TCS Daily

'A Privatization From Below'

By Carlos Ball - April 6, 2005 12:00 AM

Back in the 18th Century, some of the Spanish colonies in what today we call Latin America were richer, better developed, and the population enjoyed a higher standard of living than the English colonies in North America. That was to going to change after the wars of independence. The Founding Fathers of the United States made sure that the power of the English king would not be replaced by a local aristocracy, and both the Declaration of Independence and the Constitution made clear that all powers reside in the people, not the politicians or bureaucrats. Unfortunately, in Latin America, we inherited from Spain some very bad public policies that gave far too much power to politicians and government officials, and the State had from day one the ownership of the subsoil; therefore the wealth from gold, silver, and oil was soon flowing into the pockets of politicians and their friends.

The first Constitution of Venezuela, my old country, was ratified in 1811, and it was by far the best we ever had. It was quite similar to the U.S. Constitution, written to protect the citizen from government abuse. But the current Venezuelan Constitution, number 25, is the worst so far, having become a kind of institutional piata that offers every social right imaginable. That makes the Constitution totally impossible to comply with, so politicians and bureaucrats are then able to decide who gets what, and they can reward their followers and friends, while penalizing their enemies, whose property and wealth are taxed and redistributed.


Better than the Venezuelan Constitution of 1811 was the Constitution of Argentina of 1854, which was based on the writings of Juan Bautista Alberdi, who had been strongly influenced by Thomas Jefferson and James Madison. Alberdi believed that the primary purpose of government is to ensure the individuals' inherent rights to life, liberty, and property.


In his book "Bases for the Political Organization of the Argentine Republic", published in 1852, Alberdi wrote: "Today we must strive for free immigration, freedom of commerce, railroads, the navigation of our rivers, the tilling of our soil, free enterprise, not instead of our initial principles of independence and democracy, but as essential means of assuring ourselves that these will cease being mere words and will become realities." Alberdi even envisioned a free trade area for the whole of Latin America.


I mention these two South American countries because Argentina and Venezuela, at different times, became the most prosperous nations in the region, with an income per capita reaching 75% of the income per capita of the United States in those years: Argentina early in the 20th Century and Venezuela in the late 1950s. Both countries then enjoyed those institutions that are fundamental for growth and prosperity: a strong currency with no inflation, rule of law, free markets, respect for private property, relatively small governments, and low taxes.


Today, Chile is Latin Americas most prosperous country. Why? Because the free market reforms instituted in the 1980s were so successful that even its current socialist administration has not dared to tamper too much with them. Two key reforms were the unilateral reduction of tariffs and the privatization of social securitys retirement accounts. They may appear to be totally different policies, but actually both were based in a strong belief that individuals -- rather than government bureaucrats -- know better what is in their own best interest.


Chile had a pay-as-you-go plan, very similar to America's 70-year old Social Security system, under which the workers' contributions are not savings for their eventual retirements, but payroll taxes used to pay for the pensions of those already retired.


That system was based on the 19th Century ideas of Bismarck, then chancellor of Prussia, that avoided any relation between contributions made by a worker and the benefits he would receive upon retirement. That means that there is no connection between effort and reward. Another problem relates to demographics. When President Franklin Roosevelt created Social Security in 1935, the average life expectancy was 63 years, so most workers did not reach retirement age, and couples then had many more children than now, so the work force was rapidly expanding. The opposite takes place today, when relatively fewer workers support a rapidly increasing number of retired people.


José Piñera was appointed minister of Labor and Social Security of Chile in 1978, and in 1980 the Security Reform Act became law. It is interesting to note that Piñera first read about the idea of privatizing Social Security in Milton Friedmans book "Capitalism and Freedom," published in 1962. In 1977, Piñera gave a speech describing the future of Chile under economic freedom, and the following day he was invited by President Pinochet, whom he had never met, to repeat the speech to him and his Cabinet. In December of 1978, he was appointed minister to reform the pension system and the inflexible, anti-employment Chilean Labor Law.


Chileans were then given the choice of remaining in the traditional government-run Social Security program or opting out by investing their previous 10% of wages payroll tax in a privately-managed personal retirement account. 95% of the workers chose to have their own accounts and the 5% that chose to remain in the old system were mostly workers near retirement. The result was what Piñera calls "a privatization from below" of Chile's Social Security system.


The Chilean government guaranteed those already retired and receiving their Social Security pension that their benefits would not be touched by the reform.


And the new private accounts did not start from zero but received an amount from the Social Security administration in accordance to the length of the workers' past contributions. There is no employer contribution to those new accounts, but the worker has a choice of contributing up to an additional 10% of his salary. His savings then grow tax free until his retirement.


For the management of their private pension accounts, Chilean workers choose among many private pension fund companies, called Administradoras de Fondos de Pensiones or Pension Fund Administrators (PFAs) that compete for their business. To those afraid of having a private fund administer their savings, I ask how they prefer to send a package worth several thousand dollars, taking it to the Post Office or sending it by FedEx or UPS.


And to those that still trust governments more than they do the private sector, let me read the promises made back in 1936 by a U.S. Social Security publication: "After the first 3 years -- that is to say, beginning in 1940 -- you will pay, and your employer will pay, 1.5 cents for each dollar you earn, up to $3,000 a year Beginning in 1943, you will pay 2 cents, and so will your employer, for every dollar you earn for the next 3 years... And finally, beginning in 1949, twelve years from now, you and your employer will each pay 3 cents on each dollar you earn, up to $3,000 a year... That is the most you will ever pay."


In Chile, each PFA operates five mutual funds, with different bond/share proportions. Older workers have to own mutual funds with mostly fixed income securities, while young workers can have up to 80% of their funds in shares. Investment decisions are made by the PFA, but the worker can choose both the PFA and, within limits, the preferred fund.


Since workers are free to change from one PFA to another, there is strong competition to offer the best returns and the best service for the lowest commission. The average commission charged by the PFAs is 0.7%, which is below the commission charged by most mutual funds in the U.S. Clients receive a statement every three months showing the accumulated amount of his retirement fund and its performance. Those are assets he personally owns and that his family will inherit if he dies, which is not the case with the traditional Social Security.

One of the great attractions of the Chilean system is that it allows for individual preferences instead of a mandated one-size-fits-all. And the reformed system has kept a "safety net" for those that contribute for 20 years but their benefits are below what the law defines as minimum pension.


The old system was closed to new entrants into the work force, and the myth that employers pay part of the payroll taxes soon vanished in Chile. From the point of view of the employer, what they have to pay in payroll taxes is part of the cost of hiring an additional worker, so as economists have always known all payroll taxes are really paid by the workers. This was proven once again in Chile, when salaries increased after the privatization of Social Security, in response to supply and demand.


Today, nearly every member of Chiles labor force has a privately managed personal retirement account and the private companies that manage those accounts extend disability insurance and health insurance plans to their clients. The steady increase of Chilean wages allows workers to purchase health insurance from those same companies, so they stand on their own feet and no longer depend on the government for retirement or health.


As can be imagined, the program faced opposition from those that are against the idea that individual workers should make important decisions regarding their own, and their families' future. A labor union approached minister Piñera to offer its support for the privatization if instead of each worker choosing the pension fund company to invest in, that decision was left to the directors of his union. Piñera's response was that he could not do that, since pension fund managers would find it much cheaper to buy the support of union leaders by paying them under the table than to compete in a free market.


The next visitor to Piñera's office was the chairman of one of Chiles largest banks, who told the minister that the banking sector supported his ideas, but that private funds should be managed only by local banks, because foreign financial institutions should not be allowed to compete.


Unfortunately, that is a common business practice throughout Latin America. So much economic power is held by politicians and government officials that rather than compete openly in the market, pseudo-capitalists prefer to concentrate their efforts in raising import tariffs or getting regulators to make life difficult to their competitors.


According to Piñera, "for Chileans, their retirement accounts represent real property rights. Indeed, the accounts, not risky government promises, are the primary sources of security for retirement, and the typical Chilean worker's main asset is not his used car or even his small house (probably still mortgaged) but the capital in his retirement account."


While the American worker's return on his contributions to Social Security is less than 1%, the return on investment of the Chilean workers private retirement account averages 10.7% above inflation, and the resources accumulated in those accounts amount to 70 percent of the countrys GNP.


Turning workers into investors in the Chilean economy was a brilliant structural change that greatly contributed to increase the annual growth rate of the economy, from 3% to 7.2% in the period from 1985 to 1997.


There are some 20 countries that have in some way privatized Social Security. Even India is now considering doing so. To me it is unthinkable that India will be ahead of the United States in such an important public policy issue.


I shall end by quoting my old friend José Piñera one last time: "The ultimate lesson of the Chilean experience is that the only revolutions that are successful are those that trust the individual and the wonders that individuals can do when they are free."


Mr. Ball is editor of AIPE, a Spanish-language news organization based in Florida, and adjunct scholar with the Cato Institute.


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