While reading Krugman's appraisal on the 1994 economic crisis in Mexico, I couldn't help but notice that Mexico's crisis and the U.S.'s recent predicament share a similar cause.
A little background on the crisis: In the early 90's international economists noticed that inflation in Mexico was rising faster than in the U.S. so it was proposed that the Mexican govermment take steps to devalue its currency. At the time, the political parties opposed taking any strong stance on the issue given the proximity of an upcomming presidential elections (sort of like now). Once the elction took place, however, the policy passed and it was not long before it was labeled the "December Mistake".
Krugman argues that the eventual magnified consequence of the policy can best be explained by faltering investor confidence. When the policy devalued the peso less than was expected, investors felt more devaluations would follow. Further burdening confidence in the Mexican market was news that certain insiders had been privy to the devaluation long before it had been announced. The circumstanced drop the value of the peso in half but the effect was not limited in Mexico. Rather, the drop in confidence spread onto other Latin American countries (this is what's known as the Tequila effect). Mexico's efforts to resolve their crisis with higher interest rates and a large $50 billion loan from the U.S. only sent them into a recession and it wasn't until 1996 that the situation seemed to have improved.
Krugman boldy claims "if the analysis of the crisis given above is correct, many countries may be vulnerable to what amounts to the whims of the capital markets"(191). Indeed, his analysis is correct but as we've seen this vulnerability is not limited to developing countries Krugman underlies the power of investor confidence by adding: "A country need not follow unsound policies to get in trouble; all that need happen is for investors to conclude... that the country is at risk- and their loss of confidence will produce a crisis that justifies their fears"(191).
Now, I'm not saying that the situation in the U.S. is as bad as it was in Mexico. Aside from facing inflation, Mexico was also facing political turmoil which only gave investors more to worry about: an indigenous uprising in Chiapas (which had declared war on the Mexican government) and the mysterious assassination of a presidential candidate. Now, given the validity of Krugman's theory on the power of investor confidence and their present sensitivity, it's clear that any such occurrence in the U.S. would send consumer confidence over the edge.
