Political economy

The domestic political economy of exchange rate policy
Political factors within nations give rise to pressures for – or against –
coordination and cooperation in the international arena. This is because exchange rate
policies involve tradeoffs with domestic distributional and political implications. The
tradeoffs governments confront are conditioned by interest group and partisan pressures,
political institutions, and the electoral incentives of politicians.
The two most important choices confronting policymakers involve the exchange
rate regime and its desired level. The regime decision involves choosing whether to
allow the currency to float freely or to be fixed against some other currency. Floats and fixed regimes are only two possible options, and a wide variety of intermediate regimes
exist (Frankel 1999). For all but irrevocably fixed-rate regimes, policymakers also
confront choices involving the level of the exchange rate, the price at which the national
currency trades in foreign exchange markets. Level decisions fall along a second
continuum that runs from a more depreciated to a more appreciated currency. Although
regime and level decisions are interconnected, we treat them separately to ease the
exposition.
Choice of exchange rate regime. Regime decisions involve tradeoffs among
desired national goals, whose benefits and costs of may fall unevenly on actors within
countries. Fixed exchange rate regimes have two main national benefits: they promote
trade and investment and they help stabilize domestic monetary conditions. Fixed rates
encourage trade by reducing exchange rate risk. Indeed, countries that share a common
currency (or have a long-term peg) appear to trade much more than do comparable
countries with separate currencies (Rose 2000). A fixed regime promotes domestic
monetary stability by imposing a monetary policy rule that constrains policymakers to
follow a time-consistent path. Without such a rule, monetary policymakers are tempted
to choose a suboptimal inflation policy – one that has higher inflation and no lower
unemployment than a policy with lower inflation. Fixing is a rule because monetary
policy must be subordinated to the peg, effectively “tying the hands” of the authorities.
(Giavazzi and Pagano 1988, Canavan and Tommasi 1997). In the nineteenth century, the
gold standard eliminated discretion. Today, governments in need of credibility peg their
currencies to the currency of a large, low-inflation country.
Fixed rates, however, have costs, the most important of which is the forfeit of
domestic monetary policy independence (i.e. the ability to have a local interest rate that
diverges from the world rate). Under fixed rates, monetary policy cannot be used for
macroeconomic stabilization because domestic interest rates cannot differ from world
interest rates. Monetary independence can only be obtained by floating the exchange rate
or by limiting international financial flows – options that entail obvious tradeoffs.
Fixed rates stimulate trade and investment and improve inflation performance, at
the cost of eliminating autonomous domestic monetary policy. Whether a nation is better off fixing or floating is partly a matter of economic circumstances, and the Optimal Currency Area literature points to openness, economic size, sensitivity to shocks, and labor mobility as important considerations (Tavlas 1994). Whether an interest group, political party, or politician is better off floating or fixing depends on how the benefits and costs of regime choice are distributed within a nation.
The distributional effects of regime choice are perhaps most pronounced at the
interest group level (Frieden 1991). Groups involved in foreign trade and investment
(international investors, exporters, multinational banks) should favor exchange rate
stability because it reduces the risks of international business. By contrast, groups whose economic activity is limited to the domestic economy (nontradables producers, importcompeting sectors) should prefer a floating regime that allows the government to affect domestic economic conditions.
These basic predictions regarding interest group politics have been tested in a
variety of contexts (Hefeker 1995, Eichengreen 1995, Frieden 1997, Frieden, Ghezzi, and Stein 2001, Frieden 2002). But research has not yet incorporated many aspects of exchange rates that should condition the regime preferences of particular sectors. One
omission is the impact of exchange rate “pass-through,” the extent to which an exchange
rate change is reflected in the prices of imported goods. Typically, there is a much higher degree of pass-through for more homogeneous commodities (e.g. wheat or copper), where the law-of-one-price might hold, than for highly differentiated manufactured products. This implies that producers of differentiated goods should prefer fixed regimes, since the prices of their goods are more sensitive to currency volatility.
Producers of simple commodities, by contrast, should be less concerned with currency fluctuations.
Research has also failed to give sufficient attention to collective action problems
that complicate group lobbying. The broad macroeconomic nature of exchange rates
suggests that, under normal circumstances, interest groups will have trouble acting
collectively on the issue. A fixed exchange rate regime, for example, benefits all
industries in the export sector, and thus reduces individual incentives to lobby (Gowa
1988).
Concern with collective action is reduced somewhat when political parties are
available to articulate the regime preferences of social groups. Political parties may, in
fact, be the institutions though which group preferences find political expression (Bearce
2003).
More broadly, parties aggregate the preferences of social groups, with centrist and
rightist parties likely to support fixed regimes as their business constituencies benefit
from the credible commitment to low inflation (Simmons 1994). By the same token,
center-right parties are likely to be enthusiastic about stable exchange rates due to the
expansion of trade and investment made possible by fixing. Left-wing parties, by
contrast, favor flexible regimes since labor bears the brunt of adjusting the domestic
economy to external conditions.
Partisan influences, however, are not straightforward, and several factors
condition the regime preferences and political influence of parties. Among the mitigating
influences is the degree of capital mobility, the structure of wage bargaining institutions
and independence of the central bank, “linkage” to trade and other policies, and
policymakers’ beliefs. These conditioning factors may, in turn, relate to fundamental
differences in electoral and legislative institutions.
Political institutions can affect the electoral incentives of politicians in governing
parties to adopt alternative exchange rate regimes (Bernhard and Leblang 1999). In
countries where the stakes in elections are high (e.g. single-member plurality systems),
politicians may prefer floating exchange rates, as a means to preserve the use of monetary
policy to engineer greater support before elections. Where elections are not as decisive
(e.g. proportional representation systems), fixing has smaller electoral costs, implying
that fixed regimes are more likely to be chosen. When the timing of elections is
predetermined, governing parties are less likely to surrender monetary policy by pegging,
since it can be a useful tool for winning elections. When election timing is endogenous,
there is less need for monetary flexibility, so pegging is more likely.
In the developing world, it may be the extent of democracy, rather than its form,
that matters. One regularity is that non-democracies are more likely to adopt a fixed
regime for credibility purposes than democracies (Broz 2002, Leblang 1999). Nondemocracies may peg because they are more insulated from domestic audiences, and bear
lower political costs of adjusting the economy to the peg. Or they may peg because other
alternatives, like central bank independence (CBI) are less viable in a closed political system. More generally, if fixed exchange rates and CBI are alternative forms of
monetary commitment, then we should analyze the decision as a joint policy choice.
Governments choose among monetary institutions that include a fixed exchange
rate, an independent central bank, both, or neither (Bernhard, Broz, and Clark 2003). The
conditions under which fixed rates and CBI will be direct substitutes may depend on the
availability of fiscal policy as an alternative to monetary policy, and the magnitude of
partisan and electoral pressures. Domestic “veto gates” (checks and balances) may also
shape the decision. For example, if CBI is more effective in lowering inflation in the
presence of multiple veto players, but fixed exchange rates do not require checks and
balances to be effective, then domestic institutions play a large role. The particular form
of veto player can matter, as when sub-national governments in federalist systems and
political parties in multiparty systems are the relevant veto players.
While there is little consensus on the specific role of political influences on
exchange rate regime choices, there is recognition that regime decisions involve tradeoffs
having domestic distributional and electoral implications. Selecting an exchange rate
regime is as much a political decision as an economic one.