Critique of Central Banking

By
Henry C K Liu

Part III-d: The Lesson of the US Experience

Part 4a: The Asian experience

Since the beginning of the new millennium, the world's three leading economies, the United States, the European Union and Japan, have experienced a rare synchronous slowdown while much of the developing world, including Asia, remained mired in economic and financial difficulties that started in Asia in 1997.

This development has rendered inoperative the strategy of having the global economic engine stabilized by sequential boosts from the synchronized phasing of domestic business cycles in connected yet independent economies, like the well-timed sequential firing of a multi-cylinder internal combustion engine. The current global economic stagnation is not an accidental breakdown. It is the visible result of the coordinated operation of global central banking, burning out the economic spark plugs with super-rich gas in the form of universal and reflexive tight monetary measures, which have produced overlapping long-term imbalances in the global economy's major regional dynamos.

The decade-long post-bubble deflation in Japan was linked to financial globalization that challenged the efficacy of the traditional Japanese financial system. The Tokyo Big Bang (financial deregulation) on April 1, 1998, crowned with a Central Bank Law on the same day, was designed to boost the value of the Japanese stock market, aiming to re-establish Tokyo's position as one of the top three global financial centers. Once the largest stock market in the world, Tokyo by 1998 had fallen steadily to less than half the size of New York in contrast with the latter's astronomical expansion. Although the Japanese had savings of about US$9 trillion in 1998, a third of the world total, most savings were held in low-interest bank and postal accounts on which the Japanese government traditionally relied for low-cost capital to fund its national economic plans. The population was aging rapidly and the government was worried there would not be enough money in the economy to support future pensioners because of the low return on savings.

Neo-liberal market fundamentalists pushed through a series of radical reforms designed to change the way money traditionally flowed around the Japanese economy, recycling more savings into the stock market to boost yield. The government hoped to bring Tokyo back in line with the high trading levels of London and New York, pulling the value of the recycled savings up with it by increasing their rate of return. The reforms were called the Big Bang after a similar exercise in Britain 12 years earlier on October 27, 1986, which in turn was inspired by May Day in the US in 1975, which ended fixed minimum brokerage commissions that marked the beginning of diversification into electronic trading.

Instead of bringing new prosperity and high returns to fund exploding pension obligations, the Tokyo Big Bang reduced Japanese banks, which earlier had been operating with spectacular success in a national banking regime in support of Japanese industrial policy, to near-terminal cases in a global central banking environment. Subsidized policy loans that had served postwar national purposes for half a century suddenly became non-performing loans (NPLs) as defined by new international standards set by the Bank of International Settlement (BIS), as corporate borrowers were forced by dollar hegemony to sacrifice profit margin to expand market share, while financial deregulation put downward pressure on the traditional norm of high price-earning ratios of Japanese equity. The banks' traditional holding of significant equity position in their corporate borrowers and the tradition of a controlled domestic market caused structural problems for the Japanese financial system in the new globalized competitive environment. The banks were squeezed by falling cash flow from loan service payments by their distressed debtors and by the falling market value of loan collateral and capital held in the shares of their borrowers.

The Tokyo stock market's key Nikkei index tumbled from an all-time high of 21,552.81 recorded on June 13, 1994, to below the psychologically crucial 15,000 level in July 1995 when the yen's sharp appreciation hit manufacturers and exporters. The Nikkei is now around 8,500 and Japanese officials would kill to get it back to 15,000, but it seems to be an impossible dream because global central banking has forced deregulated markets to discount the market value of the Japanese system that had worked so miraculously for the previous half-century. The government tried to solve the problem with Keynesian deficit financing, only to be hit with international credit-rating downgrades on government bonds, despite the fact that Japan remains the world's biggest credit nation.

Concurrently in Europe, persistently high levels of unemployment and anemic growth plagued the euro zone, whose European Central Bank (ECB) came into being on June 1, 1998, two months after Japan's. And in the United States, by the beginning of 2000, a steady collapse of the debt bubble began, generated by unsustainably high consumer, business and external debt levels that had been first engineered by the Federal Reserve (Fed) through regulatory indulgence and then later deflated through sharp rises in interest rates.

Since then, the global economic engine has been stalled in all three cylinders by the efforts of the world's three dominant central banks to impose on the global economy destructively inoperative monetary policies.

After allowing regulatory indulgence on the part of the US Security and Exchange Commission (SEC) to feed a historic bubble in US asset prices inflated by accounting fantasies, fraudulent analyses, and financial manipulation, the Fed, reversing its loose monetary policy since 1997, conducted a pre-election monetary tightening, repeatedly raising interest rates in quick succession during the second half of 1999 and the first half of 2000 to slow down the real economy. The Fed also spurred the ECB to follow suit, despite already slow growth and high unemployment in EU member economies.

The Fed had discovered that for the United States, domestic consumer price stability in an expanding economy could be achieved through a strong-currency policy that would generate a capital account surplus to finance a current-account deficit that produced a low inflation reading through low-cost imports, as long as key commodities, such as oil, were denominated in US currency. For a whole decade, wealth has been created primarily through financial acrobatics, not real economic expansion either within the US or around the world. Conspicuous consumption along chic shopping boulevards, cruised by gas-guzzling sport-utility vehicles, to fill homes that rose in price by 60 percent annually, supported by the wealth effect of a stock-market bubble that made office clerical workers millionaires, buoyant by a trade regime that enabled a massive transfer of wealth from the poor to the super rich, is mistaken for economic growth. Fed chairman Alan Greenspan proudly called this US financial hegemony and told Congress that the financial crises that hit Asia in 1997 would have "salutary" effect on the US economy.

During the past decade, central banks worldwide have achieved unprecedented heights of policy dominance through their function as chief guardians of strong national currencies in globalized, unregulated financial markets. Simultaneously, monetary authorities the world over have been promoting the doctrine of central-bank independence from duly constituted national governments and their national economic policies, as if populist government and people-oriented policies are financial evils that must be resisted. Poverty and unemployment are hailed as the foundation of sound money that should not be jeopardized by political pressure. This elitist doctrine is fundamentally incompatible with a political world order of independent nation states and the principle of consent of the governed. Any nation that forfeits its monetary prerogative also forfeits its political independence.

The ECB's institutional structure represents the ultimate real-world application of this doctrine on a regional scale. In the name of central-bank autonomy, the Maastricht Treaty explicitly prohibits the ECB from seeking or taking instruction from constituent national governments, or European Community institutions such as the European Parliament, or "any other body", and bars constituent national governments from attempting to influence the decisions of the ECB. Critics have pointed out that those same rules place no reciprocal restrictions on the ECB's policy advocacy. ECB president Wim Duisenberg has unreservedly pushed euro zone economies to refashion their labor, product, services, capital and credit markets along neo-liberal market-fundamentalist lines, even in economies under social democratic governments. This has contributed to the EU's slow growth and high unemployment. Germany, the dominant economy in the EU, has persistently suffered high unemployment, which hit 9.7 percent in November, rising above the politically sensitive 4 million level; in eastern Germany, the unemployment rate was 17.6 percent.

Article 105 of the Maastricht Treaty states clearly: "The primary objective of the European System of Central Banks shall be to maintain price stability." The wording of the Maastricht Treaty was not so much influenced by economic insights as it was written in a very specific political context: to persuade an inflation-averse Germany to exchange the deutschmark for the euro, by guaranteeing the stability of the new currency. This explains the focus on price stability and the fact that other objectives were mentioned separately and secondarily. The statutes of other central banks, such as the Fed, can be changed by action of a single legislature. The ECB would require all 15 member states and their parliaments to change the treaty that defines the structure and institutional mandate of the ECB. This makes the ECB one of the most independent central banks in the world. The treaty did not define "price stability", leaving a vacuum quickly filled by the new and independent ECB by defining price stability as "an inflation rate that does not exceed 2 percent over the medium term", a very tight definition by any standard. Interest-rate policy alone is an inadequate tool because a single instrument cannot hit multiple targets. Furthermore, using interest rates to control asset markets risks inflicting significant collateral damage on the rest of the economy, which was exactly what happened in the past few years.

The BIS harbors latent ambitions to turn itself into a de facto World Central Bank (WCB) with the ECB as a model, while the argument for the need for a WCB is floated around in the upper reaches of internationalist monetary circles.

Asia is home to 58 percent of the world's 6.25 billion people, with 43 percent of Asians living in East Asia and 37 percent in China alone. According to US Central Intelligence Agency (CIA) data, the US economy accounts for 21 percent of gross world product (GWP - $47 trillion in 2001), the EU accounts for 20 percent and Japan accounts for 7.3 percent. The three leading economies together account for $22 trillion - 47.3 percent of GWP.

China, the second-largest economy in the world based on purchasing power parity (PPP; 12 percent of GWP), and seventh on a nominal basis ($1.3 trillion in 2001, 2.8 percent of GWP) is an exception to global trends of slow growth, continuing its rapid annual growth, officially announced as 7.3 percent in 2001 and 8 percent in 2002. Yet lest we should get carried away by statistics, the Chinese per capita gross domestic product (GDP) of about $900 in 2001 remains solidly in the less-developed-countries (LDC) category, way below Japan's $32,500. Of the 129 countries covered by the World Development Report, China ranked 76th in per capita GDP on a nominal basis and 68th on a PPP basis, a modest climb. China's economic strength rests purely on its size. China also adopted a Central Bank Law in 1995 and gave the People's Bank of China central-bank status, but the Chinese economy has remained a growth economy mostly because its currency is not freely convertible and its financial market is not open, and its central bank not fully independent.

There is increasing evidence that the crisis in the Japanese banking system is not the cause but merely the symptom of that nation's economic malaise. This malaise can largely be traced to the Japanese economy's over-dependence on export for dollars, which in turn has resulted from the disadvantaged structural financial position Japan has allowed itself to fall into in the global financial system. BIS regulations, which force traditional Japanese national banking in support of a strong economy to shift toward central banking in support of a strong national currency, are a big part of that structural disadvantage. This is the reason Japan has been resistant to US demands for bank reform. The NPL problem in Japanese banks traces directly to BIS regulations. This is also true for all of Asia, particularly South Korea, and increasingly China. No doubt Japan needs to reform its banking system, but it is highly debatable that the reform needs to go along the line proposed by US neo-liberals, or that bank reform alone will lift the Japanese economy out of its decade-long doldrums (see The BIS vs national banks, May 14, 2002).

All these problems contributed to and in turn were magnified by structural flaws and disorders in the international financial architecture and global trade, notably misaligned currency values and interest rate disparities. This has led to escalating mismatches between productive capacity and effective demand, which has been exacerbated by a "free trade" regime that has degenerated into a mad scramble for dollars that the United States can print at will. The whole world lives on an over-reliance on export to a US consumer market fueled by debt sustained by dollar hegemony. The ABC of the global economy is now expressed as America prints dollars to Buy the world's products on Credit provided by the world's producers. The US is exempt from a day of reckoning, since the US only has to print more dollars, as Fed Board member Ben Bernanke pronounced recently. Foreign creditors will only devalue their massive dollar holdings if they try to collect from the US economy. It is the ultimate demonstration of debtor power, with the debtor holding the power to print currency in which the debt is denominated. Asia, because of its largest population of low-wage workers, is holding the shortest end of the biggest global trade stick.

The Asian financial crisis that began in 1997 had its genesis in Mexico, incubated by a decade of globalization of financial markets. The currency crisis that started in Mexico in 1982, in Britain in 1992, again in Mexico in 1994, in Asia in 1997, spreading to Russia and Latin America since and finally hitting both the EU and the US in 2000, and the deeper structural financial challenges facing the entire global economy, have been the inevitable result of the Fed, the ECB and the Bank of Japan applying their unified institutional mandates of domestic price stability through domestic interest-rate policies that have destabilized the post-Bretton Woods international finance architecture.

The Mexican financial crisis of 1982 set the pattern for subsequent financial crises around the world. To recycle petrodollars beginning in 1973, US banks had sought out select LDCs, such as Brazil, Mexico, Argentina, South Korea, Taiwan, the Philippines, Indonesia, etc, for predatory lending. By 1980, LDCs had accumulated $400 billion in foreign debt, more than their combined GDP. In 1982, impacted by the Fed under Paul Volcker raising dollar interest rates sharply in 1979 to fight inflation in the United States, Mexico was put in a position of not being able to meet its obligations to service $80 billion in dollar-denominated short-term debt obligations to foreign, mostly US, banks out of a GDP of $106 billion. Debt service payments reached 62.8 percent of export value in 1979. Exports accounted for 12 percent of GDP while government expenditures accounted for 11 percent, which included public-education expenditure of 5.2 percent. Mexico was paying more in interest to foreign banks than it did to educate its young. Mexican foreign reserves had fallen to less than $200 million and capital was leaving the country at the rate of $100 million a day. Against this background, neo-liberal economists were claiming that poverty was being eradicated in Mexico by "free" trade, a claim they made the world over.

A Mexican default would have threatened the survival of the largest commercial banks in the United States, namely Citibank, Chase, Chemical, Bank of America, Bankers Trust, Manufacturer Hanover, etc. To negotiate new loans for Mexico, all creditors would have to agree and participate, so that the new loans would not just go pay off some holdout creditors at the expense of the others. Many other creditor banks were smaller US regional banks that had only limited exposure to Mexico, and they did not want to "throw good money after bad" merely to bail out the major money center banks. The big banks had to lobby the Fed to step in as crisis manager to keep the smaller banks in line for the good of the system, notwithstanding that the crisis had been caused largely by the Fed's failure to impose prudent limits on the money center banks' frenzied lending to the Third World in the previous decade and Volcker's sudden high-interest-rate shock treatment in 1979, instead of traditional Fed gradualism that would have given the banks time to adjust their loan portfolios. Third World economies were falling likes flies from the weight of debts that suddenly became prohibitive to service, not much different from private businesses in the United States, except that countries could not go bankrupt to wipe out debt the way private business could in the US. Volcker's triumph over domestic inflation was bought with the destabilization of the international financial system, whose banks had acted like loan sharks in the Third World with Fed approval. The International Monetary Fund then came in to take over the impaired bank loans with austerity "conditionalities" forced on the debtor economies, while the foreign banks went home whole with the IMF new money.

As a result, Third World economies, including those in Asia, fell into a debt spiral, having to borrow new money from the IMF to service the old debts, being forced by new loan "conditionalities" to forgo any hope of future prosperity. Living standards kept declining while foreign debts kept piling higher, leading to even higher unemployment and more bankruptcies.

US banks, while continuing to advocate free markets and financial deregulation, were at the same time falling into total dependence on government bailouts, both domestically and internationally. US taxpayers were footing the bill the Fed incurred in bailing out its constituent banks, through higher government budget deficits, which contributed to higher inflation, which led to higher interest rates, which in turn intensified the Third World debt spiral, in one huge vicious circle.

By the late 1980s, Mexico had temporarily resolved its debt crisis, though not its debt spiral, and was able to resume a Ponzi-scheme economic growth, relying to a great extent on rising foreign investment. To attract more foreign capital, the Mexican government, coached by neo-liberal market-fundamentalist economists, undertook major economic reforms in the early 1990s designed to make its economy more open to foreign investment, more "efficient", and more "competitive", neo-liberal code words for disguised neo-imperialism. These reforms included privatizing state-owned enterprises, removing trade barriers that protected domestic producers, eliminating restrictions on foreign investment, and reducing inflation by tolerating higher unemployment and pushing down already low wages and limiting government spending on social programs by marketizing them. Most important, it suspended exchange control within a fixed-foreign-exchange-rate regime.

This was in essence a Washington Consensus solution and much copied all over Asia in the early 1990s. In effect, it was a suicidal policy masked by the giddy expansion typical of the early phase of a Ponzi scheme. The new foreign investment was used to provide spectacular returns on earlier foreign investment with the help of central-bank support of overvalued fixed exchange rates, while neo-liberal economists were falling over one another congratulating themselves on their brilliant theoretical insight and giving one another awards at insider dinners, while collecting fat consultant fees from banks and governments. Star academics at Harvard, Massachusetts Institute of Technology (MIT), Chicago and Stanford, multiple snake heads of the academic Medusa, as well as those in prestigious policy-analysis institutions with unabashed ideological preferences that served as waiting lounges for policy specialists of the loyal opposition, busily turned out star disciples from the Third World elite who, armed with awe-inspiring foreign certificates and diplomas, would return to their home countries to form influential policy-making establishments, particularly in central banks, to promote this scandalous game of snake-oil economics. Every year, sponsored by the IMF and the World Bank, central bankers gathered in Washington, housed in luxurious hotel suites served by fleets of limousines to reassure one another of their monetary magic, communicating through opaque press releases couched in cryptic jargon.

Mexico's devaluation of the peso in December 1994 precipitated another crisis in the country's financial institutions and markets that caused an abrupt collapse of a "booming" economy that had not benefited Mexico as much as foreign capital. Within Mexico, most of the benefit went to the elite comprador class at the expense of the general population, particularly the poor but even the middle class. International and domestic investors, reacting to falling confidence in the peso, sold Mexican equity and debt securities. Foreign-currency reserves at the Bank of Mexico, the nation's central bank, were insufficient to meet the massive demand of disillusioned investors seeking to convert pesos to dollars. In response to the crisis, the United States organized a financial rescue package of up to $50 billion in funds from the US, Canada, the IMF and the BIS. The multilateral rescue package was intended to enable Mexico to avoid defaulting on its debt obligations, and thereby overcome its short-term liquidity crisis, and to prevent the crisis from spreading to other emerging markets through contagion. It was not to help a Mexican economy hemorrhaging from a bankrupt monetary policy, one that allowed international investors to collect their phantom Ponzi peso profits in real dollars. The Mexican rescue package in 1995 created moral hazard on a global scale.

In the weekend before Mexico's pending default, the US government took the lead in developing a rescue package. The package put together by the Fed under Alan Greenspan and the Treasury under Robert Rubin, a former co-chairman of Goldman Sachs and a consummate bond trader, included short-term currency swaps from the Fed and the Exchange Stabilization Fund (ESF), a commitment from Mexico to an IMF-imposed economic austerity program for $4 billion in IMF loans, and a moratorium on Mexico's principal payments to foreign commercial banks, mostly US, with Fed regulatory forbearance on bank capital adjustments that affected bank profits. It also included $5 billion in additional commercial bank loans, additional liquidity support from central banks in Europe and Japan, and prepayment by the US to Mexico for $1 billion in oil, and a $1 billion line of credit from the US Department of Agriculture.

The ESF was established by Section 20 of the Gold Reserve Act of January 1934, with a $2-billion initial appropriation. Its resources has been subsequently augmented by special drawing rights (SDR) allocations by the IMF and through its income over the years from interest on short-term investments and loans, and net gains on foreign currencies. The ESF engages in monetary transactions in which one asset is exchanged for another, such as foreign currencies for dollars, and can also be used to provide direct loans and guarantees to other countries. ESF operations are under the control of the Secretary of the Treasury, subject to the approval of the president. ESF operations include providing resources for exchange-market intervention. The ESF has also been used to provide short-term swaps and guarantees to foreign countries needing financial assistance for short-term currency stabilization. The short-term nature of these transactions has been emphasized by amendments to the ESF statute requiring the president to notify Congress if a loan or credit guarantee is made to a country for more than six months in any 12-month period.

It was Bear Stearns chief economist Wayne Angell, a former Fed governor and advisor to then Senate majority leader Bob Dole, who first came up with the idea of using the ESF to prop up the collapsing Mexican peso. Bear Stearns had significant exposure to peso debts. Senator Robert Bennett, a freshman Republican from Utah, took Angell's proposal to Greenspan and Rubin, who both rejected the idea at first, shocked at the blatant circumvention of constitutional procedures that this strategy represented, which would invite certain reprisal from Congress. Congress had implicitly rejected a rescue package that January when the initial proposal of extending Mexico $40 billion in loan guarantees could not get enough favorable votes. The chairman of the Fed advised Bennett that the idea would only work if Congress's silence could be guaranteed. Bennett went to Dole and convinced him that the whole scam would work if the majority leader would simply block all efforts to bring this use of taxpayers' money to a vote. It would all happen by executive fiat. The next step was to persuade Dole and his counterpart in the House, Speaker Newt Gingrich. They consulted several state governors, notably then Texas governor George W Bush, who enthusiastically endorsed the idea of a bailout to subsidize the border region in his state. Greenspan, who historically opposed bailouts of the private sector for fear of incurring moral hazard, was clearly in a position to stop this one. Instead, he used his considerable power and influence to help the process along when key players balked.

The peso bailout would lead to a series of similar situations in which private investors got themselves into trouble, vindicating the moral-hazard principle that predicts such people will take undue risks in the presence of bailout guarantees. As Thailand, Indonesia, Malaysia, South Korea, and Russia stumbled into crisis, culminating in the collapse of hedge-fund giant Long-Term Capital Management (LTCM), which played key roles in precipitating the crisis to begin with, Greenspan moved to increase liquidity to support the distressed bond markets. At the helm of LTCM was yet another former member of the Fed board, ex-vice chairman David Mullins. Mullins was there to plead for help from his former colleagues. When New York Fed president William McDonough helped coordinate a bailout of LTCM at his offices, Greenspan defended McDonough before a congressional oversight committee. Reflecting on all the corporate welfare being doled out to prop up bad private-sector investments worldwide, Bill Clinton appointee Alice Rivlin, the able former congressional budget director, observed that "the Fed was in a sense acting as the central banker of the world". During Clinton's first term, Greenspan had handed the president a "pro-incumbent-type economy" and was rewarded with a seat next to the First Lady in Clinton's televised State of the Union address and a third-term appointment as Fed chairman. Crony capitalism was in full swing.

Short-term currency swaps are repurchase-type agreements through which currencies are exchanged. Mexico purchased dollars in exchange for pesos and simultaneously agreed to sell dollars against pesos three months hence. The US earned interest on its Mexican pesos at a specified rate.

Historically, the US and Mexican economies have always been closely integrated in a semi-colonial relationship. In 1994, the United States supplied 69 percent of Mexico's high-value-added imports and absorbed about 85 percent of its low-cost labor-intensive exports. US investors have provided a substantial share of foreign investment in Mexico and have established numerous manufacturing facilities there to take advantage of low wages and unregulated labor and environmental regimes. Also, the US has served as a large market for illegal Mexican immigrant labor in its underground economy and farm sector, which has grown to be a sizable foreign-currency earner for Mexico. Mexico has long been the third-largest trading partner of the United States, accounting for 10 percent of US exports and about 8 percent of US imports in 1994. The maquiladora assembly industry concentrated on the Mexican side of the US-Mexico border was hailed by neo-liberals as a model of successful free trade, instead of the sweatshop zone it actually was.

In 1994, under newly installed president Ernesto Zedillo, a Yale-educated economist, Mexico entered the North American Free Trade Agreement with the United States and Canada. NAFTA, conceived as a regional economic counterweight to the EU, further opened Mexico to foreign investment and bolstered investor interest on the hope that with NAFTA, Mexico's long-term prospects for stable economic development were likely to improve, at least for the benefit of foreign investors. NAFTA, as negotiated and signed in December 1992 by the administrations of Mexican president Carlos Salinas de Gortari and US president George Bush Sr, and as amended and implemented by the Salinas and Clinton administrations in 1993, did not offer Mexico any significant increase in access to the US market. Rather, Mexico was blackmailed into signing NAFTA to prevent Mexican businesses from being bankrupted wholesale by sudden waves of pending US protectionism.

Mexico was also advised by neo-liberals to adopt an exchange-rate system intended to protect foreign investors who could exchange their peso earnings for dollars at the Mexican central bank at an overvalued rate. In 1988, the nominal exchange rate of the peso had been fixed temporarily in relation to the US dollar. However, because the inflation rate in Mexico was greater than that in the United States, a peso nominal depreciation against the dollar was needed to keep the real exchange rate of the peso from increasing. With the nominal exchange rate of the peso fixed, the real exchange rate of the peso appreciated during this period. In 1989, this fixed-exchange-rate system was replaced by a "crawling peg" system, under which the peso-dollar exchange rate was adjusted daily to allow a slow rate of nominal depreciation of the peso to occur over time. In 1991, the crawling peg was replaced with a band within which the peso was allowed to fluctuate. The ceiling of the band was adjusted daily to permit some appreciation of the dollar (depreciation of the peso) to occur. The Mexican government used the exchange-rate system as an anchor for an unsustainable economic policy, ie, as a way to reduce inflation through shrinking the economy, to force a politically destabilizing fiscal policy, and thus to provide a comfortable climate for foreign investors, who managed to carry home the same dollars they brought in via a short circuit, while leaving only their peso holdings behind that the Mexican central banks had promised to guarantee as fully convertible at an over-valued fixed exchange rate despite predictable unsustainability.

Before 1994, Mexico's strategy of adopting sound monetary and austere fiscal policies appeared to be having its intended effects of making foreign capital feel secure while the Mexican economy was steadily being hollowed out. Inflation had been steadily reduced by the inflated peso, government social spending was down to reduce the budget deficit, and foreign capital investment was increasing. Moreover, unlike in the years before 1982, most foreign capital was flowing to Mexico's private sector that yielded higher returns rather than as low-interest loans to the Mexican government to finance budget deficits. Although Mexico was experiencing a very large current-account deficit, both in absolute terms and in relation to the size of its economy, neo-liberal policy makers did not consider it an immediate problem. They pointed to Mexico's large foreign-currency reserves, its rising exports, and its seemingly endless ability to attract and retain foreign investment. This attitude ignored the fact that true wealth was leaving Mexico through the turning of peso assets into dollar assets, masked by a Mexican stock-market bubble fueled by an over-valued peso.

Reality finally unmasked the faulty neo-liberal theory by late 1994. Mexico's financial crisis was the inevitable outcome of the growing inconsistency between its monetary and fiscal policies, its over-dependence on export for growth, and its exchange-rate system pegged to the dollar. Partly because of an upcoming presidential election, Mexican authorities were reluctant to take actions in the spring and summer of 1994, such as raising interest rates or devaluing the peso, that could have reduced this inconsistency. This structural policy inconsistency was exacerbated by the government's response to several economic and political events that created investor concerns about the likelihood of a currency devaluation. In response to investor concerns, the government issued large amounts of short-term, dollar-indexed notes called tesobonos. By the beginning of December 1994, Mexico had become particularly vulnerable to a financial crisis because its foreign-exchange reserves had fallen to $12.5 billion while it had tesobono obligations of $30 billion maturing in 1995.

A country can respond to a current-account deficit in four ways:

1. Attract more foreign capital denominated in dollars. The US does not need to do this because of dollar hegemony, but Mexico, which could not print dollars, thus was forced to attract more foreign capital denominated in dollars with a Ponzi scheme of paying old capital with new capital.

2. Use foreign-exchange reserves to cover the deficit. The US can do this by printing dollars, the reserve currency of choice, but Mexico could not print dollars, only pesos, which put more pressure on the peso-dollar exchange rate.

3. Allow its currency to depreciate, thus making imports more expensive and exports cheaper. But for deeply indebted Mexico, a depreciated peso would make servicing existing foreign loans more expensive in peso terms.

4. Tighten monetary and/or fiscal policy to reduce the demand for all goods, including imports, shrinking the economy.

A country such as Mexico can only use (3) and (4), as most Asian countries also found out in 1997.

It was obvious that Mexico was experiencing a large current-account deficit financed mostly by short-term portfolio capital that was vulnerable to a sudden reversal of investor confidence. Nevertheless, neo liberal policy makers in both Mexico and Washington, while acknowledging that the peso was overvalued and the existing exchange rate was unsustainable, were undecided about the extent to which the peso was overvalued and if and when financial markets might force Mexico to take action. Estimates of the overvaluation ranged between 5 and 20 percent. Moreover, Fed and Treasury officials under Alan Greenspan and Robert Rubin respectively did not foresee the magnitude of the crisis that eventually unfolded. The IMF was oblivious to the seriousness of the situation that was developing in Mexico and, for most of 1994, did not see a compelling case for a change in Mexico's exchange-rate policy. In the period prior to July 1997, when the Asian financial crises broke out first in Thailand, the IMF was praising South Korea and most other Asian economies for its continuing growth and sound exchange-rate policies. Even after financial contagion was in full force, the IMF kept releasing complacent prognoses of the temporary nature of the crisis as a passing liquidity crunch, while denying its structural causes.

The objectives of the US and IMF rescue packages for Mexico, after the December 1994 devaluation and the subsequent loss of market confidence in the peso, were (1) to help Mexico overcome its allegedly short-term liquidity crisis and (2) to limit the adverse effects of Mexico's crisis spreading to the economies of other emerging market nations and beyond. No effort was directed at restructuring fundamental neo-liberal policy faults, nor to admit that localized isolation is empty hope in a globalized system.

Many observers opposed any US financial rescue to Mexico. They argued that tesobono investors should not be shielded from financial losses on moral-hazard grounds, and that neither the danger posed by the spread of Mexico's crisis to other nations nor the risk to US trade, employment, and immigration was sufficient to justify such bailout.

The Bank of Mexico, the central bank, increased the interest rate from 9 percent to 18 percent on short-term, peso-denominated Mexican government notes, called cetes, in an attempt to stem the outflow of capital. However, despite higher interest rates, investor demand for cetes continued to lag. Investors were demanding even higher interest rates on newly issued cetes because of their perception that the peso would be subject to progressively larger devaluation by rising interest rates. It was a classic vicious circle. Options available to the Mexican government at this time included (1) offering even higher interest rates on cetes; (2) reducing government expenditures to reduce domestic demand, decrease imports, and relieve pressure on the peso; or (3) devaluing the peso. All three options would lead to increased downward pressure on the peso and the economy. The only workable option, exchange control in the form of restrictive capital flow, was not considered by the Harvard-Yale-trained Mexican central bankers, nor encouraged by US advisors. It was not until 1998, when Malaysia successfully adopted exchange control, that some born-again market-failure fundamentalists, led by MIT economist Paul Krugman, grudging acknowledged it as a legitimate option.

From the perspective of the Mexican authorities, the first two choices were unattractive in a presidential-election year because they could have led to a significant downturn in economic activity and could have further weakened Mexico's banking system. The third choice, devaluation, was also unattractive, since Mexico's success in attracting substantial new foreign investment to feed its Ponzi scheme depended on its commitment to maintain a stable exchange rate. In addition, a stable exchange rate had been an essential ingredient of long-standing policy agreements among government, labor, and business, and these agreements were perceived as ensuring economic and social stability. Also, the stable exchange rate was considered a key to continued reductions in the inflation rate by orthodox neo-classical economics. Ironically, typical of all Ponzi schemes, success was fatal because it accelerated unsustainability.

Rather than adopting any of these options, the government chose, in the spring of 1994, to increase its issuance of tesobonos. Because tesobonos were dollar-indexed, holders could avoid losses that would otherwise result if Mexico subsequently chose to devalue its currency. The government promised to repay investors an amount, in pesos, sufficient to protect the dollar value of their investment. Tesobono financing in effect dollarized Mexican sovereign debt and transferred foreign-exchange risk from investors to the Mexican central bank and government and to provide a short-term liquidity solution that would exacerbate long-term structural problems. Tesobonos proved attractive to domestic and foreign investors. However, as sales of tesobonos rose, Mexico became vulnerable to a financial market crisis because many tesobono purchasers were portfolio investors who were very sensitive to changes in interest rates and related risks. Furthermore, tesobonos had short maturities, which meant that their holders might not roll them over if investors perceived (1) an increased risk of a government default or (2) higher returns elsewhere. Market discipline operated like a pool of circling hungry sharks.

Nevertheless, Mexican authorities viewed tesobono financing as the best way to stabilize foreign-exchange reserves over the short term and to avoid the immediate costs implicit in the other alternatives. In fact, Mexico's foreign-exchange reserves did stabilize at a level of about $17 billion from the end of April through August 1994, when the presidential elections came to a conclusion. Mexican authorities expected that investor confidence would be restored after the August presidential election and that investment flows would return in sufficient amounts to preclude any need for continued, large-scale tesobono financing.

After the election, however, foreign-investment flows did not recover to the extent expected by Mexican authorities, in part because peso interest rates were allowed to decline in August and were maintained at that level until December. During the autumn of 1994, it became increasingly clear that Mexico's mix of monetary, fiscal, and exchange-rate policies needed to be adjusted. The current-account deficit had worsened during the year, partly as a result of the strengthening of the economy related to a moderate pre-election loosening of fiscal policy, including a step up in development lending, which was considered by market fundamentalists as a big no-no. Imports had also surged as the peso became further overvalued. Mexico had become heavily exposed to a run on its foreign-exchange reserves as a result of substantial tesobono financing. Outstanding tesobono obligations increased from $3.1 billion at the end of March to $29.2 billion in December. Also, between January and November 1994, US three-month Treasury bill yields had risen from 3.04 percent to 5.45 percent, substantially increasing the attractiveness of US government securities. In the middle of November 1994, Mexican authorities had to draw down foreign-currency reserves to meet the demand for dollars.

On November 15, 1994, in response to US domestic economic conditions, the Fed raised the federal funds rate by three-quarters of a percentage point to 5.5 percent, raising the general level of dollar interest rates and further increasing the attractiveness of US bonds to investors. By late November and early December, poor economic performance spilled over to political incidents that caused apprehension among investors regarding Mexico's political stability. These concerns were compounded on December 9, when the new Mexican administration revealed that it expected an even higher current-account deficit in 1995 but planned no change in its exchange-rate policy. This decision led to a further loss in confidence by investors, increased redemptions of Mexican securities, and a significant drop in foreign-exchange reserves to $10 billion. Meanwhile, Mexico's outstanding tesobono obligations reached $30 billion, all coming due in 1995. However, Mexican government officials continued to assure investors that the peso would not be devalued.

On December 20, Mexican authorities sought to relieve pressure on the exchange rate by announcing a widening of the peso-dollar exchange-rate band. The widening of the band in effect devalued the peso by about 15 percent. However, the government did not announce any new fiscal or monetary measures to accompany the devaluation - such as raising interest rates. This inaction was accompanied by more than $4 billion in losses in foreign reserves on December 21 and, on December 22, Mexico was forced to float its currency freely. The discrepancy between the stated exchange-rate policy of the Mexican government throughout most of 1994 and its devaluation of the peso on December 20, along with a failure to announce appropriate accompanying economic-policy measures, contributed to a significant loss of investor confidence in the newly elected government and growing fear that default was imminent.

Consequently, downward pressure on the peso continued. By early January 1995, investors realized that tesobono redemptions could soon exhaust Mexico's reserves and, in the absence of external assistance, that Mexico might default on its dollar-indexed and dollar-denominated debt.

As 1994 began, signs were visible that Mexico was vulnerable to speculative attacks on the peso and that its large and growing current-account deficit and its exchange-rate policy might not be sustainable. However, neo-liberal economists generally thought that Mexico's economy was characterized by "sound economic fundamentals" and that, with the major economic reforms of the past decade along Washington Consensus lines, Mexico had laid an adequate foundation for economic growth in the long term. In reality, Mexico was exporting real wealth and importing hot money with the help of a flawed central-bank policy that was attracting large capital inflows and held substantial foreign-exchange reserves derived from foreign debt. Concerns about the viability of Mexico's exchange-rate system increased after the assassination of presidential candidate Luis Donaldo Colosio in the latter part of March and the subsequent drawdown of about $10 billion in foreign-exchange reserves by the end of April. Just after the assassination, US Treasury and Fed officials temporarily enlarged long-standing currency-swap facilities with Mexico from $1 billion to $6 billion. These enlarged facilities were made permanent with the establishment of the North American Financial Group in April. The initiative to enlarge the swap facilities permanently preceded the Colosio assassination. Mexican foreign-exchange reserves stabilized at about $17 billion by the end of April 1994.

At the end of June 1994, a new run on the peso was under way. Between June 21 and July 22,