The Peso Crisis was the first of our recent “Global Financial Crises” (the Asian Financial Crisis of 1997-98, Russian 1999, and Argentina 2001 being the others).  As the Peso dropped in value and the Mexican economy headed for a deep recession many of us economists were caught flat footed and were lost for an explanation, much less a solution.

Since then we have come up with a laundry list of potential warning signs of an impending financial crisis.  First, fixed exchange rates can not last forever.  Countries and central banks wishing to gain confidence in their currencies may establish fixed exchange rates for a short period of time.  The stability of fixed exchange rates reassures foreigners that the value of their foreign investments will not be wiped out unexpectedly via a rapid devaluation.  The fixed exchange rate allows the local central bank time to “prove itself” as a respectable, well run institution.  Once this reputation has been built, however, it is time to move either toward a monetary union or (more likely) flexible and eventually floating exchange rates.

Doing the latter is easier said then done.  Often central banks are reluctant to remove their fixed exchange rates because “things are going so well.” Thus the if-it-isn’t-broke-why-fix-it mentality takes hold and the fixed exchange rates remained fixed for far too long.  As pressures build (current account deficits, monetization of the public debt, poorly capitalized banks, etc.) and build eventually the fixed exchange rate explodes, rapid devaluations occur, capital rushes out of the country and the financial crisis is underway.

The second thing we have learned is that bad banks do not fix themselves.  Commercial banks are critical to the functioning of a modern market economy.  Yet often times these banks come under intense political pressure to lend money based on “non-market criteria.”  That is, they are often pushed to lend money based on factors other than the borrowers’ ability to repay.  When these borrowers than fail to repay the loans they become “non-performing assets.”  Generally banks have owner’s equity (called bank capital) to offset these non-performing assets.  Badly run banks lack this capital and quickly become insolvent.

Insolvent banks need to be closed or merged with healthier banks.  More importantly the lending practices of these banks need to be changed.  Loans need be made based on sound risk analysis, not political considerations.  Merely recapitalizing these banks (a.k.a. bank bailouts) without fundamentally changing how they lend money will not resolve the situation.  Even more important is the timing of this bank restructuring.  Restructuring must be done before the crisis hits.  Waiting until the crisis occurs greatly increases the social cost of this, much needed, reform.  Worse still is the argument that a “growing economy” will somehow, magically, right these bad banks.  This is a head-in-the-sand policy that will only hasten the onslaught of the financial crisis.

Which gets us to the third thing we have learned about financial crisis:  structural or institutional reform is just as necessary as policy reform.  In order for market economies to function properly, they need sound economic institutions:  well functioning labor markets; well functioning, diversified financial markets; legal systems that enforce contracts and protect property rights; governments that provide public goods efficiently and without corruption; tax codes that do not distort incentives; and sound, enforced accounting systems.  While sound monetary and fiscal policies are necessary conditions for economic stability and growth they are not sufficient.  All too often policymakers and aid agencies have pushed for better economic policies without addressing the issue of economic institutions.

There are, of course, other things that have contributed to our global financial crises (asset bubbles, interbank lending, trade protectionism, etc.) but the three described above seem to play a major role.

In the case of Mexico they have done much to fix the first two problems, but not enough on the third issue.  Since the crisis the Peso has been allowed to float and it has functioned well as a pressure release value for the Mexican economy.  Notice that the Peso has been one of the few currencies that have fallen against the U.S. dollar over the last year.  The markets are being allowed to function.

Market forces are also at work in the Mexican banking and financial system.  Today the Mexican banking system is quite strong, there is an expanding bond market and the stock market is showing healthy gains as the Mexican economy expands.

And yet the Mexican economy is not expanding as fast as it could or should.  The economy desperately needs to modernize its labor markets and labor laws.  The legal system also needs to be overhauled, modernized and streamlined.  Perhaps most importantly the Mexican education system needs vast improvements.  As Mexico continues to grow and expand it going to need to better educate and train its young workforce.

Despite all of its problems the future for Mexico looks good.  It has recovered well from the crisis of a year ago.  It has a very young population for whom the future looks bright.  It looks much, much brighter than it did 10 years ago.

All the best,

MB