16 - International Bailouts and Moral Hazard

Summary

In 1995, the treasury led an IMF bailout of foreign investors in Mexico. The bailout set off a chain of destabilizing events. The amount of money potentially made available to prevent default by Mexico on dollar-denominated debt made banks willing to hold large amounts of short-term debt in U.S. allies. That debt made possible the Asia crisis. Banks made what looked like sure one-way bets in lending to Asian banks and then abandoned them en masse when currency devaluations caused insolvencies large enough to threaten the international safety net. The FOMC responded to the Asia crisis with expansionary monetary policy, which exacerbated an unsustainable rise in asset prices. The fall of lofty equity valuations created the 2000 recession.

The Mexico Bailout

By late 1994, the Mexican peso had become overvalued due to an unwillingness of the Mexican government to allow the exchange rate to depreciate sufficiently to compensate for domestic inflation. From 1990Q1 through 1994Q3, the Mexican CPI doubled. Over this same period, the U.S. price level rose by 18% and the peso price of the dollar rose by 30%. The combined rise of these last two variables, 48%, offset just less than half of the rise in the Mexican price level. By the end of 1994, U.S. goods looked 50% cheaper to Mexicans than they did at the beginning of the 1990s. Mexicans responded to the relative cheapening of U.S. goods by going on a shopping spree in the United States.

How did Mexico maintain an overvalued exchange rate?