When Austerity Is a Bigger Problem Than Inflation


The unwelcome landmarks continue to fall. Last week, US inflation rose above 9% for the first time in four decades, and the value of a euro dropped below the value of a dollar for the first time in two. Round numbers shouldn’t matter, and both continued trends that had been around for a while. But of course they do. 

To try to gain a perspective, let me offer how all of this is perceived in Mexico, where I spent last week. The grand country of 129 million that shares a long border with the US has a frustrating recent economic history of failing to grow despite many sincere attempts. But Mexico’s story does cast the battle against inflation and the strength of the dollar in a new light. 

And given that Mexico’s growth continues to disappoint, while organized crime is tightening its grip over ever more of the country, some of its performance is surprising. Turning to inflation, remarkably, it is lower in Mexico than in the US, as I showed last week:

Meanwhile, the peso has held up very much better than most currencies as the dollar has surged. This is how the euro and the peso have performed compared to the US dollar since the beginning of 2000. Despite everything, Mexico’s currency has held its value slightly better over that time than the euro:

If we look at a ranking of emerging market currencies against the dollar so far this year, the picture of Mexican resilience continues. It has barely given any ground against the dollar, while two other Latin American nations, Brazil and Peru, have gained slightly. For others, it’s a different story:

All of this has happened as Mexico churns through the fourth year of the presidential term of Andres Manuel Lopez Obrador (known as AMLO, his initials), an aggressive populist who had scared foreign investors throughout the two decades he acted as the left’s figurehead and campaigned for the presidency. AMLO has not made the mistakes many had feared. He may well, however, have made some very different but equally serious ones whose pain is not yet totally apparent.

The big thing that many didn’t grasp about AMLO is that frugality is his thing; he hates spending money and regards tight spending as virtuous. That meant that Mexico did less in fiscal terms than any comparable country to alleviate the hurt caused by the pandemic. Looking at the budget deficit of Mexico and the US as a percentage of gross domestic product, it’s impossible to tell that the pandemic even happened south of the border, while it led to a historic deficit north of it:

Hair-shirt economics like this help to strengthen the country’s currency and credit rating. After various economic disasters in the last 50 years, this is a big deal. AMLO witnessed the last two presidents to attempt sweeping populist growth policies suffer severe peso crises and hyper-inflation as they left office: Luis Echeverria in 1976 and Jose Lopez Portillo in 1982. Both borrowed and spent heavily. He has successfully avoided making the same mistake. But is this a good idea? Weirdly, many of his critics on the right in Mexican politics, along with many allies on the left, now complain that he has been too conservative.

Carlos Capistran, chief Mexico economist for Bank of America, suggests that austerity is not the same thing as fiscal discipline:

Mexico plans to continue with austerity as the driver of its fiscal policy. For the administration, austerity means keeping a primary balance close to zero no matter what. To achieve this “fiscal rule,” the government cuts expenditure (ex-emblematic projects) to whatever revenues (resources) it is able to get without hiking taxes. Investors have welcomed Mexico’s austerity because it has kept rating agencies at bay. But lower expenditure contributes to weak growth which turn into lower revenues which under austerity turn into low expenditure. This vicious circle will be difficult to maintain as expenditure cannot be cut ad infinitum. Fiscal discipline is sustainable, austerity is not.

The Organization of Economic Cooperation and Development shows that Mexico’s investment is startlingly low compared to the average of OECD members:

Meanwhile, domestic critics point out that Costa Rica, a much smaller country with fewer natural advantages, has managed to keep its GDP growing over the pandemic era. Mexico has not:

The risk is that a “social deficit” catches up with Mexico in the longer term, with the weakening of public services and failure to invest for industrial growth leading to a later reckoning. With many small companies forced out of business during the pandemic and receiving no compensation, the coronavirus era (which hit the country very hard) is likely to have longer lingering economic effects than in other nations. 

Mexican inflation is lower than in the US. Nevertheless, shouldn’t prices be rising more slowly? Mexico, as we’ve seen, didn’t do anything like America’s fiscal splurge. Its central bank also started to hike rates 12 months ago, long ahead of the Federal Reserve. With both fiscal and monetary policy far less likely to be inflationary, and with a growth problem, how to account for an inflation rate that has risen alarmingly to 8%?

The argument here is that Mexico’s minimum salary has grown sharply under AMLO (and had also started to grow in the closing years of his predecessor, Enrique Pena Nieto). Economic orthodoxy suggests that this should be inflationary, and more minimum salary rises are planned. However, policy makers rebut this by pointing out that the minimum wage was allowed to tank in real terms after the Tequila Crisis of late 1994, when the peso’s value against the dollar collapsed, ushering in an era of high inflation. In real terms, taking the minimum salary and deflating it by the Mexican consumer price index, it was irrelevant for two decades. Even now, after sharp increases, it’s only a third higher than before the Tequila Crisis. That’s not great growth for the workforce of a growing nation:

The other defense offered by policy makers is to blame Mexico’s very openness. It depends on exports to a great degree and is unavoidably exposed to its huge neighbor to the north. On which subject…

What about the strength of the peso? It’s impressive because Mexico’s open economy (exports account for 40% of GDP, compared to 17% for Brazil and 10% for the US) tends to make the currency deeply sensitive to the strength of global growth. As Capital Economics Ltd. of London points out, the peso’s correlation with the global stock market is stronger than any other currency, bar the Korean won: 

The peso has avoided falling as the global stock market swoons in large part because it is so inextricably entwined with the US. As a rule, when US growth is doing well, the peso is doing even better, and vice versa. A US recession, much feared, would have a serious impact on the Mexican economy and would also undermine support for the currency:

There are risks, then. The peso is currently attracting flows as a perceived haven, while its relative high yield and stability also draws funds from “carry traders” who short other low-yielding currencies such as the yen and euro. Such a trade is working very well at present, and helping to prop up the peso. History suggests, however, that this can turn around quickly. 

There are perhaps two key factors that are helping Mexico navigate the rough market waters. First, the flow of money from migrant workers, the great majority of whom are in the US, has reached new heights. In May, the last month for which there are data, it topped $5 billion for the first time. Typically, these are checks going to mothers in poor regions that have been hollowed out by migration. Thus they function as a direct injection of funds to the people who most need it and are most likely to spend it. 

Also, incidentally, note that as Mexican workers tend to be in the least well-paid jobs, these numbers suggest robust health in the US labor market. In the context of inflation, that can be read as either good or bad news:

The other great source of hope is in manufacturing exports. It’s been a central aim of Mexican policy since at least the North American Free Trade Agreement came into effect in 1994 to try to build a manufacturing sector. The country has succeeded in doing this. Manufacturing exports stagnated for several years after Chinese accession to the World Trade Organization in 2001, which was a disaster for Mexico (the last WTO member to vote to admit China). They dipped during the recessions that followed the Global Financial Crisis in 2008 and the pandemic in 2020, but over the last three years the success has been clear:

Mexico made a bet on globalization — and would have liked to make an even greater one by gaining freedom of movement for labor. It hasn’t delivered anything like the growth that had been hoped for. But the country has found a way to make things that other people will buy, while its migrant workers are providing a service for which people will pay. In certain vital ways, globalization is paying off. 

Where Does This Leave Us?

Austerity does seem to have worked as a way to avoid currency devaluation of a market attack on the sovereign rating. Others take note. It also may have helped to moderate inflation. But Mexico’s openness to the world economy made inflation almost unavoidable. Anyone trading as heavily as Mexico does is going to suffer higher prices. To avoid inflation at home might therefore have required not only austerity but also some retreat from globalization. As for Mexico itself, the “tail risk” of a major crisis is much smaller than in other similar countries; as jitters about the risks created by the strong dollar intensify, the peso is likely to maintain its role as a (very unlikely) haven.

The main readthrough, though, is to avoid making assumptions about the economic policy that any given politician will apply when in office. AMLO is certainly a “populist” rather than a liberal (“pueblo” comes up all the time in his speeches, while “libertad” almost never does). But many question whether it’s even accurate to call him “left-wing.” He talks in soaring language, but it tends to be free of the left’s ideological buzzwords.

In Mexico, it’s natural for a populist to have a deep distaste for the comfortable and corrupt life many bureaucrats enjoy — hence a campaign of austerity. And having watched a succession of presidents borrow too much and fall foul of international markets as a young man entering politics, it’s not surprising that AMLO was determined to avoid the same mistake. It’s an idea to listen to politicians when they say what they believe in. He’s declared loudly that a president who devalues the currency also devalues his presidency, and his previous tours in governments were also marked by austerity. 

Those who thought that an AMLO presidency meant an imminent risk of another classic Mexican financial crisis were wrong. But an attempt to cut down on government while not encouraging investment by the private sector isn’t a great way to create growth. This version of populism has proved equal to the challenge of keeping the currency strong. We’ll know in a few years whether maintaining austerity during a pandemic was a good idea. At this point, it’s hard to believe that it is.

OK, another tip for anyone considering traveling to Mexico City. It claims to have more museums and art galleries than any other city in the world, and I can believe it. The whole place is a feast for the eyes. Artists and photographers have long been attracted to the country by the color and the light.

To follow the beaten path (but it’s still great), you can track the star-crossed lovers Frida Kahlo and Diego Rivera. The giant bauble known as the Palacio de Bellas Artes in the center of town is full of Rivera’s greatest murals; Frida’s house (the “casa azul”) in the Coyoacan neighborhood is extraordinary, as is the modernist studio designed for them in nearby San Angel by the architect Juan O’Gorman; and the most fun is the Museo Dolores Olmedo at the city’s south end. Olmedo was an extraordinary figure who enjoyed affairs with three different Mexican presidents. She also had a lengthy affair with Rivera, mostly while he was married to Kahlo. Ironically, the museum, set in gorgeous grounds, has a massive collection of Kahlo’s paintings. It also has some of Rivera’s smaller scale works, which show that he — like Picasso — could have been a great artist in any format. And most impressively, Olmedo seemed determined to prove that she and not Kahlo had been the greatest love of Rivera’s life. The place is full of affectionate letters and gifts from the artist, and Olmedo also took care to place Rivera’s nude charcoal sketches of herself and Kahlo next to each other. Let’s say they certainly give the impression that Rivera was more attracted to Olmedo.

For a less well-known treasure, try the Centro de la Imagen, which is a great treasure trove of photography. Current exhibitions include Mujeres de Peso (women of weight) by Patricia Aridjis — and please note that the link will take you to photos that include nudity — and a retrospective of the photography of Mariana Yampolsky, who recorded Mexican society for decades. 

It’s all good. Now, back to inflation and equity and bond bear markets in New York. Have a great week everyone. More From Other Writers at Bloomberg:

• Supreme Court ‘Originalists’ Are Flying False Flag: Noah Feldman

• Data-Focused Fed Runs Out of Data to Change Plan: Jonathan Levin

• Dollar ‘Doom Loop’ Threatens World Markets: Alloway and Weisenthal

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”

More stories like this are available on bloomberg.com/opinion

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