William Krehm
La singular Historia del Rescate Bancario Mexicano 1994-1999 (The Amazing Bank Bailout of Mexico 1994-1999) by Francisco J. Vega Rodriguez, Biblioteca Plural Economia, Finanza y Politica, 1999, Mexico, 780 pages)
The evidence that Globalization and Deregulation was not working has piled up so high that it is toppling over on all continents. Crowning interest rates as sole “tool” for enforcing the unenforceable – a flat price level in a world undergoing undreamt of urbanization and technological revolution – has split the world into murderous camps. The Koran after all condemns to eternal hell-fire those persisting in charging interest, let alone making usury the cornerstone of statesmanship. Historians like the late Ferdinand Braudel long ago caught the point that a developed urbanized society implies vastly more public services and thus a growing layer of taxation in price. Yet the point still eludes economists.1
So I decided to celebrate my 90th year sampling some of the “heterodox economic conferences” springing up across the world. The 1930s had been a period of black despair, but at least there was a substantial degree of free enquiry even in Washington. Without that, the world could never have groped its way out of the Depression. Even high executives of some large corporations espoused heterodox views on money creation. A Utah banker. Marriner Eccles, was Roosevelt’s Secretary of the Treasury, largely responsible for the reform of the monetary system along “Keynesian” lines without having heard of Keynes.
Keynes not only rethought much basic economic theory, but gave due credit to the great independent thinkers in the field – Karl Marx, Gesell, Douglas. Resistance to such rethinking came less from governments than from academic economists. In Oxbridge it was his colleagues who restrained the other- wise unrestrainable Keynes from going public with his ultimate conclusion – “Equilibrium [theory] is blither.”
A Back Door Left Open for the Bank Comeback
The urgencies of the war and reconstruction provided the framework for the emergency work to be done. But the language of “official” economists remained that of equilibrium theory that assumed a self-balancing “pure and perfect market.” And that left the back door open for a comeback of the financial sector, when it finally got out of the doghouse. Banks had been severely separated from other capital pools, such as insurance and the stock market, precisely because of their money-creation powers. Ceilings had been set on what interest they could pay or charge. But left flying on the flagpole, marginal theory proclaimed that stable prices will result from a “free and perfect” market that in a stunning bit of circular reasoning was itself defined as one that keeps prices stable. All actors are posited of such tiny size that nothing any one does or doesn’t do can affect the market. However, when the immense public investment got underway to repair the neglect of 10 years of depression and six of war, when price controls came off (just in time for the Korean war!), prices moved up jauntily. And that set the stage for a coup d’état behind President Truman’s back. The Treasury and the Federal Reserve had been negotiating for weeks about adjusting interest rates to the price movement. In his memoirs Truman tells of his surprise in learning that his own Treasury had double-crossed him, and surrendered the interest-rate peg as such. In the long run that empowered the banks to throttle and choke.
The book that we are reviewing begins by establishing that the “free and perfect market” is something that never existed. It goes on to show that Deregulation and Globalization, blasting in from Washington, combined with Mexico’s rich tradition of corruption to give rise to crises that just missed bringing down the world financial system.
In 1981 Mexico’s banks were in such bad shape that the government nationalized them as a “more economical way of avoiding their bankruptcy than bailing them out.” The dean of specialists on the international economy, Robert Triffin of Yale, on analyzing the venerable institution of the gold standard, concluded that the textbooks describe what never existed. Similarly, the existence of a respectable, orthodox banking tradition in Mexico before the banks’ nationalization is a fiction created by those who lost their power. Legislation had granted immense discretion to the private bankers. In the late 1960s and early 1970s the merging of banks was allowed and a banking monopoly resulted. Special privileges took the form of anonymity of bank stock- holders, preferential tax treatment, and the prohibition of bank employees’ unions. The Bank of Mexico, the central bank, was a limited society, with private bankers prominent on its board.
“The structure of the banking system shielded speculators from undesirable obligations of ownership so ingeniously as to attain sheer beauty. The banks could advance funds to economic agents (corporation treasuries, and exchange and stock market operators) having ties to bank shareholders. The latter in turn were able to buy dollars against nominal guarantees. And when speculation approached its peak, the wealthiest of these could secretly divest themselves of their equity, and deposit the proceeds in offshore banks. Such scams continued long after the reserves of the central bank had vanished and devaluation was inevitable.
“Such practices made the economic elite particularly arrogant in their dealing with government functionaries who knew that they would shortly be shorn of office. That is basic to the crisis psychology that accompanies the installation of a new president every six years. The nationalization of the banks in 1982 was not a response to populist pressure. It resulted in a lack of mediation between the incoming and outgoing elites. “In addition, during the 1981-2 deficit, Mexico’s foreign balance of payments suffered from a dramatic fall in oil prices, and the explosion of international interest rates due to the madcap monetarist experiment of the US Federal Reserve under Paul Volcker in the name of prudence. The Mexican market experienced an acute shortage of both domestic and foreign currency. Between 1977 and 1981 four fifths of the deficit in the current account was due to financial services. The financial deficit amounted in 1982 to 16% of the NDP. The collapse of the economy was imminent.
“The government of Jose Lopez Portillo responded with what has been considered the ‘first macroeconomic readjustment since the oil boom of 1977-1980. This consisted of a combination of orthodox and heterodox remedies. Its main compo- nents were:
“Devaluation of the currency, with rate changes for successive quarters of 8.4%, 10.7%, 12.4%, and 16.4%. Import controls. Increasing domestic interest rates. A projected domestic budget reduction of 8%.
Mexico’s Debt Becomes Dollar-denominated
“Only the circle around the President failed to see that the projected devaluation would lead to a panicky flight of capital. Between 1980 and 1981, $10,915 million left the land. By October, 1981 inflation had shot up to 100%, the federal debt doubled to $12,544 million. Bank liabilities had become dollar-denominated. The debt of firms exploded in peso terms. Deregulation and Globalization prevented any barrier to the free exchange of currencies. In February,1982, the free float of the peso advocated by Milton Friedman was brought in.
“Reintroducing import controls.“Increasing export subsidies.
“Increasing domestic interest rates.
“A projected reduction in the annual budget of the public sector of 8%.
“The policy pursued after February 19th was the usual orthodox macroeconomics. The 1983 budget showed a reduction of 3% over that of the previous year; domestic interest rates were raised; restrictions on imports were removed; users’ fees were increased in the public sector; and confirmation issued that Mexico would respect international commitments. An onerous increase in private debt resulted from both the higher interest rates and the devaluation. This led to labour disputes and threatened the liquidity of large Mexican corporations. By June Mexico was no longer able to obtain foreign credits without special guarantees. There was nowhere to go but nationalize the banking system. Only under government guarantee could Mexico hope for more credit.
“The outgoing president Lopez Portilla began negotiations with the IMF. This paved the way for a new era of austerity under his successor, President de la Madrid. The central bank authorized the banks to receive deposits that could be withdrawn at pre-established dates, the withdrawals being denominated in so-called Mex-dollars. Like the tesobonos – dollar bonds issued by the government – they left the economy vulnerable to further shocks. No margin remained for further flights of capital. Nationalization of the banks and general control of all currency change alone could stave off total disaster. The American press, and even the banks, temporarily set aside their prejudices against nationalization.
“Under cover of the technological and financial revolutions, centuries of experience went into the dustbin. It was proclaimed that only a free market could guarantee order and progress. And its key weaponry was the new derivative products: futures, options, swaps. The resulting experiments encroached on the state domain. Denationalizing the currency was part of the program. Money creation was to be shifted from public to private firms.”2
Bank nationalization left the stock market with a virtual monopoly of speculative money creation in Mexico. This reversed the sequence in Canada where the control of money creation had been shifted from the central bank to private bankers; and then by further bank deregulation, to a stock market that banks, drawing on their annual entitlement under their bailout, had been able to take over to a growing extent.
“In Mexico the elevation of the stock market elite to control had to do with the explosion of government debt. The main component of this were the ‘CETES’ distributed by auctions on the stock market. This deprived the nationalized banks of the lucrative business of placing the government’s swelling debt.” The new stock market elite grew fat and imperious. For sheer cheek, it even outstripped what happened in Canada where our banks, freshly bailed-out banks, were then deregulated.
In either case, the Bard put it best: “Thrift, Thrift, Horatio, The funeral baked meats did coldly furnish forth the marriage tables.”
Not all Bubbles come from Clay Pipes
The bubble on the Mexican Bolsa de Valores was without precedent. In 1982 there had been only 66,000 investors trading on that stock market, but by September 1987, this had risen to 417 million. Many folks mortgaged or sold their houses and automobiles to plunge into the game. On October 5, a day after the inauguration of President Salinas, shares traded were up 26,677 points during the first hour. Two weeks later, this had become “Black Mon- day.” Panic took over. Everybody wanted to sell, but no buyers were around. More than 180 thousand investors lost their money at a single stroke. Multi-millionaires suddenly found themselves penniless, but the brokerage houses overnight acquired huge fortunes. A new financial elite had replaced the banks which, due to their nationalization, were absent from the orgy.
“The euphoria culminating in this crash, the devaluation of the peso, and the subsidence of inflation all resulted from President Miguel de la Madrid’s obstinate insistence to pay off the debt. It had grave consequences on income distribution, employment and production. The magnitude of the transfers for interest payments abroad were compared with the tribute paid after a lost war. It brought on the break-up of the old government party, the PRI, after more than a half-century in power. In the 1990s, the ‘technocratic’ takeover produced an armed revolution in the southern state of Chiapas, and rocked the economy.
“When Carlos Salinas de Gortari took over the presidency, after the most questioned election since the war, he proposed bringing the economy back to health by an ambitious program of privatization. It was to take place in fields as diverse as telecommunications, mining, food production, and above all the banks. And it led to the free trade treaty (TLC). On top of that he staged a series of political coups (the jailing of trade union leaders, and notorious functionaries and promoters) that won him some popular support. Few suspected that all this would lead to the most devastating Mexican crisis since 1910.
“A radical rethinking of the role of the state began. No longer were growing powers of government over the economy seen as progress. Throughout the world an anti-statist counter-revolution had begun.
“It was with a touch of mourning, that the general directors of the nationalized banks met at the Mexican president’s residence, Los Pinos, on May 2, 1990. They had already been notified that their banks were to be privatized. Despite their economic persuasion, heading a government bank had bestowed on them all sorts of influence. However, as usually happens in Mexico, the Minister of the Interior had already summoned the members of the ruling party in the national legislatures and among the state governors and informed them of the position to take. None of them, including the minister himself, was without misgivings. The nationalized banks, with PRI members occupying key positions and sharing information to which only banks are privy, had its advantages. Virtually only the party of the left, the PRD, founded by Cuauhtemoc Cardenas, son of the president who in 1936 had nationalized the petroleum industry, opposed the privatization. What would be next? The national oil company itself?
The Vast Booty of Privatization
“Yet the booty for insiders was vast – 18 bank corporations, 4,500 branches (40 abroad), 200,000 employees not allowed to organize trade unions. Stock brokers, the business tycoons and financiers of Monterrey, and the former bank owners competed for the quarry.”
Canadians should be interested in the detail that one of the advantages offered bankers by the privatization was the replacement of statutory reserves in legal tender (encaje legal) with a liquidity quotient of 30% of the banks’ liabilities. This corresponded to the abolition of the statutory reserves in the 1991 Canadian Bank Act revision slipped through our Parliament in 1991. Both in Mexico and Canada these moves allowed the banks far greater leverage in their operations. “The concept of ‘liquidity’ is difficult to confirm in the real banking world.” Instead of “cash,” the ghost-like concept of “liquidity” became the yardstick of bank soundness. In Mexico, for a tiny portion of the going rate on Wall St., you could get an accountant to swear that a bank’s liability was “capital.”
Government bonds, proclaimed “risk-free” by the Bank for International Settlement’s “Risk-Based Capital Guidelines” brought in shortly before, actually lose value whenever the central banks push interest rates on new bond-issues higher than the coupons of the old ones hoarded by banks under the new dispensations. And higher interest rate to “lick inflation” had become holy script to central banks. In Canada it made it possible for banks to quadruple their holdings of federal debt without putting up money of their own. The effect in Mexico was similar. It paved the way for the Mexican bank crisis of 1994 that almost brought down the world financial system.
“After the banks were privatized, the ‘liquidity coefficient’ was wholly suppressed. This was the main factor flaring Mexico’s credit bubble. The so-called ‘L’ bond series was introduced that allowed holding companies to acquire liabilities and to merge with other financial companies in highly leveraged transactions.”
“The belief took over that the unfailing mechanism of the market would itself ensure order. A new bumper harvest of ‘derivative’ products were contrived to serve the experiments in globalization and deregulation: futures, options, swaps. This moved in step with the proposals of the most radical neo- classical thinkers like Professor Hayek who advocated the closing down of central banks and denationalizing the currencies. Money creation was to be entrusted to private enterprise.” Mexico was marching to a world bass drum. Since the early 1970s no other legal tender existed in the world than the debt of government. Govern- ment, from “the lender of the last resort,” was overnight transmuted to the donor of the first resort. In this way the multiplication of government debt was brought about by the very monetarists who professed to loathe it.
“In choosing C.S. First Boston as advisers for the bank privatization, the outgoing Mexican president, Carlos Salinas, passed on a time- bomb to his successor, Ernesto Zedillo. In its report First Boston, true mercenary, emphasized the rise in the stock market index – 69% and 37% in dollar terms during 1989 and 1990, the relative low ratio of prices to earnings compared to that of most markets in the world; presented the Mexican market as the most liquid in Latin America; and the best serviced. On the market crash of 1987, and the financial scandals that led to jail sentences, it was mum.”
First Boston’s Expertise in Misleading Markets
“[Instead] the rapidity with which privatization was carried out and the handsome prices obtained for the banks were interpreted as a sign of the Salinas administration’s success.” Obviously no small part of the expertise of First Boston was its skill in misleading markets. A few months later, in the elections for the deputies of the Assembly, the official party, the PRI, swept in victoriously, without need for fraud. Between June 7, 1991, and July 3, 1992, every single bank was taken over by private buyers.
“But trouble loomed. To straddle the gap between the dollar and the peso and cover the banks’ losses, the government had issued ajustabonos, middle- and long-term debt in dollars. But another canyon suddenly yawned deep and wide. To lick ‘inflation’ once and for all Paul Volcker, head of the Federal Reserve in the United States, was shoving up interest rates, without thought of the effect on banks that had loaded up with totally leveraged debt as the means of their bailout. As the international interest rates continued rising, the market value of earlier debt with lower coupons plummeted. A single bank, Banamex, was absorbing 200 million of old pesos lost in ajustabonos, and the plight of other banks and brokerage houses was similar. The National Banking Commission, the National Securities Commission, and the Bank of Mexico had no clue of these losses. A special futures market in these instruments papered over the evidence. This black-out of reliable information had been critical for the privatization success taken as a sign of the soundness of Mexican banks. Only much later was it revealed that they had unloaded ajustabonos and other low-yield securities onto their trusting clients to earn handsome commissions and lighten their own exposure.”
And on top of it all was the swarm of new derivatives, some hardly understood even by their authors on Wall St., and completely beyond the ken of the Mexican market. The lights simply went out in Mexico’s hour of trial. And from this witches’ brew there was supposed to emerge a miraculously self-balancing market!
“Not until 1994, three years later, did the government make even a pretence of bringing in rigid capital requirements for the banks.”
It is a remarkable feature of the Vega book that for each of the great bank scandals the author breaks down the complex frauds coming together from all directions – Wall St. and Pancho Villa traditions, derivatives and political bagman smarts. And in doing so the book, published in 1999, was able to anticipate many irregularities similar to those Eliot Spitzer exposed years later. The major role in all this of blind faith in the self-balancing market is laid bare – something absent in Spitzer’s other- wise spectacular performance. In both the US and Europe, piety warns off research as it approaches ground consecrated to burial rather than disinterment. There the Canadian record is the most dismal – near-total absence of investigations that might embarrass Bay St.
Take for example, what Vega calls “Typical operations of bank treasuries and money shops based on private intermediation.
“The present market and bank treasuries in Mexico allow significant trades of bank and government securities outside the market through simple off-record agreements. This is known as ‘private intermediation’ that by-passes licensed brokerages and banks. One of several examples:
“The promoter in a brokerage or bank attracts clients by offering loans at yields varying from 0.25% to 2.5% below market. The brokerage or bank then places the loans directly on the interbank market or through the intermediary. The yield is guaranteed.
“The promoter receives the commissions of the brokerage or bank as profit arising from the differential in the yields agreed upon. Taxes are paid. The net profit of the promoter is shared amongst all those involved. Brokerages in particular succeeded in contriving commissions amounting from 20 to 60%. In this variant the longer term loans are the most profitable and most sought after.”
The play here is attracting borrowers with lower rates, and then creeping up on them with exorbitant ongoing commissions. Something similar is practised in Canada and the US – abusing innocent customers with initial low rates.
“Those who work this strange market carry out different combinations [involving differentials not only interest rates, but of currency ex- change rates]. Some prefer small returns in yield so that the quotes don’t differ markedly from market and the game is less likely to be unmasked. Profits though small are constant. Other operators prefer adhering to normal practice and then surprising the victim from time to time with substantial divergences. Whatever the route chosen, the result can be a substantial transfer of wealth. It can work only in a highly concentrated market as to location, complexity of financial instruments available, an intimate buddy-system, and the existence of private intermediation, controls feeble or absent. Mexico satisfied all these requirements.”
Derivatives, still unregulated, help immensely in keeping such deals off balance-sheet, and capitalizing the lack of transparency. They permit the unrecorded sale and even the shorting from an original equity position while still peddling the stock to clients. This happened with at least of two of the largest Canadian banks in Enron partnerships, and earned them huge fines plus public-relation black eyes.There has never, of course, been a better laboratory for studying scabrous financial practices than Mexico. And to not a few of these its great northern neighbour has generously contributed.
“Early in 1996 the Mexican National Commission on Banking and Securities issued a report on a series of typical operations on the local financial market over the previous decades. The report concluded an underground network that had been created in just two decades made possible a vast accumulation of private wealth that transformed the very political and economic structure of the country.
“Mexico’s financial bubble had been blown up to such outlandish proportions, that the question arises, how could it have been unchallenged? Vega addresses the question, and draws heavily on the warnings of John Kenneth Galbraith who had certainly sounded his magic whistle forewarning of the busts of 1987 and 1994 – to little effect. Rudiger Dornbusch of MIT had conducted a campaign pointing out that Mexico had to devalue its currency by 20% to reduce its commercial deficit and its dependence on foreign credit. The entire apparatus of the Mexican state reacted by satanizing Dornbusch as ‘a dangerous man.’ Speaking engagements were cancelled. Mexican economic policy became entangled with the marketing needs of New York financial houses, as well as with those of the new elite at home.” The argument of The Wall Street Journal and others was that the since the commercial deficit arose from the expansion of the private sector it was not dangerous but necessary. Besides, Mexico’s growth rate was nowhere near that of Singapore! But the money borrowed abroad was not invested in building factories. Instead, it covered the short-term borrowing of the government, and the flight of capital from the country. Agustin Carstens of the Bank of Mexico defended “a monetary policy that was strictly anti-inflationary”, and cited the econometric doctrine of “Monetary Neutrality” of Robert Lucas, that was supposed to prove that the monetary variables had no real economic effect “in the long run.” Lucas was the Nobel Prize for Economics laureate of 1995.
Sitting in the Soup
Since the notion of a “level playing field” is basic to equilibrium theory, let us examine this Monetary Neutrality theory in its light. The different actors, and the different social classes are affected in quite different ways by the unlimited “long run” that the “free market” may take to work its supposed magic. Financial institutions are consoled by ever higher interest rates during the long wait. Their income becomes richer en route. That is hardly the case with those thrown out of jobs to bring in the “natural rate of unemployment.” Even the formulation of such a model, let alone bestowing a prize on its authors, is an insolence.
However, it was on these grounds that the Bank of Mexico rested its case for doing nothing about the peso’s overpricing:
“The deficit on current account is simply the counterpart of the positive balance in the capital account.
“The existence of perfect financial markets proves that there can be no such thing as an overvalued currency.
“The exchange value of the peso is determined by real factors, and it cannot be affected in a lasting way by any monetary or exchange rate policy.”
During the Russian Civil War of the early 1920s, the great Russian satirist, Isaac Babel, wrote a powerfully mordant account of the atrocities of both sides in his “Red Cavalry.” This drew a sharp rebuke from the legendary Soviet cavalry chief Marshal Budyenny, who made much of the fact that comrade Babel (who also happened to be a Jew) served in the commissariat and took no part in the actual fighting. To this Lenin is supposed to have replied, “Comrade Budyenny, to be a good cook, you don’t have to sit in the soup.” Sometimes, however, that does help. And that was the case of Mexico on the receiving end of just about every swindle that Wall St., the US academe, and its own gifted financiers could devise.
“Denting these dreams of equilibrium, imbalances grew severe enough to trigger disastrous political effects of serious economic consequence. Thus the Zapatista rebellion broke out in southern Mexico. The assassination of two leading figures of the Mexican official party – were clear indications that the old alliances of different social groups reaching back over sixty years were crumbling. The sense of well-being created by the prospect of the Free Trade Treaty suffered. Mexico lost $10 billion of its $28 billion cash reserves. By the end of 1994 the outstanding tesobonos that little more than a year before had amounted to $1.3 billion touched the $20 billion figure. To make matters worse, in November the US Fed raised interest rates by 0.75%.“The full toll of the depression became clear in 1995. The GDP dropped by 6.2%, construction was down 23.5%, private investment by 31.2%, total investment by 29%, imports by 15%. In January, the US congress turned down a bill presented by President Clinton for $40 billion of credit guarantees for Mexico to forestall the further collapse of the peso. The full danger of the crumbling of Mexico’s economy reached the ears of Leon Panetta, the head of Clinton’s cabinet on a cold afternoon on January 30. He was silently contemplating the dozens of possible solutions presented by Robert Rubin and Larry Summers for the greatest financial rescue in history to convince Michel Camadessus, the stubborn president of the International Monetary Fund. At 8 p.m. a call reached him from the new Mexican Minister of the Economy, Guillermo Ortiz, announcing that the Bank of Mexico had used up its foreign exchange reserves, and Mexico was on the verge of chaos. A second call from Senator Gingrich, head of the Republican majority, announced that there would be no support for a further credit to Mexico. That meant that President Clinton alone would have to assume the entire responsibility for such a loan. There was no other recourse but to go back to the IMF and ask that it increase its support from $7.7 billion already committed by another $10B. Faced with the alternative, Camdessus, suspending the monetarist faith of a lifetime, consented. By the next morning President Clinton was able to announce that with the help of the IMF, the World Bank, and the Canadian government, he had succeeded in putting together over $50 billion aid to Mexico, even without the consent of Congress. Camdessus hailed the coup as an answer to the first great crisis of the 21st century.” Without, of course, mentioning the deeper implications of that statement.
Pontius Pilate in the Guise of a Mexican Economist
“In its annual report for 1995 the Bank of Mexico stated its position on the seismic happenings of the previous months: ‘The crisis, the report argued, was not the consequence of policies adopted. Instead, what was to blame was the adverse movements of the economic variables: reversed capital flows, devaluation, expectations of greater inflation, the rise of interest rates and the drop in aggregate demand.’
“No reason was given for the accumulation such a tremendous amount of foreign capital, without the government becoming aware of the dangers of such a situation. There was no explanation of the self- deception that ‘takes for granted’ that monetary neutrality prevails, the accepted doctrine of the Bank of Mexico. According to this creed monetary variations do not affect the real equilibrium of the economy!
“Up to 1994 the exchange rate of the currency was taken to be the anchor of the economy and the central bank undertook to keep the exchange rate of the peso within an acceptable band. Monetary policy was subordinated to keeping prices within the national currency in a determined range. The effectiveness of such a regime depended on the monetary authority being able to fend off speculative attacks against the local money.
“Under the new regime, the nominal anchor of the system was the monetary base and domestic and foreign credit. These are the variables assigned the main role. This doctrine led to the following policies:
“Strict limits imposed on the net growth of domestic credit.
“A floating exchange rate.
“An average zero statutory reserve set for the banks.
“Limits were imposed on the positive balances of credit institutions, to be calculated by monthly averages.
“In auctioning credit the rate of interest for financing was kept free.
“Limits were set on the borrowing by commercial banks for from the central bank. The new policy adopted was based on quantitative limits of monetary control, and on a zero average of the banks statutory reserves.” [My emphasis.] In the opinion of the Bank of Mexico this was of exceptional importance. The monetary authorities affirmed that such a policy permitted it to control the economy at the lowest possible cost. (The central bank did not include unemployment amongst such costs.)”
The Fiction of Market Efficiency
“Two important officials of the central bank, Agustin Carstens and Alejandro Reynoso set forth the monetary policy of Mexico as follows: ‘In the first semester report of the Bank of Mexico in 1997, the two ideas formed the central content of the document: firstly, the neutrality of its counter-cyclical monetary policy; and secondly, the role played by liquidity in the development of the financial markets in support of long-term growth.’
“The doctrine of monetary neutrality holds that nominal variations cannot affect the real equilibrium of the economy. Their only effect is to alter the rate of inflation.
“Monetary equilibrium, according to this doctrine, rests on the view that the key variables of the economy, the interest rate, the exchange rate, the wage rate do not have a ‘natural’ level, but each of these are governed by conventional motives of a psycho- logical nature. When Alan Greenspan warns against irrational bubbles of speculation as the cause of financial crashes, and when George Soros pleads with authorities to impose restrictions on speculative flows when these become destabilizing, they are asserting that the aforesaid variables (interest rates, exchange rates, etc.) have no centre of gravity, i.e., a ‘natural rate’ towards which the system tends.
“This conventional view of the interest rate and the exchange rate explains why the system does not automatically generate full employment, since its volatility is unable to compensate for the fluctuations in investment.
“Such a view is tantamount to the recognition that private investment is an extremely volatile factor, related as it is to expectations of future profits. That is why it is subject to surprising fluctuations having nothing to do with the level attained by the interest rate. In such a context, monetary policy, to be effective, would have to resort to very substantial changes in interest rates, to the point where these would have negative effects on the economy. This means that monetary policy alone is incapable of stabilizing the economy. This idea was dramatically borne out in the 1994-1999 period. According to the neoclassical doctrine of the neutrality of money, the economy can be stabilized through the flexibility of the prices and wages throughout the system if the money supply is held to a fixed rate of increase. The central bank economists tend to forget in their rigid fundamentalism, that monetary equilibrium can be reached at any level of employment. The doctrine of monetary neutrality tries forcing a complex capitalist system with a highly developed bank and financial sectors to behave like a simple monetary economy where money is simply another commodity, in which the flexibility of variables leads automatically in the longer term to full employment.
“Contrary to neoclassical doctrine, it is not true that floating exchange rates and perfectly flexible interest rates promote an efficient distribution of resources, and an optimal rate of capital accumulation and stable employment. The hidden variables are manipulated by our central bank, and a menu of other measures is used by the government to try stabilizing the economy.”
This careful analysis should finally lay the notion of the neutrality of monetary policy to rest.
“The cost of this adventure to Mexico was eventually $70 billion, when the peso finally collapsed, as the President finally revealed in February 1995.“The vicious circle of credit speculation had been made possible by the banking and monetary deregulation, especially the disappearance of the statutory reserves” (p. 352). (Our emphasis for the attention of Canadian readers.)
There is a further neglected area, vital to economic analysis, that the Vega book brings to the fore.
“The centralization of political decisions in the hands of the Mexican president seemed an advantage in the massive introduction of market reforms. [However] in the midst of so much goodwill and misplaced confidence in Mexico on world markets, Salinas overreached himself in political initiatives. He undertook key unacknowledged borrowing from the programs of the opposition – the rightist agenda of PAN and even some concern for human rights from the leftist PRD. This helped him to a resounding electoral victory in 1991. But [mistaking political strength for economic soundness] he ignored the vulnerability of the economy, and tried bringing inflation below its double-digit level. Salinas depended on the Free Trade Treaty to help him deal with the collapse of his economic and political positions.” And overnight his apparent strength turned to dust. “Jeffery Frieden of Harvard has documented the idea that the exchange rate of currencies is essentially a political variable. Frieden’s theory helps draw attention to the obscure ties between the fundamental economic variables and the political processes in which they are embedded. Salinas was intent on avoiding the short-term costs of a traumatic devaluation of the peso, since that would have cost him popularity amongst the middle and working classes.” The anti-inflation obsession of Salinas resulted in a 45% depreciation of the peso in 1994.
The Role of Social Institutions in Determining Economic Well-being.
In the light of this, Vega gives prominence the ideas of an American economic historian, Douglass North, Nobel Prize for Economics laureate in 1993. In his early work he used neoclassical tools and econometrics, but arrived at the realization that he had need of Marx’s analysis to reach an understanding of social institutions. That is particularly relevant in Canada. Our 1991 banks’ bailout, followed immediately by their further deregulation, wrecked the reigning Progressive-Conservative Party. And the surrender of most of our money creation to banks was continued with hardly a burp by the Liberals who succeeded them. Now the Liberals seem faced with a similar fate for the same reasons as the Conservatives before them. The broad social alliance that both the “Red” Conservatives and the Liberals espoused after World War II lies dismantled. When an important shift occurs in the distribution of the national income, the old distribution of political power amongst stakeholders becomes outdated. It is like the geological drift that converts seabed into mountain chains.
Canadians may wish to call this “the Brian Mulroney syndrome” since the surrender of money creation with attached interest was achieved under his reign. Mexicans would call the disastrous surrender of their financial system to their new stock market elite “the Salinas syndrome.” The British may end up talking of “the Thatcher Syndrome.”
While seeking secret “weapons of mass destruction” in Iraq, and itself aspiring to them in outer space, the Washington Consensus has sup- pressed the economic understanding dearly bought by the West in the 1930s. This increases the prospect of an eventual military clash with China that could wipe out humanity as we know it. The Globe and Mail (22/05, “China Feasts on Canada’s Re- sources” by John Heinzel) contains this significant passage: “In a bid to prevent the bubble from bursting, China’s central bank has raised reserve requirements for banks.”
Canada however, did away with such reserves in 1991 without debate or press release. That was the defining measure of the “Mulroney Syndrome.” The United States and the UK retain them but make little use of them as a matter of deep dogma. That gives China a crucial advantage over the West in any future armament race. And the disadvantage that imposes on the West can only encourage China to move aggressively to solve its own vast internal problems. No need to seek foreign spies for having deprived Western governments of the use of government credit for its survival needs. It was the drive to exponential growth of the financial sector that carried out that unqualifiable blow to the world’s security.
In its well-documented indictment of the Washington Consensus the Vega book is a powerful tool for society’s defence.
William Krehm
1. Krehm, William (1975). Price in a Mixed Economy – Our Record of Disaster. Toronto. Krehm, William (May 1970). “La stabilité des prix et le secteur public” in Revue Économique. Paris.
2. “In the neo-liberal excitement, the misgivings concerning the self-balancing market” of one of the great creators of marginal theory (A. Cournot) to another (L. Walras) were forgotten: “I shudder – Cournot wrote to Walras – when I note that your curves of intensive and extensive utility would lead to pure Laisser Faire, that is, in domestic economies to the deforestation of the globe, and in the international economy, to the suffocation of plebeian races by the privileged ones as per the theory of Mr. Darwin” (Vega Rodriguez, p. 167).
-- from Economic Reform, June 2004