In Mexico, Too Much Money Still Chases Too Few Goods

Reprinted from the Wall Street Journal © 1999 Dow Jones & Company, Inc. All rights reserved.
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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 lastelection cycle, leading up to the 1994 peso devaluation and a severeeconomic crisis in 1995, still dominate investors' memories. Thus, it canbeexpected that until the July 2nd election close attention will be paid tothebank's moves, in order to measure whether it is acting independently, asan 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 totrump economics in determining monetary policy, investors both inside andoutside Mexico will respond accordingly.

Thus far, the bank, under the guidance of central bankpresident Guillermo Ortiz, President Ernesto Zedillo's former financeminister, has a worrisome record. Although it has somewhat stabilized the value ofthe peso against the U.S. dollar, money growth and inflation remainexcessive and real interest rates are at a five-year high. Bank officialsmay say that they are simply accommodating the public's demand for currencyandthat zero inflation is not politically feasible. The first point,however, is specious, and the second inconsistent with the case for central bankindependence.

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

Persistent inflation is ipso facto evidence of excessivebase money creation, notwithstanding the fact new base money ismainly being used to "accommodate" the public's need for currency. That wasthe lesson learned by managers of the Reischsbank during the Germanhyperinflation of the early 1920s, who also insisted -- with horribleconsequences -- that they were merely trying to make up for a shortage ofcurrency.

It is thus necessary to reject Grupo FinancieroBancomer's August 1999 Economic Report claim that "The central bank's policytoward the monetary base is neutral in the sense that theauthorities met the demand for cash based on the daily transactions of the moneymarket." The reality is that during the first half of 1999, the monetary basegrew more than 20% and is now exceeding forecasts that were made onlyseveral months ago. This base growth has been responsible for both risingprices and the rising demand for cash.

The bank's long-term track record and its currentexpansionary monetary policy leave investors with little confidence that therate of inflation will decrease. They are nervous about the real value ofMexican bonds at maturity and are therefore demanding a hefty riskpremiumto hold government debt. Real interest rates on 28- and 91-daytreasury bills "are higher than the worst moment of the 1995 crisis and aresignificantly greater than last year," notes the Bancomer report. Thisis a result of inflationary expectations, yet conventional wisdom hasitthat real rates are high because money is tight.

The failure to confront inflation head on has tarnishedthe bank's credibility because it violates the trust that should exist betweenthe supplier of money and the holders of central bank liabilities. Thecitizens' property rights in their currency are attenuated by the governmentconfiscation that occurs as inflation erodes the purchasing power of money. Thishas been, and continues to be, the Mexican experience.

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

The benefits to the Mexican people of moving quickly toaregime of stable money would far outweigh the short-term costs. Reducingthe risk premium in real interest rates and helping the poor requiresstable money and economic liberalization. The bank cannot do anythingabout the latter, but it can and must end the erosion in the value of money. Asthe Bancomer report correctly states, "Due to their effect oneconomicgrowth, it is preferable to have lower real interest rates. Thiscannotbe achieved by decree or by relaxing monetary policy, but byguaranteeing that inflation be lowered even in the presence of political orinternational `shocks.'"

At the root of the problem is the bank's reluctance tomake a clear choice between controlling inflation and controlling theexchange rate; it cannot do both. In fact, the bank now has a record $30 billion inforeign exchange reserves, indicating that it is running a dirty floatwith a goal of controlling the exchange rate. Under a clean float, when dollarscomeinto the country, the foreign-exchange value of the peso would go up,whilethe supply of pesos in circulation -- and thus the internal purchasingpower of the peso -- would remain steady. With a clean float, the compositionof private portfolios would change in favor of dollar assets, andthere would be no accumulation of dollars by the central bank. Thus, therewould be no change in the monetary base. Instead, the Bank of Mexicois intervening in the foreign exchange market -- buying dollars with newbase money -- to prevent the peso from appreciating. The result has beenexcessive base growth and inflation, leaving independent observers toconclude that exporters have exerted their political influence to keepthe peso "competitive."

There is little doubt that during a campaign theincumbent party has an interest in expanding social spending, keeping exportershappy, bailing out banks and reducing unemployment. But the independentcentral bank is supposed to resist the temptation to fix the economy byway of monetary policy. If the bank appears under pressure, the marketwill rightly conclude that inflation will not end anytime soon.

If the central bank cannot bind itself to a monetaryrulethat limits the quantity of money to a non-inflationary growth rate,thenperhaps it is time to allow full currency competition and let Mexicanschoose whatever currency they believe will best retain its long-runvalue.

James A. Dorn

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