Created 7/15/1996
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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.


Created 7/15/1996
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Associate Professor of Economics Brad De Long, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
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