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Resolving the Peso Crisis
Rescuing the Peso Was a Good Idea
Chris DeLong, Brad DeLong, and Sherman Robinson
Today many claim that U.S. policy toward Mexico has failed. The
New York Times discusses "the rapid unraveling of the Mexican economic
achievements of 1988-1993" and reports that freer trade has increased
the flow of narcotics through Mexico. Harper's reports that NAFTA
demonstrates the Clinton Administration's indifference to the "hemorrhage
of American jobs abroad." To top it all off, the far left and the far
right fulminate on TV that the peso rescue package was a government hand-out
to Wall Street plutocrats and undeserving third-worlders.
Defenders of liberal internationalism have disappeared this election season.
For instance, the once-presidential Senator Dole now grumbles that he would
not sign NAFTA in its current form.
So it is important to recall that the peso support package was a valuable
component of the United States's policy of "economic engagement":
the policy of encouraging Mexico to undertake market-friendly reforms. "Economic
engagement" must be more than cheerleading. It requires containment
of crises when foreign investors get skittish--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 fled from the U.S. market,
triggering the second worst depression in American history).
For the peso rescue package to have been good policy, four basic things
about the world must be true. First, it must be good for the U.S if Mexico
becomes more prosperous and stable. This proposition should be self-evident--yet
many refuse to see it, as if Mexico would go away if ignored. But Mexico
is not going away. And the U.S. will be a better place if, in a generation,
Mexico is middle-income, low population growth, and staunchly democratic.
In a richer Mexico fewer people will attempt the dangerous, disruptive,
and illegal migration to El Norte and fewer government officials will succumb
to the corruption integral to narcotics traffic.
Second, the "liberal" policies espoused by the World Bank, the
IMF, and the U.S. international financial establishment must work--or fail
less badly than alternative policies. This is far from certain, but at the
moment the evidence suggests that these market-friendly strategies are optimal.
To understand why requires a bit of recent economic history. Much of the
world has not shared 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. 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 during the twentieth century? Population growth receives too much
of the blame; it is as much a result as a cause of national poverty. Nevertheless,
it is hard to boost capital per worker if the number of workers grows rapidly.
Low rates of saving and investment deserve more of the blame. Governments
running chronic deficits soak up savings that would otherwise finance productive
investment. Industrial policies favoring the politically powerful increase
the cost of important machines. Easy credit from governments saves "connected"
businesses from their own incompetence.
These major problems can be controlled by the "liberal" policies
the World Bank and IMF recommend. Since these policies can mitigate at least
some obstacles to economic development, they appear to be a good bet. Only
rarely does one see odds this good.
Third, the Mexican peso crisis must genuinely have been a liquidity and
not a solvency crisis. In a liquidity crisis, a country can pay its debts
but for a temporary lack of cash. In a solvency crisis, a country has debts
that outweigh its assets, both liquid and illiquid. We know now that the
IMF and the U.S. Treasury were right when they classified Mexico's crisis
as a "liquidity" and not a "solvency" crisis because
the peso support package worked and Mexico is now generating enough of an
export surplus to pay off its debts that were rescheduled at high interest
rates: 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. In this case at least, the judgment that funds committed
to the rescue package faced little risk was sound.
Fourth, the rescue package must not create a "moral hazard" by
encouraging other developing nations to pursue risky policies knowing that
others will pay if the policies go awry. Critics argue that the Mexican
government took serious economic risks by relying on capital inflows to
finance industrialization, a strategy that can facilitate rapid growth but
can also lead to deep recessions (as the U.S. discovered in the late 1800s).
Fundamentalist free-marketers fear that the peso rescue package will allow
emerging economies to adopt a development strategy of (i) heads, we win,
but (ii) tails, the IMF will bail us out.
This fear of "moral hazard" should be taken very seriously: think
of the spectacular Savings and Loan and the Orange County bankruptcies of
the past decade.
Nevertheless, we do not think that this criticism applies to the peso rescue
package. A rescue package creates "moral hazard" only when those
who took the risks are happy-or at least indifferent--after the fact because
of the bail out. Those who rent cars may drive a bit more carelessly and
scrape the paint in the parking lot because the car rental company offers
them insurance. But the rental car company's commitment to pay for collision
damage does not render anyone more eager to attempt a hazardous merge in
front of a ten-ton truck on an interstate entrance ramp.
We believe that the peso crisis is more akin to the flattening of the rental
car by the ten-ton truck than to scraping the paint in the underground lot--the
analogue to the Orange County bankruptcy. The top Mexican government officials
who coordinated economic policy before the peso crisis now suffer global
disgrace for their "obvious" policy blunders. Moreover, their
domestic political standing has been wrecked. Last, and most important,
the recession triggered by the peso crisis has caused profound harm to the
Mexican economy and Mexican workers. Given the current position of Mexican
economic decision-makers, the consequences of the peso crisis were disastrous
for Mexico's government officials and for the Mexican economy, despite the
fact that Mexico received assistance.
Mexico's destiny is still wide open, but it is better because of the peso
rescue package that kept Mexico's liquidity crisis an economic misfortune--as
opposed to an economic disaster possibly on the scale of Mexico's Great
Depression. 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 one sees a different story. Negative sound
bites float by: "the controversial and expensive Mexican financial
bailout"; "NAFTA, followed by the collapse of the Mexican economy
at the end of 1994"; and "the rapid unraveling of the Mexican
economic achievements of 1988-1993." From our perspective, these sound
bites are dead wrong. They should be "successful peso rescue program
that prevented a Mexican Great Depression"; "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."
This piece is adapted from an article appearing in the May-June 1996
issue of Foreign Affairs.
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Associate Professor of Economics Brad De
Long, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax