Political economy

Political economy

It is a commonplace of macroeconomics that the exchange rate is the most
important price in any economy, for it affects all other prices. In most countries, policy
toward the national currency is prominent and controversial. Exchange rates are so
central to the world economy that economic epochs are often known by the prevailing
exchange rate system – the Gold Standard Era, the Bretton Woods Era. Contemporary
developments reinforce the centrality of exchange rates to economic trends, from the
creation of an Economic and Monetary Union in Europe to the currency crises that have
swept the developed, developing, and transitional economies.
The analysis of the political economy of currency policy has focused on two sets
of questions. The first is global, and has to do with the character of the international
monetary system. The second is national, and has to do with the policy of particular
governments towards their exchange rates. These two interact. National policies,
especially of large countries, have an impact on the international monetary system. By
the same token, the global monetary regime influences national policy choice. For ease
of analysis, however, it is useful to separate analyses of the character of the international
monetary system from analyses of the policy choices of national governments.
The international political economy of exchange rate policy
International monetary regimes tend toward one of two ideal types. The first is a
fixed-rate system, in which currencies are tied to each other at publicly announced rates.
Some fixed-rate systems involve a common link to a commodity such as gold or silver;
others peg to a national currency such as the U.S. dollar. The second ideal-typical
monetary regime is free floating, in which national currency values vary with marketconditions and national macroeconomic policies. There are many potential gradations between these extremes.
In the past 150 years, the world has experienced three broad international
monetary orders. For about fifty years before World War One, and again in modified
form in the 1920s, most of the world was on the classical gold standard, a quintessential
fixed-rate system. Under the gold standard, governments committed themselves to
exchange gold for currency at an announced rate. From the late 1940s until the early
1970s, the capitalist world was organized into the Bretton Woods monetary order, a
modified fixed-rate system. Under Bretton Woods, currencies were fixed to the U.S.
dollar and the U.S. dollar was fixed to gold. However, national governments could
change their exchange rates when they deemed it necessary. Under this “adjustable peg”
system, currencies were not as firmly fixed as under the classical gold standard. Since
1973 the reigning order has been one in which the largest countries have had floating
national currencies, while smaller countries have tended either to fix against one of the
major currencies or to allow their currencies to float with varying degrees of government management.
Monetary regimes can be regional as well as global. Within the international freefor-all that has prevailed since 1973, a number of regional fixed-rate systems have
emerged. Some countries have fixed their currency to that of a larger nation: the CFA
franc zone ties the currencies of many African countries to each other and to the French
franc (now to the euro). Several countries in Latin America and the Caribbean have
pegged their exchange rates to the U.S. dollar. European monetary integration began
with a limited regional agreement, evolved into a Deutsche mark link, and eventually became a monetary union with a single currency and a common central bank. Countries
in the Eastern Caribbean and southern Africa have also developed monetary unions.
Global or regional monetary systems are the result of interaction among national
exchange rate policies. Fixing as part of a regional or global fixed-rate system is
fundamentally different than doing so in the context of generalized floating. In the
former case, choosing whether or not to fix is tantamount to choosing whether to
participate in the reigning world or regional monetary order. Conversely, when the world monetary system is one of floating currencies, a national choice to fix the exchange rate is principally available to small countries that want to lock their currencies with a trading and investment partner.
Interaction among states’ international monetary policies involves coordination
among national government policies, and/or more complex cooperation among them.
Coordination entails interaction among governments to converge on a focal point – such
as linking national currencies to gold or to the dollar. This implies the existence of a
Pareto improving Nash equilibrium (often more than one), such as is the case in an
Assurance game: countries want to choose the same currency regime, but may disagree
over which one to choose. Cooperation involves interaction among governments to
adjust policies consciously to support each other – such as joint intervention in currency
markets. This implies the existence of a Pareto inferior Nash equilibrium, which can be
improved upon (i.e. to a Nash bargaining solution), such as is the case in a Prisoners’
Dilemma game: countries can work together to improve their collective and individual
welfare. The two problems are not mutually exclusive; indeed, the resolution of one
usually presupposes the resolution of the other. But for purposes of analysis it is helpful to separate the idea of a fixed-rate system as a focal point, for example, from the idea that its sustainability requires deliberately cooperative policies.

Coordination in international monetary relations. An international or regional

fixed-rate regime, such as the gold standard or the European Monetary System, has
important characteristics of a focal point around which national choices can be
coordinated (Meissner 2002; Frieden 1993). Such a fixed-rate system can be selfreinforcing: the more countries were on gold, or tied their currencies to the Deutsche
mark, the greater the benefits to other countries of going down this path. This can be true even if the motivations of countries differ: one might particularly appreciate the
monetary stability of a fixed rate, the other the reduction in currency volatility. It does
not matter, so long as the attractions of the regime increase with its membership (Broz
1997).
Most fixed-rate regimes appear to grow in this way, as additional membership
attracts ever more members. This was certainly the case of the pre-1914 gold standard,
which owed its start to the centrality of gold-standard Britain to the nineteenth-century
international economy, and its eventual global reach to the gradual accession of other
nations to the British-led system. So too did it characterize the process of European
monetary integration, in which the Deutsche mark zone of Germany, Benelux, and
Austria gradually attracted more European members. But just as the focal nature of a
fixed-rate system can lead to a “virtuous circle” as more and more countries sign on, so
too can the unraveling of the regime lead to a “vicious circle.” The departure of one or
more important countries from the system can dramatically reduce its centripetal pull, as with the collapse of the gold standard in the 1930s: British exit began a stampede which
led virtually the entire rest of the world off gold within a couple of years.