Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Foreign Relations, U.S. Senate, January 26, 1995

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Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Foreign Relations, US Senate, January 26, 1995

I am pleased to appear before this committee today to review the Mexican economic and financial situation and the important efforts under way to avoid a major international financial disruption and to restore market confidence in Mexico.

Mexico's current financial difficulties are best understood in the context of much broader trends in international finance during the past ten to fifteen years--the globalization of finance--in which Mexico in recent years has participated and from which it has benefited. As a result of very rapid increases in telecommunications and computer-based technologies and products, a dramatic expansion in financial flows across borders and within countries has emerged. The pace has become truly remarkable. These positive technology-based pressures have affected the behavior of markets to a point where governments, even reluctant ones, increasingly felt compelled to deregulate and free up internal credit and financial markets.

Although there can be little doubt that these extraordinary changes in global finance have, on balance, been beneficial in facilitating significant improvements in economic structures and living standards throughout the world, they also have some potential negative consequences. In fact, although the speed of transmission of positive economic events has been an important plus for the world in recent years, it is becoming increasingly obvious--and Mexico is the first major case--that significant mistakes in macroeconomic policy also reverberate around the world at a prodigious pace. In any event, progress--and indeed developments affecting the emerging global financial system are truly that--is not reversible. We must learn to live with it.

Mexico, which had been hobbled for a number of years after the debt crisis of 1982, has more recently gone through a major economic metamorphosis toward significant improvement in its economic and financial structure. As a consequence, Mexico has been able to broaden its participation in the global economic and financial environment.

Over the past decade Mexico has made major strides. It has shed what was an inflation-prone, highly unstable economic structure with excessive government involvement and has taken on the characteristics of a vibrant economy oriented toward open markets. As a result, in 1990 Mexico was able to reenter the international credit markets on a significant scale. Foreign investors began voluntarily lending to Mexico substantial amounts for the first time since 1982. Shortly thereafter, as is characteristic of the new global financial system, foreign capital investment in Mexico began to accelerate. Indeed, in 1992 and 1993 the inflow of capital was so considerable that the Bank of Mexico had to buy dollars on a substantial scale to prevent the peso from becoming too strong. As a consequence, Mexico's international reserves increased to well over $25 billion at their peak in early 1994 from under $10 billion in 1990. Nonetheless, Mexico's trade deficit soared, and its current account deficit reached approximately 6 percent of gross domestic product in 1993.

As part of efforts to accelerate its move toward status as an industrial country, the government of Mexico endeavored to link the peso to the U.S. dollar. It adopted a complex exchange rate regime through which the Mexican peso was linked to the U.S. dollar via a moving exchange rate band. Like many nations that have tried to "import" the anti-inflationary policies of another country by locking their exchange rates, to a greater or lesser extent, to the currency of a major trading partner, Mexico hoped to gain quick benefits through significant reductions in inflation. And indeed, Mexico was remarkably successful for several years. The inflation rate fell sharply from almost 160 percent in 1987 to 7 percent by 1994, but at the same time Mexico was losing international competitiveness and its current deficit widened. …