NCPA - National Center for Policy Analysis

What Would Work In Mexico?

January 2, 1996

Judged by the standard of how well it maintains a stable currency, Mexico has one of the worst central banks in the world, ranking 101st out of 108 in an analysis published in 1994 -- before the monetary crisis that led to the $50 billion bailout by the United States and others.

To avoid future financial and political turmoil, Mexico must establish a system that allows the peso to be exchanged with other currencies at a rate that doesn't vary greatly over time. There are three basic kinds of such exchange rate systems: pegged, floating and fixed.

Pegged exchange rates are used by Mexico and most other developing countries.

  • In Mexico, the peso is linked to the U.S. dollar, and the central bank trades pesos with dollars to keep the exchange rate within a range, but allows the peso to gradually sink in value.
  • Unlike a free market, pegged rates require constant intervention by the central bank to manage both the peso-dollar exchange rate and the peso money supply.

The European Union hasn't been able to make a pegged system work, and in developing countries it leads to sky-high interest rates or foreign exchange controls that prevent people from trading weak currencies for strong ones.

In Mexico, the peg has been "adjusted downward," meaning the peso was devalued, many times, and as in other countries with this system, there are periods of high inflation, contractions and high unemployment.

A second system, floating exchange rates, creates a free market in currencies and is used by the U.S., Germany, Japan and many other developed countries. However, the central bank must keep tight control over the money supply -- which developing countries aren't likely to do for political reasons.

Under fixed exchange rates, a local currency is backed 100 percent by a strong reserve currency or gold or silver, and can be traded for it at an absolutely fixed exchange rate. Before World War II, few countries had central banks, but more than 70 had local currency boards that kept the currency in line with reserves. The system is used successfully in Argentina, Hong Kong and a few other countries.

Mexico would do better with a fixed rate system tied to the U.S. dollar. Under currency boards, undeveloped countries enjoyed higher growth rates and greater price stability than they have with their own central banks.

Source: Steve H. Hanke, "A Tale of Two Pesos: A Comparison of Currency Policies in Mexico and Argentina," Heritage Lecture No. 552, 1996, Heritage Foundation, 214 Massachusetts Avenue, NE, Washington, DC 20002, (202) 546-4400.

 

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