Post-mortem on the Mexican crash

By Jonathan Power

LONDON (JP): In a most unusual public confession, the International Monetary Fund published recently a report admitting it got its interpretation of the Great Mexican crash late last year totally back-to-front. It wasn't the foreign investors who pulled the plug on the peso. It was Mexico's own countrymen, who got wind of disturbing political and economic trends two weeks before the volatile foreigners, their over-paid fund advisors and the computerized, long-distance, stock wizards.

Perhaps this is the right moment for the "Washington consensus," all those institutions and financial networks centered in the world's de facto capital, to make another mea culpa -- that their free trade and sound money nostrums of the late 1980s and early 1990s were also off-center, over-rated and ill-formed. "We went into Latin America not knowing anything about the place," noted one fund manager, "and now we are leaving without knowing anything about it."

Stanford University economist Paul Krugman puts his finger right on it in a Foreign Affairs article in the current issue when he observes that the "emerging market funds" bubble burst when Mexican reality finally punctured the conventional wisdom that once free market policies were implemented, progress could only be onward and upward.

At first, it all seemed to go like clockwork. Unprecedented amounts of foreign, mainly portfolio, investment was attracted to a wide range of developing countries, from the Philippines to Hungary, from Mexico to Argentina -- countries that, unlike the Asian "Tigers", had never been richly favored before in the investment capital business.

As Krugman argues so well, it wasn't because trade liberalization or sound money are intrinsically rewarding, but because they were hyped by the "Washington consensus" as being the proof of economic correctness. In reality, such policies, although on balance positive, bring only limited returns -- for example, a highly protectionist developing country, by moving completely to free trade, would get a one-time economic boost to its growth that China achieves every five or six months. And the rewards for sound money are even less, at least for those countries not experiencing stratospheric rates of inflation, Argentina style.

But such sober truths didn't really matter in those euphoric years. Success was in the air and all one had to do to get rich was to follow the pack. This was the time when "emerging market funds" started to be advertised on TV and in the pages of popular magazines.

At the capital-receiving end, it appeared to be a modern miracle. Mexico, down in the dirt since its 1982 debt crisis, found that its problems appeared to melt away. Real interest rates fell from 405 to 5 percent. Far from being shut out of international financial markets, capital poured in on an ever- growing scale. Growth resumed in a long-stagnant economy. And so it was for many other countries. The interlocking social groups of the "Washington consensus" made it imperative for a critic, whether academic, journalistic or political, to find an audience. When conventional wisdom is at its fullest strength, one's agreement with the conventional wisdom becomes a litmus test of one's suitability to be taken seriously. People believe certain stories because everyone important tells them and people tell those stories because everyone important believes them.

Yet if investors had researched indicators other than the measures of trade liberalization and sound money, they might have unearthed some warnings. But they didn't want to look. There were over-valued currencies, disappointing economic growth rates below population growth, rising unemployment and a worsening income distribution. Ignorance was bliss.

A crisis of confidence, political, intellectual or financial, was, at some point, bound to arrive. In the end, in Mexico it was the interaction of all three. The Chiapas uprising and the assassination of a presidential candidate precipitated it, but even on pure economic grounds it was inevitable anyway.

Other developing countries were hit by the Mexican tidal wave. Now they are forced to fight to show that they are not doomed to go the same way. No wonder the International Monetary Fund recently chose to strengthen their defenses by itself bucking the "Washington consensus" and giving its approval to capital flight controls.

Capital controls are a good way of sobering up the keyboard investors. They have to learn that while they should be able to reap, well into the distant future, reasonable returns from Third World investments, they cannot expect that a couple of free- market criteria are enough to guide them to success.

Developing countries themselves need a second layer of reforms on top of those of free market liberalization if they are to grow in a sustained way. They need policies that absorb labor and reduce unemployment, that create more socially aware civic institutions and a fairer distribution of economic rewards.

Public money now going to universities, the military or urban infrastructure needs to be reallocated to preventive health care, primary education and rural communities. After all, this was essentially the recipe followed by the Asian "dragons" and look where they are today. Unforgivably, the "Washington consensus" overlooked this earlier achievement. It was a costly mistake by those who should have been educated enough to know better.