The Need for Monetary Reform in Mexico

There is perhaps no more striking feature in Mexico's economic history than the persistent instability of the general level of prices. For any sufficiently long period for which there are reliable statistics, high and variable inflation is a consistent phenomenon. As a result of this behavior, living standards have been severely damaged, as reflected in several indicators, including low economic growth, frequent business fluctuations, sharp declines in real wages, and the worsening of the distribution of income. This dismal record has prevented Banco de Mexico, in operation since 1925, from attaining a solid reputation in terms of its commitment to price stability. During most of the 20th century, the country's monetary policy was conducted under a variety of predetermined exchange rate systems, which invariably ended in failure, with major devaluations of the peso against the U.S. dollar and consequent outbreaks of inflation. Following the 1995 crisis, the central bank has applied a flexible exchange rate policy, and since 1999 has moved toward an inflation-targeting approach. Even though inflation has recently fallen to rates not seen for several years, it is still high in terms of international standards. Furthermore, the episodes of instability during the 1990s have given way to proposals in favor of extreme fixed exchange rate regimes, including a currency board and the adoption of the dollar as the country's legal tender. Although such ideas have lost ground in light of the recent progress in domestic stabilization and the abandonment, mainly for fiscal reasons, of the Argentine currency board, they cannot be rejected a priori. The long and winding road toward stabilization and the limitations of current monetary policy make it necessary to consider alternatives to improve the likelihood of permanent price stability. From the long list of proposals traditionally entertained by economists, two options have gained ground, namely, improving current monetary policy under a purely flexible exchange rate regime with inflation targeting, and the adoption of the dollar as legal tender, or dollarization. This second alternative could also be advanced as the natural outgrowth of the increasing integration of Mexico with the United States and Canada, particularly since the approval of the North American Free Trade Agreement (NAFTA). The purpose of this paper is to examine the problem of chronic inflation in Mexico and propose alternatives to permanently overcome such an obstacle. My main claim is that Mexico should not continue to be underdeveloped in terms of price stability, since the tools to attain this goal are readily available. Hence, I first describe the phenomenon of Mexico's inflation and the serious costs associated with it, and address the question of why inflation has been so persistent in the country. In the next two sections, I identify some limitations of current monetary policy under flexible exchange rates, and analyze the improvement of that policy and the alternative of dollarization. Then, I reexamine the latter regime from the vantage point of Mexico's economic integration with North America and, finally, I present some concluding remarks. Inflation: A Chronic Malady During most of the 20th century, the Mexican economy was persistently subject to high and variable inflation that severely damaged living standards and the country's capacity for economic growth. During that century, inflation sank deep roots in the economy, turning into an affliction that the patient has yet to overcome. Inflation stubbornly appeared in every sufficiently long period of time. Figure 1 illustrates the evolution of inflation since 1935, using the GDP Implicit Price Deflator. The chart shows that price growth tends to be high and subject to abrupt fluctuations. Average annual inflation during the 66-year period was 19. …

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