In an Uncertain World

by Robert Rubin

  Nor, with requirements this large, could the international financial institutions—the IMF and World Bank—arrange a rescue on their own, as they had in many other cases. Michel Camdessus, the French managing director of the IMF, was unknown to most Americans despite his tremendous influence. Skillful and audacious, Camdessus was prepared to weather the anger of his organization’s European shareholders to make a stabilization loan to Mexico of unprecedented size. But the sums needed exceeded the IMF’s available capability. The only realistic chance of avoiding disaster was help from the United States. The questions for me then became the possible consequences of financial chaos and default in Mexico, the danger of the program failing, and the possible costs of that failure.

  What has guided my career in both business and government is my fundamental view that nothing is provably certain. One corollary of this view is probabilistic decision making. Probabilistic thinking isn’t just an intellectual construct for me, but a habit and a discipline deeply rooted in my psyche. I first developed this intellectual construct in the skeptical environment of Harvard College in the late 1950s, in part because of a yearlong course that almost led me to major in philosophy. I started to employ probabilistic decision making in practice at Goldman Sachs, where I spent my career before entering government. As an arbitrage trader, I’d learned that as good as an investment prospect might look, nothing was ever a sure thing. Success came by evaluating all the information available to try to judge the odds of various outcomes and the possible gains or losses associated with each. My life on Wall Street was based on probabilistic decisions I made on a daily basis.

  This was the background I brought to the question of whether we should intervene in Mexico. With an enormous number of competing considerations, the key to reaching the best possible decision was identifying all of them and deciding what odds and import to attach to each—probabilistic decision making at work. Doing that also meant recognizing that our knowledge would never be as complete or perfect as I—or the rest of the team at Treasury—would like. Moreover, even with the most systematic and thorough work, a decision, though informed by the facts and analysis, would never emerge automatically from the yellow pad on which I scribbled notes. The final component of decision making was the intangible of judgment. The process of decision making that we evolved in the Mexican crisis—and that I would use over and over again in my time at Treasury—was familiar to me from my life in the private sector. But the range of considerations was much broader. For example, we had to think about the damage that a failed intervention could do to America’s credibility. If we attempted to help Mexico and did not succeed, our backing would be a less useful tool in some future crisis.

  Success had dangers as well. Even if our efforts helped stabilize Mexico, we might create a problem of what is known as “moral hazard.” Investors, after being insulated from the consequences of risk in Mexico, might pay insufficient attention to similar risks the next time, or operate on the expectation of official intervention. In Mexico, investors had become complacent, following a herd mentality in buying short-term dollar-linked bonds throughout 1994 without paying sufficient attention to the danger that the central bank’s currency reserves might not be sufficient to maintain their promised convertibility into dollars. We worried that our program to prevent Mexico’s failure might encourage investors to make similar mistakes again in the future.

  It was my good fortune to be able to think through these issues with Alan Greenspan and Larry Summers. In our backgrounds, our professional training, and our temperaments, the three of us were alike and very different. Alan is a conservative free-marketeer and an economist grounded in both macro policy and an acute empirical understanding of the American economy. Before entering government, he had his own private-sector consulting firm and traded actively for his own account. He is a precise man with an exceedingly good and understated wit. Larry, whose parents are both Ph.D. economists and who has two uncles who won Nobel Prizes in economics, was one of the youngest professors ever to receive tenure at Harvard. He is a forceful, self-assured theoretical economist with a good feel for the practical, both in politics and in markets. I had a pretty good conceptual understanding of economics, had spent a career in trading operations and management on Wall Street, and had been involved in Democratic politics. People who know me are familiar with my distrust of definitive answers and my habit of asking questions. While our personalities differed, they meshed—perhaps because our analytical approaches to a problem like Mexico proved highly compatible. Equally important was the spirit in which we worked. Though none of us is without ego, there was a remarkable lack of it in our meetings. Each of us tried to work with the others to find the best answer, not to show off his intellect or defend preconceived notions. Another crucial component of our relationship was the mutual trust we developed. For four and a half years, Alan, Larry, and I had breakfast or lunch at least once a week, along with many other meetings and discussions. After I resigned in 1999, Larry and Alan continued the tradition. To the best of my knowledge, nothing any of us said in any of those private meetings ever leaked out. (For this book, they gave me permission to refer to these conversations.)

  I had seen Greenspan periodically during my time at the White House but hadn’t known him very well before I became Treasury Secretary. When we were both thrown into the peso crisis, we got to know each other rather quickly. I was deeply impressed with the way he thought about the problem. Alan, who believes strongly in the discipline of markets, was very focused on the issue of moral hazard. This was why he had opposed the government rescue of the Chrysler Corporation in 1979. But, despite his opposition to the idea of government intervention in markets, Alan weighed the moral hazard against the risk of having Mexico go into default. He was a pragmatist, trying to find the best way to balance competing considerations.

  ALAN, LARRY, AND I AGREED about what had caused the crisis. Mexico, despite reforms in many areas, had made a serious policy mistake by borrowing too much in good times, leaving it vulnerable when sentiment shifted. And when markets began to lose confidence, the government put off facing reality for as long as possible. It borrowed still more, at shorter and shorter terms, issuing dollar-linked debt and spending its limited dollar reserves on holding up the peso, which had an exchange rate fixed to the U.S. dollar. At the same time, creditors and investors—both Mexican and foreign—were paying little attention to the buildup of economic imbalances. Their continued financing allowed the problem to become almost unmanageable when the crunch finally came.

  The trouble really began in the early 1990s, when Mexico’s current account deficit—basically the trade deficit plus net interest payments and some similar items—began expanding rapidly. To cover this gap, the country needed dollars, which it attracted by issuing government bonds. At first, it sold peso-denominated assets. But later, as investors became less willing to take on the exchange rate risk, the government started issuing large quantities of Tesobonos, short-term obligations whose value was linked to the U.S. dollar. For a while, these bonds proved attractive to Mexicans and foreign investors. But Mexico’s large current account deficit combined with a fixed exchange rate was not sustainable indefinitely. To make matters worse, Mexico’s banking system was weak and under strain.

  Underlying imbalances like Mexico’s are the real cause of resulting crises, but often some event that might otherwise not have created trouble serves as a trigger. In this case, a violent insurgency in the Chiapas region at the beginning of 1994 and the assassinations of two leading Mexican politicians created a deep sense of alarm in financial markets. Mexican bonds began to look much riskier and started to trade at steep discounts. Domestic and foreign investors became less willing to keep money in Mexico. The central bank had to sell more and more of its foreign exchange reserves as it struggled to meet the demand for dollars while holding the exchange rate unchanged. At the same time, the Mexican government found it more and more difficult to roll over its debt, despite of
fering higher and higher interest rates.

  As so often happens in financial markets, these negative effects became self-reinforcing. As investors feared that the exchange rate might fall, they moved into dollars and drove the government’s reserves down still further. This in turn made a peso decline more likely and exacerbated fears of a government default. The promise to repay Tesobonos with however many pesos were required to keep investors whole in dollar terms came to look less and less credible. With the foreign exchange reserves running out, the authorities made a last-ditch attempt to save the fixed-exchange-rate system with a partial devaluation, but that didn’t stem the tide. Domestic capital continued to flee, foreign market confidence plunged, and the government was forced to let the exchange rate float freely. Market attention shifted to the huge quantities of Tesobonos coming due in the weeks and months ahead. The demand for new bonds had dried up. So the government would have had to flood the market with pesos to pay off the maturing Tesobonos—which would send the exchange rate down further.

  The Mexican crisis is usually viewed as a failure of Mexican policy. But it was, crucially, also a failure of discipline on the part of creditors and investors—a point about crises that would become very important a few years later, when we faced the return of the same kinds of problems elsewhere and on an even larger scale. Lured by the prospect of high returns, investors and creditors hadn’t given sufficient consideration to the risks involved in lending to Mexico. Once investors became nervous, however, their reaction was swift and unforgiving. Mexico promptly lost access to international capital markets and couldn’t refinance the short-term Tesobonos. Most observers believed that in the long run Mexico would be able to repay its debts. But in the short run, with less than $6 billion left in foreign currency reserves and almost $30 billion in dollar-indexed bonds coming due in 1995—$10 billion in the first three months—Mexican and foreign investors wanted out. For better or for worse, there’s no international law enabling countries to reorganize their debts in bankruptcy court. Thus, our declining to intervene would likely have led to the default of a country that mattered to us in many ways.

  Mexico is a good example of a situation—often encountered by policy makers as well as by those in the private sector—in which all decisions had the potential for serious adverse consequences and the key was to find the least bad option. In this case, the dangers of not acting were severe economic duress in Mexico, a contagious decline in emerging markets, and a setback to American growth and prosperity. The risk of acting was failure—potentially endangering repayment of billions of dollars of taxpayer money—or, if we succeeded, moral hazard. Alan, Larry, and I all opposed making the holders of Tesobonos whole. But we concluded—I think rightly—that Mexico couldn’t be rescued without the side effect of helping some investors.

  We also worried that the Mexican crisis could affect the global movement toward trade and capital market liberalization and market-based economic reforms. NAFTA had just gone into effect on January 1, 1994. If Mexico went into default a year later, in part for failure to properly manage the influx of foreign capital, the case for further reform might be set back in the United States and abroad. Larry, who had served as chief economist at the World Bank before joining the Clinton administration, was especially concerned with this problem. “Letting Mexico go,” he argued, would send a discouraging signal to other developing nations—such as Russia, China, Poland, Brazil, and South Africa—that had been moving forward with market-oriented reforms. Though we took turns playing devil’s advocate, Larry, Alan, and I all came to a rough consensus in the days before my swearing in. All of us came to think that the risks of not acting were far worse than the risks of acting. Alan captured all of our views when he called a support program the “least worst” option.

  On the afternoon of January 10, the three of us, joined by a number of others, including my successor at the NEC, Laura D’Andrea Tyson, had our last meeting to confirm our recommendation to the President while waiting for my confirmation papers to arrive. Larry and I shared Alan’s view that we should put up a substantial amount of money, significantly more than we thought would be needed. In this, we were employing a corollary to Colin Powell’s doctrine of military intervention. The Powell Doctrine, which became well known during the Persian Gulf War, says that the United States should intervene only when American interests are at stake and that intervention must be with an overwhelming level of force.

  Of course, no one could say with certainty how much force would be needed to overwhelm the problem in Mexico. One benchmark was the total value of the outstanding Tesobonos, which at that point was about $30 billion. Even that might not be enough, taking into account other government debt, the external debt of Mexican banks, and the potential for “capital flight” as domestic holders of pesos converted them into dollars. Knowing the IMF would also put up a significant amount of money, we proposed $25 billion in U.S. loan guarantees—which had the same financial risk to our government as loans but with some technical advantages.

  No “right answer” or formula can exist for how much money is enough in such circumstances, because restoring confidence is a psychological matter that varies from case to case. In this instance, Tesobonos were on the minds of market participants and we decided to make available more than we thought Mexico would actually need. Like a big military arsenal, a large financial one can make a considerable psychological difference to the markets. If investors believe that a government has sufficient resources to right itself and that reforms are in place to deal with the underlying problems, the outflow should stop.

  WHEN WE GOT THE MESSAGE that my confirmation papers had arrived, Larry and I bundled up our notes and hurried over to the White House. We could not have been bringing the President a more difficult decision at a worse time. Only nine weeks before, he had been dealt a severe political blow—the Democrats had lost both houses of Congress for the first time in forty years. Newt Gingrich and his Contract with America were gracing every magazine cover, and President Clinton was fighting to reestablish himself politically. And here we were, coming into his office on January 10 asking him to make what was likely to be an unpopular and politically risky decision—which also had a real risk of not succeeding—based only on the policy merits.

  As usual, it didn’t take Bill Clinton long to grasp the situation. He had a few questions for Larry and me. Is there a real risk of cataclysmic consequences if we don’t do this? Clinton asked. We said yes. Second, the President wanted to know whether there was a good chance our program could prevent those consequences. While there was no guarantee of success, I repeated, the chances were good. Finally, the President asked how much money we could lose if the rescue didn’t work. Larry explained that the loan guarantees would be offered in increments of about $3 billion at a time. If the medicine didn’t seem to be helping, we should be able to stop our losses short of the full $25 billion.

  Once he heard our analysis and the seriousness of the situation, Clinton responded without hesitation that he would have to live with the political hazards. “This is what the American people sent us here to do,” he said. I also remember the President saying that he wouldn’t be able to sleep at night if he didn’t come to Mexico’s aid. Often, when I’ve heard criticism of Bill Clinton as indecisive or driven by politics rather than policy, I’ve remembered and cited that night as a response. He gained nothing politically by helping Mexico and risked much at a time when his political capital had already been greatly diminished.

  When our discussion was done, Clinton walked over to his desk, picked up the phone, and asked to be connected to the congressional leaders of both parties. Within a couple of hours, Senators Bob Dole (R-KS) and Tom Daschle (D-SD) and Representatives Newt Gingrich (R-GA) and Richard Gephardt (D-MO) all promised to back his emergency request for the loan guarantees. Larry and I went to see them all on Capitol Hill the next day, to solidify their support. At the outset, even Alfonse D’Amato (R-NY), the new chairman of the Senate
Banking Committee, who had been investigating Clinton relentlessly over Whitewater, was supportive. D’Amato said we ought to put up more than $25 billion, so that the financial markets wouldn’t think they could “overpower” us. With that encouragement, we increased our proposal to $40 billion. A critical component of the proposal also required Mexico to commit to various economic reforms and to pledge its oil export earnings to assure repayment.

  Despite this support from the congressional leadership, the reaction when Alan and I went to Capitol Hill to explain the plan was overwhelmingly negative. Meeting with more than a hundred legislators from both parties on January 13, we got our first taste of just how difficult getting Congress to act was going to be. Several members asked for a promise not to put U.S. tax dollars at risk. Some questions were very sensible but hard to answer. Senator Joseph Lieberman (D-CT) pressed us on why the Japanese and Europeans weren’t sharing the risk with us. I responded that our allies were making their contribution through the IMF. A less diplomatic response would have been that I believed our allies should have also contributed bilaterally, because a crisis in Mexico and possible contagion would have affected them as well. But they weren’t going to, perhaps in part because they considered Mexico our problem but also because they didn’t share our judgment about the global danger a Mexican collapse would create. In any event, none of this changed the fundamental point: acting was in our interest. Afterward, Larry and I went on a full-scale media and political blitz to press our case. Among the calls I made was to the governor-elect of Texas, George W. Bush, who offered his support for our effort. Like many border-state politicians, Bush instinctively grasped what was at stake and became a strong public supporter of our aims and efforts.