Metroeconomica 57:3 (2006)

365–388

FINANCIAL FRAGILITY AND FINANCIAL CRISIS IN MEXICO Julio López Gallardo, Juan Carlos Moreno-Brid and Martín Puchet Anyul* Universidad Nacional Autonoma de México and Economic Commission for Latin America and the Caribbean (February 2004; revised January 2005)

ABSTRACT The objective of this paper is to show how Mexico’s strategy of financial deregulation and liberalization set the stage for the crisis that the country suffered in December 1994. The theoretical underpinning is Post-Keynesian, and more precisely, a Minsky-inspired analytical perspective extended to the open economy. In the first section the authors carry out a theoretical discussion dealing with some Post-Keynesian theories of the business cycle. A second section is devoted to examining and identifying the stylized facts in the evolution of the Mexican economy, with special emphasis on the interaction between the financial and real variables. In the last section the authors propose a simplified model which shows how and why a strategy of financial deregulation and liberalization may lead to financial fragility and to a crisis.

1. INTRODUCTION

After the traumatic experience of the early 1980s, which saw an ill-managed oil boom turn into a major financial crisis,1 Mexico completely overhauled its economic strategy. The economic role of the state was forsaken, the domestic market was opened-up to imports, international financial transactions were fully liberalized and the domestic financial sector was re-privatized and deregulated. * The authors would like to thank Josep González Calvet and two anonymous referees of this journal for their very useful comments, to Elvio Accinelli for his technical support and to Alejandro Cruz for his extremely efficient and enthusiastic research assistance. The opinions here expressed are the responsibility of the authors and do not necessarily coincide with those of the institutions with which they are affiliated. 1 In 1955–56 there was a balance-of-payments crisis that was rapidly corrected through a depreciation of the exchange rate and a selective—rather expansionary—fiscal policy. This adjustment strategy succeeded, besides avoiding a full fledged financial crisis, in placing the Mexican economy in a long-term path of high and sustained growth with relatively low inflation that would last practically until the 1970s. This period is known as the ‘Desarrollo Estabilizador’ in Mexico’s economic history. © 2006 The Authors Journal compilation © 2006 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA 02148, USA

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The objective of this paper is to show how the strategy of financial deregulation and liberalization set the stage for the crisis that Mexico suffered in December 1994; a crisis that caused real GDP to fall in 1995 by about 6 per cent with respect to the level it had achieved one year earlier. Our theoretical underpinning is Post-Keynesian, and more precisely, a Minsky-inspired analytical perspective extended to the open economy. Thus, this paper can be read from two different perspectives. It can be read as an analysis of Mexico’s 1994–95 crisis, seen with the perspective of the Post-Keynesian business cycle theory. It can also be read as a present-day reflection on and extension to an open economy of Post-Keynesian business cycle theory, illustrated with the particular case of the Mexican experience. The structure of the paper is as follows. In the second section we carry out a theoretical discussion dealing with some Post-Keynesian theories of the business cycle. A third section is devoted to examining and identifying the stylized facts in the evolution of the Mexican economy, with special emphasis on the interaction between the financial and real variables. In section 4 we propose a simplified model that shows how and why a strategy of financial deregulation and liberalization may lead to financial fragility and to a crisis. Final remarks are in section 5.

2. THEORETICAL DISCUSSION

Growth in capitalist economies is subject to cycles that, under certain circumstances, may turn into crises. The original Post-Keynesian theoretical literature on the subject, on which our approach relies, was formulated assuming a closed economy and in this context we can distinguish two perspectives. The first one was put forward by Kalecki, who developed a business cycle theory whereby investment decisions are a function of the changes in the factors determining the rate of profit and of the current entrepreneurial savings. In his theory Kalecki integrated in a novel way financial considerations, which enter via an argument related to firms’ own financial resources and the principle of increasing risk. Nevertheless, he implicitly assumed that monetary conditions remained unchanged, and that the reaction of firms to financial conditions does not vary during the course of the cycle.2 The second approach was formulated by Minsky (1975, 1982), who identified the varying target rate of indebtedness of firms and of lending of banks 2

Note, however, that in Kalecki (1942), where he presented a second version of his model he admitted, en passant, the elasticity of investment decisions to firm’s internal savings may in fact change.

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as one of the underlying causes of the cycle.3 Of course, the recognition of the influence of firms’ indebtedness in their investment decisions was not new; and in fact it played a significant role in the analytical framework and in the empirical reflection of the man to whom we pay homage today. Thus, in Steindl’s (1952) original stagnation theory, unwanted changes (i.e. an unforeseen rise) in the gearing ratio make it difficult for capitalist economies to spontaneously overcome the tendency towards stagnation brought about when the rate of growth of investment tends to decline. But the idea of a cycle of financial origin is mostly associated with Minsky, while the seminal contribution of Steindl in this area has largely gone unnoticed (but see Lavoie, 1995). It may be recalled that in the Minsky closed-economy story the cyclical upswing is brought about because, after a period of tranquility, firms and banks become more optimistic, so that investment and demand for external finance—i.e. liquidity provided by the financial system—rises at a faster pace and supply of finance accommodates this thanks to financial innovations implemented by banks. Now, the boom looses momentum because external finance to firms is increasingly restricted, becoming more expensive and more difficult to get. More precisely, the hike of the indebtedness coefficients gives rise to a situation of ‘financial fragility’, in the sense that the ratio of private debt to capital or to profits increases progressively reaching critical levels and, accordingly, financial factors have an ever greater bearing on the development of the economy. If domestic credit supply is not forthcoming, either because banks become more cautious or because monetary authorities implement restraining measures, the boom would get busted as firms would be forced to downgrade their investment projects and ultimately their business perspectives. Investment growth is thus reduced and, if accompanied with a slowdown in the rate of expansion of the other determinants of profits, this will feed back into slower growth of effective demand and of profits. Hence the rate of profits will decline and the economy will enter a downward spiral. Without adequate policies—fiscal and monetary—the subsequent slowdown or recession may turn into a full-blown debt crisis. If we extend his analysis to an open economy,4 we must take into account that the upswing gives rise to an important imbalance, of external nature, as imports rise faster than exports and thus increasingly put pressure on the 3

Although Minsky made extensive use of, and acknowledged the importance of Kalecki’s theory of profits, to the best of our knowledge he never recognized how much his theory of investment owed to Kalecki’s principle of increasing risk. See Nasica (2000) for an excellent presentation and development of the literature concerning Minsky’s model, and for a most useful list of references. 4 See Arestis and Glickman (2002) for an interesting extension of Minsky’s ideas to the open economy.

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availability of foreign exchange. To be more precise on the nature of this imbalance, as exports fail to grow in tandem with the domestic upswing, debt requirements and financial external fragility increase. External financial fragility has a microeconomic and a macroeconomic dimension. The former takes place when the mismatch between earnings and payments in foreign currency in the balance sheets of economic agents reaches a critical level. The latter can be identified as a situation in which a country is at high risk of holding insufficient foreign reserves to satisfy the demand to convert a large proportion of the cumulative saving done in national currency, into foreign currency. Because a fast-growing economy breeds enthusiastic expectations and banks (both domestic and international) are in the business of profiteering after all—with ‘herd’-like behavior (Steindl, 1990, pp. 371–5)—during the early phase of the upswing it may be easy to finance the external imbalance with resources provided by international creditors. However, with debt persistently rising, eventually at a faster pace than exports, or income, or both, international banks would have to reassess the solvency of the thriving debtors and of the country as a whole, and decide to accept or not a systematic increase in their exposure. Thus, an excessive external exposure, or worsening international financial or trading conditions, may also put an end to the upswing and bring about the downturn. Most importantly, considering the volatility and interdependence of private agents’ expectations in modern global capitalism, a credit restriction—by increasing interest rates or contracting the available funds for lending—in the international capital markets may lead eventually to a financial crisis. Also, a foreign recession may be imported by provoking a fall of exports’ earnings, either because they cut down the volumes exported or because they cause unit prices to decline. The possibility of any compensational policies aiming to put a stop to the downward spiral, which require foreign defensive indebtedness, is more difficult than in the closed economy, as it depends on the international financial system’s flexibility. If foreign credits were to be rationed this could force one after another round of cuts in domestic expenditure and profits, and further abase investment. The influence of institutional changes can easily be incorporated into the previous analytical framework. Steindl provided two very interesting examples, related with the changing financial environment in a closed economy. Thus, in Steindl (1952), he showed that the institutional innovation associated with the development of the capital stock market in the US economy stimulated the rate of capital accumulation—and, accordingly, prevented the tendency towards stagnation to emerge earlier than it actually did—thanks to the decline it brought about in the cost of external financial resources to firms. He remarked that, surprisingly, this very important development had

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not been given much consideration either in the theoretical or in the empirical literature of his time. His second example was related to the emergence of a steady stream of new durable and relatively expensive consumer goods, and the parallel generalization of consumer credit at advanced stages of capitalist development (Steindl, 1964).5 He argued that the first phenomenon might have imparted a downward bias to the long-run development of the economy if the purchase of durable goods had required a rise in the saving coefficient. He added that such a situation was prevented by the massive expansion of consumer credit, which ultimately brought about a decline in the medium time-lag between personal income and personal expenditure, thus contributing to an upward drift in the long-run rate of growth of capitalist economies. Minsky envisioned institutional changes as ‘thwarting mechanisms’ that would somehow put limits, or floors, to the spontaneous development of the system (Minsky and Ferri, 1992). But, following the two examples provided by Steindl, we can also consider some institutional changes as ‘triggering mechanisms’, which may disrupt a dynamic process that would otherwise be smooth and tranquil, and turn it into a trajectory leading to cycles or even to a chaotic development. For example, such a change, or a bifurcation, may come about if a ‘positive financial shock’ happens to take place—e.g. if financial reforms are implemented that allow banks to expand lending beyond the ‘paying capacity’ of the economy. Also, the ‘triggering mechanism’ may be related to too relaxed conditions in the world financial system. As we argue below, in Mexico’s experience the 1988–94 mini-boom that led to the 1995 crisis, was the consequence of a combination of an ill-conceived and drastic financial deregulation that led to an excessive opening-up to financial inflows, mainly short-term capital. We shall later put forward a very simplified analytical model where we attempt to identify the main interactions between the real and the financial sectors of a semi-industrialized economy, on the basis of which we can study financial crises. But before that, we shall give an account of Mexico’s experience and of the road to the crisis.

3. MEXICO’S EXPERIENCE

Let us first consider the basic institutional facts. Until the beginning of the 1980s Mexico’s central bank set the deposit interest rates that financial institutions were allowed to pay to depositors and credit was regulated through 5

It is unfortunate that our author did not include this very important essay in Steindl (1990).

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a complex system of reserve coefficients and preferential lending rates for specific sectors or activities. In the mid- and late 1980s institutional reforms began to be executed that led to deregulation, re-privatization6 and liberalization of Mexico’s financial system, went along the following lines (Mantey, 1996; Tello, 2004). The first step was the implementation of a system of auctions, whereby the interest rates were established for commercial bank deposits at the central bank and lending from the central to commercial banks. Later on, in the second half of the 1980s, the mandatory reserve ratio of banks was drastically reduced (from 50 per cent to 10 per cent) and the interest rates for some specific banking instruments were liberalized. In turn, commercial banks were given complete freedom to allocate according to their own preferences the resources obtained from these instruments. This reform was followed by the full and complete liberalization of domestic interest rates in 1988. The banking system was re-privatized in 1990, and a year later the mandatory reserve ratio was eliminated for all banking liabilities denominated in domestic currency. In 1993 commercial banking portfolio investment was completely deregulated. On the other hand, by the end of the 1980s, banks were permitted to borrow abroad—although with some minor restrictions—and non-residents were allowed to invest in domestic financial assets with practically no limitation. Finally, it may be worth mentioning that the functioning of Mexico’s stock market was not modified to any important degree in the course of the reforms, and remained extremely shallow. Very few firms, about 200 in all, trade their shares in the Bolsa Mexicana de Valores (Mexican Stock Exchange). These are all gigantic firms whose aggregate sales represent about 30 per cent of Mexico’s GDP. On the other hand, shares do not figure prominently within the assets of the private sector. In 1998 they represented less than 1 per cent of the total assets of pension funds, and a bit over 1 per cent of the total assets of commercial funds. We now describe the main features of Mexico’s macroeconomic evolution after the reforms. To motivate our story, we make use of figures that shed light on peculiar but important aspects of this country’s development.7 The first point worth mentioning is that after a protracted period of stagnation following the 1982–83 crisis, economic growth resumed from about the mid-1987 onwards, and continued up until December 1994, when the crisis erupted (see figure 1). However, the economy’s growth rate was modest, especially when compared with Mexico’s historical growth record. 6 7

By the end of 1982 the banking system had been nationalized. Please note, in the figures the arrows indicate the reference axis for the respective variables.

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<-----------------GDP 0.01

14.2 0.01 14.1

0.01 14.0

Real exchange rate --------------->

13.9

0.01

13.8 0.00

1980

1985

1990

1995

2000

Figure 1. GDP and the real exchange rate.

In spite of the mildness of the recovery, the import elasticity of demand dramatically rose and the current account balance significantly deteriorated. This latter feature can be explained, on the one hand, by the steady appreciation of the domestic currency shown also in figure 1 (on which more later),8 and on the other hand, by the dismantling of the previous system of protection of the domestic market (Moreno-Brid, 2001). Anyway, full liberalization of capital movements and privatization of public enterprises, coupled with high domestic interest rates and with a relatively low price of Mexico’s financial and real wealth instruments, attracted large inflows of foreign resources that financed the current account deficit. The inflow of foreign capital contributed to the expansion of the monetary base and the resources of the banking system. Simultaneously, the deregulation of the financial domestic sector enlarged banks’ freedom to manage assets and liabilities, to reduce their reserve requirements and to innovate with new financial instruments.

8 The real exchange rate r shown in figure 1 is defined as: r = (p/Ep*), where E is the nominal exchange rate (say pesos per dollar), p* is the price index of international prices and p is the price index of domestic prices. Hence, a rise in r denotes a currency appreciation. We thus depart from the Latin American tradition where the real exchange rate is usually defined as q = E(p*/p).

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372 50

0.75 40 0.70 30 0.65

20

0.60

10 0

0.55

Credit to private sector to banks total assets----->

-10

Lending real interest rate <------------

-20 -30

0.50

0.45

0.40 1980

1985

1990

1995

2000

Figure 2. Credit to the private sector and interest rate.

With larger resources at their disposal, and with much more freedom to manage assets and liabilities, banks expanded their lending at a very fast rate, as evidenced by the evolution of the ratio of lending to the private sector to total bank assets, which started to rise in the mid-1980s, reaching its peak somewhere before the crisis, and whose evolution appears to coincide with the evolution of the GDP9 (figure 2). In addition, it is noteworthy that after the financial reforms were implemented a somewhat anomalous situation appeared regarding interest rates. Indeed, in spite of the rise in the lending capacity of banks, the real interest rate did not decline (see again figure 2). But regardless of the high real interest rates, easier access to bank credit allowed some members of the ‘fringe of unsatisfied borrowers’ (Keynes’s dixit)—i.e. those who previously had been credit-rationed—to obtain finance in the formal credit market, with real

9

One of the referees to our paper has pointed out that the decline of inflation rates may have influenced money demand and credit supply. However, the (indirect) empirical evidence does not seem to lend support to this argument (see Galindo and Cardero, 2001). At any rate, in this paper we explore a different chain of causation; in the model below, we emphasize the impact of credit expansion on effective demand and on the rise in the price of domestic financial assets, which attracted foreign funds that contributed to the appreciation of the domestic currency (which in turn played a role in the reduction of inflation).

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0.018 0.017

<----------Real exchange rate

Dollar price of shares ------------>

0.016

17.5

15.0 0.015 12.5

0.014 0.013

10.0

0.012

7.5

0.011 5.0 0.010 0.009

2.5

0.008

0.0 1980

1985

1990

1995

2000

Figure 3. Price of shares and real exchange rate.

interest rates that were probably below what they were in the informal market. In other words, a larger part of latent demand for credit could now manifest itself as actual demand. Unsurprisingly, the dollar price of shares rose with the real exchange rate (see figure 3); but apparently this price rise was also influenced by the inflow of short-term foreign capital that now had access to the share market (figure 4), as well as the concurrent rise in credit to the private sector, which both enlarged the demand for Mexican financial assets. As shares do not figure prominently in private wealth, the rise in their price could not have played a large direct role on private demand. However, it is quite likely that the rise in their price also reflected a general rise in the price of Mexican financial and real assets, which probably stimulated higher private spending decisions. A part of the ‘extra’ spending decisions took the form of consumption demand, and in particular demand for imported consumer goods dramatically rose, favored by the appreciation of the peso (and by the reduction of tariff and non-tariff barriers). But private investment also increased, and in fact investment grew at a faster pace than consumption. As suggested previously, the rise in the price of shares may have contributed to stimulate private investment in Mexico (Mantey, 1996).10 This 10

Guerrero (1997) carried out an econometric estimate of private investment in Mexico, which corroborates the positive impact of the price index of shares on investment.

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374 12500

10000

Price of shares--------> Capital account balance <----------

15

7500

10

5000

2500 5 0

-2500

0 1980

1985

1990

1995

2000

Figure 4. Price of shares and capital account balance.

phenomenon can be rationalized on the basis of Minsky’s (1975) and Tobin’s (1969) theories. The rise in the value of the firm’s capital probably reduced the marginal risk of new investments, and also left firms with an untapped indebtedness disposition, because the ratio of commitments to own capital declined when the value of the latter rose. It may be important to point out also that new investment was not financed to any relevant extent through the equity market. In fact, as previously mentioned, this market did not really show any major changes after the liberalization of the financial system. Thus, firms satisfied their financial needs with loans from the domestic banks and (in the case of large firms) in the international capital market. Anyway, from the latter part of the 1980s onwards a persistent positive capital account balance critically contributed to sustain the level of foreign reserves (figure 5), and to the appreciation of the domestic currency (figure 6). The latter brought about a capital gain to foreign investors, which appears to have further attracted capital inflows. It is also likely that the real appreciation of the peso contributed to expand domestic demand and output. Indeed, evidence for Mexico strongly suggests that a positive association exists between the real exchange rate and private demand (see again figure 1). However, in concert with the business upswing, domestic and international financial fragility developed, with ever-growing indebtedness of the private

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40

<---------------International reserves

35

10,000

30

8,000

25

6,000

20 4,000 15 2,000 10 0 5 -2,000

0

Capital account balance-----------> 1980

1985

1990

1995

2000

Figure 5. International reserves and capital account.

<---------Capital account balance 10000

0.016

7500 0.014

5000 0.012 2500

0.010 0

Real exchange rate-------->

-2500

1980

1985

1990

0.008

1995

2000

Figure 6. Capital account balance and real exchange rate.

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sector vis-à-vis the banking sector, and of the national economy vis-à-vis foreign lenders. Indeed, between 1988 and 1994 the share of outstanding credit of firms with the banking system rose from being equivalent to 8.9 per cent of GDP in 1988 to 35.5 per cent in 1994. The figures for households show an even greater increase; i.e. their share rose from 14.2 per cent to 55.3 per cent (OECD, 1995). On the other hand, the share of government loans in total loans from the banking system declined from being a little above 60 per cent in 1988 to less than 10 per cent in 1994. These two phenomena, the rise in private indebtedness and the decline in the share of lending to the government from banks, we take as prima facie evidence of a rise in domestic financial fragility. In fact, it appears that the reduction in the share of the safe (government) loans in the total loans of the banks contributed to the rise of non-performing loans, whose share in the total assets of the banking system grew from less than 1 per cent in 1988 to over 5 per cent in 1994.11 As regards external financial fragility, at the microeconomic level the inflow of foreign funds resulted in heavy external indebtedness of the private sector, including the banks; the exposure of the latter in foreign currency rose from about 19,000 (million of dollars) in December 1992, to about 24,000 in December 1993, and to 25,000 in December 1994. Also, during the course of the business upswing important signs of macroeconomic international fragility appeared. Perhaps the most salient sign was the rise in the ratio of the accumulated current account deficit to GDP, which steadily and persistently grew, and the ratio of M2 to international reserves, which started to grow prior to the crisis. As the crisis itself showed, Mexico’s booming current account deficit had gone too far, bringing about a critical level of external financial fragility. But what is also striking is that the critical indicators, and particularly the ratio of M2 to international reserves, whose rise is considered in the empirical literature as one of the most clear signs that can anticipate a crisis, was rather stable (and below what it had been in the recent past) for quite some time after the current account balance had been showing a high deficit. In fact, notwithstanding the deterioration of the current account, Mexico’s new strategy received not only abundant foreign funds, but also praise from international financial institutions. In the domestic front, and in spite of the mildness of the upswing, and of the mounting evidence of financial stress of firms and banks, expectations also improved. According to the survey of 11

González (1997) estimated an econometric model for non-performing loans for the 1980–95 period, where the importance of the deregulation of credit and of the share of government loans in total loans is confirmed.

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entrepreneurial opinion that Mexico’s central bank conducts twice a year, in the second semester of 1986 the proportion of respondents that considered the economic climate as good was the same as the proportion that considered the economic climate as bad (at about 20 per cent each). A year later the proportion of the former rose (to 30 per cent) while that of the latter fell (to 14 per cent), and in the second semester of 1989 the respective proportions were 67 per cent and 3 per cent. Finally, in the second semester of 1994 (i.e. just before the crisis), the proportions were 64 per cent and 2 per cent, respectively (Cruz, 2004). There was certainly an ideological preconception, which helps one understand why in spite of the ever-growing current account deficit in a context of a quite modest business upswing, the international financial institutions, the press and domestic opinion maintained their support for Mexico’s economic strategy, and why in spite of the rise in the dollar price of Mexico’s financial assets the inflow of foreign funds could continue.12 In fact, one is reminded of the beauty contest analogy so convincingly put forward by Keynes—here the ideal type of beauty had taken the shape of the strategy advocated by the Washington consensus. Another reason comes from the difficulty to evaluate the soundness or otherwise of foreign indebtedness, since Mexico’s fundamentals appeared at first sight satisfactory and the signs coming from the market were in any case far from clear. As previously mentioned, investment had grown and capacities had expanded. On the other hand, exports were growing at a relatively fast rate, in spite of the appreciation of the currency. Also, the curse of inflation appeared to have been defeated. Finally, it was not easy for the economic authorities, for both economic and political reasons, to depreciate the domestic currency in order to redress the foreign balance. The benevolence of international financial institutions and foreign investors lasted approximately until the first quarter of 1994 (although expectations of domestic entrepreneurs remained optimistic until the crisis erupted). The capital account balance and the reserve position deteriorated in the course of 1994 (see figure 5). Even though the former remained positive, and reserves were at a relatively high level until the crisis erupted in December 1994, in the course of that year the government had to offer ever more favorable conditions to foreign investors in order to attract foreign funds, and the composition of the latter dramatically changed. Thus, the share accounted for by short-term capital inflows over total capital inflows rose about 50 per cent with respect to the previous year. 12

The rise in the dollar price of shares coincided with the rise in the price of shares in the USA, so that their relative price did not grow.

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However, what is also remarkable is that when a shift of opinion of foreign agents appears to have taken place, this was due to events to a large extent exogenous to the evolution of the Mexican economy. These events had to do with the rise in international interest rates, and with domestic political events that appeared as capable of destabilizing the ruling regime. Recall, the Zapatista uprising had taken place in January of 1994, later came the assassinations first of the presidential candidate of the ruling party, and later of the secretary general of that same party, which all provoked a change in this generous attitude. Of course, with the above we do not want to imply that the crisis was the consequence of exogenous factors. In fact, the ultimate cause of the crisis was the ever-growing external financial fragility Mexico’s economy was accumulating. But the precise date when the crisis erupted was certainly determined by factors that were not only economic sensu strictu. We shall now take stock of the previous theoretical and historical discussion in order to specify a model capable of explaining a balance-of-payments crisis, and the collapse of the domestic currency under conditions of imperfect information and a confidence breakdown.

4. MODELING THE DEVELOPMENT OF FINANCIAL FRAGILITY AND A FINANCIAL CRISIS

The main features of the model we shall develop are the following.13 First, we assume that output is governed by aggregate demand, and we posit that demand is affected by the trade balance and by domestic autonomous expenditure; the latter is assumed to depend on the availability of credit and on the distribution of income. Second, the economy is assumed to be open to foreign capital inflows, but domestic and international financial assets are imperfect substitutes. Third, we assume ‘credit rationing’. More specifically, we suppose that the volume of credit, and thus the quantity of money, is supply determined, by the supply from banks, and not by demand. This is a rather extreme assumption, but we adopt it here as a simple device in order to stress a peculiarity of Mexico and possibly other semi-industrialized economies, where small- and medium-sized firms are indeed credit rationed, and large firms tend to have recourse to foreign credit. Thus, although we 13

Our model owes a lot to Bhaduri (2003), Erturk (2004), and most especially to Frenkel (1983). The latter is particularly important in the Latin American context because, to our knowledge, it was the first to put forward the interrelationship between high domestic interest rates, foreign capital inflows, domestic credit expansion and external financial fragility.

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share the usual assumption of the Post-Keynesian school that credit and money are endogenous for the private sector as a whole, we distance ourselves from the so-called ‘horizontalist approach’. Finally, in order to simplify matters the model will be specified in linear terms. The model is composed of the following set of equations:14 B = br r − bYY ; br , bY > 0

(1)

F = f i i + fQ Q ;

f i , fQ > 0

(2)

Y = yr r + yC C ; yr , yC > 0

(3)

C = cR R − ci i ; cR , ci > 0

(4)

Q = Qr

(5)

Q = qC

(6)

R˙ = F + B

(7)

r˙ = q (R − R ); q > 0

(8)

Equation (1) specifies the current account deficit B, which depends on the real exchange rate r, and the level of output Y. We assume that the Marshall–Lerner conditions holds, and that a higher level of output is associated with a higher level of imports, and hence with a larger current account deficit. Please note that for the sake of simplicity we disregard factor payments. Equation (2) states that net capital inflows F (net of profit remittances abroad, of amortization payments etc.) responds to the level of the domestic interest rate on government bonds i, and to the dollar value of domestic financial assets Q , where Q = Qr according to equation (5), Q being the price in pesos of domestic assets. Thus, we assume, on the basis of Mexico’s experience, that a capital gain brought about by higher demand for domestic assets, and by appreciation of the currency, further stimulate capital inflows.15

14

br is the partial derivative of B with respect to r, etc. In a more realistic version of the model, it could be assumed that the relationship between Q and F is non-linear; however, we do not explore this issue, which is left for future research. 15

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Equation (3) states that gross output Y depends on the real exchange rate and on credit availability C.16 We assume that credit availability raises output through its impact on effective demand, and that currency depreciation diminishes effective demand. Our reasons for the latter assumption are as follows. First, currency depreciation will probably bring about inflationary pressures, which may be followed by a deflationary monetary and policy stance. Second, if depreciation does not bring about wage inflation, it will entail a reduction in real wages, or at least a reduction of the share of wages in value added. The consequent shift from profits to wages will induce a rise of the share of saving that will diminish the value of the multiplier. Finally, currency depreciation will raise the indebtedness ratio of firms indebted in foreign currency that may discourage new investment. Thus, unless net exports rise very strongly (which will depend on the price elasticity of exports and imports), output is likely to fall.17 Equation (4) specifies the factors affecting domestic credit C, namely, the change in foreign reserves R, and the domestic interest rate i. It is assumed that foreign reserves are the only source of the monetary base, and that bank lending rises when foreign reserves rise. On the other hand, a higher rate of interest on government bonds, which are the only safe financial assets, discourages bank lending because banks can earn profits without taking any risk. We assume that the domestic interest rate is always above the international interest rate. In equation (6) we posit that the peso price of domestic assets depends on the availability of credit. Finally, the dynamics of the model is made explicit in equations (7) and (8), where we take R and r as our state variables. The change in reserves by definition depends on (net) capital inflows F, and on the current account balance B. Furthermore, the currency tends to appreciate whenever the level of reserves exceeds a given value R .18 16

The variable C denotes the stock of credit outstanding, and not the flow of new credit. Anyway, our conclusions would not change if we assumed that output depends on the flow of new credit. 17 It is usually taken for granted that the depreciation of the currency will be expansionary provided the ‘Marshall–Lerner condition’ is fulfilled. However, this is not necessarily the case. See the classic paper by Krugman and Taylor (1978). By the way, since a currency depreciation with constant money wages is analogous to a reduction of real wages, we are implicitly assuming a ‘wage-led’ regime, using the terminology coined by Bhaduri and Marglin (1990). 18 The theory underpinning equation (8) views the dynamics of the exchange rate as dependent, in the first place, on the change in the country’s net assets of foreign exchange (since foreign reserves are by definition equal to the foreign asset position but less than the foreign liability position). In the second place, the dynamics depends on conventions. More specifically, R is to be taken as that the level of reserves that foreign exchange operators consider sufficient (or safe) for a given country. Thus, R is not a target level of reserves fixed by the authorities, but a convention determined by the market. As Keynes pointed out long ago, conventions need not be closely related to economic fundamentals, and they can abruptly change.

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Upon substitutions we specify (7) and (8) as functions of r and R.19 Then we have R˙ = a − br − cR + drR

(9)

r˙ = q (R − R )

(10)

where the positive parameters are a = fi i + bY yC ci i b = br + bY yr + fQ qci i c = bY yC cR d = fQ qcR We find now the equilibrium points (R*, r*) such that (9) and (10) are both cR * − a equal to zero. From (10) we get R* = R . And from (9) we get r* = . dR * − b Since the system is non-linear, we take the best linear approximation using the standard procedure. The Jacobian evaluated at the equilibrium point turns out to be dr * − c dR * − b  J R ,r =  ( * *)  q 0 

(11)

The dynamical behavior of the model in its linearized form is given by the signs of the trace and determinant of (11):20

19

The steps are as follows: R˙ = F + B = fii + fQ Q − br r − bYY

from (1) and (2)

= fii + fQ qC r − br r − bY ( yr r + yC C ) from (5), (6) and (3) = fii − br r − bY yr r + ( fQ qr − bY yC )C = fii − br r − bY yr r + ( fQ qr − bY yC )[cR R − cii ] from (4) = ( fii + bY yC cii ) − (br r + bY yr + fQ qcii )r − (bY yC cR )R + ( fQ qcR )r R Recall that when det(J) < 0 we have a saddle point; and when det(J) > 0 we have a sink if tr(J) < 0, and a source when tr(J) > 0. 20

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382 CASE A. Subcase A.i r

CASE B Subcase B.i r=0

r=0

r

R=0

R=0

(R*,r*) c d a b

a b c d

(R*,r*)

R=0

R=0

RB CASE A. Subcase A.ii r

c d a b

a b c d R=0

R

RB CASE B Subcase B.ii r

r=0

R=0

a b c d

(R*,r*)

R r=0

(R*,r*) R=0

R=0

a b c d

b a d c

RA

R

b a d c

RA

R

Figure 7. Phase diagrams.

tr(J ) = dr * − c det(J ) = −q (dR * − b)

(12)

We discuss now the dynamical trajectories of our two state variables, R and r, with the help of the different phase diagrams (see figure 7). As will be seen, the type of trajectory depends mostly on two sets of variables; on the one hand, on the value taken by R , the level of reserves that foreign exchange operators consider sufficient (or safe) for a given country. On the other hand, on the relative elasticity of the parameters a, b, c and d. Consider the linearized version of the model.21 In the table below we show the main properties of the equilibrium points and how they are related to the 21

The homogeneous non-linear model we obtain due to the algebraic manipulations has only one non-linear term, which satisfies and validates the Liapunov theorem about the first approximation of a system of ordinary differential equations.

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level of R and the structural parameters of the model. Note that the equilibrium point is unique in each one of the cases and subcases described below: R Low High

Parameters (a/c) < (b/d) (a/c) < (b/d)

(a/c) > (b/d) (a/c) > (b/d)

To start with, it may be pointed out that when (a/c) > (b/d), then we have a b < ⇔ fi fQ q < br yc (br + by yr ) c d

(13)

Now, an interesting feature of the model is that the left-hand side parameters of (13) are related with the financial side of the economy, while the right-hand side parameters are related to the real side of the economy. It appears, therefore, that the stability properties of our model are closely related with the relative strength of the financial vis-à-vis the real side of the economy. On the other hand, it must be mentioned that our assumption regarding the value taken by yr, the partial derivative of demand to the real exchange rate, also plays a role in connection with the stability conditions. The latter are more easy to be met when demand reacts positively to a rise in the real exchange rate than when the opposite is the case. Let us now dwell further on the mathematical properties of the model. Take first the case when the strength of the ‘financial’ parameters is low vis-à-vis the strength of the ‘real’ parameters, which we label Case A; then we have two subcases: (i) When R is low, the equilibrium point is a sink. Thus, the system is stable. (ii) When R is high, then the equilibrium point is a saddle point. There is only one convergent path. The saddle point is above the (a/b) ratio. On the contrary, in what we label Case B, namely when the strength of the ‘financial’ parameters is high vis-à-vis the strength of the ‘real’ parameters, then we have again two subcases: (i) When R is low, the equilibrium point is a source. Thus, the system is unstable. (ii) When R is high, then the equilibrium point is again a saddle point. There is only one convergent path. The saddle point is below the (a/b) ratio.

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The model in its non-linearized form gives rise to the following dynamical configuration. (a) R low, and whatever (a/c) < (b/d) or (a/c) > (b/d), then the paths followed by the state variables are spirals. In the first case, the system converges towards the equilibrium point, while in the second one it diverges from it. In this sense, the stability properties are the same as in the linearized version of the system. (b) R high, and whatever (a/c) < (b/d) or (a/c) > (b/d), then the paths followed by the state variables are saddle points. As was mentioned, when R is low, both in Case A and in Case B the equilibrium point is a spiral. However, no limit cycle can be said to exist. In order for a limit cycle to appear, it is necessary that non-linearities occur in any one of the original behavioral equations. In our model, the non-linearities arise due to the algebraic transformations of the original equations. Finally, it should be noticed that it is possible that in: Case A: (a/c) < R < (b/d), then no equilibrium point exists; or in Case B: (b/d) < R < (a/c), no equilibrium point exists. Notice also that instability of the exchange rate r and of the level of reserves R implies that the current account balance will also be unstable, but in the opposite direction. Indeed, the dynamics of the current account balance can be easily shown to be B˙ = −br r˙ − by ( yC cr R˙ + yr r˙)

(14)

We reconsider now the most important results from an economic perspective. In the first place, the value taken by R , the level of reserves that foreign exchange operators consider sufficient (or safe), plays a fundamental role regarding the trajectory of the state variables and of the system. Stability only can arise when R is low. The question arises, why is this so? In our opinion, this occurs because, when R is low, then even a small acceleration of output will tend to bring about a negative value for r˙ in (8). Accordingly, the exchange rate will depreciate. Now, depreciation of the exchange rate will have a negative impact on demand and output, as well as on the dollar price of domestic assets, which will tend to dampen capital inflows; which in turn will tend to dampen growth in R. On the other hand, a low R is merely a necessary, not a sufficient condition. Stability requires also that condition (13), (a/c) < (b/d), be fulfilled. It would appear, therefore, that when financial variables speedily react to stimuli, then any shock that takes the economy away from its equilibrium will move it further and further away from equilibrium.

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Nevertheless, we should also mention that policies can play a role in order to ensure that the conditions for stability are met; namely, the economic authorities could implement measures to establish Case A. Recall first that we have distinguished three regions depending on the value taken by R visà-vis the parameters of the model. In Case A, when R < (a/c), we are in the low zone sensu strictu. Then for (a/c) < R < (b/d) we are in a zone where no equilibrium can exist. Finally, when R > (b/d), this is the high zone. Now, stable equilibrium can occur only in the low zone. However, the value of the low zone is not a given constant. Even when conventions are such that the value of R is high, what matters is not its absolute value, but rather its value vis-à-vis the parameters of our model, namely fi, fQ, q, br, yc, by and yr. But even though these appear as parameters, the monetary authorities could exert an influence upon them.

5. FINAL REMARKS

On the basis of our analysis of Mexico’s recent experience with financial deregulation and liberalization, we have set up a model that appears to validate, in an open economy context, the conjectures about the volatility of capitalist economies put forward by two authors that have been frequently cited in this paper, Steindl and Minsky. In one of his last contributions, the former remarked that ‘Contrary to some opinions . . . diversity of expectations is a condition for the attainment and maintenance of equilibrium in [speculative] markets’ (Steindl, 1990, p. 371). And expectations need in fact diverge among operators in the financial markets, especially in order for capital inflows to be not too sensitive to changes in the interest rate and in the dollar price of domestic assets (low value for fi and fQ); which are important conditions on which stability depends. Minsky, on the other side, asserted in several places his belief that capitalist economies with developed and complicated financial structures are liable to fluctuate, and may even be highly unstable; thus requiring thwarting mechanisms to set limits and floors to these fluctuations (see especially Minsky and Ferri, 1992). What is more, we hope to have shown that instability due to financial factors is not a problem affecting only developed economies but also, and perhaps with vengeance, less developed ones as well. We think that conditions for instability can be expected to arise rather easily, following financial liberalization and deregulation in economies of this type. As seen in Mexico’s experience, in particular capital inflows turned out to be very responsive to rises in both the price of assets and the interest rate; the price of assets strongly responded to expansion of credit, and bank lending also swiftly

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responded to a greater availability of resources. We can then easily understand why in Mexico the exchange rate appreciated and foreign reserves were increasing, in spite of the deterioration in the current account situation. Of course, the persistent deterioration of the current account that accompanied the appreciation of the currency and the growth of reserves could not last forever. But the precise date when the situation would explode cannot be made precise with this, or with any other model. Rather, the only thing that the model can tell us is that an unstable situation was developing, and that the economy, under the prevailing rules, did not endogenously give birth to forces that would contribute to offsetting the tendency towards instability. In Mexico’s case, we may posit that during a first stage, the accumulation of an increasing current account deficit did not pose grave problems. The government acquired increased legitimacy and the country had a very good press, and further the renegotiation of the servicing of the external debt reduced foreign payments. But at a later stage, together with the accumulation of an ever-increasing current account deficit, its sustainable value was also reduced due to adverse economic and political events, national and international. Thus, the crisis was the consequence of the simple unfolding of the economic expansion, in the context of an ever-increasing external financial fragility. In other words, even a moderate growth rate and an unchanged government policy stance became extremely risky, and actually were not sustainable any longer under the existing institutional framework—i.e. in a financially very open economy—because the danger existed that investors might easily switch from peso-denominated to dollar-denominated financial assets. The question finally arises, why there is no evidence that a new crisis appears on the horizon, in spite of Mexico’s economy operating under essentially the same institutional setting? Answering this question in full would probably require another document. However, we could suggest very briefly that some of the reasons may have to do with changes in the speed of reaction of the financial parameters of the model, and especially in fi, fQ and q. That is, the reactions of capital inflows to changes in the interest rates and in the value of domestic assets, and of the price of financial assets to credit expansion, may be now less strong than they were before the crisis, precisely because a deep crisis took place.22

22

Of course, factors left outside of the model may be also playing a role. Thus, in a recent work Blecker (2004) discusses some of these factors. On the one hand, when the peso became overvalued in 2001–2, the government was able to devalue it without inviting a speculative attack. In addition, rise of the share of FDI (foreign direct investment) over ‘hot money’ helped to stabilize Mexico’s balance of payments. Finally, Mexico’s growth slowdown since 2001 has had the effect of reducing import demand and thereby preventing an excessive trade deficit.

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REFERENCES Arestis, P., Glickman, M. (2002): ‘Financial crisis in Southeast Asia: dispelling illusion the Minskyan way’, Cambridge Journal of Economics, 26, pp. 237–60. Bhaduri, A. (2003): ‘Capital flows, the balance of payments and the exchange rate’, in Dutt, A., Ros, J. (eds): Development Economics and Structuralist Macroeconomics: Essays in Honor of Lance Taylor, Edward Elgar, Cheltenham. Bhaduri, A., Marglin, S. (1990): ‘Unemployment and the real wage: the economic basis for contesting political ideologies’, Cambridge Journal of Economics, 14, pp. 375–93. Blecker, R. (2004): ‘The North American economies after NAFTA: a critical appraisal’, International Journal of Political Economy, 33 (1) (Fall 2003 issue, published 2005), pp. 5–27. Cruz, M. (2004): ‘The 1994–95 Mexican financial crisis: a further analysis using a PostKeynesian approach’, PhD thesis, University of Manchester. Erturk, K. (2004): ‘Reflections on currency crises’, Investigación Económica, 53 (248), pp. 15–40. Frenkel, R. (1983): ‘Mercado financiero, expectativas cambiales, y movimientos de capital’, El Trimestre Económico, 50, pp. 2041–76. Galindo, L. M., Cardero, M. E. (2001): ‘El proceso de monetización en México: la experiencia reciente’, Aportes, 6 (17), pp. 37–56. González, C. (1997): ‘Determinantes de la cartera vencida en México: un análisis de cointegración y modelo de corrección de errores’, Unpublished MA thesis, Maestría en Ciencias Económicas, Universidad Nacional Autónoma de México. Guerrero, C. (1997): ‘Los determinantes de la inversión privada en México’, Unpublished MA thesis, Maestría en Ciencias Económicas, Universidad Nacional Autónoma de México. Kalecki, M. (1942): ‘Studies in economic dynamics’, included in Osiatynsky, J. (ed.) (1991): Collected Works of Michal Kalecki, vol. II, Oxford University Press, Oxford. Krugman, P., Taylor, L. (1978): ‘Contractionary effects of devaluation’, Journal of International Economics, 8, pp. 445–56. Lavoie, M. (1995): ‘Interest rates in Post-Keynesians models of growth and distribution’, Metroeconomica, 46 (2), pp. 146–77. Mantey, G. (1996): ‘La liberalizaciòn financiera en Mèxico y su efecto en el ciclo econòmico’, Economìa Aplicada Nr. 26, Maestria en Ciencias económicas, UNAM, Mexico. Minsky, H. (1975): John Maynard Keynes, Columbia University Press, New York. Minsky, H. (1982): Can ‘It’ Happen Again? Essays on Instability and Finance, M. E. Sharpe, New York. Minsky, H., Ferri, P. (1992): ‘Market processes and thwarting systems’, Structural Change and Economic Dynamics, I, pp. 79–91. Moreno-Brid, J. C. (2001): ‘Liberalización Comercial y la Demanda de Importaciones en México’, Investigación Económica, 62 (240), pp. 13–51. Nasica, E. (2000): Finance, Investment and Economic Fluctuations: An Analysis in the Tradition of Hyman P. Minsky, Edward Elgar, Cheltenham. OECD (1995): ‘Mexico’, in Economic Surveys, OECD, Paris. Steindl, J. (1952): Maturity and Stagnation in American Capitalism, Basil Blackwell, Oxford. Steindl, J. (1964): ‘On maturity in capitalist economies’, in Problems of Economic Dynamics and Planning, Polish Scientific Publishers, PWN, Warsaw. Steindl, J. (1990): Economic Papers 1941–88, St. Martin, New York. Tello, C. (2004): ‘Transición financiera en México’, Nexos, 320, pp. 19–30. Tobin, J. (1969): ‘A general equilibrium approach to monetary theory’, Journal of Money, Credit and Banking, 1, pp. 15–29.

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Julio Gallardo Universidad Nacional Autonoma de Mexico Facultad de Economía Ciudad Universitaria México D.F. 56-22-21-10 y 56-22-21-86 E-mail: [email protected] Martin Puchet Universidad Nacional Autonoma de Mexico Facultad de Economía Ciudad Universitaria México D.F. 56-22-21-10 y 56-22-21-86 E-mail: [email protected]

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Juan Carlos Moreno-Brid Economic Commission for Latin America and the Caribbean (CEPAL) Organisation of the United Nations Presidente Masaryk 29, piso 13 Mexico D.F Mexico 11570 E-mail: [email protected]