Created 2/21/1996
Go to
Brad De Long's Home Page

Teaching | Writing | Career | Politics | Book Reviews | Information Economy | Economists | Multimedia | Students | Fine Print | Other | My Jobs

is always very welcome...

The Mexican Peso Crisis

In Defense of U.S. Policy Toward Mexico

Bradford DeLong (University of California at Berkeley),
Christopher DeLong (Howard, Darby, and Levin), and
Sherman Robinson (International Food Policy Research Institute)[*]

March, 1996

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).[1]

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 package.

The Case for NAFTA
The Context

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 twentieth century.

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.[2] 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.[3] 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 NAFTA
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 reform.

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 people.

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.[5] 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 overvalued.

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.

Liquidity Crisis

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.[6] 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.[7] Moreover, Mexico's foreign exchange reserves as of the end of January 1996 were a healthy $16 billion.

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.[8] 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.[9] 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 elsewhere.

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 world.

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.[10] 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[11]--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.[12] 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.[13]

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.[14]

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.[15] 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 history.

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 without intervention.

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,[16] 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 Great Depression.

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."[17] 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 decade.


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 Economics

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 (Spring 1994).

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, 1996).

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]

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 xerox, 1995).

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 525, 1995).


Created 2/21/1996
Go to
Brad De Long's Home Page

Associate Professor of Economics Brad DeLong, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax