Mexico in the World Economy

Robert Mundell Columbia University

Universidad Autnoma de Baja California Tijuana, Mxico

September 27, 2007

I. Global Megatrends

Global Megatrends

Globalization IT Revolution The Euro Rise of China US and Global Governance

Currency Areas, 2007

Canada
Korea

Russia U.K. Sweden

Taiwan

RMB

Hong Kong

A India
Singapore Brazil

Mexico

Gulf Countries
CFA Nigeria

Latin American & Caribbean

A$

$
1.4

The Euro Cycle

1.3

1.2

1.1

1.0

0.9

0.8 Dollar per ECU/Euro 0.7

Plaza Accord

Yen per Dollar

140

-$ Rate and the Asian Crisis

130

120

110

Asian Crisis

100

90

Should the RMB float?

Wrong Question! An Oxymoron! Flexible Exchange Rate not a monetary rule. It is the removal of a monetary rule. Flexible rates are consistent with hyperinflation. Correct Question: Should Chinas fixed exchange rate monetary rule be replaced by an alternative monetary rule?

Choice of Monetary Rules

Exchange Rate Target? Inflation target? Money supply target? Which is better for China?

Observations
Since 1997, China has achieved better price stability by targeting the dollar than any other major country by inflation targeting. The major countries include the United States, the Euro area, Chile, Mexico, Brazil, U.K., or Russia.

China should not float

Chinas policy of targeting the dollar has given the Yuan an anchor, and policymakers a rudder for determining the best policy mix. An adequate case has not been made for changing that system. As long as the dollar is stable in terms of the US price level, China should maintain its current policy.

Asian Currency
Asia is considering the formation of an Asian Monetary Area. Would help insulate the area against G-3 Instability. Would eliminate competitive devaluation within the area. Would enhance Asias power in the world.

Asia Wakes Up, 2020?

India
Asian Currency Area

Russia

Baht

RINGITT WON Africa Rupiah

YEN P-Peso 15 RMB HK$

EURO

Arab Bloc

Australia-NZ

What about Latin America?

Would a Latin-American Dollar be Useful to the Region?

Conditions for a Latin American Monetary Union

Criterion for Monetary Stability Common Measure of Inflation Lock Exchange Rates Common Monetary Authority Division of Seigniorage Fiscal Stability

Larger union is Preferable to a Smaller Union

Should include: Brazil, Mexico, Argentina, Columbia, Venezuela, Peru, Chile, Ecuador, Uruguay, Paraguay, Bolivia, the Central American Countries and the Caribbean.

First Steps
1. Latin American Monetary Fund 2. Choice of Anchor 3. Narrowing of Exchange Rates 4. Pooling of Reserves 5. Common Monetary Policy

World Currency Map: 2020?

India

Russia

Euro Area

RMB

Africa Latin $

Dinar Area
Indonesia

Or Maybe

2020?

India
Asian Currency Area

Russia

Baht

RINGITT WON Africa Rupiah

YEN P-Peso 15 RMB HK$

EURO

Latin $ Arab Bloc

Australia-NZ

II. Macroeconomic Policy

Some of My Contributions to Economic Theory

The Mundell-Fleming Model. Mundell-Tobin Effect The Mundell-Dornbusch Model The Theory of Optimum Currency Areas Supply-Side Economics

Nobel Prize in 1999

It was for the first and fourth of these contributions that I received the Nobel Prize in 1999. The Academy of Science in Stockholm stated that it was awarding me the Prize for (my) analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.

Phelps the 2006 Winner

My colleague and friend at Columbia University, Edmund (Ned) Phelps won last year. It is perhaps interesting that I was the last solo winner of the 20th century, Phelps was the first solo winner in the 21st century. The following are before and after pictures of Phelps. They show the prize makes a difference!

This one is before.

And this one is after!

Phelps Prize

Phelps won his prize for his analysis of intertemporal tradeoffs in macroeconomic policy.

The Phillips Curve

In the early 1950s, monetary policy was strongly influenced by the idea of the Philips Curve, named after a New Zealander Professor at the London School of Economics. The Philips curve was a trade-off between unemployment and inflation. The implication was that an increase in the rate of monetary expansion would raise the inflation rate and lower the rate of unemployment.

Inflation Expectations
Around 1968, Phelps and Milton Friedman independently made a critique of the Phillips Curve, taking into account inflation expectations. They argued that the Philips curve assumed that labor unions would be indifferent to the inflation rate and not change their wage demands to compensate for inflation. Their incorporation of inflation expectations into the model reduced the effectiveness of inflation as a stabilization policy. If wage rates rise with inflation expectations, real wage rates would not fall and employment would not increase.

When inflation increases the Phillips Curve theory implies that equilibrium moves from A to B. But taking account of inflation expectations, the Phillips Curve shifts to the right and unemployment stays at the level indicated by C. .

C A

Phillips Curve
= rate of inflation; u = rate of unemployment u

The Natural Rate of Unemployment

Contrary to the Keynes model, the new theory implies that there is an equilibrium rate of unemployment independent of monetary policy. This has been called the natural rate of unemployment. Classical Economics was right after all!

The Natural Rate of Unemployment

The dotted red line gives the equilibrium rate of Unemployment independently of the inflation rate.

C A

Phillips Curve
u

Blow to Keynesianism
The Friedman-Phelps critique combined with the application of rational expectations to the problem by Lucas sunk the idea that economic performance could be improved by surprise inflation.

Not just not better, but worse

The end result is that there would have been no permanent reduction in unemployment, whereas there would have been a permanent increase in inflation. The bottom line is that any short run gain would be more than wiped out by the long run loss.

III. Mexico in the World Economy

The International Monetary System

No discussion of any country in the world economy could be relevant without considering the international monetary system. The IMS shows how prices expressed in different national currencies are connected together to enable trade in goods and services, capital and money to take place.

The World Economy Since WWII

The post-war international monetary system sometimes called the Bretton Woods system-that was set up after World War II, evolved out of the international gold standard.

The International Monetary System in 1969

Korea

Soviet Union
Canada

$
France

Sweden

RMB
India

DM

Mexico

CFA Italy

Latin American & Caribbean

8 Peso
The Mexican peso was fixed to the dollar at the exchange rate of $M12.5 = $US1.00. The Mexican peso was worth 8 US cents from 1954 until 1976. Throughout this period (or at least until 1971) Mexico had both a stable exchange rate and a pretty stable price level. How does the Friedman-Phelps Critique of the Phillips Curve work in that period.

New Critique of the Model

I want, however, to make a new critique of both the Phillips Curve and the FriedmanPhelps Critique based on the fact that it was based on a closed economy. In the 1960s the United States was not only an open economy but an open economy that was part of a fixedexchange rate international monetary system.

Monetary Policy and Fixed Exchange Rates

Under fixed exchange rates, monetary policy is not free to choose its own inflation rate. With an international monetary system such as existed under bimetallism, or the gold standard, or in the dollar-based gold exchange standard era from 1934 to 1971, there is a common inflation rate shared by all countries.

The World Economy

If the Phillips Curve was applicable at all, it was to the entire world economy, not to the individual nations making it up. The same applies for the Friedman-Phelps Critique.

Mexicos Fixed Exchange Rate

Let us accept the correctness of the Phillips Curve critique of Friedman and Phelps and see how it can be made relevant to an economy like Mexicos. From 1954 to 1976 Mexico had a fixed exchange rate. The peso was 8 cents. The exchange rate was 12.5 pesos = $1.00.

The Law of One Price

In fluid markets, prices in one country have to equal prices in other countries after converting into the same currency. Thus p = ep* gives the equilibrium price p of a good in (say) Mexican pesos where p* is (say) the US price in dollars, and e is the exchange rate, the price of the dollar in terms of pesos.

Dynamics
Differentiation of the equation p = ep* gives: = * + where is the rate of inflation in Mexico, = * is the US rate of inflation, and is the rate of depreciation of the peso against the dollar. If the exchange rate is fixed, equilibrium of the Mexican price level requires the same rate of inflation in Mexico as in the U.S.

The dotted red line gives the equilibrium rate of Unemployment independently of the inflation rate.

= * +

Variations around the Mean

There are of course reasons why inflation rates would differ even under fixed exchange rates. The price levels might not be in equilibrium. Differential changes in prices of domestic and international goods . Blocks in information. Changes in trade impediments. Capital movements.

Mexico in the World Economy

We have now brought the discussion into the macroeconomic situation in Mexico. Lets now discuss Mexico in the world economy.

II. Mexico and the World Economy

Flexible Exchange Rates

In 1971, the U.S. took the dollar off gold, and the European countries took their currency off the dollar. This gave rise to floating exchange rates, but nobody liked it so they went back to the dollar after a few months. But this didnt work out and generalized flexible exchange rates came into being in 1973.

Inflation
Flexible exchange rates mean that many countries gave up their monetary discipline, giving rise to generalized inflation in the 1970s. Mexico discovered oil in 1976 and promptly moved toward inflation. The dollar was devalued and then it floated.

Mexico floats and inflates; Europe stabilizes within itself

From 1976 until 1990 Mexico lost all monetary discipline and had the greatest inflation in its history. Floating rates so far had proved to be a disaster because it was not associated with a policy for controlling the money supply. Europe wanted fixed rates and so formed the EMS (European Monetary System) and the ERM (exchange rate mechanism).

Currency Areas October 1990 after Britains Entry into ERM

Soviet Union

Poland

Canada

Korea

$
France

Sweden Neth

Denmar

RMB

DM
Italy

Belgium

Hong Kong India Mexico

Gulf Countries

Austria
Spain

Latin American & Caribbean

CFA Franc

Euro Creates a New Power Center in 1999

Canada

Russia

Korea

$
Taiwan

Sweden

RMB

India

Indonesia

Hong Kong

Mexico Australia
Latin American & Caribbean

Brazil

CFA

Gulf Countries

The Currency Reform

Flexible exchange rates in Mexico led to inflation so drastic that by 1990 it became necessary to have a currency reform, to lop off unnecessary zeros. De facto Mexico went back to almost fixed rates in the 1990s with the US$ = $M 3.5 and Mexico recovered monetary stability. But political factors in the 1994 election combined with undisciplined monetary policy, creating the crisis of 1994-95, and the largest bailout in IMF history.

Mexico 1995-2006
Since 1994 the peso has depreciated and the dollar has risen from $M3.5 to around or above $M 10.00. Prices rose with the depreciated peso but the rate of inflation has been kept below two digits in recent years.

Remittances
Mexicos balance of payments has been succored by emigrants remittances which in recent years has come to be a leading element in the receipts side of the ledger. It is hard to separate drug money from the remittance accounts. Combined the total now comes to about $25 billion annually and will probably increase in the next few years.

Remittances, Poverty and Development

Most of the person-to-family remittances are a great benefit to Mexico from the standpoint of alleviating poverty. They should not be relied upon, however, as a tool of development. Most of the remittances probably go into consumption rather than investment and therefore do not contribute much to development.

Lessons from Mexicos Monetary History

The fixed exchange rate system worked well for Mexico in 1954-1976 in bring both price stability and exchange rate stability. The fixed exchange rate system is a good way of controlling the money supply if the automatic mechanism is allowed to work.

Events of 1976
But it was abandoned because of (1) IMF pressure and (2) spendthrift fiscal policies. The Board of Governors of the IMF had failed to find a way in the period 1972-74 to restore the international monetary system. It passed a second amendment to the charter, endorsing flexible exchange rates, which is the absence of an international monetary system.

Flexible Exchange Rates and Control of the Money Supply

The IMF started to push the new arrangement of flexible exchange rates, and Mexico was one of its first victims. The movement to flexible rates in the late 1970s proved to be a disaster because there was no control over the money supply and Mexico moved into hyperinflation.

Verdict on the 1994-5 Crisis

The currency reform in 1990s brought back monetary discipline and price stability along with exchange rate stability. But it was allowed to break down because of the political turmoil in the election year, and the monetary policy of the Bank of Mexico, which prevented the loss of dollars from reducing the money supply. Instead of a modest depreciation of about 40%, the peso depreciated as the dollar soared.

Recent Policy
Recent policy in Mexico has been more realistic than in the past. The floating rate has been combined with monetary discipline through inflation targeting. This is a great improvement over the flexible exchange rate period 1976-90.

Problem of Overvaluation
Mexico has been using monetary policy to control the inflation rate and to bring it down to target levels. The experience of other countries is that this method is successful at bringing about disinflation, but it is achieved through overvaluation of the currency. After the target inflation has been reached, the currency is overvalued and there is either a currency crisis or a pre-emptive devaluation.

Setting the new Exchange Rate

An alternative stabilization policy is to use the exchange rate as the instrument of stabilization. If inflation is currently, say, 10 per cent, and the target inflation rate is 3 per cent, plans for stabilization at the end of two years would require an exchange rate of (10 3) x2 = 14 per cent below the current equilibrium. If, for example the current exchange rate is 10% overvalued (because of the disinflation policy), the new equilibrium exchange rate should be in two years 24% below the current level.

Prerequisites of Stabilization
It would be desirable in the long run to return to a fixed rate, as in the period 1954-1976, and most of Mexicos earlier history with the silver standard. But prerequisite of a successful stabilization are at least threefold: (1) control over the budget, so recourse to central bank finance is not needed; (2) a substantial buildup of foreign exchange reserves; and (3) consensus on that policy by the top leaders of the government.

General Verdict
The two worst monetary systems are as follows: One is flexible exchange rates without monetary and fiscal discipline. Mexico had this between over the period 1976-1990. The other is fixed exchange rates without monetary and fiscal discipline. Mexico had this in 1974-76.

Benefits from Fixed Rates

There are great benefits from fixed exchange rates, especially for a country like Mexico that is next to the supereconomy. It should be remember that the growth miracles of Germany and Japan in the 1950s, and China in the past fifteen years were all achieved with export-led growth with fixed exchange rates and substantial foreign direct investment.

Monetary Stability
Mexico may be poised to follow in the same direction but it requires careful preparation and attention to the prerequisites. Monetary stability is not everything, but without it no country has ever been prosperous in a sustained way.

Gracias!