Economic Review

Economic Review
C O N T E N T S
January/February 1996, Volume 81, Number 1

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Editor's Note

In the early 1990s the Mexican economy seemed healthy, growing again after stumbling through the 1980s. Culminating in implementation of the North American Free Trade Agreement at the beginning of 1994, Mexico's rise above hard times seemed secure. Less than twelve months later, though, the country faced economic disaster, with devaluation of the peso in December and a financial crisis set in motion that cut the peso's value in half, stimulated inflation, and set off a severe recession.
The two articles in this issue offer differing perspectives on this economic crisis in Mexico. Joe Whitt discusses the devaluation as the inevitable result of fiscal, monetary, and exchange rate policy imbalances in the Mexican economy that might have been corrected by earlier adjustments in macroeconomic policy. Marco Espinosa and Steven Russell systematically review this conventional view of the crisis. Their analysis casts doubts about its validity. They present an alternative view emphasizing deepening investor concerns about the safety of Mexican financial obligations combined with the short-term nature of the bulk of Mexican debt. Their policy recommendations deal mainly with the term structure of private debt.

Each article is an integrated whole in itself, chronicling the historical events that led to the crisis and interpreting them in terms of its authors' views. Presented together, the two articles demonstrate how different economic models influence the interpretation of events and in turn lead to different policy prescriptions.

1	The Mexican Peso Crisis Joseph A. Whitt, Jr.	Hoping to avoid an economic slowdown during 1994, Mexico tried to maintain its quasi-pegged exchange rate while limiting monetary tightening by engaging in massive sterilized intervention—a policy that is not sustainable for long. The ultimate result was a collapse of the exchange rate, soaring interest rates, and probably a far worse recession than would have occurred if monetary policy had been tightened. The author of this article asks whether Mexican policy mistakes made devaluation of the peso inevitable, considering particularly Mexico's policy actions during 1994—as well as options Mexico did not take. He also reviews market response to the devaluation and Mexican and U.S. government efforts to cope with its aftermath. In his view this episode highlights the severe constraints on monetary policy that arise if a government wants to maintain a fixed or quasi-pegged exchange rate. The ensuing crisis continues to have severe consequences for the Mexican economy. Nevertheless, the author sees hope that the combination of a relatively sound budget position, more effective Mexican policies since the devaluation occurred, and the assistance arranged by the United States and the International Monetary Fund will enable Mexico to recover much more quickly from this crisis than it did after its 1982 crash.
21	The Mexican Economic Crisis: Alternative Views Marco Espinosa and Steven Russell	The authors of this article suggest that many of the explanations for the 1994 crisis are based on questionable assumptions and dubious analysis. They contend that, when trying to explain the crisis, most authors have concentrated on the wrong economic "fundamentals." They challenge the conventional view that the crisis was caused by a combination of flawed fiscal, monetary, and exchange rate policies. Their explanation for the crisis belongs in an alternative camp that emphasizes the vulnerability of the Mexican financial system to swings in expectations and investor confidence. In their view, the Mexican financial crisis was an expectations-driven liquidity crisis that shares many similarities with the financial panics that afflicted the U.S. economy during the late nineteenth century. The immediate cause of the Mexican crisis was political turmoil that created concern among foreign lenders about the safety of their investments. Mexican borrowers' "over-reliance" on short-term liabilities made both individual borrowers and the financial system extremely vulnerable to the adverse political events that shook the confidence of foreign investors. This article's principal policy recommendation is for the Mexican government to set up a system of term-graduated multiple reserve requirements for banks ("circuit breakers"). These would give financial institutions (and direct borrowers) strong incentives to lengthen the average term of their debts and make the country's financial system less susceptible to liquidity crises. The average term of the government's liability portfolio would also increase, reducing its own vulnerability to liquidity crises.

President
Jack Guynn

Senior Vice President and
Director of Research
Robert A. Eisenbeis

Research Department
B. Frank King, Vice President and Associate Director of Research
Mary Susan Rosenbaum, Vice President, Macropolicy
Roberto Chang, Research Officer, Macropolicy
Thomas J. Cunningham, Research Officer, Regional
William Roberds, Research Officer, Macropolicy
Larry D. Wall, Research Officer, Financial

Public Affairs
Bobbie H. McCrackin, Vice President
Joycelyn Trigg Woolfolk, Editor
Lynn H. Foley, Managing Editor
Carole L. Starkey, Graphics
Ellen Arth, Circulation
Linda Mundy, Administrative Assistance

The Economic Review of the Federal Reserve Bank of Atlanta presents analysis of economic and financial topics relevant to Federal Reserve policy. In a format accessable to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.

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ISSN 0732-1813