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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)[*]
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
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
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 package.
The Case for NAFTA
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
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
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 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
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
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
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
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
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
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 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. 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 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
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
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
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, 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." 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
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
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://www.j-bradford-delong.net/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; http://www.webcom.com/isadra/new_naid/dolstats.html,
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,
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; http://www.ustreas.gov/treasury/mexico/top.html,
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).
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of Economics Brad DeLong, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax