In an Uncertain World (2 page)

   

ALAN, LARRY, AND I AGREED about what had caused the crisis. Mexico, despite reforms in many areas, had made a serious policy mistake by borrowing too much in good times, leaving it vulnerable when sentiment shifted. And when markets began to lose confidence, the government put off facing reality for as long as possible. It borrowed still more, at shorter and shorter terms, issuing dollar-linked debt and spending its limited dollar reserves on holding up the peso, which had an exchange rate fixed to the U.S. dollar. At the same time, creditors and investors—both Mexican and foreign—were paying little attention to the buildup of economic imbalances. Their continued financing allowed the problem to become almost unmanageable when the crunch finally came.

The trouble really began in the early 1990s, when Mexico's current account deficit—basically the trade deficit plus net interest payments and some similar items—began expanding rapidly. To cover this gap, the country needed dollars, which it attracted by issuing government bonds. At first, it sold peso-denominated assets. But later, as investors became less willing to take on the exchange rate risk, the government started issuing large quantities of Tesobonos, short-term obligations whose value was linked to the U.S. dollar. For a while, these bonds proved attractive to Mexicans and foreign investors. But Mexico's large current account deficit combined with a fixed exchange rate was not sustainable indefinitely. To make matters worse, Mexico's banking system was weak and under strain.

Underlying imbalances like Mexico's are the real cause of resulting crises, but often some event that might otherwise not have created trouble serves as a trigger. In this case, a violent insurgency in the Chiapas region at the beginning of 1994 and the assassinations of two leading Mexican politicians created a deep sense of alarm in financial markets. Mexican bonds began to look much riskier and started to trade at steep discounts. Domestic and foreign investors became less willing to keep money in Mexico. The central bank had to sell more and more of its foreign exchange reserves as it struggled to meet the demand for dollars while holding the exchange rate unchanged. At the same time, the Mexican government found it more and more difficult to roll over its debt, despite offering higher and higher interest rates.

As so often happens in financial markets, these negative effects became self-reinforcing. As investors feared that the exchange rate might fall, they moved into dollars and drove the government's reserves down still further. This in turn made a peso decline more likely and exacerbated fears of a government default. The promise to repay Tesobonos with however many pesos were required to keep investors whole in dollar terms came to look less and less credible. With the foreign exchange reserves running out, the authorities made a last-ditch attempt to save the fixed-exchange-rate system with a partial devaluation, but that didn't stem the tide. Domestic capital continued to flee, foreign market confidence plunged, and the government was forced to let the exchange rate float freely. Market attention shifted to the huge quantities of Tesobonos coming due in the weeks and months ahead. The demand for new bonds had dried up. So the government would have had to flood the market with pesos to pay off the maturing Tesobonos—which would send the exchange rate down further.

The Mexican crisis is usually viewed as a failure of Mexican policy. But it was, crucially, also a failure of discipline on the part of creditors and investors—a point about crises that would become very important a few years later, when we faced the return of the same kinds of problems elsewhere and on an even larger scale. Lured by the prospect of high returns, investors and creditors hadn't given sufficient consideration to the risks involved in lending to Mexico. Once investors became nervous, however, their reaction was swift and unforgiving. Mexico promptly lost access to international capital markets and couldn't refinance the short-term Tesobonos. Most observers believed that in the long run Mexico would be able to repay its debts. But in the short run, with less than $6 billion left in foreign currency reserves and almost $30 billion in dollar-indexed bonds coming due in 1995—$10 billion in the first three months—Mexican and foreign investors wanted out. For better or for worse, there's no international law enabling countries to reorganize their debts in bankruptcy court. Thus, our declining to intervene would likely have led to the default of a country that mattered to us in many ways.

Mexico is a good example of a situation—often encountered by policy makers as well as by those in the private sector—in which all decisions had the potential for serious adverse consequences and the key was to find the least bad option. In this case, the dangers of not acting were severe economic duress in Mexico, a contagious decline in emerging markets, and a setback to American growth and prosperity. The risk of acting was failure—potentially endangering repayment of billions of dollars of taxpayer money—or, if we succeeded, moral hazard. Alan, Larry, and I all opposed making the holders of Tesobonos whole. But we concluded—I think rightly—that Mexico couldn't be rescued without the side effect of helping some investors.

We also worried that the Mexican crisis could affect the global movement toward trade and capital market liberalization and market-based economic reforms. NAFTA had just gone into effect on January 1, 1994. If Mexico went into default a year later, in part for failure to properly manage the influx of foreign capital, the case for further reform might be set back in the United States and abroad. Larry, who had served as chief economist at the World Bank before joining the Clinton administration, was especially concerned with this problem. “Letting Mexico go,” he argued, would send a discouraging signal to other developing nations—such as Russia, China, Poland, Brazil, and South Africa—that had been moving forward with market-oriented reforms. Though we took turns playing devil's advocate, Larry, Alan, and I all came to a rough consensus in the days before my swearing in. All of us came to think that the risks of not acting were far worse than the risks of acting. Alan captured all of our views when he called a support program the “least worst” option.

On the afternoon of January 10, the three of us, joined by a number of others, including my successor at the NEC, Laura D'Andrea Tyson, had our last meeting to confirm our recommendation to the President while waiting for my confirmation papers to arrive. Larry and I shared Alan's view that we should put up a substantial amount of money, significantly more than we thought would be needed. In this, we were employing a corollary to Colin Powell's doctrine of military intervention. The Powell Doctrine, which became well known during the Persian Gulf War, says that the United States should intervene only when American interests are at stake and that intervention must be with an overwhelming level of force.

Of course, no one could say with certainty how much force would be needed to overwhelm the problem in Mexico. One benchmark was the total value of the outstanding Tesobonos, which at that point was about $30 billion. Even that might not be enough, taking into account other government debt, the external debt of Mexican banks, and the potential for “capital flight” as domestic holders of pesos converted them into dollars. Knowing the IMF would also put up a significant amount of money, we proposed $25 billion in U.S. loan guarantees—which had the same financial risk to our government as loans but with some technical advantages.

No “right answer” or formula can exist for how much money is enough in such circumstances, because restoring confidence is a psychological matter that varies from case to case. In this instance, Tesobonos were on the minds of market participants and we decided to make available more than we thought Mexico would actually need. Like a big military arsenal, a large financial one can make a considerable psychological difference to the markets. If investors believe that a government has sufficient resources to right itself and that reforms are in place to deal with the underlying problems, the outflow should stop.

   

WHEN WE GOT THE MESSAGE that my confirmation papers had arrived, Larry and I bundled up our notes and hurried over to the White House. We could not have been bringing the President a more difficult decision at a worse time. Only nine weeks before, he had been dealt a severe political blow—the Democrats had lost both houses of Congress for the first time in forty years. Newt Gingrich and his Contract with America were gracing every magazine cover, and President Clinton was fighting to reestablish himself politically. And here we were, coming into his office on January 10 asking him to make what was likely to be an unpopular and politically risky decision—which also had a real risk of not succeeding—based only on the policy merits.

As usual, it didn't take Bill Clinton long to grasp the situation. He had a few questions for Larry and me. Is there a real risk of cataclysmic consequences if we don't do this? Clinton asked. We said yes. Second, the President wanted to know whether there was a good chance our program could prevent those consequences. While there was no guarantee of success, I repeated, the chances were good. Finally, the President asked how much money we could lose if the rescue didn't work. Larry explained that the loan guarantees would be offered in increments of about $3 billion at a time. If the medicine didn't seem to be helping, we should be able to stop our losses short of the full $25 billion.

Once he heard our analysis and the seriousness of the situation, Clinton responded without hesitation that he would have to live with the political hazards. “This is what the American people sent us here to do,” he said. I also remember the President saying that he wouldn't be able to sleep at night if he didn't come to Mexico's aid. Often, when I've heard criticism of Bill Clinton as indecisive or driven by politics rather than policy, I've remembered and cited that night as a response. He gained nothing politically by helping Mexico and risked much at a time when his political capital had already been greatly diminished.

When our discussion was done, Clinton walked over to his desk, picked up the phone, and asked to be connected to the congressional leaders of both parties. Within a couple of hours, Senators Bob Dole (R-KS) and Tom Daschle (D-SD) and Representatives Newt Gingrich (R-GA) and Richard Gephardt (D-MO) all promised to back his emergency request for the loan guarantees. Larry and I went to see them all on Capitol Hill the next day, to solidify their support. At the outset, even Alfonse D'Amato (R-NY), the new chairman of the Senate Banking Committee, who had been investigating Clinton relentlessly over Whitewater, was supportive. D'Amato said we ought to put up more than $25 billion, so that the financial markets wouldn't think they could “overpower” us. With that encouragement, we increased our proposal to $40 billion. A critical component of the proposal also required Mexico to commit to various economic reforms and to pledge its oil export earnings to assure repayment.

Despite this support from the congressional leadership, the reaction when Alan and I went to Capitol Hill to explain the plan was overwhelmingly negative. Meeting with more than a hundred legislators from both parties on January 13, we got our first taste of just how difficult getting Congress to act was going to be. Several members asked for a promise not to put U.S. tax dollars at risk. Some questions were very sensible but hard to answer. Senator Joseph Lieberman (D-CT) pressed us on why the Japanese and Europeans weren't sharing the risk with us. I responded that our allies were making their contribution through the IMF. A less diplomatic response would have been that I believed our allies should have also contributed bilaterally, because a crisis in Mexico and possible contagion would have affected them as well. But they weren't going to, perhaps in part because they considered Mexico our problem but also because they didn't share our judgment about the global danger a Mexican collapse would create. In any event, none of this changed the fundamental point: acting was in our interest. Afterward, Larry and I went on a full-scale media and political blitz to press our case. Among the calls I made was to the governor-elect of Texas, George W. Bush, who offered his support for our effort. Like many border-state politicians, Bush instinctively grasped what was at stake and became a strong public supporter of our aims and efforts.

I'm still not sure I fully understand the depth of the negative reaction to our package in Congress. At one level, congressional opinion simply mirrored public opinion. Xenophobia may have explained some of this opposition, but many people just didn't see any need to risk our tax dollars on this effort. Perhaps we could have done a better job of making the case. But the situation was probably too novel and too complicated to be assimilated quickly. In 1995, the notion that a poor country's macroeconomic miscalculations could affect the largest economy in the world simply didn't register with a lot of people. A few years later, when the Asia crisis took hold, it still didn't. For most Americans, the global economy remains an abstraction, with little meaning in their daily lives.

The opposition we encountered in Congress also seemed to reflect entanglement with other issues. Many Democratic legislators had bucked their supporters in organized labor to vote for NAFTA. Now the opponents of NAFTA were taunting them—
look, we told you so.
On the Republican side, some of the new group of highly energized freshmen were eager to fight the President and skeptical of international engagement. Why help a country that sends us narcotics and illegal immigrants, especially when that help would benefit Wall Street at the same time? I tried—with little success—to explain that our purpose was not Mexico's or Wall Street's well-being but America's. A Mexican default would exacerbate the very problems they were concerned about. But my arguments made little headway.

Some members of both the House and Senate—such as Senators Chris Dodd (D-CT), Paul Sarbanes (D-MD), and Robert Bennett (R-UT)—understood the issues and worked to help us at many critical junctures. But most members willing to support the package wanted conditions that were either politically impractical or not germane to reestablishing stability, or that simply couldn't be worked out with Mexico as part of this program. For example, some Democrats insisted on new labor standards to protect Mexican workers. Jim Leach (R-IA), the conciliatory and internationalist-minded Republican chairman of the House Banking Committee who supported our proposal, was willing to accept some Democratic demands as the price of passage. But that incensed Leach's colleagues, who didn't see why Democrats should be calling the shots now that Republicans ran Congress. Some of them said they wouldn't support any rescue package with labor standards. This messy conflict provided a foretaste of future battles over globalization, including trade liberalization. The constituency for free trade wasn't large to begin with—but if we were going to have it, everyone wanted his particular interests protected.