The Liquidity Trap: Latin America's Free-Market Past

Michael Pettis

From Foreign Affairs, November/December 1996

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Summary:  Though hailed as a break with the past, free-market reforms prescribed by foreign experts are a familiar feature in Latin American history--as is the crash that follows.

Michael Pettis is a principal of the Hamilton Arbitrage Fund in New York City and an adjunct associate professor of finance at Columbia University's Graduate School of Business.

The story is well known in economics lore: A famous academic, one of the world's leading proponents of deregulation and free markets, is invited to Chile, which is in economic trouble. He and his followers propose a series of measures to open the economy, including easing banking restrictions, freeing credit, and eliminating tariffs. Their prescriptions are followed, and, as foreign capital pours in, the Chilean economy booms and becomes a model for the region. Or another version: In Mexico the president turns against the policies that have left the country heavily indebted and starved for domestic investment. He places a group of young foreign- trained economists and engineers in the trade and finance ministries, and they move rapidly to free up key areas of the economy and renegotiate Mexico's external debt. One of the most striking results of their reforms is a dizzying rise in inflows of foreign capital. In both cases foreign politicians, journalists, and bankers praise the reforms for spurring a transformation: from traditional, corporatist economic dogmas and their long history of poverty and economic stagnation to Anglo-Saxon-style competition and free markets.

These may sound like stories of modern Latin America, but both are old. The Chilean example does not refer to the "Chicago boys" of the 1970s and 1980s, nor does the Mexican example describe the Harvard-, Stanford-, and Columbia-trained technocrats whom President Miguel de la Madrid Hurtado pushed forward in the mid-1980s. The foreign expert who so beguiled the Chileans was the French academic Jean Gustave Courcelle-Seneuil, one of Europe's high priests of free-market capitalism, who was invited to Chile from 1855 to 1863 to advise the government. Among other reforms, his followers slashed tariffs in 1864 and even privatized the nitrate mines acquired from Peru in 1882 during the War of the Pacific. The brilliant Mexican technocrats were the cient'ficos, a party of idealistic young men who controlled key posts during the administration of President Porfirio D'az in the 1890s. Under the expert guidance of Jos? Y. Limantour, the sophisticated and forceful finance minister, their policies resulted in huge capital inflows, mostly into mining and railroad ventures, and a dramatic increase in Mexico's exports.

In neither case did the success last. The global crisis that swept through the United States and Latin America in late 1873 devastated Chile. As world commodity prices fell, the Chilean economy collapsed, a disaster exacerbated, according to many historians, by Courcelle-Seneuil's free-market policies. Fairly or unfairly, they argue that changes in the Chilean banking laws led to the failure of the country's currency and the abandonment of convertibility in 1878, that the 1864 tariff reduction brought about the destruction of domestic industry, and that privatization concentrated ownership among a small group of Chileans and foreigners.

In Mexico in the 1890s, the wealth of leading businessmen skyrocketed, workers' wages stagnated, and poverty among farmers and farm workers rose. Local banks had written too many loans to those who were politically connected or who speculated on real estate or securities, and ...

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