Random Walk... Found Items - April 9, 2006

Mexican Peso Bills from 1969 and 1988

Can the U.S.A. have a "Peso Problem"?

One Peso: 1969

10 Pesos = US$1.00
My family lived in Guadalajara, Mexico in the late 1960s.  Above is one of several bank notes I saved from that time.  A peso was then worth about US$0.10.  The Mexican Peso had been a stable currency for over a century and a half, so much so that it was used as a currency by other nations, including China, much as the American dollar is today.  In fact, the Mexican Peso was the basis for the U.S. dollar.

After a decree adopted by the United States on 6 July 1785, the peso became the official currency of most of North America; it also became the foundation for the U.S. monetary system, at a rate of one peso to one dollar. The US dollar was not issued until 2 April 1792, but the peso continued to be officially recognized and used until 21 February 1857. In Canada, it remained a legal medium of payment until 1858.

Throughout most of the 20th century, the Mexican peso remained one of the most stable currencies in Latin America, since the economy did not experience periods of hyperinflation common to other countries in the region.

WikiPedia: Mexican Peso

20,000 Pesos: 1988

20,000 Pesos = US$10.00
I returned to Mexico with my soon-to-be wife in 1988 to show her around.  Here's a 20,000 peso note like ones we were using on our trip at the time to buy a couple of sandwiches and a beer.  A long term trend in the stable value of the Mexican Peso had come to an unseemly end.  What happened?
Although the Mexican economy maintained its rapid growth during most of the 1970s, it was progressively undermined by fiscal mismanagement and a resulting sharp deterioration of the investment climate.  The GDP grew more than 6 percent annually during the administration of President Luis Echeverría Álvarez (1970-76), and at about a 6 percent rate during that of his successor, José López Portillo y Pacheco (1976-82).  But economic activity fluctuated wildly during the decade, with spurts of rapid growth followed by sharp depressions in 1976 and 1982.

Fiscal profligacy combined with the 1973 oil shock to exacerbate inflation and upset the balance of payments...  The balance of payments disequilibrium became unmanageable as capital flight intensified, forcing the government in 1976 to devalue the peso by 45 percent.  The action ended Mexico's twenty-year fixed exchange rate.

Although significant oil discoveries in 1976 allowed a temporary recovery, the windfall from petroleum sales also allowed continuation of Echeverría's destructive fiscal policies.  In the mid-1970s, Mexico went from being a net importer of oil and petroleum products to a significant exporter. Oil and petrochemicals became the economy's most dynamic growth sector.  Rising oil income allowed the government to continue its expansionary fiscal policy, partially financed by higher foreign borrowing.  Between 1978 and 1981, the economy grew more than 8 percent annually, as the government spent heavily on energy, transportation, and basic industries. Manufacturing output expanded modestly during these years, growing by 9 percent in 1978, 9 percent in 1979, and 6 percent in 1980.

This renewed growth rested on shaky foundations. Mexico's external indebtedness mounted, and the peso became increasingly overvalued, hurting nonoil exports in the late 1970s and forcing a second peso devaluation in 1980.  Production of basic food crops stagnated, forcing Mexico in the early 1980s to become a net importer of foodstuffs.  The portion of import categories subject to controls rose from 20 percent of the total in 1977 to 24 percent in 1979.  The government raised tariffs concurrently to shield domestic producers from foreign competition, further hampering the modernization and competitiveness of Mexican industry.

The macroeconomic policies of the 1970s left Mexico's economy highly vulnerable to external conditions.  These turned sharply against Mexico in the early 1980s, and caused the worst recession since the 1930s.  By mid-1981, Mexico was beset by falling oil prices, higher world interest rates, rising inflation, a chronically overvalued peso, and a deteriorating balance of payments that spurred massive capital flight.  This disequilibrium, along with the virtual disappearance of Mexico's international reserves--by the end of 1982 they were insufficient to cover three weeks' imports--forced the government to devalue the peso three times during 1982. The devaluation further fueled inflation and prevented short-term recovery.  The devaluations depressed real wages and increased the private sector's burden in servicing its dollar-denominated debt.  Interest payments on long-term debt alone were equal to 28 percent of export revenue.  Cut off from additional credit, the government declared an involuntary moratorium on debt payments in August 1982, and the following month it announced the nationalization of Mexico's private banking system.

Country Data.com

A sad turn of events for a great currency, with a moral for those of us in the U.S. who understand that Oh yes, it can happen here

Let's fast forward to 2013 and imagine a possible future Country Data.com report on the U.S. dollar.

Although the U.S. economy maintained its rapid growth during most of the 1990s and 2000s, it was progressively undermined by fiscal mismanagement and a resulting sharp deterioration of the investment climate. The GDP grew about 4 percent annually during the administrations of President Bill Clinton (1993-2001) and during that of his successor, President George W. Bush (2001-2009), except for a brief recession following the collapse of the stock market bubble in 2000.  But asset prices fluctuated wildly during the decade, with booms and busts in the stock, bond and real estate markets.

Fiscal profligacy combined with the 2008 oil shock exacerbated inflation and upset the balance of payments. The balance of payments disequilibrium became unmanageable as capital flight intensified, forcing the government in 2008 to devalue the dollar by 30 percent. 

Although a bubble in bond and real estate prices from 2001 to 2006 allowed a temporary recovery, the windfall from sales of financial assets to foreign central banks also allowed continuation of the Bush administration's destructive fiscal policies. In the mid-1980s, the U.S. went from being a net exporter of goods and to a significant importer. Sales of financial assets became the economy's most dynamic growth sector.
Net foreign purchases of U.S. financial assets grew from 50% of issuance in 1996 to nearly 80% in 2005. Rising foreign borrowing allowed the government to continue its expansionary fiscal policy. Between 2001 and 2006, the economy grew more than 4 percent annually, as the government spent heavily on the military and the real estate and financial sectors provided more than 50% of private sector employment.   

This renewed growth rested on shaky foundations. The United States' external indebtedness mounted, and the dollar became increasingly overvalued, hurting exports in the late 2000s and forcing a second dollar devaluation in 2010. 
The action effectively ended the U.S. dollar's status as a reserve currency.  The portion of import categories subject to controls rose from 10 percent of the total in 2008 to 24 percent in 2010. The government raised tariffs concurrently to shield domestic producers from foreign competition, further hampering the modernization and competitiveness of U.S. industry. As unemployment rose to more than 20%, government policies to limit immigration fueled further increases in wage rates and inflation.

The macroeconomic policies of the 2000s left the U.S. economy highly vulnerable to external conditions. These turned sharply against the U.S. in the late 2000s, and caused the worst recession since the 1930s. By mid-2010, the U.S. was beset by rising oil prices, higher world interest rates, rising inflation, a chronically overvalued dollar, and a deteriorating balance of payments that spurred massive capital flight. This disequilibrium, along with the virtual disappearance of the U.S. international reserves--by the end of 2010 they were insufficient to cover three weeks' imports--forced the government to devalue the dollar three times during 2012. The devaluation further fueled inflation and prevented short-term recovery. The devaluations depressed real wages and increased the private sector's burden in servicing its dollar-denominated debt. Interest payments on long-term debt alone were equal to 28 percent of export revenue. Cut off from additional credit, the government declared an involuntary moratorium on debt payments in August 2013, and the following month it announced the nationalization of the U.S. private banking system.
One Peso: 2006

10 Peso = US$1.00
Returning to the present, there is a happy ending for the Mexican Peso.  In the 1990s, new political regimes returned the peso to its former glory, at least for now.

A government economic strategy called the "Stability and Economic Growth Pact" (Pacto de estabilidad y crecimiento económico, PECE) was adopted under President Carlos Salinas. On 1 January 1993, the Bank of Mexico introduced a new currency, the nuevo peso ("new peso", or MXN), written "N$" followed by the numerical amount. One new peso, or N$1.00, was equal to 1,000 of the obsolete MXP pesos.

On 1 January 1996, the modifier nuevo was dropped from the name and new coins and banknotes – identical in every respect to the 1993 issue, with the exception of the now absent word "nuevo" – were put into circulation. The ISO 4217 code, however, remained unchanged as MXN.

Nowadays, due to the stability of the Mexican economy, and the growth in foreign investment, the Mexican peso is among the 15 most traded currency units in the world, and the most traded in Latin America. It has been fairly stable for the last few years; since the late 1990s the peso has traded at about 10 to 1 to the U.S. dollar, and is currently about $10.85 per dollar. This makes it relatively easy to convert from dollars to pesos and back; the 50¢ coin (tostón) is worth about the same as a U.S. nickel, and a 200 peso note about USD $20.

WikiPedia: Mexican Peso

Moral #1: A nation can go through a severe inflation and come out ahead.  Inflations are bad, yes.  End of the world, no.  A major inflation is a severe economic error but by no means a fatal error.  Under severe circumstances, inflation can even be an optimal policy choice.  The benefit: foreign and internal debts are erased; the nation starts again with a clean slate.  The tarnished image does not last long.  Markets tend toward nearly pathological forgiveness because market participants focus not on the money that was lost in the past -- that's gone -- but on the money to be made in the future.

Moral #2: In the past 70 years or so since the world monetary system went off the gold standard, inflation has been the policy option of choice for governments of nations with a significant balance of payments disequilibrium; when an external shock causes the disequilibrium to assert itself as a unmanageable demand by creditors to pay, the government is faced with the choice between high inflation and high unemployment.  Invariably, governments chose the former over the latter.  The U.S. did so after the collapse of the stock market bubble in 2000, creating asset inflation in bonds and real estate that generated employment in the financial services and housing industries.  The Bernanke Fed has broadcast loud and clear its intention to provide ample liquidity once the current asset bubbles collapse as a result of continued rate hikes aimed at an inflation target of 2% to 3%, while inflation is today between 6% and 7%.  I believe that the path of collapse is likely to be chaotic and the results of the subsequent reflation program via the promised liquidity injection will be unpredictable and undesirable to holders of dollar denominated assets. 

Moral #3:  During the inflationary period in Mexico, if you lived there at the time it was a good idea to have your assets in U.S. dollars or a bunch of the above. 
As interest rates rise in countries that are major lenders to the U.S., especially Japan and the UK, the American dollar may experience a "peso problem."  Without co-dependent support from China, Japan and the UK, the dollar will begin to truly "float" against the yuan RMB, the yen and British Pound.  If U.S. dollar depreciates in the manner of the once stable Mexican Peso, then what currency should one hold during such a dollar depreciation?  Mexicans in the 1970s could store their wealth in American dollars to ride out the peso inflation.  But what currency can North Americans rely on to ride out a dollar inflation?

* Peso Problem: "No one knows the precise origin of the term peso problem, but it is often attributed to Nobel laureate Milton Friedman in comments he made about the Mexican peso market of the early 1970s.  At that time, the exchange rate between the U.S. dollar and Mexican peso was fixed, as it had been since 1954.  At the same time, the interest rate on Mexican bank deposits exceeded the interest rate on comparable U.S. bank deposits.  This situation might seem like a flaw in the financial markets, since investors could borrow at the low interest rate in the United States, convert dollars into pesos, deposit the money in Mexico and earn a higher interest rate, then convert the proceeds back into dollars at the same exchange rate and pay off their borrowings, making a tidy profit.  Friedman noted that the interest rate differential between Mexico and the United States must have reflected financial market concerns that the peso would be devalued.  Otherwise, the interest-rate differential would soon disappear as investors increasingly took advantage of it.  In August 1976, those concerns were justified when the peso was allowed to float against the dollar and its value fell 46 percent."  -- FEDERAL RESERVE BANK OF PHILADELPHIA BUSINESS REVIEW SEPTEMBER/OCTOBER 2000: Understanding Asset Values: Stock Prices, Exchange Rates, And the "Peso Problem" (PDF)


Sources:

Previous Random Walk... Found Items
March 6, 2006: Distribution of Income Gains by Income Bracket
March 22, 2006: CATO Conference on
Monetary Institutions and Economic Development

March 25, 2006: Net Foreign Acqusition U.S. Financial Assets
March 29, 2006: Gold, DJIA and Inflation (Two periods compared - 1974 to 1984 and 2001 to 2006)
April 5, 2006: S&P vs Interest Rates - 1860 to 2020


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