Creature From Jekyll Island by G. Edward

Paul Volcker, head of the Federal Reserve, rushed to meet with Mexico's finance minister, Jesus Silva Herzog, and offered to put the American taxpayer into the breach.

A $600 million short-term loan was extended to get Mexico past its election date of July 4. It was called a 'currency swap' because Mexico exchanged an equal number of pesos which it promised to redeem in U.S. dollars. Pesos, of course, were worthless in international markets—which is the reason Mexico wanted the dollars.

The importance of this loan was not its size nor even the question of repayment. It was the manner in which it was made.

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first, it was made by the Federal Reserve directly, acting as a central bank for Mexico, not the U.S.; and secondly, it was done almost in total secrecy. William Greider gives the details:

The currency swaps had another advantage: they could be done secretly. Volcker discreetly informed both the Administration and the key congressional chairmen, and none objected. But the public reporting of currency swaps was required only every quarter, so the emergency loan from the Fed would not be disclosed for three or four months.... By that time, Volcker hoped, Mexico would be arranging more substantial new financing from the IMF.... The foreign assistance was done as discreetly as possible to avoid setting off a panic, but also to avoid domestic political controversy.... Bailing out Mexico, it seemed, was too grave to be controversial.1

DEBT SWAP

The currency swap did not solve the problem. So, in March of 1988, the players and referees agreed to introduce a new maneuver in the game: an accounting trick called a 'debt swap.' A debt swap is similar to a currency swap in that the United States exchanges something of real value in return for something that is worthless.

But, instead of currencies, they exchange government bonds. The transaction is complicated by the time-value of those bonds.

Currencies are valued by their immediate worth, what they will buy today, but bonds are valued by their future worth, what they will buy in the future. After that differential factor is calculated, the process is essentially the same. Here is how it worked.

Mexico, using U.S. dollars, purchased $492 million worth of American Treasury Bonds that pay no interest but which will pay $3.67 billion when they mature in twenty years. (Technically, these are called zero-coupon bonds.) Then Mexico issued its own bonds with the U.S. securities tied to them as collateral. This meant that the future value of Mexico's bonds, previously considered worthless, were now guaranteed by the United States government. The banks eagerly swapped their old loans for these new Mexican bonds at a ratio of about 1.4 to 1. In other words, they accepted $100

million in bonds in return for canceling $140 million in old debt.

That reduced their interest income, but they were happy to do it, because they had swapped worthless loans for fully-guaranteed bonds.

1 Greider, pp. 485-6.

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THE CREATURE FROM JEKYLL ISLAND

This maneuver was hailed in the press as true monetary magic.

It would save the Mexican government more than $200 million in annual interest charges; it would restore cash flow to the banks; and—miracle of miracles—it would cost nothing to American taxpayers.1 The reasoning was that the Treasury bonds were sold at normal market rates. The Mexican government paid as much for them as anyone else. That part was true, but what the commentators failed to notice was where Mexico got the American dollars with which to buy the bonds. They came through the IMF in the form of 'foreign-currency exchange reserves.' In other words, they were subsidies from the industrialized nations, primarily the United States. So, the U.S. Treasury put up the lion's share of the money to buy its own bonds. It went a half-billion dollars deeper in debt and agreed to pay $3.7 billion more in future payments so the Mexican government could continue paying interest to the banks.

That is called bailout, and it does fall on the American taxpayer.

IMF BECOMES FINAL GUARANTOR

The following year, Secretary of State, James Baker (CFR), and Treasury Secretary, Nicholas Brady (CFR), flew to Mexico to work out a new debt agreement that would begin to phase in the IMF as final guarantor. The IMF gave Mexico a new loan of $3.5 billion (later increased to $7.5 billion), the World Bank gave another $1.5

billion, and the banks reduced their previous loan values by about a third. The private banks were quite willing to extend new loans and reschedule the old. Why not? Interest payments would now be guaranteed by the taxpayers of the United States and Japan.

That did not permanently solve the problem, either, because the Mexican economy was suffering from massive inflation caused by internal debt, which was in addition to the external debt owed to the banks. The phrases 'internal debt' and 'domestic borrowing' are code for the fact that government has inflated its money supply by selling bonds. The interest it must pay to entice people to purchase those bonds can be staggering and, in fact, interest on Mexico's domestic borrowing was draining three times as much from the economy as the foreign debt service had been siphoning off.2

1. 'U.S. Bond Issue Will Aid Mexico in Paying Debts,' by Tom Redburn, Los Angeles Times, December 30,1987.

2. 'With Foreign IOUs Massaged, Interest Turns to Internal Debt,' Insight, October 2,1989, p. 34.