My trip to Mexico last week was not planned to coincide with its latest financial crisis, yet I was not in Mexico City 24 hours and there it was. The peso was at 6.4 to the dollar when I arrived Wednesday. It traded as low as 7.4 on Thursday and ended the week at 7.14, with the Bank of Mexico raising overnight interest rates to 52% to halt the slide. The Bolsa, which was being pounded earlier in the week, fell another 8% mid-week before a Friday rebound. In several meetings I had with business and political leaders, editors and journalists, and government officials past and present, I found a general sense of depression and despair about the course of Mexico’s near term. From these limited soundings, there seems almost no confidence shown by Mexico’s ruling class in the leadership of President Ernesto Zedillo and his Finance Minister, Guillermo Ortiz. Over the weekend, it was only raw fear that propelled business and labor leaders to sign a new Pacto with the government, a hopeless King Canute effort to hold back wages and prices in the face of a government-induced inflationary tide.
The agreement may bring momentary relief in the financial markets, but there is nothing in it to reverse the decline in real incomes for the great mass of ordinary people, whose spirit is being crushed by the incompetence of their government. And yet, there is little hostility toward Zedillo himself, who became president by an accident of fate. When Luis Donaldo Colosio, the PRI’s candidate to succeed President Salinas, was assassinated early last year, a legal quirk left Zedillo the only party figure eligible to replace him. We might think of the 42-year-old president as an 18-year-old boy who becomes head of the household when his parents are killed in an accident. He was not prepared for the presidency, and it shows. He maintains a brave front, as if persistent calls for staying the course will persuade his little brothers and sisters that he knows what he is doing and soon all will be well. Running the country from a textbook, his Yale Ph.D. in economics is a liability, not an asset, as is Ortiz’s Ph.D. from Stanford. They are fixated on a policy that dooms Mexico to economic contraction, the perverse practice of targeting the real exchange rate. The idea stems from a misreading of last December’s peso crisis, an event that occurred when the Ivy League economists at the U.S. Treasury and International Monetary Fund persuaded the Zedillo team that too much capital had flowed into Mexico during the Salinas years when the peso was tied to the dollar.
Imagine a trade flow of calories between a 7-year-old boy and his 30-year-old father being forced to balance and you will have some idea of the wickedness of the idea. The father’s caloric intake keeps him from gaining weight and so does his son’s. The practice roughly parallels England’s imperialist strategy toward its colonies, keeping them drawers of water, hewers of wood. Denied an inflow of foreign capital, Mexico thus is kept “competitive” by steady downward pressure on the real wages of the work force. The policy now has unemployed 1.8 million workers and depleted the life savings of several million households. On Friday afternoon, about 10,000 public sector workers, who now are earning an average of 30 pesos per day ($4.28), angrily assembled in the city square to protest the steady decline in the purchasing power of their wages. Several hundred riot police looked on. In Acapulco on Wednesday, members of a consumer advocacy group stripped naked to protest the stratospheric interest rates. Pawn shops in Mexico City closed last week, their warehouses full.
Ortiz will cite the effectiveness of Chile’s capital controls as proof that a real exchange rate target is a good thing. Chile did for a period screen foreign inflows via regulation, but at the same time it promoted internal capital formation via tax reforms. And it wisely “devalued” against a deflating dollar. Ortiz doesn’t see the destructiveness of deliberately shutting out foreign investment by destroying the nation’s monetary unit of account. When asked why the peso was tumbling, I handed out our client letters of September 8 (“Woeful State”) and September 22 (“The Ortiz Problem”), written after Ortiz’s visit to Wall Street. There, he astonished knowledgeable investors with his cavalier attitude toward the peso -- unable to see that even at 6.2 pesos per dollar, the general price level would still have to rise by 50% to catch up with the doubling of the price of gold in the last year. At 7.1 per dollar, the Pacto signed this weekend is a cruel joke, permitting a 20% increase in the minimum wage over the next three months, to $3 per day! At the same time that the government shuts out foreign capital, it haplessly impedes domestic capital formation by discouraging new enterprise with higher taxes (the Pacto reserves tax breaks to mature business via investment tax credits). Pedro Noyola, Ortiz’s deputy for tax policy, last week proposed a new tax on hotel rooms, to finance a government promotion of the tourist industry!!!
There is no help from the Bank of Mexico. Director Miguel Mancera, who could have stanched last year’s flight from the peso by selling peso assets out of the Bank’s portfolio, now hides behind a floating peso policy as an excuse to do nothing. The peso isn’t floating anyway, as the Bank intervenes on an almost daily basis to manage the monetary base -- holding it at about 47 billion pesos, which at 7 to 1 equates to $6.4 billion. A year ago, it was closer to $15 billion, which tells us how dramatically the economy has imploded. The idea of targeting the monetary base is almost as vacuous an idea as targeting the real exchange rate. When any external shock hits the economy in a way that causes a decline in peso demand, the peso must fall in value producing inflation as the inevitable result, with Mancera looking on helplessly.
What should be done? Last November, when then-Finance Minister Pedro Aspe turned his last budget over to the Zedillo team, it contained serious relief on capital gains taxation for all incorporated businesses. This was stripped out after Zedillo’s inauguration in December, a decision that dampened peso demand and helped trigger the subsequent devaluation. In each of my meetings last week, I made the point that nothing could help the peso (and the financial markets) more than a revival of at least that Aspe measure -- which would boost peso demand and all peso assets. Even with the monetary base frozen at a nominal 47 billion pesos, the currency would retrace its steps back to 6.2 or better. Interest rates would fall and Acapulco’s Lady Godivas could get dressed. No one can imagine this with Ortiz at Treasury. A second-best treatment would be to drop the fiction of a floating peso, announce a target of 6, and drain liquidity until the target is reached. This was my advice to Mancera last January, when it could have kicked the peso back to 3.5, avoiding this impoverishment of the population. He’s not likely to do it now without clear political support, which is not in sight.
There is also no help from PAN, the primary opposition party, which does not really have a defined economic agenda. On Saturday, I met with a senior PAN official, who has a better economic grasp than I’d expected, and suggested his party publicly nudge Zedillo in the right direction. I came away feeling his team at the moment is happy enough standing aside and watching Zedillo flounder. They are more interested in planning for the 1997 congressional elections, which they hope to sweep, rather than sharing political risk with the party in power on an immediate rescue effort. I suspect Zedillo may now be more open to fresh advice as a result of last week’s peso crisis, probably scared to death at the growing distress of the general population. If I were he, I would invite Pedro Aspe over for a chat. Aspe, who was one of the best finance ministers in the world during his eight years in that office, is teaching economics at the university, anguished at what is happening but biting his tongue. An arch-enemy of devaluation, he had been offered the transportation ministry last November, which would be like offering Alexander Hamilton the teamster’s union. When the peso slide resumes, Zedillo will have few better options.