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The Mexican Peso Crisis
In Defense of U.S. Policy Toward Mexico
Bradford De Long (University of California at Berkeley),
Christopher De Long (Howard, Darby, and Levin), and
Sherman Robinson (International Food Policy Research Institute)[*]
A shorter version of this essay (lacking extensions, digressions, qualifications,
and references) appeared in the May-June 1996 issue of Foreign Affairs.
Today you hear many claim that U.S. policy toward Mexico has failed. Open
Harpers, and read that NAFTA shows that the Clinton Administration
has "little concern" with "the continuing hemorrhage of American
jobs abroad." Open the New York Times, and read about "the
rapid unraveling of the Mexican economic achievements of 1988-1993."
Open any publication, and read that freer trade has increased narcotics
transshipped through Mexico. Watch the far left or the far right on TV and
see them claim that the Mexican peso crisis is proof of U.S. policy failure:
the failure of President Bush's and Clinton's policy of economic engagement--the
NAFTA, support for the privatization of Mexican state-owned industries,
neo-liberal market- and investment-friendly development strategies, and
the support package to contain the winter 1994-1995 peso crisis.
Such critics are sure that "economic engagement" was worse than
an "economic nationalism" that would have--well, it is not so
clear. Should the U.S. have shut its eyes and hoped that Mexico would go
away? Built a 2,000-mile wall to shut out Mexico and Mexicans, and thus
created a tangible north-south divide with the symbolic power of the Berlin
Wall? Refused all trade with Mexico until Mexico's labor standards and wage
levels approached the U.S.? Allowed the Mexican peso crisis to trigger slow-downs
in California and Texas, and further crises in other developing countries?
Mexico is not going to go away. Mexico is a relatively poor, high population
growth, not very democratic country on the strategic southern border of
the U.S. The interests of the U.S. will be greatly advanced if, in a generation,
Mexico is middle-income, low population growth, and staunchly democratic.
Middle-income countries have an easier time maintaining democratic rule.
Their citizens see opportunity at home and are less likely to try to move
to the U.S. Their bureaucrats and law enforcement agencies are less likely
to be overwhelmed by a web of corruption, and hence less likely to permit
narcotics shipments. U.S. policy should seek to make Mexico a richer, more
democratic, and slower population growth country.
This is "economic engagement." Support Mexican governments that
seek to boost economic growth, attract investment, and better utilize humanity's
storehouse of industrial technology to raise productivity. Promise, through
NAFTA, that businesses and investors building Mexico's industry will not
be wiped out by some future wave of protectionism in the U.S. or Mexico
But successful "economic engagement" requires more. It requires
containment of crises when foreign investors get skittish about Mexico's
development process--and foreign investors do get skittish, whether in Mexico
in 1994, Austria in 1930-31, Argentina in 1890, or the U.S. in 1873 (when
British investors, frightened by the bankruptcy of the largest American
investment bank, closed off the flow of capital to America; the pace of
investment in the railroad transportation infrastructure essential for U.S.
economic development fell by three-quarters).
When a financial crisis springs from foreign investors' fears that others
are pulling their capital out of a developing country--as was the case in
Mexico--the world's central banks can contain the crisis by providing liquidity
and support. In such "liquidity crises" those providing support
do not lose. They make money--it appears that the U.S. will make an accounting
profit of $1 billion or more on its contribution to the Mexican support
The Case for NAFT
The twentieth century has been extraordinarily good along one dimension:
the generation of wealth in the world's industrial core. The present-day
inhabitant of the United States has eight to twenty-four times the real
standard of living as his or her counterpart of a century ago (depending
on how youestimate changes in living standards). The best previous century,
the nineteenth, saw perhaps a doubling of standards of living as a result
of the industrial revolution. Before that, Europeans in 1800 may have been
fifty percent richer than their counterparts in 1600.
Before that? Were you better off as a subject of Queen Elizabeth I of England
in 1600 or a citizen of Athens in the time of Pericles (430 B.C.)? It is
not clear. No segment of the world has ever enjoyed anything approaching
the explosion of wealth that has occurred in the industrial core in the
But much of the world has shared little in the twentieth century's explosion
of wealth. Purchasing-power-parity estimates suggest that Mexico today has
about one-sixth the standard of living of the United States. Adjusting for
differences in the quality of U.S. and Mexican production would suggest
a larger gap. A century ago, the relative gap between the U.S. and Mexico
was only half as large
Why has the relative income gap between developed and developing countries
widened so much over the course of the twentieth century? Population growth
receives too much blame; it is as much a result as a cause as relative national
poverty. Nevertheless, it is hard to increase productivity by investing
in more capital per worker if the number of workers grows rapidly.
Part of the responsibility must go to low rates of saving and accumulation:
governments running chronic deficits soak up savings that would otherwise
finance productive investment, and industrial policies favoring the politically-powerful
vastly increase the cost of the machines needed in a modern industrial economy.
A large part of the responsibility must also go to institutions that protect
businesses from the consequences of productive inefficiency. Examples include
tariff walls shielding monopoly industries from foreign competition and
state-owned enterprises that can rely on credits from the central government
to offset their losses.
Over the past fifty years economists have watched the relative inequality
in the world's income distribution rise, and have also seen many conspicuous
development failures--including much of Latin America at various times,
and much of Africa--and many conspicuous successes--in southern Europe and
eastern Asia. In general, the closer a country has come to the "neo-liberal"
policy pattern, the faster its economy has grown. There are exceptions,
outliers, and anomalies. Moreover, regions evidence enormous differences
in development performance that are surely due to other, deeper, social
and cultural factors. But only rarely do you get an opportunity to make
a bet at such favorable odds as developing countries can bet today on the
benefits of "neo-liberal" approaches to development. Governments
can make policy choices to aid capital accumulation and investment rather
than hinder it with large deficits and investment-unfriendly tariff and
foreign investment policies. Businesses should have to compete in the world
market rather than shelter behind tariff walls. Industries ought to be privatized,
so that loss-making businesses must become more efficient or disappear.
In the mid-1980s, the controlling faction of Mexico's authoritarian Institutional
Revolutionary Party [PRI] broke with Mexico's previous economic policies
by reducing restrictions on imports, beginning the privatization of the
large state-owned sector, and encouraging foreign investment. The policy
shift was accelerated after the 1988 election, as newly-installed President
Carlos Salinas de Gortari accelerated the pace of reform.
The Salinas government was determined to change the direction of the Mexican
economy. They were also aware of the political changes that were likely
to accompany economic reforms that undermined the PRI's ability to control
the economy, and thus to punish dissent. However, they clearly underestimated
the power of the PRI's established political elite in resisting political
changes, and the potential for violence.
The North American Free Trade Agreement, as negotiated and signed in December
1992 by the Salinas and the Bush administrations and as amended and implemented
by the Salinas and Clinton administrations in 1993, offered Mexico two major
benefits. It did ]not offer Mexico any significant increase in access
to the U.S. market: the U.S. market was already almost completely open
to imports from Mexico. Rather it offered, first, a solemn promise to Mexican
businesses and investors that their enterprises would not be bankrupted
by a sudden wave of U.S. protectionism.
A second and more important benefit of NAFTA for Mexico lay in the obligations
to continue market-friendly reforms that the treaty placed on future Mexican
governments. The NAFTA tied Mexico's program of economic reforms to a formal
international agreement, diminishing the chance that Mexico would abandon
reform. Most of the benefits from pro-market reform programs in developing
countries hinge on their actual and perceived permanence. The worst of all
worlds is to enact policies that hurt politically-powerful interests,but
then to fail to reap the benefits because investors and producers fear that
the policies will not be sustained. The NAFTA helped avoid this trap.
Note that every single one of these benefits for Mexico becomes more
important, not less, in the context of the 1994-1995 peso crisis. Had
it been forseen during the NAFTA negotiations that at the end of 1994 foreign
capital would flee from Mexico, the case for NAFTA would have been yet stronger.
As a consequence of the crisis, guaranteed access to the U.S. market has
become a more important determinant of long-term investment in Mexico, and
Mexico's visible commitment to reform policies has become more important
for renewed growth.
And the U.S.? The Mexican peso crisis raises the stakes. The fact that Mexico
is not going to have as easy a time becoming a prosperous industrial democracy
as we had hoped three, four, or five years ago increases the U.S. interest
in supporting "economic engagement" which can lock Mexico into
continuing economic reform.
The costs of NAFTA to the U.S.? The claims of Ralph Nader and Pat Buchanan
that imports from Mexico would impoverish America's workers, and raise unemployment?
You do not hear much about such claims these days. The "giant sucking
sound"? The five or so millions of jobs and the four percent of U.S.
employment that were "at risk" according to Ross Perot and Pat
Choate? The U.S. unemployment rate has not jumped by four percentage points
since the implementation of NAFTA began, but has declined. The level of
employment in the U.S. these days is much more the result of decisions made
by the Federal Reserve, rather than changes in trade with Mexico.
There have been applications to the Labor Department for the transitional
training and job search funds established to assist U.S. workers adversely
affected by NAFTA. Through the end of 1995, about 35 petitions were being
filed a month, and about 2,000 workers a month have claimed aid under this
program. To put such estimates in context,
remember that the U.S. has an economy in which ]two million workers
lose their jobs every month (and another two million workers quit their
jobs). Thus NAFTA-related churning of the employment market caused perhaps
one out of every thousand job separations in 1995, and perhaps one out of
every thousand job accessions. The U.S. would be a better place if it had
more stable employment, and employers saw their strong interest in ensuring
that their workers acquired skills; but NAFTA's contribution to U.S. employment
instability is orders of magnitude less than the statistical error in the
monthly employment reports.
The benefits of NAFTA to the U.S.? As the Congressional Budget Office Report
on NAFTA explicitly said in its introductory summary, "small, [with
estimates of the net gains to the U.S.] ranging only as high as about one-quarter
of one percent of gross domestic product." Some shifts in U.S. employment
from relatively low-wage labor-intensive industries to high-wage capital-
and knowledge-intensive industries, amounting to perhaps 0.03 percent of
the labor force in each of the next ten years.
The Mexican economy is, in total, about the size of the economy of Los Angeles:
small relative to the economy of the U.S. The net benefits from NAFTA estimated
by honest think-tanks were always less than the month-to-month errors in
economic statistics.[4 ] Trade with Mexico
never had the potential to add significantly to U.S. employment. Perhaps
production in capital goods-making industries is higher, and perhaps
a few tens or hundreds of thousands of additional U.S. workers will be employed
making capital goods for export to Mexico than if NAFTA had not been implemented;
but if so then domestic interest rates are higher by some small amount,
and fewer U.S. citizens are making capital goods for use here in the U.S.
The Debate Over NAFT
During the debate over the ratification of NAFTA there was a whiff of Europe's
politics in the 1920s and the 1930s--when right and left joined together
with glee to assault the center, both sure that they would benefit
when the center collapsed. At that time only one side was right: the Fascists.
1993 saw a whole host of different arguments made for NAFTA by various elements
within and without the administration, for the Clinton administration and
its supporters on NAFTA were a very heterogeneous bunch.Some of the arguments
for NAFTA--the U.S. duty of leadership in foreign policy; the U.S. national
interest in a faster-growing and more-democratic Mexico; the global interest
in economic policies to help someday make us one world, rather than two
or three--made us applaud. Some of the arguments for NAFTA--economic alliance
with the emerging Mexican superstate, defeating the Japanese on the battlefield
of the Mexican market, using the Mexican labor force in a mercantilist struggle
against Japan--made us wince.
One argument for NAFTA that was especially weak was that it would imporve
the U.S. balance of trade with mexico and significantly boost net employment
in the U.S.: employment gains from exports would exceed losses from increased
imports. But focusing on a single bilateral trade balance (with Mexico or
with, say, Japan) makes no sense at all, and leads to the Mercantilist view
that all exports (on whatever terms) are good and all imports (on whatever
terms) are bad. The lesson of post-WWII growth is that expanded international
trade is beneficial because it boosts productivity, not because it provides
a large direct boost to employment. Both sides in the NAFTA debate raised
these Mercantilist arguments, and thus gave additional downward momentum
to the decline in the level of the political debate over trade issues.
All but one of the arguments against NAFTA made us wince. The only
argument against that we felt had force was the fear that NAFTA implementation
would devastate Mexico's peasant agriculture: Iowa corn and North Dakota
wheat seemed likely to swamp the Mexican market, leaving Mexico's small
farmers with diminished market incomes. The political and social consequences
for Mexico seemed dangerous. But the negotiators did recognize this danger:
the implementation of NAFTA allows ten to fifteen years for agricultural
adjustment, and the Mexican government has already begun substantial agricultural
The othe anti-NAFTA arguments never held water. NAFTA would not destroy
America's job base, but shift it very marginally in the direction of higher-paying
occupations and industries. NAFTA would not curb America's control over
its own labor and environmental policies. NAFTA would not swamp America's
labor force with immigrants, turning America's lower middle class into working
poor (if anything, faster Mexican development would diminish immigration
from Mexico to the U.S.). Low-quality Mexican goods would not explode in
America's kitchens. Low wages in Mexico seemed an argument for increasing
trade with Mexico, to raise demand so that Mexican employers must scramble
for workers, and so bid up wages.
The NAFTA debate seemed to spring from a magical-realistic novel by Gabriel
Garcia Marquez or Carlos Fuentes, as the media accepted bizarre and perverse
arguments as normal. The solid, substantive arguments hit the press and
died. Few seemed interested in the U.S.'s long-run national interest in
a prosperous Mexico, or in the rationale behind openness to world trade
and investment as a development strategy, or in NAFTA as a joint U.S.-Mexican
commitment to support economic liberalization in Mexico. Those were boring.
Other arguments, like the giant sucking sound of American jobs heading south,
the Mexican labor force as a mercantilist weapon, or the threatened abrogation
of American sovereignty, were in the judgment of the press more interesting.
Never mind that they were fantasy.
And so the exaggerated fears of opponents battled the exaggerated claims
that NAFTA amounted to an irrevocable choice of America's future economic
direction, which it had never been. The small net plus for the U.S. economy
and the big deal for the Mexican economy vanished behind the cloak of rhetoric:
it must be important for the U.S. economy because it excited so many
We watched with growing concern as our left-wing and union-movement friends
pushed the "economic nationalist" button, and the engine of American
public opinion sputtered, coughed, and started. They were ecstatic to find
an issue that resonated. Never mind that pushing the button of economic
nationalism moved the country in the direction that Pat Buchanan wanted.
Serious and valid issues of grave concern to the country and particular
concern to labor--falling wages, worsening income distribution, union-busting
Republican policies, the threatened collapse of the social safety net, the
need for education and training--were crowded out of the poltiical debate
by the focus on isolationist trade policies and nonsensical claims about
the magnitude of NAFTA's impact on American labor.
The Case for the Rescue Package
In the spring of 1994, one of us went to hear M.I.T. professor Rudiger Dornbusch
talk about the current state of the Mexican economy.
Mexico was doing most things right, said Rudi: the government budget had
shifted from substantial deficit to surplus (thus no longer draining Mexicans'
savings pool), businesses were privatized, tariffs were being lowered. Yet
growth was slow: only three percent per year. Since 1989, the government
deficit had fallen from five percent of GDP to zero. The inflow of capital
had risen from zero to five percent of GDP. Yet investment as a share of
GDP had risen by only half that amount.
Dornbusch and Werner had an interesting diagnosis. Internal Mexican inflation
and the fixed peso-dollar exchange rate had left Mexico uncompetitive. While
foreign investors still viewed Mexico as a good place to put their money,
Mexicans realized that at current exchange rates additional real investments
in Mexico were likely to be unprofitable. Mexicans were taking the additional
money foreign investers offered, but they were using it to finance increased
consumption rather than increased investment. Dornbusch and Werner were
not alone in their diagnosis. Calvo, Leiderman, and Reinhart, and also the
Congressional Budget Office report on NAFTA diagnosed the Mexican peso as
The solution? Devalue the peso by twenty percent, and let the peso then
drift downward by as much as Mexican inflation exceeded U.S. inflation in
order to keep Mexico from losing competitiveness again.
In December 1994, after a year of political assassinations, a not-very-clean
presidential election, and an armed guerrilla movement that appeared in
Chiapas in January (and thereafter relied not on its weapons but on the
justice of its demands and grievances), Mexico ran to the edge of its foreign
exchange reserves and announced the devaluation of the peso. But the peso
fell by far more than the twenty percent that Dornbusch and Werner and others
had forecast was necessary to restore equilibrium.
The peso fell not by twenty but by fifty percent. Economists and observers
had been expecting to see a small devaluation that would diminish many of
Mexico's economic problems. But what took place was a large devaluation
that turned into an economic crisis.
From nearly $30 billion before the assassination of Presidential candidate
Colosio in March, foreign exchange reserves had fallen to perhaps $5 billion
when the decision to abandon the pegged exchange rate against the U.S. dollar
was made in December. At each stage of 1994, the Mexican government--preoccupied
with the not-very-clean election campaign--bet that the drawdown of reserves
was a temporary shock, rather than a permanent change in foreign investors'
demands for Mexican assets.
Up until late summer it was hard to say that the Mexican government was
wrong: even in October of 1994 foreign exchange reserves were some $18 billion,
more-or-less unchanged from April 1994. The flow of foreign portfolio investment
into Mexico had stopped in the wake of political assassinations and the
Chiapas rebellion, but the flow of portfolio investment had also stopped
when the U.S. Congress looked ready to reject NAFTA, only to resume after
the NAFTA implementation votes. And Mexico's economic fundamentals--a balanced
federal budget, a successful privatization campaign, financial liberalization--were
strong enough in the spring of 1994 to elicit "a strong and unqualified
endorsement of Mexico's economic management" by the IMF.
Part of the Mexican government's strategy for retaining confidence in its
stable exchange rate throughout 1994 was to replace conventional short-term
borrowing with the famous "Tesebonos", a short-term security whose
principal was indexed to the dollar, as a means of retaining the funds of
investors who feared devaluation. In retrospect, this was a double or nothing
bet. This policy was effective in the short term but risky: it did retain
some $23 billion of foreign financing, but it meant that if a large devaluation
did come it would be an order of magnitude more dangerous.
By the end of 1994 it had become public knowledge that the inflow of foreign
portfolio capital to Mexico had not resumed. Each investor in Mexico feared
that other investors would pull their money out of Mexico no matter what
the cost, and that the last investor to withdraw money would lose the greatest
amount of invested principal--either through near-hyperinflation, as the
Mexican government frantically printed pesos to cover its peso-denominated
debts; through capital controls, which would trap money in Mexico for an
indefinite time (and eat up a substantial fraction of its value); or through
formal default: a repeat of 1982's dealings with commercial banks. Given
that all investors feared being the last one out, it made no sense for ]any
investor to keep his or her principal in Mexican assets a minute beyond
its maturity date.
With $5 billion in reserves, with $23 billion in Tesebono liabilities that
would be converted into dollars and pulled from Mexico as it matured, and
with no one willing to lend in hard currency to Mexico for fear of becoming
losers in the financial crisis, Mexico faced possible default, possible
hyperinflation, and a probable Great Depression. Either the Mexican government
would push interest rates higher than sky-high to keep capital inside the
country--in which case the extraordinary cost of money would strangle investment
and employment, and a Great Depression would come rapidly--or the Mexican
government would find itself unable to borrow, start printing money at a
rapid rate to meet its applications and see a spiral of 1980s Argentina-style
hyperinflation and depreciation, in which case a Great Depression would
come slowly as hyperinflation eviscerated the productive economy and ripped
Mexico from its connections in the world trade network. To make things worse,
the panic began to spread--what came to be called the "tequila effect"--creating
the risk that other developing countries would be forced into strongly contractionary
policies and deep recessions.
But all this was not preordained, for as an economy Mexico was not insolvent.
It was merely illiquid. If investors had been willing to roll over Mexico's
short-term debts, contractionary policies and a moderate devaluation to
reduce imports and encourage exports to pay the Mexican government's foreign
liabilities as they came due. Such a moderate devaluation coupled with contractionary
policies might cause a recession (however, in Britain in late 1992 it did
not), but a recession that would be much shorter and much shallower than
what faced Mexico in the absence of funds to roll over its short-term debts.
Thus the support package: the United States, the International Monetary
Fund, and stray other amounts totalling perhaps $40 billion in dollar-denominated
assets that Mexico could draw upon.
How do we know that Mexico was not insolvent but illiquid, and that once
its debts were rescheduled, the country would be able to make the payments
on its foreign debt? We know in the first place because the support package
worked: Mexico registered a $7.4 billion trade surplus in 1995. Real
exports were more than 30 percent higher in 1995 than in 1994, while imports
fell by more than 8 percent.
Generating such an export surplus in such a short time was a consequence
of the involuntarily-large devaluation and the squeeze the crisis put on
the Mexican economy. Real GDP fell by 9.6% between the third quarter of
1994 and the third quarter of 1995.
There is now little doubt that Mexico will export enough to earn the foreign
exchange needed to service its debt service obligations. The governments
and international institutions that contributed to the support package are
making money: $750 million in interest payments have so far flowed back
into the U.S. Treasury. Moreover, Mexico's
foreign exchange reserves as of the end of January 1996 were a healthy $16
All these moves toward international financial stability to deal with foreign
investors' skittish reluctance to lend or roll over lending to post-crisis
Mexico have come at a substantial cost to Mexico: 1995 Mexican GDP was seven
percent below 1994 levels. But measures
of Mexican unemployment have improved since August, and other data suggest
that the bottom has been passed. The severe recession following the adverse
reaction of investors to the involuntary devaluation is much, much better
than the Great Depression Mexico might have undergone in the absence of
the liquidity support package.
What would have happened if there were no support package? A Great Depression
in Mexico seemed almost inevitable in the absence of an international rescue.
Such a near-collapse of the Mexican economy would almost surely lead to
regional slowdowns in California and Texas, and a substantial jump in illegal
immigration into the U.S. There was a chance--no one knew how large, or
was willing to estimate how likely--that the crisis would spread to all
developing countries. A sudden end of
the $150 billion a year flow of private investment from the industrial core
of the world economy out to the developing periphery would have likely caused
Great Depressions in Argentina, elsewhere in Latin America, and perhaps
The Erosion of Political Support
The initial willingness of the executive and legislative branches of the
U.S. government to work together to minimize the impact of the peso crisis
was heartening. After all, "economic engagement" with Mexico was
the policy of the Democratic executive and of the Republican legislative
majority. On January 12, 1995, all four Congressional party leaders issued
a joint statement with the President pledging their backing for legislation
to enact the Administration's proposed peso support package. The following
day, Treasury Secretary Rubin briefed more than a hundred Congressmen on
the issue. At the close of the briefing, Speaker Gingrich stated that "we
have zero choice on this": Congress would have to vote for the support
package to stem a Great Depression in Mexico and possibly the entire developing
But odd things began to happen. Speaker Gingrich's lieutenant, Majority
Leader Armey, began to demand that the Administration gather over 100 House
Democratic votes for the package. Perennial presidential candidate Patrick
Buchanan called the support package a gift to Wall Street: "not free-market
economics [but] Goldman-Sachsanomics." Ex-consumer advocate Ralph Nader
urged the Congress to vote down the support package and to demand that Mexico
raise wages. Columnists in the Wall Street Journal demanded that
support be provided only if Mexico first returned the peso to its pre-December
parity. Isolationist Republicans and anti-NAFTA Democrats claimed that NAFTA
had caused the crisis, and vowed to fight the package, with House Republican
Zach Wump emerging from one briefing by Federal Reserve Chairman Greenspan
to crow that this was "an issue made for talk radio."
Perhaps more troubling, newspapers like the New York Times and the
Washington Post, usually staunchly internationalist, ran not-very-coherent
op-ed pieces denouncing the support package.
Within a week and a half, the package was in deep political trouble. A Los
Angeles Times poll claimed that 81 percent of Americans disapproved
of the package. Senator Feinstein lectured Secretary Rubin: "I know
no one in the financial community who is against this. I know no one in
my constituency who is for it." On January 30, Speaker Gingrich announced
that he could not put together a vote before the middle of February.
Perhaps the strangest development came in a letter Republican Congressional
leaders sent to President Clinton. They urged the President to use the Treasury's
Exchange Stabilization Fund [ESF] to make loans to Mexico. The legislation
governing use of the ESF assumed that it would be used for short-term exchange
market interventions to stabilize the dollar's value in terms of a basket
of other major international reserve currencies; it had never entered anyone's
mind that the Executive Branch had the power to use the ESF to stabilize
the peso against the dollar.
The Congressional leadership thus abandoned a measureable amount of Congress's
institutional power with not a single whimper. The legislative branch is
usually jealous of its authority, and eager to defend its powers against
other branches. But not here, where the legislative leadership abdicated
control over some $20 billion of U.S. assets to the Executive Branch.
By January 31 the quest for legislative authorization was over, and the
White House moved ahead with the joint Executive Branch-IMF support package
that drew heavily on the ESF.
Thus a policy that promised to (a) stem an international liquidity crisis,
(b) avoid a Great Depression in our neighbor to the south (and hence avoid
a large increase in illegal immigration), (c) possibly avoid a worldwide
recession in all developing countries, (d) avoid regional slowdowns
in Texas and California, and (e) probably make money for the U.S. Treasury--turned
out to be impossible to push through the Congress in early 1995. It was
not that anyone disagreed with the argument that Mexico was suffering from
a liquidity crisis in which substantial support from other countries could
do a lot of good at minimal risk--the debate was never joined on those terms.
What seemed to excite rage was that the U.S. government wanted to do
something nice for Mexico. And, even worse, to do something nice
for investors in Mexico.
Politics After the Crisis
Hence the current applause line on the American left and right: that the
U.S. government undertook a $50 billion bailout for Treasury Secretary Robert
Rubin's Wall Street friends. We have
an economic system in which investors, those who provide capital, bear the
bulk of the financial risk and opportunity. Perhaps this is why it is called
"capitalism." There are alternatives both to the left (tried
from 1917-1989) and to the right (tried from 1924-1945, or later in Spain
and parts of South America.
Part of the problem is that, with the collapse of communism, there is no
clear consensus about what constitutes a "good" economic system.
Everyone in the U.S. or used to agree that the best balance is a "mixed
economy," in which government provides key investments and services,
a safety net, and "social insurance," but in which most of the
risk and reward from enterprise should be left to entrepreneurs and investors.
Republican rhetoric these days repudiates this earlier consensus, and seeks
to retreat to an earlier form of capitalism that was far from satisfactory.
Democrats so far have failed to provide either a defense of the mixed economy
or a reasoned alternative. The result is muddled debate, like that around
NAFTA and the Mexican rescue package.
Because those who provide capital bear the bulk of risk and opportunity,
they reap the greatest benefits from good times and have the most to lose
in bad times. Great Depressions hurt investors: companies and governments
default on their bonds, equity investments cease to pay dividends, and risky
asset values fall. Avoid a Great Depression in Mexico, and find that you
have enriched investors substantially, relative to what would have happened
had the crisis been allowed to proceed to its natural end.
But the support package did not make investors richer by making anyone else
poorer. Stemming financial crises is a positive-sum game: everyone wins.
Workers keep their jobs and small businesses avoid bankruptcy. These benefits
are as real and add more to the sum of human welfare than the higher asset
values quoted on Wall Street. To abandon these benefits in order to make
sure that Wall Street investors suffer--you have perhaps heard of the proverb,
"cutting off your nose to spite your face"?
You can think--correctly--that the current Mexican recession imposes an
unfair burden of adjustment, even if it is only a shadow of the macroeconomic
disaster that threatened without the liquidity support package. Mexican
real GDP in 1995 dropped 7 percent from its value of a year earlier. The
true unemployment rate in Mexico in late 1995 was some 3 to 6 percentage
points above the rate of a year earlier. Yet investors in "Tesebonos"--investors
who knew the risks--came out of the
crisis completely whole.
It would have been nice if a rapid and efficient way could have been found
to impose the burden of the crisis more equally, without causing the the
legal and economic mess of formal default and without increasing the risks
that the liquidity crisis would spread. Some say that they would have welcomed
formal default: Mexican creditors would then have had to negotiate with
the Mexican government for repayment, and would have had to bear some of
the cost. Never mind that such negotiations
after formal default are never concluded quickly, cast a powerful prosperity
and investment-discouraging shadow for the half-decade or decade they take,
and vastly increase the magnitude of the economic losses and depressions--in
Mexico and elsewhere, as investors think "Mexico defaulted; maybe country
X will also" as they disinvest from other regions.
Even with hindsight there is no clear path to a better alternative solution:
alternatives that spread the costs more widely would have amplified them
as well. And the unfair distribution of the economic losses from the peso
crisis is small change relative to unequal rewards to labor and skills across
countries, or inequality within the U.S.
Any assessment of what the political firestorm over the peso support package
means for future management of the world economy must be a depressing one.
Faced with what in prospect seemed highly likely to be, and in retrospect
seems a classic example of, a "liquidity" crisis in which international
support produces huge economic benefits at very little risk, the U.S. Congress
could not step up to the plate. The only positive note struck is that the
Congress was equally unwilling to put itself on the line by blocking those
whowere doing the right thing.
Perhaps worse, a few echoes of the sentiments of the U.S. Congress were
audible in the comments of some industrial-country governments with substantial
voting shares in the IMF: that the Mexican crisis was not a "systemic
problem," and that the rescue program bailed out those who had made
imprudent short-term investments in Mexico.
Germany and Britain abstained from the IMF executive board meeting that
authorized the IMF's contribution to the support package. Ultimately the
IMFdid step up to the plate; the IMF executive did win support for
its decisions from its directors and the IMF does proclaim its willingness
to do so again. And it may have to: the role of the IMF becomes more crucial
in a context in which the major economic powers are unable to react quickly
to damp down liquidity crises.
At the end of the day, it looks as if much of the U.S. political nation
conceives of U.S. policy toward Mexico in metaphorical terms: being "tough"
in order to demonstrate that America comes first in the sense of economic
nationalism. The potential tragedy of this vision of the peso support package--which
can only be seen as fantastic in the sense of an episode in a magical-realist
novel--is that it reinforces the false belief one country's economic gain
must come at someone else's expense, a notion with an old and pernicious
What would have happened had the isolationists in Congress and elsewhere
had their way, and had the support package collapsed? All we have to go
on is historical analogies: what happened in previous historical episodes
when financial liquidity crises were allowed to roll forward to their conclusions
The most extreme historical analogy to the Mexican crisis of 1994-1995 is
the Austrian crisis of 1930-1931, when French Premier Pierre
Laval (who had styled himself a politician of the left: the Clarence
Darrow of France) blocked the proposed international support package for
Austria that followed the collapse of Austria's largest bank, the Credit-Anstalt,
in 1931. According to Barry Eichengreen,
Premier Laval refused to provide the French contribution to the Bank for
International Settlements-led attempt to provide Austria with the resources
to fight the run on its currency in 1931. Laval insisted on substantial
Austrian political concessions and a sharp distancing of its relations with
Germany as the price of French support.
The Austrian government refused to make the required political concessions.
Austria lost: the support package collapsed. But France lost too: the crisis
spread by contagion first to Germany and then, in late 1931, to Britain.
What had been a moderately severe recession in Europe turned into the
The most favorable face that can be put on French actions in 1931 is that
Laval had played the nationalist game before a domestic audience for political
advantage so long that he had forgotten that there was a real world influenced
by his policies. But the backlash reached France. The Depression arrived
in France late, in the mid-1930s, but it arrived.
And the ultimate consequences for France of the failure to stem the international
financial crisis of 1931 at its Austrian beginnings were extremely bad.
The rise to power of Adolf Hitler in Germany is inconceivable in the absence
of the Great Depression. Nine years after the Credit-Anstalt crisis the
French government, unwilling to carry on the war from exile, surrendered
to the Nazis.
Pierre Laval was not greatly inconvenienced at first by the Nazi conquest
of Europe. He discovered that he was really not a leftist but a Fascist,
and became the second most powerful figure and the true focus of decision
making, in France's wartime collaborationist Vichy government. He was greatly
inconvienced later: he was executed by the restored French democratic government
for treason after the end of World War II.
It is far from certain that the story of Mexican economic development over
the next generation will be a happy one. It is true that Mexico appears
likely to have turned the economic corner on its most recent crisis.
Some forecasters see GDP growth at 3 percent in Mexico in 1996. The measured
unemployment rate peaked in July of 1995, and has declined by more than
two percentage points since. The balance-of-payments adjustment made necessary
by the cessation of foreign investment with the peso crisis has been accomplished:
a swing from a current account deficit of $18.5 billion in 1994 to
a surplus of $7.4 billion in 1995, accompanied by a more than thirty
percent rise in exports and a nearly ten percent fall in imports.
The long-term benefits from the economic policy reforms remain. Tariffs
and non-tariff barriers to imports to Mexico have been slashed. Restrictions
on foreign investment have been lifted. Perhaps a thousand state-owned enterprises
have been privatized. A central government budget deficit of 13% of GDP
in 1987 has been transformed into a balanced budget. And inflation is down
from 150% in 1987.
However, the development strategy of relying on foreign capital inflows
to finance industrialization is a risky one. It can lead to rapid growth
but it can also lead to deep recessions, as the U.S. discovered in the 1800s
when it relied to a substantial extent on British financing for its industrial
and infrastructure development. In addition, the Mexican banking sector
remains under considerable strain; inflation continues at about 27 percent
per year; and un- and underemployment remain very high.
Moreover, the Mexican political system may collapse under the strains of
development and political liberalization with the extra burden laid on by
the consequences of the peso crisis. That keen-eye commentator Jorge Castañeda
fears that the triple assassinations of Cardinal Posadas, Luis Donaldo Colosio,
and Jose Francisco Ruiz Massieu show that non-violent dispute resolution
mechanisms among Mexican elites are in "a terminal state of dysfunction." Should the Mexican political system collapse
suddenly, what follows may not be better.
More likely, the Mexican political system will muddle along toward greater
democracy. But slow evolution of the current system is no guarantee of rapid
economic growth, or even of the long-run continuation of economic reforms
and liberalizations that are the best bet for spurring Mexican growth.
Mexico's destiny is its own to make, and is wide open. There is an apocryphal
story that Zhou Enlai was once asked his opinion of the consequences eighteenth-century
French Revolution: his answer was, "It is too soon to tell."
But whatever Mexico's destiny is, it is surely a better one as a result
of the policies of economic engagement that have been pursued by the past
two U.S. administrations. NAFTA has increased the odds that successive Mexican
governments will continue to dismantle the structures of government control
and political influence that have kept Mexico's growth far below what it
might have been. More important, perhaps, NAFTA has increased the odds that
foreign investors will believe that Mexico is committed to pro-growth policies,
and so boost Mexico's long-term ability to draw on the pool of the world's
savings to finance its purchases of the capital goods and construction of
the infrastructure needed to use humanity's storehouse of industrial technology.
The peso support package kept Mexico's liquidity crisis an economic misfortune,
as opposed to an economic disaster. And the risks run in providing support
were seen as, and so far have turned out to be, quite small.
But turn on the TV news, and recognize that the U.S. policy of economic
engagement may have been the apogee of liberal internationalism in economic
policy. The sound bites that float by are phrases like "the controversial
and expensive Mexican financial bailout"; and "NAFTA, followed
by the collapse of the Mexican economy at the end of 1994"; or "the
rapid unraveling of the Mexican economic achievements of 1988-1993."
From our perspective, at least, the U.S. political system has learned false
lessons from the experience of the past several years: the sound bites should
be "successful peso rescue program that prevented a Mexican Great Depression";
"NAFTA, which improved the odds that Mexico will sustain pro-growth
economic policies"; "the successful maintenance of the pro-growth
economic reforms undertaken by emerging market economies in the 1980s and
early 1990s"; and "the preservation of the worldwide flow of capital
out to the developing world."
There has been much discussion in the past several years of a failure of
political vision on the part of the statesmen and women of this generation.
The collapse of Soviet communism must have created as great an opportunity
to remake the world in a better image as the opportunity that was successfully
seized at the end of World War II and the opportunity that was decisively
botched at the end of World War I. Yet the counterparts of Dean Acheson,
George Marshall, and Arthur Vandenberg have been hard to find. NAFTA --not
an enormous deal for the U.S., or for the world as a whole--has been about
the limit of vision.
Looking at the lessons that the political nation has drawn from the U.S.-Mexican
experience of the past few years, you must conclude that the chances are
slim that future U.S. Presidents and Congresses will risk even the limited
vision to remake the world for the better that we have seen in the past
Alberto Alesina and Roberto Perotti, "The Political Economy of Growth:
A Critical Survey of the Recent Literature," World Bank Economic
Review 8:3 (1994).
Jorge Casteneda, The Mexican Shock: Its Meaning for the U.S. (New
York: The New Press, 1995).
Guillermo Calvo, "Capital Flows and Macroeconomic Management: Tequila
Lessons" (College Park, MD: University of Maryland xerox, 1996).
Guillermo Calvo, Leonardo Leiderman, and Carmen Reinhart, "Capital
Inflows and Real Exchange Rate Appreciation in Latin America," IMF
Staff Papers 40:1 (1993), pp. 108-51.
Guillermo Calvo and Enrique Mendoza, "Reflections on Mexico's Balance-of-Payments
Crisis: A Chronicle of a Death Foretold," Journal of International
Congressional Budget Office, An Analysis of the Economic and Budgetary
Impact of NAFTA (Washington: GPO, 1993).
Rudiger Dornbusch and Alejandro Werner, "Mexico: Stabilization, Reform,
and No Growth," Brookings Papers on Economic Activity 1994:1
Barry Eichengreen, Golden Fetters: The Gold Standard and the Great Depression
(New York: Oxford University Press, 1992).
Barry Eichengreen and Albert Fishlow, Contending with Capital Flows:
What Is Different About the 1990s? (New York: Council on Foreign Relations,
Jeffrey Frankel and Andrew Rose, "Exchange Rate Crashes in Emerging
Markets: An Empirical Treatment," Journal of International Economics
Jeffrey Frankel and Sergio Schmukler, "Country Fund Discounts and the
Mexican Crisis of December 1994: Did Local Residents Turn Pessimistic Before
International Investors?" (Berkeley, CA: U.C. Berkeley xerox, 1996).
George Graham, Peter Norman, Stephen Fidler, and Ted Bardacks, "Mexican
Rescue: Bitter Legacy of Battle to Bail Out Mexico," Financial Times
(February 16, 1995). [Re-posted at http://econ161.berkeley.edu/imfdirectorsbalk.html.]
Raul Hinojosa-Ojeda et al., Job Loss in the USA Due to NAFTA
(WWW Site of the North American Integration and Development Center at UCLA;
updated Feb. 20, 1996).
Paul Krugman, "Dutch Tulips and Emerging Markets," Foreign
Affairs 74:4 (July/August 1995), pp. 28-44.
Allan Meltzer, "A Mexican Tragedy" (Pittsburgh, PA: Carnegie-Mellon
OECD, OECD Economic Surveys: Mexico 1995 (Paris: OECD, 1995).
Sergio Schmukler and Jeffrey Frankel, "Crisis, Contagion, and Country
Funds" (Berkeley, CA: U.C. Berkeley xerox, 1996).
U.S. Department of the Treasury, The Treasury Secretary's Monthly Report
to Congress on Mexico (WWW Site of the U.S. Department of the Treasury;
updated Feb. 2, 1996).
Andrew Warner, "Was Mexico's Exchange Rate Overvalued in 1994?"
(Cambridge, MA: Harvard Institute for International Development Disc. Paper
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Associate Professor of Economics Brad De
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University of California at Berkeley; Berkeley, CA 94720-3880
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