Commentary

In Mexico, Too Much Money Still Chases Too Few Goods

Reprinted from the Wall Street Journal © 1999 Dow Jones & Company, Inc. All rights reserved.
Now that Mexico’s legendary ruling party, the Institutional Revolutionary Party (PRI), has completed its historic primary, the country is gearing up for what promises to be its most openly competitive presidential election yet.

The Bank of Mexico’s policy decisions during the last election cycle, leading up to the 1994 peso devaluation and a severe economic crisis in 1995, still dominate investors’ memories. Thus, it can be expected that until the July 2nd election close attention will be paid to the bank’s moves, in order to measure whether it is acting independently, as an April 1994 law requires, and is on the route to its “primary objective” of long-term price stability. If it appears that politics are continuing to trump economics in determining monetary policy, investors both inside and outside Mexico will respond accordingly.

Thus far, the bank, under the guidance of central bank president Guillermo Ortiz, President Ernesto Zedillo’s former finance minister, has a worrisome record. Although it has somewhat stabilized the value of the peso against the U.S. dollar, money growth and inflation remain excessive and real interest rates are at a five-year high. Bank officials may say that they are simply accommodating the public’s demand for currency and that zero inflation is not politically feasible. The first point, however, is specious, and the second inconsistent with the case for central bank independence.

The Bank of Mexico has direct control over Mexico’s monetary base, which consists almost entirely of outstanding currency. If it allows that base to grow too rapidly, bank reserves and deposits will rise, along with nominal spending and prices. The increase in bank deposits and the price level will naturally lead to an increased demand for currency. The central bank can then claim that it is merely accommodating demand. But it is also creating that demand by producing too much base money in the first place.

Persistent inflation is ipso facto evidence of excessive base money creation, notwithstanding the fact new base money is mainly being used to “accommodate” the public’s need for currency. That was the lesson learned by managers of the Reischsbank during the German hyperinflation of the early 1920s, who also insisted — with horrible consequences — that they were merely trying to make up for a shortage of currency.

It is thus necessary to reject Grupo Financiero Bancomer’s August 1999 Economic Report claim that “The central bank’s policy toward the monetary base is neutral in the sense that the authorities met the demand for cash based on the daily transactions of the money market.” The reality is that during the first half of 1999, the monetary base grew more than 20% and is now exceeding forecasts that were made only several months ago. This base growth has been responsible for both rising prices and the rising demand for cash.

The bank’s long-term track record and its current expansionary monetary policy leave investors with little confidence that the rate of inflation will decrease. They are nervous about the real value of Mexican bonds at maturity and are therefore demanding a hefty risk premium to hold government debt. Real interest rates on 28- and 91-day treasury bills “are higher than the worst moment of the 1995 crisis and are significantly greater than last year,” notes the Bancomer report. This is a result of inflationary expectations, yet conventional wisdom has it that real rates are high because money is tight.

The failure to confront inflation head on has tarnished the bank’s credibility because it violates the trust that should exist between the supplier of money and the holders of central bank liabilities. The citizens’ property rights in their currency are attenuated by the government confiscation that occurs as inflation erodes the purchasing power of money. This has been, and continues to be, the Mexican experience.

Erratic monetary policy also reduces the efficiency of the market price system, misallocates resources and further impoverishes the poor. Most Mexicans have not come close to restoring the losses in net worth or wages incurred during the 1994-95 currency crisis and inflation offers little hope for the future.

The benefits to the Mexican people of moving quickly to a regime of stable money would far outweigh the short-term costs. Reducing the risk premium in real interest rates and helping the poor requires stable money and economic liberalization. The bank cannot do anything about the latter, but it can and must end the erosion in the value of money. As the Bancomer report correctly states, “Due to their effect on economic growth, it is preferable to have lower real interest rates. This cannot be achieved by decree or by relaxing monetary policy, but by guaranteeing that inflation be lowered even in the presence of political or international `shocks.’”

At the root of the problem is the bank’s reluctance to make a clear choice between controlling inflation and controlling the exchange rate; it cannot do both. In fact, the bank now has a record $30 billion in foreign exchange reserves, indicating that it is running a dirty float with a goal of controlling the exchange rate. Under a clean float, when dollars come into the country, the foreign-exchange value of the peso would go up, while the supply of pesos in circulation — and thus the internal purchasing power of the peso — would remain steady. With a clean float, the composition of private portfolios would change in favor of dollar assets, and there would be no accumulation of dollars by the central bank. Thus, there would be no change in the monetary base. Instead, the Bank of Mexico is intervening in the foreign exchange market — buying dollars with new base money — to prevent the peso from appreciating. The result has been excessive base growth and inflation, leaving independent observers to conclude that exporters have exerted their political influence to keep the peso “competitive.”

There is little doubt that during a campaign the incumbent party has an interest in expanding social spending, keeping exporters happy, bailing out banks and reducing unemployment. But the independent central bank is supposed to resist the temptation to fix the economy by way of monetary policy. If the bank appears under pressure, the market will rightly conclude that inflation will not end anytime soon.

If the central bank cannot bind itself to a monetary rule that limits the quantity of money to a non-inflationary growth rate, then perhaps it is time to allow full currency competition and let Mexicans choose whatever currency they believe will best retain its long-run value.

James Dorn is a monetary specialist at the Cato Institute in Washington and coeditor of Money and Markets in the Americas (Fraser Institute, 1996).