Government leaders of more than 15 countries have called upon Arnold
Harberger's expertise. With a reputation as a hands-on practitioner
of economics, Harberger has also held consulting positions with
global organizations, including the International Monetary Fund,
the Asian Development Bank and the Organization of American States.
Numbered among his students at the University of Chicago and the
University of California Los Angeles are at least a dozen central
bank presidents and two dozen foreign government ministers.
But Harberger may best be known for his leadership of a group of
known as the "Chicago Boys," so named because of their connection
to the University of Chicago. The "Chicago Boys" were significant
free-market reformers in Chile during the 1970s.
Currently a professor of economics at UCLA, Harberger spent 38 years
at the University of Chicago, where his research contributions were
mainly in the fields of public finance, cost-benefit analysis, international
economics, the economics of inflation and economic policy for developing
In the following interview Harberger takes the reader around the
world as he discusses economic policies and problems in Latin America
and Asia, and shares stories of his mentors and colleagues over
REGION: The Federal Reserve is always open to advice, expert or
otherwise. What advice do you have for the Fed?
HARBERGER: When I go to Latin America and other places
people ask me, among other things, about the prosperity in the United
States and the rather amazing economic expansion and minimal recessions
that we've had in recent times. I say, "Well I think that's all
because of Greenspan"; I know that it's the whole Board and not
just Greenspan, but just about everybody identifies the Board by
its chairman's name.
I think the Greenspan Board has forged a new path, somewhere between
Milton Friedman and James Tobin. Friedman conceived of the demand
for money as a very stable and immobile function, one that you could
rely on. At the same time he thought of bureaucrats and officials
as a very unreliable lot, not to be trusted. These views led him
to advocate a simple rule of monetary expansion based on the demand
for money. Then you have the other extreme: Jim Tobin thinks the
demand for money is so volatile as to be completely unreliable.
I think that the truth has proved to be somewhere between these
two extremes. You can try fitting as many demand functions for money
as you like, and you're not going to find one that has exhibited
during recent decades the degree of stability that Friedman was
But at the same time I just don't believe that the demand function
for money is not a real and live and important relationship. So
we have to deal with a very essential function, central to monetary
theory and policy, but with the unfortunate attribute of shifting
over time. My view is that even if we cannot predict these shifts,
we can try to understand them when they occur. We can reach judgments
about whether a given shift is transitory or more lasting. And we
can then use these judgments to guide monetary policy. When the
demand for money shifts upward, you give the public more money so
as to avoid deflationary pressures, and when it shifts downward,
you take money away from the public in order to forestall inflation.
I think of Greenspan as having a whole corps of detectives doing
detective work on the demand for money, trying to find out when
it has shifted and when it has not. When they see what looks like
a shift, they ask whether it is likely to last, or if it is purely
transitory or an error of observation. This detective work is done,
always with the idea that once one learns how the public's demand
for money has shifted, one accommodates these shifts, thus helping
to stifle important inflationary and deflationary pressures before
they gain much force. I really think that that is a fair description
of what the Fed tries to do. Indeed, I had occasion a little more
than a year ago to sit next to Greenspan at a lunch and I asked
him what he thought of this interpretation. He said he considered
it a good representation, except that he found the detective work
to be a lot more difficult than I had intimated!
REGION: When I asked several economists at the Minneapolis
Federal Reserve about you before the interview, they invariably
said, Harberger is known in the economics world mainly for two or
three things. What would you guess they said?
HARBERGER: Well, I really have no idea what your colleagues
in Minnesota might say, but I know what I would have liked them
to say, and for what I would like to be remembered. There are three
main things. First, I've had over my long academic life lots and
lots of students of whom I am very proud. They have distinguished
themselves both in the academic world and in policymaking. Quite
a number were among the important architects of major revolutionary
changes in their countries' economies, particularly in Latin America.
A few of them (notably Gregory Chow, Zvi Griliches, Bob Lucas, Merton
Miller and Marc Nerlove) have also been responsible for significant
advances in economic science.
Second, I would like to be thought of as an advocate and a missionary
of economic ideas in the world. I believe, more than most economists,
in the great strength and pervasiveness of economic forces, and
in the power of economic policy to do all sorts of things. No one
can deny that when it's bad enough, economic policy can certainly
ruin an economy. And if bad economic policy can ruin the economy,
good economic policy can certainly correct it. Therefore I feel
that we have a very important role to play. The role of economists
in the world, in some sense the duty of the economics profession,
is for us to represent economic knowledge in the councils of government
and in debates about policies in all kinds of forums. Policy decisions
about economic matters should be built on what we have learned,
and it is our job to see that the voice of sound economics is heard
by those who make decisions. This is what I have been fighting for,
for almost all of my professional life.
The third thing that I would like to be remembered for is that
I was a genuine professional economist who practiced what he preached.
I have worked hard on lots of problems, in lots of places, covering
lots of areas of economics. I would like people to think of me as
somebody who, with a very simple kit of robust tools based on economic
fundamentals, was able to go out and face many different problems
in many different places and come up with some pretty good answers.
REGION: Your students are salted throughout the international
organizations and central banks and universities of the world. Is
there a way that we can understand who they are, where they are
and what they're doing?
HARBERGER: In the developing world and Latin America in
particular, I have been fortunate to have a large number of students
over the years. I've taught something like 300 or more Latin American
students in American universities, plus many more in the shorter
courses that I've given down there. In any case, I am very proud
of what they have accomplished. I think my number of ministers is
now crossing 25, and I know my number of central bank presidents
has already crossed a dozen. Right now the central bank presidents
of Chile, Argentina and Israel were my students, and the immediate
former central bank presidents in Argentina, Chile and Costa Rica
were also my students. So that's at one level.
In the international agencies they have also built an enviable
record. There was one moment in time when four regional chief economists
at the World Bank had been my students in Chicago. One of them,
Marcelo Selowsky, went off to be the chief economist for the newly
minted ex-Soviet empire area, which is the biggest such job in the
whole bank. And guess what? He was replaced by yet another former
student, Sebastian Edwards. So it's very nice to see these people
moving up, and I'm proud to have played a part in their development
as economists. But I certainly don't want to claim anything like
exclusive responsibility for their training.
I think the entire atmosphere at Chicago for a long period there,
in the 1960s and 1970s in particular, made it a cradle for the training
of people in policy economics, always emphasizing fundamentals and
always trying to give them a true sense of how economics links to
the real world. These attributes are woefully lacking, I think,
in much of the training that goes on today. Far too much time is
now spent, in most graduate schools, on highly formalized techniques
that are very remote from the real world and that do much less to
prepare future policy economists than was done in that era at Chicago
and a number of other places.
REGION: So if you were to generalize about what your students
might have in common, the "Harberger" in them, it might be this
practical hands-on approach.
HARBERGER: Underneath it all I think is a certain element
of modestya recognition that we're not going to be able to
"model" the world, that the world is not just going to accommodate
itself to some little frame that we make up. On the other hand,
there is almost no economic event where supply and demand does not
enter. So if you really know how to handle supply and demand, put
it into different contexts at different times, you're way ahead
of the game. People coming from graduate school are going to fall
flat on their face if they try to apply ultra-sophisticated models
in tough real-world situations like the ex-Soviet empire. Those
situations will be much better understood, diagnosed and acted upon
by more fundamentals-oriented people who say, "Well here we've got
proto-markets that are just now being created; how do we see the
forces of supply and demand working here?"
And I think the reason why these Chicago products of the 1960s
and 1970s rose like corks in the international agencies and in other
policy arenas came from the fact that, on so many different occasions
in countless boardroom and brainstorming sessions, they seemed to
see problems more clearly; diagnose them more accurately, and to
draw more direct policy implications from their analyses than most
of their competitors. And to build these attributes, I believe their
fundamentals-based, real-world-oriented training was the key.
REGION: I would also imagine that your students reflect
predominately free market thinking?
HARBERGER: Correct. I think that when people talk of the
Chicago School who haven't been there and who only read about it
in the press, they tend to think of Chicago as being characterized
for a long period of time by an ideological slant on economics.
Nothing could be farther from the truth. It was never like that.
Milton Friedman had his office next to mine for something like 20
years and I can vouch that Free to Choose was never used
in classrooms. Nor were the messages of Free to Choose put
forth in the classroom. A Monetary History of the United States
and Milton's text on price theory and its applications was used.
I think three basic tenets characterized the Chicago School during
the years that I was active there.
First, everybody believed theory was important. Theory was important
because otherwise you can't cope with very complex issues in an
organized way. The second tenet was that theory is important only
insofar as it helps us really understand and interpret the way the
world works. Theory for its own sake (or what I sometimes call stratospheric
theory) had very little place in "Chicago" thinking at that time.
And the third tenet of the Chicago School is a firm, unshaking
conviction that market forces really work. It isn't that markets
are perfect. It isn't that they lead to the beautifully refined
equilibria of contemporary theory. They're genuine forces: The one
law that nobody can repeal is the law of supply and demand, and
those who try to fight that law are headed for big trouble. This
view was shared by all the people who were active in Chicago. The
faculty all believed it and they kept showing students one real-world
example after another, looking at it and saying, "Behind what we
observe are these fundamental forces. You observe, you reason, you
gain understanding, and finally you predict on the basis of these
forces." This way of thinking became an integral and essential part
of the way most Chicago students ended up viewing the world and
exercising their profession.
REGION: Hayek came during your tenure at Chicago?
HARBERGER: He was in and out, but not in economics.
REGION: On the Committee on Social Thought?
HARBERGER: He was on the Committee on Social Thought, upstairs
on the fifth floor. There was amazingly little interaction between
and Hayek and the rest. I think it would have been more interesting
if there had been more interaction. There was a great difference
in focus between Hayek (the Austrians) and Chicago as a whole. I
really respect and revere those guys. I am not one of them, but
I think I once said that if somebody wants to approach economics
as a religion, the Austrian approach is about as good as you can
get. They approach it from the angle of philosophy: They derived
the principles of free market economics from what they saw as "the
nature of man" and other fundamental principles. Their approach
pays little attention to empirical measurements and testing. If
the price of something goes up and the quantity goes up, they infer
that the demand must have shifted. That's true. But then they ask,
how can you infer anything from anything if you can explain any
given paradoxical event by such an easy ploy? That's their story.
Whereas the economics department people in Chicago, while being
just as devoted to good theory as the Austrians, really ultimately
paid a great deal of attention to the empirical world and the use
of economics in the empirical testing of theoretical propositions.
REGION: So, does the Chicago School still exist?
HARBERGER: I think it does. As the faculty rolls over it
takes on different forms. In the period to which I refer "policy
economics" was the top thing in Chicago. We had T. W. Schultz, Milton
Friedman, George Stigler, D. Gale Johnson, Harry Johnson, Bob Mundell,
Jacob Frenkel, George Tolley, Larry Sjaastad, and myself, among
many others less directly interested in policy issues. Policy economics
was the hallmark of Chicago in that period. It was why many students
went there, and what many students took advantage of after they
Today, policy economics is very little represented at Chicago
and there are really two main centers. One is the macroeconomic
center that surrounds Bob Lucas, along with Lars Hansen, Nancy Stokey
and others. Then on the other side you have a group of people that
I package together under the umbrella of "human resources": Gary
Becker, Jim Heckman, Sherwin Rosen, Bob Topel and Kevin Murphy (who
won the latest John Bates Clark Award, given every two years to
the economist under 40 who has made the most significant contributions
REGION: One gets the sense from your speeches and writings
that to you successful economic policy in developing countries is
best understood in terms of the people who provided the leadership.
Is that correct?
HARBERGER: I would start with the fact that most major
economic policy changes come in moments either of actual crisis
or perceived crisis, that societies that are comfortable rarely
want to change their comfort level even though sensible reforms
promise to improve things. They may be willing to make "little"
sacrifices but not big ones in the hope of promised improvements.
This helps explain why major changes have nearly always come at
moments when people were reacting to a crisis situationwhere
in some sense they had "had it up to here" and were willing to risk
taking daring new trails. Now, let that be the backdrop.
When I use the word "risk" here I really mean it. It is typical
of crises that people really don't know what to do. The authorities
are often just as perplexed as everybody else. They too often have
turned to the wrong people for advice, people who prescribed medicine
that was altogether wrong and that drove the country's economy to
the wall. Examples are Indonesia in the time of Sukarno, Chile in
the time of Allende, Nicaragua under the Sandinistas, Argentina
under Isabelita Perón, Peru under Alan GarcÍa. And
then there are those wonderful occasions where people who really
know what to do, and who embody good economics, are given their
head, so to speak. Having such people in the right place at the
right time can really propel an important revolution. I think the
Indonesian miracle of 1968 and onward, the Brazilian miracle of
1965 and onward, Chile's performance since 1973 and Argentina's
since 1990 all have that characteristic.
REGION: So really it is a timing issue?
HARBERGER: I think in terms of the translation of economic
ideas into policy. The maturation of economic ideas in the cauldron
of academic life is a continuing process; goes on forever. But I
think that for making major policy changes in a country, the element
of crisis is critical. It creates opportunity and that opportunity
may fall into the lap of somebody who just doesn't know what to
do or does it badly. But with luck the reins of policy will be given
to people who really know what to do and how to do it.
REGION: Let's talk about the "Chicago Boys" in Chile and
your role as their "father." Does the story begin with "El Ladrillo"?
HARBERGER: That is an interesting place to start the story.
Eduardo Frei (the father of the current president of Chile) was
elected in 1964 and his term ended in 1970. Allende was the candidate
of the left in the 1970 election, and the Christian Democrats (quite
unfortunately from my point of view) named Radomiro Tomic as their
candidate. Tomic was from the left wing of the Christian Democratic
party and seemed to rival Allende in terms of what they were promising.
They almost looked like peas in a pod.
Well, it wasn't just Harberger that reached the judgment that
this didn't look like a very happy choice. A whole segment of the
Chilean body politic was troubled by it. This led to a late candidacy
by Jorge Alessandri. Since his candidacy was getting off so late,
they called upon a group of younger economists (many of them former
students of mine) to put together an economic platform. They worked
very intensively and produced what I thought was a very good platform
That platform turned out to be too reformist and too free-market
for Alessandri. His political team so modified it that none of the
authors wanted to be identified with the end product. But they stayed
together as a group thinking about policy issues. Allende was elected
(with 38 percent of the vote) and after that this group, plus a
few others, kept meeting, working with their 1970 policy prescriptions
and evolving them through time. Their aim always was to specify
in concrete terms what should be done to straighten out the Chilean
As a result of this continuing operation, a document, later called
The Brick ("El Ladrillo") was created. As far as I know, at the
time the military coup took place in Chile it existed only in typewritten
copies with many carbons. It wasn't even duplicated. After the coup,
who was around who had thought about any of the problems of transforming
Chile in a positive way? I believe it's fair to say that these guys,
most but not all from Chicago, were the only game in town. They
became key advisers on economic policy, but the military kept the
ministries for about a year and a half.
During that time, inflation kept roaring on, in spite of the fact
that part of the reason for the military coup was to stop inflation.
Under the Allende government there were enterprises that had been
taken over by the government via a legal expropriation process,
but many others that had simply been "intervened" by the government,
which left the owners sitting out there in the cold but still the
owners. The "interventors," whom I called commissars, paid little
attention to efficiency and profitability, and as a consequence
ran huge deficits.
Then came the coup, and the commissars were replaced by colonels.
From on high came an order to each colonel: Thou shalt not have
a deficit. Here is another case of flying in the face of economic
laws. You cannot eliminate deficits by fiat, and they did not eliminate
them. How had the commissars financed their deficits? They remembered
some guy they studied with in Moscow some years back who was running
a bank, so they'd go to him and ask for credit. Well, the colonels
who took over from the commissars did much the same thing. They
remembered some colonel that went to military school with them who
ran a bank and leaned on him for the credit to finance their deficits.
After about 18 months inflation was still running at virtually
20 percent a month and things were not getting better. Ultimately
the decision was reached by the military to throw in the towel.
They named Jorge Cauas, a good friend of mine, not a Chicago person
but one who could be, as a sort of super minister. That is when
the "Chicago Boys" began to rise up to positions of top authority
like minister, central bank president, etc., whereas up to that
time they had been one notch lower in the hierarchy.
That is the time when major fiscal reform took place and when
a good part of the transformation took place. Certain reforms had
happened under the military. They had eliminated price controls
on nearly everything very soon after the coup. They had unified
and freed the exchange rate; they had also acted early on the first
steps of a tax reform and had begun a process of privatization.
Thus it wasn't that no reforms had taken place before this passage
of control from the military to the technocrats, but the big macroeconomic
story of inflation and the budget was where the military had failed
to cope. Finally, after 18 months, they recognized that they had
failed. That was how it came about that the team known as the "Chicago
Boys" took over in the top economic policy posts.
REGION: And your role?
HARBERGER: I don't know how people ever got the idea that
I somehow was acting as the conductor of Chile's economic policy
orchestra. It was nothing like that. When people see "my hand" in
the package of policies actually put in place in Chile, the source
of that "hand" was more than 90 percent likely to be my lectures
and seminars in Chicago, and the interminable bull sessions that
I and my Chilean students had been having ever since the late 1950s.
Moreover, at the same time I was troubled by some of the things
that were happening on the political scene during and after the
military coup. As a consequence there were five years at least,
in which I absolutely refused to be a "consultant" to the Chilean
government in the same way as I worked in other countries. The closest
I got was writing a couple of papers for a private think tank, the
Center for Policy Studies, in Chile. But at the same time I took
every opportunity I could get to go to Chile, to see what was going
on and to talk to my former students who were ministers, vice ministers
or president or vice president of the central bank. We would meet
at lunch and talk about problems. I don't know if I did anything
except express my enthusiasm for the positive things I saw being
done, and maybe every now and then emphasize the need for them to
approach their policy problems in a mature and measured way, weighing
benefits against costs, and trying to find policy designs that would
strengthen support for and lessen the opposition to their programs.
REGION: During the authoritarian Pinochet government, the
"Chicago Boys" promoted free-market reforms. Isn't it ironic that
in a top-down situation you could make bottom-up solutions work?
HARBERGER: For a long time opponents would say these were
reforms that would never be adopted by a democratic government.
Then what happened is that one democratic government after another
in Latin America adopted virtually identical reforms. Argentina,
in particular, compressed the period so that they did in less than
five years most of what it took Chile 15 years to do. So you can't
say that these reforms are inevitably shackled to a military government.
Now it can be said, however, that the first ones to do something,
the pioneers, always have a harder time than those that follow them.
And in the context of the middle and late 1970s in Latin America
it took a great deal of courage to take those steps. Given that
there was a military government, the idea that they were willing
to cede economic authority to a group of technocrats made that transition
easier than it would have been in a democratic context of the same
time and place.
REGION: Milton Friedman played a different, lesser role
in Chile, yet because of this connection with the Pinochet government,
it had quite an effect on his life.
HARBERGER: And mine too.
REGION: How so?
HARBERGER: Milton, in a sense, is a big hero in that he
took a lot of heat on the basis of just a single visit to Chile.
He went there for a private foundation in March of 1975, and gave
lectures in the universities and to broader audiences. Notably,
these included lectures on the principles of freedom and similar
topics. He spent less than a week in Chile and he came back to five
years of demonstrations against him wherever he went. There was
no justice in that, but Friedman really took it with great dignity
and strength of character.
REGION: Even onto his Nobel Prize.
HARBERGER: That was only one year later. I encountered
the same kind of student demonstrationsin Wisconsin, Berkeley,
Davis and Duke. In Harvard I was made an offer of what is now Jeffrey
Sachs' job, and there was a set of reverberations surrounding the
Chilean story. In the end I wisely turned down that offer. I felt
that it made no sense to enter a new and challenging job and to
have to spend your first couple of years beating down other people's
misinformed and false images of yourself. It's counterproductive
for anybody to be in that situation.
REGION: The Mont Pelerin Society met in Chile.
HARBERGER: In 1981.
REGION: What was the significance of picking Chile?
HARBERGER: Chile was being touted as a great free-market
economy and they wanted to see it. That was why it was picked. They
were very careful to have lots of sessions on freedoms of all kinds
so that it would become clear to everybody that they were not there
to endorse a military or an authoritarian government. They were
there to endorse what they thought of as very good economic policy.
REGION: You've talked a great deal about why some countries
grow more rapidly than others.
HARBERGER: I try to approach the study of growth working
up from the tangible basics. I guess that is part of my trademark
in economics. Economic growth comes in part from a growing labor
force, and/or one whose quality is improving, in a human capital
sense. It also comes as a result of investment in physical capital.
Finally, growth comes from improvements in total factor productivity.
I prefer to use the term "real cost reduction" rather than "total
factor productivity" because it's something that every businessman
in the world recognizes. This element of real cost reduction certainly
has been an extremely important part of the growth process and something
that we have known about and studied since the 1950s.
The "breakdown of growth" analysis that I'm talking about really
came into the forefront of economics in the 1950s. People like Abramowitz,
Schultz and Kendrick. Many people identify it with Bob Solow, who
was the first to build new theory on this base, but others were
working on it empirically before that time. Indeed, Tinbergen and
Stigler had the basic idea in the 1940s, before others brought it
to center stage.
One of the things that I find very puzzling is once you realize
that the increment of the labor force is one source of growth; that
the improvement in education (i.e., the quality of the labor force),
is another; that the rate of investment in physical capital is still
another; that the productivity of that physical capital is another
source of growth; and that real cost reduction is yet another, why
does 99 percent of the literature on growth not study these things
one by one? They deserve to be studied one by one because they depend
on such different elements. You can see Asian countries saving 30
and 40 percent of their GDP. That explains quite a lot of their
growth. Why not zero in on that and try to study what leads to high
and low savings rates, rather than nearly always run regressions
just for the overall growth rate? Countries with rapid population
growth will have rapid labor force increments. That doesn't come
from some endogenous growth model, it comes from the fact they have
a lot of babies, which those models don't talk about. So let's get
down to earth and try to understand what we observe.
Now I feel that in this breakdown of growth we understand reasonably
well the parts that have to do with the productive factors, labor
and capital. The one that is the most difficult for us to fully
"internalize" is the element of real cost reduction. I think we
need to do a great deal more work studying that term. We need to
try to get a much clearer picture of the elements that seem to make
it bigger or smaller at different points in time. We have been moving
in this direction in some of our recent work here at UCLA.
REGION: Can you give us some of the flavor of that recent
HARBERGER: In my 1998 American Economic Association presidential
address called "A Vision of the Growth Process," one of the things
I emphasized was what I called, in another context, the juxtaposition
of "yeast vs. mushrooms." Yeast makes the bread rise kind of evenly,
the way a balloon blows up. If real cost reduction were like that,
we'd have similar improvement in productivity in shoeshines, in
laundromats, in carwashes, in the auto industry, in pharmaceuticalseverything
would grow evenly all through the economy. The mushroom analogy
comes from the fact that it is very hard to predict where mushrooms
are going to pop uphere, there or another place. And that's
what we see. Real cost reduction is extremely uneven across industries
and activities. It is very hard to predict in advance how strong
it will be and where it will occur.
I focused on this around 1990, and subsequently I was struck by
yet another fact: Not only is this real cost reduction uneven, but
in nearly every data set broken down by industries within an economy
or by firms within an industry, you have some with falling real
cost (rising productivity) and others with rising real cost (falling
productivity) per unit. This juxtaposition is something that I'm
fascinated by right now and that I want to pursue, because if only
we could do something to reduce the incidence of rising real cost
we could gain a lot. Indeed as we study different periods, we find
that the good periods are those with low incidence of cases of falling
productivity, while the bad periods show a high incidence of such
cases. This differential incidence explains most of the difference
between good and bad results. I think we should focus our energies
on studying and understanding this phenomenon of rising real cost,
especially in light of how much difference it makes.
This has led me to the "vision of the growth process" that I tried
to convey in my presidential address. Firms are the locus where
growth takes place. Entrepreneurs and other decisionmakers within
the firms are the people who are the agents of this process. Somebody
out there finds some way to make a dramatic reduction in real cost,
does so, expands output, reduces prices, prospers. What happens
to competitors? They're driven back along their average cost curves,
and they end up having increased average costs, which is what we
measure. So those with negative real cost reductions are the losers
in the competitive battle.
Schumpeter used the term "creative destruction" for the process
of growth in a market economy. I pick up on that and say that here
we have a lot of evidence. Creativity brings about the positive
real cost reductions in the winning firms, but for a period of time
the losing firms suffer an opposite force so that the net gain for
the economy is not as great as what you're seeing in the winners
alone. Yet the losers are either going to adapt, in which case the
consumers will gain all over the place, or they'll go out of business,
in which case consumers will gain as they shift their demand to
the winners. That's my line of thinking.
In policy we have to try to make it easier for people to perceive
opportunities for real cost reduction. We have to fight against
inflation, which blurs their perceptions, and against market distortions,
which send them false signals about real costs. We have to fight
for more open markets and freer competition, both within and among
nations. This speeds the process of implementing real cost reductions
and bringing their benefits to consumers. And we have to provide
an institutional framework (laws, contracts, property rights, etc.)
and a macroeconomic policy environment (stable and broadly predictable)
that fosters a rapid adjustment of capital stocks in response to
REGION: You just came back from Indonesia. What's happening
in Indonesia with you?
HARBERGER: Indonesia was one of the big sufferers from
the great Asian crisis which started in Thailand in July of 1997
and spread rather quickly to half a dozen other Asian countries.
Indonesia was particularly hard hit because the political equilibrium
in Indonesia was not as solid as in a lot of the other countries,
and so you have a kind of political uncertainty layered on top of
an economic crisis. They underwent a huge flight of capital, which
led to an enormous depreciation of the exchange rate. Both the capital
flight and the currency depreciation helped reveal a pre-existing
weakness in the whole structure of the banking system, and in part
precipitated further weakness because these banks owed dollars to
foreign banks. The weight of this dollar-denominated debt was magnified
as the price of the dollar went from Rp 2,500 to Rp 15,000. That's
a quick description. It was a combination of a credit crunch combined
with an exchange rate crisis, a balance of payments crisis, a loss
One of the principles of dealing with a crisis of confidence of
the magnitude that happened in Indonesia is that God only knows
you don't want M2 to go down (M2 is, generally speaking, currency,
demand and savings deposits, and other balances largely held by
households). In my opinion people shouldn't really worry too much
about a declining M2 per se, but they should worry about its consequences
for bank credit, especially to the business sector. It is the credit
side that is the problem. M2 going down just by itself means that
people are going to spend more (as they get rid of unwanted cash
balances). That would not have been a problem in Indonesia in 1998.
But it is a huge problem if M2 going down means that all of a sudden
the volume of real credit is cut from a hundred billion to fifty
billion in a matter of months. What about all those firms whose
credit was cut so sharply? What about all the product that is lost
as fundamentally solvent firms are driven to the wall for pure "liquidity
reasons?" So that's the reason why you want to keep M2 up. Indonesia
was relatively successful at keeping M2 up; in that sense, they
were trying hard to save the situation.
But a very funny thing happened on the way to the forum, so to
speak. What happened was that they passed through three months of
a strange sort of price level stability. Strange in that even now
the underlying forces are quite inflationary. As the exchange rate
was dropping from its peak of over Rp 15,000 down to Rp 7,500 it
was dragging down the prices of tradables with it. The prices of
nontradables were still going up, reflecting the underlying inflationary
force of the economy. These two forces roughly canceled each other
and left the general price level basically flat. Okay, you've got
this flat price level and an interest rate on SBIs (which are like
Treasury bills), at 38 percent. This is the interest rate they were
paying on deposits when I was there in December 1998. In other places
where I've seen such high real interest rates, the situation was
driven by the demand for loansthe private sector so desperately
needed loans that they were willing to pay real interest rates of
2 and 3 percent a month and stick with it since credit was so scarce.
High real interest rates were just the rationing price of scarce
credit in these moments.
What's different about Indonesia is that (as they tell me) virtually
no debtor to a bank has amortized any of that debt in something
like 15 months. So the whole credit structure is frozen. These debtors
are not paying anything on their debt because they know that if
they pay the banks, the banks won't lend them back. The banks are
too concerned with shoring up their own tottering portfolios to
want to make new business loans or renew old ones. Now this 38 percent
interest rate which is holding up M2 is being paid somehow. Part
of it is being paid by writing up the interest on inactive deposit
accounts, and similarly adding interest charges to inactive loan
accounts so that banks' books balance at the end of the month. But
that written-up interest is still ultimately going to be paid to
bank depositors. At the same time, interest is also actually being
paid right now to depositors who withdraw their money. This is happening
and will continue to happen because Bank Indonesia, in the early
stages of the crisis, guaranteed deposits, which is something I
think it had to do. But now this promise has turned into its guaranteeing
M2 deposits with a 35 to 40 percent interest rate. And who's paying?
It's going to be Indonesia's people, its taxpayers, on whom in the
end much of the burden will fall.
Now, in somewhat similar situations that occurred in Chile and
Argentina the depositors were being paid high real interest rates
in order to finance an active market for bank credit to business
borrowers who were willing to pay, say, 40 percent for their credit.
But here you're not buying anything. I ask, for what are they paying
this 38 percent interest? Cannot a better solution be found? If
they lower that interest rate and M2 drops by a third, would the
consequences be so bad? Should they contemplate such a move, in
light of the fact that the credit market is already in a state of
deepfreeze anyway? These are the burning questions of the moment.
REGION: Were you consulting in Jakarta?
HARBERGER: Well, I have over the last 15 months gone to
Jakarta three times under the auspices of USAID (U.S. Agency for
International Development). These trips have taken me to the central
bank, the ministry of finance, the planning office and other government
agencies to talk to people and try to introduce into general discussion
a somewhat independent and "outsider" point of view. I think I got
off to a good start with the Indonesian authorities. My guess is
that the AID people asked me to come back because I could talk easily
with the Indonesian authorities and technicians about a lot of things.
REGION: And the International Monetary Fund's role in Indonesia?
Do you have any advice for them?
HARBERGER: No. In some circles the IMF has been accused
of moving with a too heavy hand in the Indonesian case. Sometime
relatively early in the crisis, October/November of 1997, the IMF
was working out a package with Indonesia and insisted that they
close something like 16 weak banks. They did close at least some
of these banks, which may have led to pressure on other banks and
thus helped to exacerbate that situation. The critics say, "Well,
the Fund was being very heavy-handed in demanding that they actually
close these banks." But you talk to people from the Fund about the
same subject and they all say, "Look, these banks were really bankrupt,
and there are plenty more that are close to technical bankruptcy.
We've got to send the signal in some way or another that something
has to be done, otherwise the predictable response will be just
to postpone, postpone, postpone. If we provide money and all they
do is postpone the problem, what's our money buying?" So you can
see there are two sides to that story.
REGION: What are your thoughts on currency boards that
economist Steve Hanke promotes?
HARBERGER: Well, I think Mr. Hanke has a lot in common
with the Austrians. To him, the virtues of the currency board come
from on high; the currency board can do no wrong. Now it's interesting
that some currency board advocates point to Argentina in the period
of the Mexican crisis as a prime example of how wonderfully a currency
board works. I point to Argentina in exactly that same period as
my evidence for why a typical grownup country shouldn't and can't
have a currency board. Formally, a currency board "prints" local
high-powered money only in exchange for "hard" foreign currency.
A currency board is supposed to function "automatically," doing
nothing but make that exchange. It is not supposed to implement
discretionary monetary policy, or to be a lender of last resort
or to be a regulator of the banking system. A currency board's base
money is simply the mirror image of its international currency holdings.
Now turn to Argentina early 1995. What happened? In the wake of
the Mexican crisis, which was I think the 20th of December 1994,
there was a period of just a few weeks in which Argentina lost one-third
of its gross international reserves and one-half of its net international
reserves. Now, under a proper currency board, the entire pyramid
of M2 would have contracted by one-third or one-half depending on
which of those is the proper base. That collapse of M2 by a third
or one-half would have so constricted credit in Argentina that they
would surely have had something like the U.S. Great Depression or
worse. Now, what did they do in fact? On an international reserves
base of only half of what it was before ( if you take the net reserves
figure), they maintained a pyramid of M2 which was 90 percent of
what it was before.
How did they work that miracle? By doing things that no currency
board advocate would ever think of. Number one, they drastically
cut the reserve requirements of the banks, and second, they took
advantage of a very sly provision that Domingo Cavallo had put into
the convertibility law. This law said that part of the dollars that
had to back the liabilities of the Central Bank of Argentina could
consist of Argentine government obligations denominated in dollars.
I think the fraction could be up to 30 percent. That authority was
used to the maximum. That's no currency board, nor is the changing
of reserve requirements compatible with the concept of a currency
board. Yet if it hadn't been for those two violations of the currency
board concept, it would have been a terrible disaster. So I say,
Argentina is a perfect example of why a currency board doesn't work.
With the currency board you're backing only base money; you're not
Currency boards can work well in situations where the demand for
money can fall sharply without inducing a corresponding contraction
of credit. This was the case in the British colonies where the currency
board idea originated. It is also the case in any town or city in
the U.S. today. A small country can approximate this result by having
most of its banking done by big international banks, assuming these
banks are willing to maintain their loan portfolios in the country
(as the big British banks used to do in the colonies) even in the
face of a large decline in deposits. That is what I feel has to
be done to make a currency board work.
REGION: In the last edition of The Region magazine,
we wrote exclusively about the importance of economic literacy.
This seems to be one of your topics. Do you have an opinion on economic
literacy at any level?
HARBERGER: Let me give you a prime example of the importance
of economic literacy. Here in the United States, we've had this
deficit with Japan for many years. Everybody knows that the bilateral
trade balance between two countries is not supposed to mean anything,
but forget that. Our governments, going back to before Reagan, have
always been saying, "Japan should spend more, they have to stop
having this surplus with us." So we are pressing Japan not to have
a trade surplus in order for us not to have this bilateral deficit
with Japan. Many people (myself included) were taught very early
on that all deficits were involuntary and therefore in the same
sense bad; you were losing these reserves that you never wanted
to lose. But most of the time in the real world, a deficit arises
when people from abroad are putting money into your country. Far
from being bad, trade deficits are a signal that others regard your
country as a good place to invest. If we look back historically,
and you say who the hell's been feeding the world capital markets
for lo these 30 or 40 years, it's been mainly Japan. To me, our
successive administrations have been saying to Japan: Stop feeding
the world capital market!
Now the question is, why does such a straightforward and sensible
economic interpretation not get anywhere. How many people have you
heard in the press, out of the press, policymakers, etc., thinking
of it this way? Yet isn't it a natural way? I think this is a case
where we obviously need more economic literacy.
REGION: You influenced so many people who studied under
you. Who do you point to as those you studied under who influenced
HARBERGER: I am the most blessed economist that I know.
Really. I can't exaggerate the amount of luck that I had in my economic
education. My three most influential classroom teachers (in alphabetical
order) were Milton Friedman, Jacob Marschak and T. W. Schultz. Milton
taught me price theory in a way that I can't imagine price theory
being better transmitted. It ended up that you internalized it.
It was not something that you learned and were able to play back
on exams. It was a part of yourself by the time you got out of that
Jacob Marschak taught me macroa very simple, neo-Keynesian
kind of macro. My vision of macroeconomics has since moved beyond
that, but he was a wonderful intellectual and a wonderful teacher.
It was through him that I got the idea of making simple models for
just about anything that I was going to do, and thinking always
in general-equilibrium terms.
T. W. Schultz was one of the great economists of the century,
I'm sure. He was true real-world in the sense that he struggled
with issues at the level of farm policy and the study of the transition
through which American agriculture was going. I'd say in his lifetime
probably the fraction of people on farms went from close to 50 percent
when he was born to like 3 percent when he died. He was the one
who, studying that phenomenon, recognized what was going on and
always fought for good economics, which means you don't try to keep
people on the family farm because the family farm has such a sacred
image. What he saw was an economic process going on and his conclusion
was that economic policy has to help this economic process work.
And then he was also, of course, one of he great advocates or the
great revivers in our century of the concept of human capital.
My Ph.D. committee consisted of Lloyd Metzler, who was one of
the great international trade economists of his era and also a wonderful
teacher. My other two you'd never guessKenneth Arrow and Franco
Modigliani. Now when I say I was blessed, do you understand what
REGION: Frank Knight?
HARBERGER: I took more classes with Frank Knight than almost
anybody. He too was a wonderful old man. He was a philosopher more
than an economist, and a true intellectual. There was nothing sacred
for Frank, especially not religion. But he also had a certain kind
of humility. You have to recognize that some representatives of
Chicago, both professors and former students who go out in the world,
could conceivably be painted as somewhat less than humble. Well,
Frank was not like that. He was constantly recognizing how much
he didn't know, and constantly wrestling with observations and ideas.
REGION: So many wonderful things came out of your "Chicago
Boys" experience in Chile. One of them for you personally was that
you found a bride in Chile. Is that right?
HARBERGER: Oh, absolutely. I met Anita in Chicago, not
in Chile. I met her at a party in the apartment shared by several
of my students, including Sergio De Castro, who became the most
prominent leader of that first big wave of Chilean reform, and Ernesto
Fontaine, who to this day is a hero in Chile (in economic terms
in my sense) because he more than any other person has made economic
project evaluation a living reality and in that country and as a
result saved the country billions of dollars.
We got married in London. I had met Anita only in October and
I was scheduled to go to England right after Christmas for a term
in London and then a term in Cambridge. She was at Northwestern
at the time, and came over at the end of the winter term. She arrived
in London on a Saturday morning and we got married that afternoon.
Our wedding took place for curious reasons but very happily in St.
Martin's-in-the-Fields. The person who gave away the bride was Lionel
Robbins and my best man was Richard Stone. Attending the wedding
were only economists (because they were the only people I knew)
and their families. Harry Johnson was there and Dick Lipsey and
Chris Archibald and Peter Bauer and Basil Yamey and goodness knows,
maybe 20 or so more.
REGION: She was Chilean?
HARBERGER: She was Chilean.
REGION: Did that influence your involvement in the Chilean
HARBERGER: I was already involved. My first visit to Chile
was the first of July of 1955 when I went with three other Chicago
professors to help determine whether we did or did not want to enter
into a program of collaboration with the Catholic University of
Chile. That was the beginning of my Chilean adventure. I had studied
Spanish in high school, did pretty well in it, went to Johns Hopkins
University, took a first-year course in Spanish, and then in my
sophomore year I was taking graduate courses in Spanish. In the
Army I went through basic training, took some tests and they classified
me as a Spanish linguist. I went to the University of Illinois for
six months and wrote a thesis on the latifundia [owner-operated
large-scale agricultural estates] in Spain while in the Army. So
the decision to take Spanish in high school influenced my army career,
it influenced a great deal of my professional life, my whole linkage
with Latin America, and my marriage!
REGION: Your house is decorated so interestingly with artifacts
from all around the world, especially I'm noticing from Hindu mythology.
Did collecting become a hobby as you went to the corners of the
HARBERGER: People think of me in connection with Latin
America, but really I have quite solid links with India because
we spent a whole year there in 1961-62 on an MIT project. Then I
had a long hiatus and I went back a couple of times in 1971 and
1972, and again more recently in connection with an International
Center for Economic Growth project. I went at the beginning of that
project in 1993 and again at the end in 1996. If the occasion had
arisen that I could have got another year's leave in 1962-63, I
believe we would have stayed on with great pleasure. But the plethora
of Indian artifacts in this house stems mainly from the fact that
the Cottage Industries Emporium in New Delhi is such a fascinating
place to shop.
REGION: When did you move to UCLA?
HARBERGER: I did some visiting here in 1982, 1983 and early
1984, and then signed on in July of 1984. That was followed by seven
years during which I was two quarters here and two quarters in Chicago.
I retired from Chicago, but I never "left" Chicago. I became Emeritus
in 1991 and since then I've been full-time here.
REGION: Thank you, Mr. Harberger.
More about Arnold Harberger
Professor of Economics at the University of California Los
Angeles since 1984; Professor Emeritus at the University of Chicago
Other academic positions include visiting professorships at
Harvard and Princeton universities, the Massachusetts Institute
for Technology Center for International Studies in New Delhi and
the University of Paris.
Member of the National Academy of Sciences of the United States.
Fellow of the Econometric Society and of the American Academy
of Arts and Sciences.
Past president of the American Economic Association.
Consultant to 16 foreign governments, nine U.S. government
agencies and eight international agencies and foundations.
Author or co-author of nearly 200 journal articles, books,
speeches and conference presentations.
Forthcoming publications include: Remarks at a conference honoring
Milton and Rose Friedman, San Francisco, June 1998, published
by the Division of the Social Sciences, University of Chicago;
and "Studying the Growth Process: A Primer" in Capital Formation
and Economic Growth, Michael J. Boskin, editor, the Hoover