Sunday, November 29, 2015

Peeling the Onion: The Mexican Oil Boom

I was driving my oldest down to stay the night with the grand parents and we had some time to talk.  As usually happens, the conversation turned to economics.  This happens with surprising frequency when I have time for discussion with the kids.  In this case, the issue of government control versus the free market came up.  Wanting to present a look at both with an pretty even hand, I chose the Mexican oil boom and subsequent collapse of the Peso.

The first stop on our journey was an example from this case history where government regulation can be helpful.  Mexico bet heavily on oil, so much so that there were no production limits.  With no production limits in place, producers produced as much oil as they could pump out of the ground.  This had the effect of lowering the global price of oil, which harmed every economy that relied on oil as a source of income, but was particularly hard on Mexico which had borrowed to finance their rapid expansion of production capacity.

So in this simplified but accurate example, we can see a need for government regulation.

But, peeling the onion a bit, let us back up and look at what really was happening.  Was free market exuberance really to blame for the troubles Mexico faced once the price of oil began to react to the nearly doubled rate of production?

Let's consider the source of the money used to finance the expansion.  In this case, Mexico borrowed from other countries.  This created a scenario where the value of the currency used in an economy, generally correlated to the GDP of the given economy, was dependent upon the return on investment of the money borrowed that must be repaid in that same currency.   Said more simply, the notes Mexico took and promised to repay would be directly affected in terms of value by the ability of the Mexican economy to remain stable.  Mexico, under this scenario, had an incentive to weaken their own currency as it would tend to reduce the impact of paying back these loans.  For governments, this is no problem except for the fact that it is most certainly a problem for people living under said government trying to live on said currency.  When currency values slide, the cost of living goes up.

So, broadly, government intervention was the root cause of the bust that followed the Mexican oil boom.  More to the point, government abuse of the power to borrow and then poorly manage things was the root cause.  What this helps us to see is the destabilizing influence a government can have on free market activities.  Let's suppose Mexico had never borrowed money to finance the expansion of oil production capacity? What limiting factor would have existed on their natural expansion rate?  Market Demand.  The free market with its ability to self regulate through supply and demand would have prevented both the oil production boom in mexico, which drove oil prices downward globally, and would have prevented the subsequent bust caused by a resulting inability to repay debts, because there would have been no debt.

The full series of mechanical linkages that caused the collapse of the Mexican economy are more detailed and complex than presented here, but as an example of whether we should look to more government regulation or less, this helps give a clear view that some regulation is needed, but usually as a direct result of some other influencing factor, like government subsidies, interest rates set by central banks, or other decisions made outside the natural bounds of the free market.

This is not to say that all decisions made by the free market, collectively, are always good and wise.  But the one thing the free market has going for it that no government will ever be able to duplicate is the speed with which the market self corrects and adjusts to new circumstances.  It may be very messy, large businesses may go bankrupt, but that is the cost of freedom that must be accepted as a risk factor if we are going to invest in large businesses which we have no real direct control over.  So, we can have very little regulation and assured ups and downs, or government regulation and assuredly see wide sweeping unintended consequences affecting huge sectors of the economy across many nations.

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