Those Who Cannot Remember the Past are Condemned to Repeat It

I started this blog as I have always been intrigued by the culture of Latin American countries. It is a region I want to explore and learn more about. I had very little understanding of the history behind the region's economy and I wanted to change that. There were three main questions that I wanted to find answers to: "What happened, who had been affected and what can we learn from this?" Sometimes revisiting history can teach us valuable lessons. George Santayana, the famous Spanish-born American Author once said: "those who cannot remember the past are condemned to repeat it". I conducted my research with this quote in mind.

Analysing the Latin American Debt Crisis and the fall out that ensued in the years following highlighted two main things for me:

1. Contagion spreads like wildfire, once the first domino falls. In the case of the Latin American Debt Crisis, Mexico was this first domino that initially defaulted on their loans, and the domino effect ensued across the region.
2. The direct impact on the general public who are already suffering at the hands of high poverty rates is devastating.

In international macroeconomics, the “impossible trinity" describes a situation where countries cannot simultaneously maintain independent an open capital account, a fixed exchange rate, and monetary sovereignty. Many countries over the years, particularly but not exclusively Latin American countries, have opted to sacrifice monetary sovereignty in the name of a fixed exchange rate and economic stability, or so they hoped. The thinking behind this was that importing policies from countries with proven track records on inflation would lead to improved outcomes at home.

However, monetary sovereignty is actually very useful. Oftentimes the domestic circumstances of the countries doing the pegging do not line up perfectly with the domestic circumstances of the countries they are pegging themselves to, which inevitably leads to problems.

In the short video below professor Tim Kehoe of the University of Minnesota describes how above all else, the Latin American Debt Crisis should teach us that countries in the European Union need more disciplined fiscal policies.

      

  

Don't Cry for Argentina

In my last two blog posts, I looked at how the Latin American Debt Crisis paved the way for Mexico’s Tequila Crisis and the fallout that ensued. Today I’m focusing on Argentina, I’m going to give an overview of how their economy and the political stability of the country fared following the Latin American Debt Crisis.

The Latin American Debt crisis contributed to the collapse of authoritarian regimes in countries like Argentina. In 1983 democracy was restored in Argentina when Raúl Alfonsín became president. Austerity measures were introduced to try and stabilize the economy.  However, inflation spiraled out of control and confidence in the government’s plan collapsed. In late 1989 after more than a decade of economic stagnation and high inflation as well as a number of failed attempts to stabilize the economy, Argentina fell into hyperinflation and what was basically an economic collapse.  As hard as it is to believe by 1989 inflation had reached a shocking level of almost 5,000%.

As you can imagine 1989 was a catastrophic year for Argentina. Inflation was rising so fast that some supermarkets called out prices over the intercoms instead of constantly updating the price labels. The data from this time is quite outrageous with only 30,000 out of 30 million Argentines paying any income taxes. Chaos unfolded and society could not function as normal. Strikes and riots broke out across the country with rioters looting supermarkets.

   

Amid the anarchy, Alfonsín resigned 5 months before the end of his term. Carlos Menem then took office in July of 1989. He adopted a free-market approach that reduced the burden of government through deregulation and privatisation. Menem managed to end the period of hyperinflation by establishing a pegged exchange rate with the U.S. dollar.

Between 1990 and 1997 Argentina's economy grew by more than 6% a year, outperforming that of most other countries in Latin America. However, all was not to be well for Argentina at this time either. The country had a dramatic fall from grace. In 1999 Argentina was the poster child for “Washington Consensus” economists and policymakers. Yet within 3 years the country was in a severe economic depression. Argentina only managed to secure funding from the IMF after lengthy negotiations. By 1998 Argentina had entered a 4-year depression, which is now known as the “great depression”. During this period its economy shrank by 28%. It has been argued that Argentina’s experience poses as a perfect example of how inadequate economic policies converted an ordinary recession into a depression.

Delving Deeper into the Tequila Crisis

My last blog post examined the so-called “Mexican Miracle” and discussed the factors that led to the Mexican Peso Crisis of 1994. Today I’m going to look at what options the Mexican government had in December of 1994 and consider some of the crucial errors officials made in the aftermath of the crisis.

The Mexican government had no easy option. They knew that the exchange rate peg needed to be abandoned however, they were also aware that keeping the peso pegged at a fixed rate had been a cornerstone of the Mexican reform programme. The fact that such a large portion of Mexico’s foreign debt was denominated in dollars made things even more difficult. A lack of foreign exchange reserves almost certainly meant that the government would have to default on these debts. On December 21st of 1994, the Mexican government lost 4.6 billion dollars in central bank reserves as investors moved money to other countries. With foreign reserves now less than 6 billion dollars in total Mexico was days away from having to default on their dollar-denominated bonds. The president-elect Ernesto Zedillo asked the minister of finance for his recommendation. He said the only option was to float the peso.

An emergency meeting of the Pacto was set up. This called for business leaders, labour leaders, and government officials to meet up to find a way to ensure inflation did not take off with the decision to float the peso. In the words of Andrés Oppenheimer, “that is when the new Zedillo government began to make a string of blunders that- mixed with a dose of bad luck- turned a critical situation into a financial debacle”.

I think that the biggest mistake the Mexican government made is that they discussed the possibility of floating the peso, which would clearly result in a devaluation. The Pacto meeting that was called took place after business hours, at 8 pm at night. This signaled to investors that the government was in trouble. The urgent meeting was not kept private in any way, reporters were gathered outside of the building waiting for officials to arrive. Before the Pacto meeting even began, business leaders were withdrawing their peso deposits and moving them abroad.

The fact that the government did little to hide how bad their situation was made investors eager to dump their pesos. Zedillo initially announced a 15% devaluation of the peso. The day after the Pacto meeting there was 4 billion dollars of capital flight from the country and the stock market value plummeted. The Mexican government's reputation in financial markets took a hit and hence lost its access to foreign credit markets.

As you can see from the graph above the free-floating peso lost almost 50% of its value against the dollar over the months following the initial devaluation, wiping out the savings of most of Mexico's middle class. The Peso crisis of 1994 is considered to be one of the first international financial crises caused by capital flight.

What Led to the Tequila Crisis?

As I mentioned in previous blog posts there were a number of both external and domestic factors that led to the Latin American Debt Crisis of the 70s. These decades of economic mismanagement eventually reached rock bottom for Mexico in 1994, in the form of the Tequila Crisis. Despite what the name suggests this crisis has less to do with the popular drink and more to do with the sudden devaluation of the Peso. Mexico's currency crisis of 1994 has been commonly dubbed the Tequila Crisis.

Mexico underwent serious Economic Reform in the 80s and early 90s. The Mexican government opened up the economy to International competition, privatised most state-owned enterprises and generally regulated the private sector less. The government also pegged the peso to the U.S dollar to keep inflation expectations in check and reduce investor uncertainty about exchange rate fluctuations. They combined this with tight monetary and fiscal policies and an explicit agreement that was negotiated yearly to keep prices down, this agreement was called the Pacto.

The adoption of a low-interest rate regime and the magnitude of the reform attracted a huge influx of foreign speculative capital, mainly from U.S banks and investors. Investors were convinced that Mexico was THE country to invest in. The speculative rush was driven by its own momentum. As more investors jumped on the bandwagon the price of Mexican stocks climbed higher and higher making it even easier for Mexican companies and the Mexican government to borrow what seems to have been an endless stream of U.S dollars.

The financial press added fuel to the fire by labeling the country's debt-fuelled growth as "The Mexican Miracle". The consequences of this now seem quite predictable, with cheap capital flowing freely, the country's banks eased their lending standards dramatically. As history proves time and time again, if something seems too good to be true.... it usually is.

As with all easy-money fuelled booms the good times came to an end. By 1994 The Mexican Miracle bubble had well and truly burst due to a mixture of political and financial forces. On the first of January 1994, a group of rebels called the Zapatistas launched a revolution in the province of Chiapas and months later in March of 1994 a Mexican presidential candidate was assassinated. These tumultuous events caused concern among investors for the country's political stability.

Fears grew among the public that the government would devalue the Mexican Peso. This devaluation did not happen until Ernesto Zedillo Ponce de Leon took office in December of 1994. At this stage, expectations had grown so much that the public devalued the currency even further, through their own actions. The era that was originally crowned the Mexican Miracle, ended up being a catastrophe for the country. The tequila crisis of 1994 shocked analysts, politicians and economists. Most people could not understand how a country praised as an example of economic strength could collapse so quickly.

Who Had the Most to Lose?

It is no secret that Latin American countries have a turbulent history of economic booms and busts, accompanied by international lending. There have been numerous instances of defaults on these debts. However, no crisis was as widespread and severe as the debt crisis of the 1980s.

The Latin American Debt Crisis spread to virtually all corners of the region having a detrimental effect on many countries. The crisis also had a huge effect on countries beyond the Latin American region. At one point the crisis became so serious that it nearly brought down some of Wall Street’s biggest banks.

As ridiculous as it sounds, most banks had no idea what they were making all of these loans for.

In his 1985 book "Debt Shock" Darrell Delamaide states that approximately 60% of the loans made by U.S banks in the 70s were categorized by “general” or “purpose unknown” or “refinancing”. The threat of an outright default by Latin American debtors had serious implications for these banks. As a result, public concern for the structural soundness and solvency of the international banking system was obviously raised.

Following the debt crisis, many of the major debtor countries adopted stronger measures for structural adjustment in their economies and banks have also strengthened their capital base and boosted their reserves against losses on loans to developing countries.

Domestic Factors at Play

In my last post, I described what I deemed to be the main external factors that led to the Latin American Debt Crisis. However, some Latin American countries were hit a lot harder by the debt crisis than others. This indicates that there were a number of domestic factors at play.

The fact that Latin American countries were receiving extortionate international loans allowed governments to increase spending without having to raise taxes. Thus enabling governments to embark on spending programmes that relied on a never-ending supply of loans. It now seems painstakingly obvious that this was completely unsustainable. When funding started to run out in the early 1980s governments were unable to raise taxes or cut spending fast enough to cover the difference.

Another important factor behind the debt crisis is the fact that a lot of countries in the Latin American region including Mexico embraced import substitution and did so at the expense of their export sectors. Most subsidies like tax credits or low-interest loans went to manufacturers producing for the home market. Currencies were allowed to become artificially overvalued relative to the dollar. This encouraged the import of key raw materials and capital goods, simultaneously hurting the productivity of export sectors.

When countries could no longer pay off old loans with new ones, they needed to find a way to raise the dollars necessary to repay the dollar-denominated loans they had taken out. The obvious way to do this would be to increase exports. However, the export sector had been left extremely disadvantaged making this a very difficult task.

Over the coming weeks, I will be looking at the consequences the debt crisis had on Mexico and Argentina. Focusing further on country-specific factors that may have fuelled subsequent currency crises in each country.

Finding The Lost Decade

The Latin American Debt Crisis is often referred to as the 'Lost Decade' or for those of you who are linguistically talented 'Crisis de la deuda Latinoamericana'. In the 1980's Latin American countries were in a position where their foreign debt exceeded their earning power so much so that they were unable to repay their foreign debt. This resulted in the Latin American Debt Crisis which has been described as the most traumatic economic event in Latin America’s economic history.

Before there can be a debt crisis, there must be an accumulation of debt.To fund industrialisation throughout the 1970s Latin American countries, mainly Mexico, Argentina and Brazil borrowed heavily from international creditors. Pre 1970s, there was not much international lending to Latin America as most countries in the region had defaulted on their debt back in the 1930s. However, there are 3 changes that I consider to be the main catalysts in fuelling the expansion of debt during the 1970s:

1. Increasing oil prices led Middle Eastern countries to deposit new revenue in European banks, leading to a dramatic expansion in the eurodollar market.
2. The innovation of loan syndication allowed banks to spread lending risk across many financial institutions. This meant banks were less worried about lending money to Latin American countries.
3. Banks began using floating rate loans where the interest rate on loans depended on market conditions in rich countries. This reduced the risk that banks would have to pay depositors higher rates than they were receiving on their loan portfolio.

You may be wondering what changed to turn this debt accumulation into a debt crisis?  Well, circumstances took a turn as the world economy went into depression. Oil prices rose immensely by almost 300%. Most Latin American countries were importers of oil, so they had to bear this huge increase in import costs. After the economy slowed down their currencies depreciated, the amount that had to be repaid was increasing as their currency depreciated. International lenders of money began raising their interest rates in an attempt to bring down inflation. This caused an entire economic stagnation in Latin American countries as 65% of government debt in the region was tied to LIBOR, meaning their debt burden increased as interest rates increased.

In 1982 Mexico announced that it was unable to repay its financial debt in time. The video below shows how this announcement posed a large threat to the financial system. After Mexico's announcement, dozens of other countries followed suit. Mexico, Argentina, and Brazil together were about $200 billion in debt. The IMF agreed to lend money to Latin American countries in an attempt to help them to recover from this debt crisis. However, the loans were given on the conditions of privatisation and the removal of trade barriers.

                                                                

I am extremely interested in exploring this financial crisis further as it is an area that I have never covered in my studies to date. I want to learn more about the consequences of this crisis for the U.S and Latin American countries. I also want to uncover what we can learn from this crisis today. If you have an interest in exploring this financial crisis with me feel free to give my blog a follow.