Lessons to learn from the “Tequila Effect” (vintage: 1994)

May 5, 2010

With so much focus on Greece lately, Cinco de Mayo is a good opportunity to discuss another fiscal crisis: Mexico in 1994.

Following two decades of overspending, Mexico faced a debt problem that was serious, but, at the time, manageable. However, violent uprisings in the country and political uncertainty led investors to question the riskiness of investing in Mexico’s debt. This led to a panicked sell-off of the debt holdings and, through a series of issues related to monetary policy, a rapid devaluation of the Peso. The crisis’s negative impact on the currencies of other South American economies was called the “Tequila Effect.”

The U.S. government threw Mexico a life preserver in the form of a $50 billion loan. While the loan helped stabilize the situation, Mexico’s economy nonetheless experienced a serious hangover from which it is, in many ways, still recovering.

In Greece, the situation is basically the same: reckless overspending and unmanageable obligations have led the country to require a “bailout” from the EU.  Even with a bailout, though, Greece is by no means in the clear. The contagion that’s feared in Europe could produce a “Tequila Effect” (maybe we should call it the “Ouzo Effect”?) for the Euro. As Businessweek reports:

For months the top leaders of the European Union resisted the idea of a bailout for Greece, wringing their hands over the estimated $61 billion cost. While the jawboning continued, the infection took hold. Bond vigilantes drove the Greeks’ borrowing costs into the double digits. Investors, fearing a contagion in Europe’s southern tier, dumped the stocks and bonds of Portugal and Spain. As it spread, markets started to pummel European banks and insurers for their exposure to what could prove to be one of the worst sovereign debt disasters ever. A bank crisis and a debt crisis rolled into one—the medical bills for this extreme case will make Europe long for the modest $61 billion of just a few weeks past.

[Note: As of this week, the EU is proposing a $143 billion for Greece.]

The real lesson here is that countries shouldn’t act as if they are immune from fiscal crises by borrowing and spending, and borrowing and spending some more. The U.S. – as we have noted numerous times — is in a similarly precarious position and needs to immediately put itself on a sustainable course by cutting spending to manageable levels. Otherwise, it could be facing the “Bourbon Effect”.

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