On Cinco de Mayo, a look at the other "Tequila Effect"

May 5, 2011

Following Portugal’s signing up for a 78 billion euro bailout today, 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 Portugal, 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, Portugal is by no means in the clear. The contagion that’s feared in Europe could produce a “Tequila Effect” for the Euro as interest rates rise and Portugal enters into a two year recession.

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. 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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