Chile. It was a win-win situation. But what happened was completely unanticipated.As a result of peso being pegged to the US dollar,the economy had to witness a serious balance of payments problem. Before 1979, the peso was devalued three times a month. This intense supervision and adjustment of the nominal exchange rate was out of constant fear of inflation. By 1979, thanks to constant supervision, Chile was seeing an inflation rate of 38.9% – definitely lower than the ridiculously high rates of 5 years earlier but it was still not acceptable to the Pinochet government, hence the decision to peg the currency. In the1970s, the US dollar was rapidly declining in value and was considered weak relative to the appreciating Peso. With the exchange rate 39 pesos to the weak US dollars, it did not take long for international investors to see the bargain. Soon, Chile was flooded with the dollars of investors buying up the strong pesos. As per the report by the New York Times, the interest rate on pesos deposits rose above that of US dollar deposits. The Chilean buying power of foreign goods started increasing drastically. But in the 1980s, when the Presidential elections took place in the US, the dollar started regaining its strong position in the world market because of better enforcement of the monetary policy. Now, it was one strong dollar for 39 weak pesos. As a result, capital investments that skyrocketed in the 1970s when the peso was strong started disappearing. Net inflows that accounted for 15% of GDP during 1979-81 fell down to 5% in 1982. In actuality, this inflow of capital was merely speculative capital which proved disastrous for the Chilean banking sector because it did not enter the country with the goal of building enterprises and was, therefore, certainly not intended to remain in the country for long. As soon as the advantage of holding pesos disappeared, speculators withdrew their investments and when that happened, it left behind many problems with which Chile had to deal. Chile had to buy up the immense amount of foreign currency to defend its fixed exchange rate for which the Pinochet government injected 70 billion pesos into the nation’s money supply. During periods of expected inflation, a large increase in the demand for loans is observed. This is exactly what happened, consumers and businesses alike started borrowing money in the hope of paying it back in the future when the currency would actually worth less than when they were borrowed. Due to an increase in borrowings, interest rates started rising once again. And as expected, inflation did follow and rose from 9% in 1982 to 25% in 1983. As a result, there was a steep decline in savings from about 16% in 1975 to 12.4% in 1981 and a rapid increase in lending as a result of which banks started turning bankrupt. By the end of 1981, Chile announced that its financial institutions were $2.5 billion in debt more than twice the capital possessed by them.And even after listening to the cries of Chilean businessmen, farmers & others suffering from the loss of competitiveness in the international market, Pinochet refused to devalue because he had confidence in the fact that Chile would be out of the crisis by 1983. William Faulkner, one of my favorite authors, once said, “confidence has the tendency to turn into stubbornness when things start to fall apart.” That is exactly what happened in Chile when its entire banking sector had to pay because of Pinochet’s stubbornness. As a result of which, the Central Bank of Chile was forced to absorb the debt of the private banking system.It is ironic how one decision to curb inflation eventually resulted in an inflationary situation. Many economists are of the view that had Chile’s exchange rate policy been handled differently, the recession may not have been completely avoided but at the very least would have been less painful.At this point one might think, could the recession of the early 1980s possibly throw overboard the efforts of all those years? Well, no. In 1983, Pinochet under pressure from IMF which considered Chile to be in deep trouble, decided to devalue. After the crisis, theIMF and World Bank stepped in to set Chile on the road to financial recovery. The World Bank granted loans to Chile to fund 4 targeted projects aimed to rebuild the economy. First, it was observed that Chile needed intervention to deal with matters relating to medium term and long-term financing.The World Bank thusresponded with the Industrial Finance Restructuring Program (IFRP) whereby a loan amount of $100 million was provided. Its principal objective was the overall financial strengthening of large industrial firms. The 2nd project conceived at the same time was Small & Medium Industry Project (SMIP), whereby a loan of $40 million was provided with the motive of assisting small & medium companies with the hope of generating jobs, thus, reducing unemployment. The next two projects were Industrial Finance Project (IFP) and Financial Markets Loan (FML). IFP was designed to provide loans worth $75 million to provide investment opportunities to industries, particularly medium-sized industries. FML, on the other hand, was distinct from the other 3 projects. It aimed to provide $100 million to the Chilean government mainly to deepen the “securities market”. In 1989, firms that had received loans out of the IFRP were witnessing an increase in revenues by more than 50% per year and around 1700 firms benefitted from SMIP, as the newly created investments funded by it turned out to be profitable.FML was considered a great success as it contributed to the rapid growth of Chilean pension funds, life insurance corporations and the security exchange. This recovery and subsequent growth took place only after Pinochet left office as it was after he left the office that banks that were nationalized during the crisis were decided by the new government to be eventually “re-privatized”. In 1985, Patricio Aylwin assumed office. He was the first President of Chile after dictator Pinochet, and his election marked the transition to democracy. His government was more focused on financial solvency and economic growth. Under his regime, exports grew rapidly and unemployment went down. There was a program “growth and equity” emphasizing both economic liberalization and poverty reduction which was completely ignored under Pinochet’s regime as economic inequality increased massively under his rule. The Aylwin government also introduced a tax reform which boosted tax revenue and enabled the administration to increase government spending on social programs. In addition to improving the income of companies and people, the Aylwin government strengthened the capital market by allowing a large group of people to own stocks. It is indeed surprising to see how Chile’s banking system, and in fact, its entire financial sector, was turned around from near bankruptcy to success. Today, Chile is in a much better situation than its neighbors. GDP Growth rate is positive, inflation is low and the budget is almost balanced. In contrast, other Latin American nations like Argentina are experiencing high levels of inflation and economic upheaval which can be illustrated in the following diagrams. And it couldn’t have been possible without Pinochet’s administration because they did bring about a complete transformation in the country and would’ve achieved the desired results had they decided to go with a free and floating system of exchange. Also, Pinochet’s dictatorship couldn’t ensure social welfare because of his utter commitment towards economic good, which is always a shortcoming in a dictatorship. There was a need for democracy or free society to ensure both social and economic welfare and the irony is, that the return of democracy in Chile was the result of free-market reforms introduced under Pinochet’s regime. To quote Milton Friedman, “the real miracle is that a military junta was replaced by a democratic society and that free markets worked their way in making it possible”.