|The Mexico Crisis
A Statement before the House Committee on Banking and Financial Services
February 10, 1995
I would like to thank Chairman Leach and the members of this committee for calling these hearings on this matter of profound importance to the future of not only our North American economy, but also to the future of the world economy. I have been studying these kinds of crises for 24 years, ever since President Nixon surprised the world — as Mexico did December 20-21 - with a devaluation of the U.S. dollar, only the second currency devaluation in American history. The first was the dollar devaluation of 1934 by President Roosevelt, when we defaulted on two-thirds of our national debt during the Great Depression by cutting the dollar's gold value by that amount. Abraham Lincoln floated the dollar in 1861, when the Civil War began, and it lost half its value during that "greenback era." But in 1873 President Grant and Congress decided to restore the pre-war gold parity at $20.67 per ounce, doing it gradually during the following six years.
Currency devaluations are always very painful affairs, especially to ordinary people who are always the last to hear that their wages, pensions and life savings have been destroyed by the amount of the devaluation. Devaluations are almost always unnecessary, though. For a nation-state to repudiate its national debt by any amount is so thoroughly a confession of failure to its own people that even the poorest countries try to avoid it at any cost. When Lincoln floated the dollar in 1861, the intent was to restore its gold value after the war, for example. In 1902, one of the great economists of this century, Wesley Mitchell, demonstrated that even Lincoln's temporary repudiation of the government's contracts with its creditors was costly and unnecessary. Mitchell's influence through his students, including the late Arthur F. Burns, helped persuade the United States to maintain the dollar/gold parity during World War II, which enabled us to finance the enormous cost of the war at 2% interest rates. In the world of classical, supply-side economics, devaluations are only imperative when you lose a war, as the creditors of the Confederate States of America discovered in 1865. There was, by the way, no discussion in Congress about bailing out the holders of Confederate bonds.
The devaluation of the Mexican peso on December 20-21, 1994 was completely unnecessary. The excuse given, that it was running an excessive trade deficit, comes as close to economic quackery as any I've ever heard. This excuse was in fact rejected by Miguel Mancera, the distinguished director of the Bank of Mexico, a man who I believe is the equal of our own Fed Chairman Alan Greenspan. Dr. Mancera unsuccessfully fought the powerful political interests who alone benefited by the government's repudiation of 35% of its national debt. The full story will require extensive hearings by committees such as this one and the Joint Economic Committee of Congress, which is already planning them. Suffice it to say that a country's trade deficit is merely a handy excuse when the speculators find a weakness in any country's political system. This, they found in Mexico City during the transition to an untested young president, Ernesto Zedillo, from an experienced man, Carlos Salinas, who had begun his presidency in 1988-89 by fighting off a comparable peso devaluation.
It never hurts to remind ourselves that the United States ran a trade deficit every year until 1914, with no exceptions, and the U.S. dollar at the end of that string of deficits was the strongest, most sought-after in the world. In large part this was because our nation's creditors experienced the integrity of our system of government after the Civil War, when pre-war bonds were paid in gold at the original promised value. In 1900, Triple A corporate bonds could be floated at 2% rates and the average maturity of corporate debt was 40 years. We are talking here of a government that keeps its promises through thick and thin.
Most of the business and financial press in the United States seems to have fallen for the "trade deficit" excuse, but not The Wall Street Journal editorial page. I would like to cite here the assertion made by the Journal In a remarkable editorial six years ago, "Dollar Turmoil," of March 23, 1989:
Confusion number one is that the best exchange rate is one that produces the "right" trade balance. With the collapse of Marxism now behind us, this has become the most pernicious idea loose on the earth today. History is replete with nations that have ruined themselves by devaluing their currency in an attempt to expand their exports. Flirtation with this notion is the most likely explanation of the 1987 stock-market crash, we believe, and also the most likely route to world inflation or recession.
Who are the people who benefit most from devaluation? Find that out and you will find out why governments are pushed into devaluations. In his testimony before the Senate Banking Committee last week, Federal Reserve Chairman Alan Greenspan said the Mexican government had ample reserves as 1994 began, but non-economic reasons caused them to be drawn down. He cited several possible reasons for the softening of demand for pesos: the Chiapas revolt, the assassination of Luis Donaldo Colosio, the PRI presidential candidate, and the uncertainties surrounding the election. It had been believed, said Greenspan, that the peso would strengthen after Zedillo won the elections with a large enough plurality to satisfy the critics of the ruling party. Instead, from September into December, pesos were still being brought to the Bank of Mexico demanding dollars.
We really do not have to speculate on why this was happening. On January 23, Mexico's Finance Minister, Guillermo Ortiz, told the Chamber of Deputies in Mexico City that the international financial institutions endorsed the idea in the months leading up to the devaluation, and so did "stockbrokers and analysts." My first thought upon hearing of the devaluation was that the export industries of Mexico had brought pressure on the government - to gain a bit of an export advantage by lowering the real wages of the Mexican work force. This is exactly what the opponents of the North American Free Trade Agreement had predicted would occur. The Ortiz statement, though, showed me I was wrong. The people who benefit most from a peso devaluation, after all, are those insiders who borrow a great many pesos, sell them for dollars, and repay them with fewer dollars after the devaluation. When an insider — an analyst or a stockbroker - knows there is going to be a devaluation, he can "short the peso" with impunity. This is as close as a speculator gets to heaven. For the ordinary people of Mexico it is close to hell. This is capitalism at its worst. It has been going on for decades, as the IMF and World Bank roam the world, looking for countries with trade deficits, and persuading them to devalue their currencies in exchange for financial assistance.
There are a great number of people in the world who hate the IMF for this reason. Most of the countries of Africa and Latin America have been decimated by IMF devaluation "programs." Haiti, the poorest nation in our hemisphere, has had several bloodlettings at the hands of the IMF, which has a team even now in Port-au-Prince, attempting to squeeze one last drop of blood from that stony land. The only reason we now have an opportunity to halt this global plague is that the Mexican devaluation was so badly botched. Guillermo Ortiz has provided us with a clear picture of the campaign to devalue the peso and his own role in the government in urging that it be done quickly, not gradually. He told the Congress and the world that for several months leading up to the devaluation, while Miguel Mancera was desperately trying to save the peso, the international financial institutions and the pilot fish that swim with them were endorsing its demise.
There was no grand conspiracy here - no men with long cigars sitting about and plotting larceny. It is rather more like the Kansas sunflower conspiracy. In the morning, the sunflowers face east, in the evening they face west. They never speak to each other, but move with the sun. In this case, the guiding force was the idea that the peso had to be devalued, because, as Ortiz told the Congress: "The deficit in the current account was at almost a yellow warning light in the international financial reports and in the greater part of the foreign stock exchanges. As we all know, on the 4th November, upon analyzing the latest presidential report, we pointed out that the peso was overvalued." Of course it was not. A government's promise to its people cannot be overvalued.
The questions this committee asked me to address are three that follow naturally from this introduction. 1. How can difficulties of this kind be detected before they grow into a crisis? 2. Can the package proposed by the President meet its objectives? 3. What should the international financial community do in the future to improve the management of similar crises?
On the first question, I will tell the committee that 15 years ago, in January of 1980, I spent three days in Los Angeles with a small group of advisers to help Governor Reagan prepare for the Republican primaries. On the first day the discussion was about national security, and I spoke only once, when the subject turned to the quality of our intelligence services. I suggested that at the cost of hiring an alert young college graduate, who would keep track of where the IMF was sending its teams, the government would know in advance which countries would become destabilized, with outbreaks of riots and civil war.
My recommendation to this committee is the same. Merely observe where this great Black Whale swims, looking for little countries to gobble up with its pernicious advice of cheap money and high taxes, and you will have the earliest possible warning signal. This is not frivolous advice. The great banking institutions on Wall Street now get those signals long before they are reported in the news media, through their contacts at the IMF and World Bank. The swinging door between the IFI's and the money-center banks is well oiled.
Those of us who are friends of Mexico were caught sleeping late last year, having been persuaded that President Zedillo's campaign pledge to maintain the peso's value was as good as gold, and that Miguel Mancera would be able to fight off the great Black Whale. Alas, we were wrong.
On the second question: Can the package proposed by the President meet its objectives? The devil is in the details, of course, and as this statement is being prepared, it is not yet clear to me how the $20 billion in the Exchange Stabilization Fund is going to be used. If it is going to be used to support Mexico's refinancing of its national debt, by buying up dollar-guaranteed tesebonos, it will be as useless as the $40 billion loan-guarantee plan first proposed by the Clinton administration and rejected by the 104th Congress. That is, the funds will simply make a round trip through Mexico to Wall Street, to buy up tesebonos, without doing a thing to restore the peso's value. If I were Chairman Greenspan, I would ask for a public statement by the President ordering me to do this, to relieve me of the responsibility for this useless maneuver. It would inevitably lead to default by Mexico and Treasury would be back up here asking for another bailout.
If, though, this Congress deploys its oversight power and insists that the $20 billion be used exclusively to revalue the peso, the value of all peso assets will climb in the process and the Mexican economy will be stronger than it would have been if the crisis never occurred. This can easily be done through the purchase of pesos by the Federal Reserve in the open market. It is almost certain that at the end of the process the Fed will have strengthened its own balance sheet, as the peso's value returns to 3.5 to the dollar. All arguments that this cannot be done rest on the fact that since December 21 new contracts have been drawn up throughout Mexico against the devalued peso. Insofar as wage and price controls are still technically in effect, the damage that would be done to debtors in the process of revaluation would be trivial, especially when compared to the change suffered by the Mexican government's many creditors. Most of the debtors are Wall Streeters and Mexican insiders who are shorting the peso now. They would get their fingers burned. Industrial contracts could be refinanced at the much-lower interest rates during the several-month phase-in period to the 3.5 rate.
On point three, the international financial community should shake hands all around on
the promise to each other that there will be no further voyages of the Black Whale. Private currency speculation will always be a fact of life. But without the guidance and protection of the IMF and World Bank, the scavenger fish would be more easily dealt with by the central banks of the developing world. There will be no more "sure things." In a magnificent essay in Wednesday's Wall Street Journal, "Suffering the Conventional Wisdom," WSJ editor Robert L Bartley cites his 1989 editorial quoted at the top of this statement and goes on to say: "Just possibly, the [peso] debacle will spell the end of devaluation as a policy instrument, not only in Mexico, but around the world." Bartley notes that the enormous success of Argentina in recent years, ending its hyperinflations, can be attributed to its finance minister, Domingo Cavallo, who rejected the conventional wisdom of devaluation, doing so by "inviting IMF advisers out of his nation."
In 1991, Minister Cavallo expressed a philosophy of social contracts in explaining his position: "Each peso is a contract between the government and the peso holder. That contract guarantees that each peso — as a unit of value that the holder has worked hard to get — will be worth as much tomorrow as it is today. If the government breaks that contract, it's breaking the law. The only role of the government in the economy should be to guarantee the integrity of market transactions."
Should the IMF be dismantled? That's another question entirely. It was originally established in 1944 to oversee the gold standard at the heart of the Bretton Woods Agreement. In his Senate Banking Committee testimony last week, Alan Greenspan said this is the reason he always favored a gold standard, as it is the best mechanism available to discourage devaluations. As it is my belief that we are on the verge of returning to an international gold standard of some sort, I believe the basically good men and women who toil at the IMF and World Bank will be able to do the work their institutions were originally designed for. It is, after all, not evil people that guide the Black Whale, only an obsolete idea.