The Domestic Political Economy Of Exchange Rate Policy
First, they promote trade and investment by reducing exchange rate risk. Countries that share a common currency or have a long-term peg appear to trade much more than comparable countries with separate currencies (Rose 2000). Second, fixed rates promote domestic monetary stability. By anchoring the value of the domestic currency to a low-inflation currency (or gold), monetary officials are constrained to follow a time-consistent path of low inflation (Giavazzi and Pagano 1988; Canavan and Tommasi 1997). The cost of fixing is the flip side of this benefit: forfeiture of domestic monetary policy independence. When local monetary conditions cannot differ from conditions in the anchor country, monetary policy cannot be used for domestic macroeconomic stabilization. The distributional effects of regime choice follow from these aggregate costs and benefits: groups involved in foreign trade and investment (international banks and investors, exporters) should favor fixed rate systems because exchange rate stability promotes trade and investment (Frieden 1991). By contrast, groups whose economic activity is limited to the domestic economy (non-tradeables producers, importcompeting sectors) should prefer a floating regime that allows the government to stabilize domestic economic conditions. Scholars have examined the role of interest groups in exchange rate regime determination in a variety of contexts, from the historical gold standard to contemporary currency politics in Europe and Latin America.
Many have found that interest groups line up as anticipated, and that they seem to have an impact on policy outcomes (Hefeker 1995; Eichengreen 1995; Frieden 1997; Frieden, Ghezzi, and Stein 2001; Frieden 2002). However, research on the role of distributionally motivated interest groups in currency relations is not well developed. The determinants of interest group preferences require more detailed analysis, to specify more precisely how economic characteristics of firms and industries relate to their exchange rate preferences. More attention also needs to be paid to organizational characteristics of such interest groups, to show how their features relate to their ability to engage in collective political action. In many instances, interest group preferences are relevant inasmuch as they are mediated through political parties (Bearce 2003). Some have argued that centrist and rightist parties are likely to support fixed regimes as their business constituencies benefit from the credible commitment to low inflation, and from the expansion of trade and investment made possible by fixing (Simmons 1994). Left-wing parties, by contrast, favor flexible regimes since labor bears the brunt of adjusting the domestic economy to external conditions.
However, the character of partisan influences on exchange rate policy is not straightforward and further analysis will need to clarify their operation, and how they, in turn, relate to differences in electoral and legislative institutions. Another suggestion for future work is to give more attention to how international regime conditions affect domestic lobbying. For example, an implication of the focal point interpretation of international regimes is that interest group pressures might be the mechanism by which nations coordinate on a certain international regime, as suggested by Frieden (1993) and Broz (1997). In this account, the reason why the attraction of joining an international regime increases with the number of members is that interest group lobbying intensifies with the growth of a regime. Researchers have also recognized that regime choice has electoral implications, which vary with the structure of political institutions (Bernhard and Leblang 1999). It is easy to envision scenarios in which an office-seeking politician would be loath to join a fixed-rate international regime, as it would mean depriving himself of a tool to influence the economy for electoral purposes. In countries where the stakes in elections are high (e.g.
single-member plurality systems), politicians may prefer a floating regime 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 absence of democracy, rather than its form, that matters. One regularity is that non-democracies are more likely to adopt a fixed regime for low inflation purposes than democracies (Broz 2002; Leblang 1999).
Non-democracies 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 it is necessary to analyze the decision as a joint policy choice in which governments weight the costs and benefits of all alternatives (Bernhard, Broz, and Clark 2003). Analysts might pursue the idea that currency regimes and domestic monetary institutions are policy substitutes, and try to explain why some nations prefer exchange rate-based sources of low inflation credibility while others adopt domestic rules and institutions. Part of the explanation may reside outside the scope of domestic institutions and politics, in the character of the international monetary regime. At the margins, the existence of a large global or regional fixed rate regime may tip the decision toward an exchange rate-based stabilization, by adding the political economy benefits of greater trade to the extant credibility gains. To appreciate or depreciate? As with the regime decision, the choice of the level of the exchange rate has distributional and electoral implications. Of course, governments cannot directly set the real exchange rate, but they can affect trends in the real exchange rate over a period long enough to be of political and economic significance—typically estimated at three to five years.
Thus a government must decide whether it prefers a relatively appreciated or a relatively depreciated currency. This choice involves a basic political-economy trade-off between competitiveness and purchasing power. The real exchange rate affects the relative price of domestically produced goods in local and foreign markets, and it also affects the purchasing power of those who earn the currency. A real appreciation increases the purchasing power of local residents, by lowering the relative price of foreign (more generally, tradeable) goods. However, by making domestic goods more expensive relative to foreign goods, it reduces the “competitiveness” of local tradeables producers. A real depreciation has the opposite effects, reducing purchasing power but improving competitiveness by lowering the price of domestically produced goods. There is no clear economic guideline as to the appropriate level of the exchange rate. A relatively depreciated currency encourages exports and expenditure switching from imports to domestic goods, thereby boosting aggregate output. However, depreciation can have contractionary effects that follow from higher prices.
While the net effect on overall national welfare is very hard to calculate, the level of the exchange rate has clear distributive consequences domestically. Export and import competing industries lose and domestically oriented (non-tradeables) industries gain from currency appreciation (Frieden 1991). Domestic consumers/voters also gain as the domestic currency price of imported (and tradeable) goods falls, lowering the cost of living. Currency depreciations have the opposite effects, helping exporting and import competing industries at the expense of domestic consumers and non-traded industries. Group currency preferences are affected by economic factors, and their ability to turn these preferences into policy is affected by political institutions. Economically, the distributional impact of exchange rate changes is contingent on economic characteristics of industries and firms, for example the sensitivity of product prices to currency movements. Many goods prices do not respond rapidly to changes in currency values, a phenomenon associated with the fact that foreign producers are reluctant to “pass through” the exchange rate change to local consumers for fear of losing market share.
Producers of goods with low pass-through—specialized, highly differentiated products, such as automobiles—will be less concerned with the exchange rate than producers of goods with high pass-through, typically more standardized products. By the same token, the extent to which an industry relies on imported intermediate inputs will also determine whether it is harmed or helped by appreciation (Campa and Goldberg 1997). A number of regularities about preferences over the currency level can be identified. These are related to points made above about regime preferences. For example, the argument that producers of simple tradeables are relatively insensitive to currency volatility complements the argument that they are very sensitive to the level of the exchange rate: producers of commodities and simple manufactures will prefer a flexible regime and a tendency for a depreciated currency. On the other hand, the argument that producers of complex and specialized tradeables are very sensitive to currency volatility complements the argument that they are relatively insensitive to the level of the exchange rate: these producers will prefer a fixed regime. Capturing an industry’s (or an entire nation’s) sensitivity to exchange rate changes involves measuring the extent to which it sells products to foreign markets, uses foreign-made inputs, and, more indirectly, competes with foreign manufacturers on the basis of price (Frieden, Ghezzi, and Stein 2001). The panoply of interests in the exchange rate makes the political institutions within which they are expressed particularly important to explaining policy outcomes. Political institutions affect the impact of special interests on economic policy, including on exchange rate policy. By the same token, exchange rate policies are likely to be affected by varieties of electoral institutions, and by election timing. This is because the real exchange rate affects broad aggregates like purchasing power, growth rates, and the price level, and these broad aggregates are almost certainly relevant to elections.
Indeed, governments tend to maintain appreciated currencies before elections, delaying a depreciation/devaluation until after the election (Klein and Marion 1997; Frieden, Ghezzi, and Stein 2001; Leblang 2002). Electoral cycles in exchange rate policy help explain some characteristics of the currency crises that have been common over the past twenty years. Although the causes of currency crises are controversial (Corsetti, Pesenti, and Roubini 1999), delaying devaluation certainly makes the problem worse. Given the political unpopularity of a devaluation-induced reduction in national purchasing power, governments may face strong incentives to avoid devaluing even when the result is a more severe crisis than would otherwise be expected. In Mexico in 1993–4 and Argentina in 1999–2001, for example, electorally motivated delays almost certainly led to far more drastic currency collapses than would have otherwise been the case. The electoral cycle is likely to be muted in countries where the central bank has sufficient insulation from political pressures, or the government has a time horizon long enough to endogenize the higher costs of delayed action on the exchange rate. Political institutions condition the extent to which politicians are willing or able to respond to short-run electoral incentives. Interest group activity on the level of the exchange rate varies greatly over time and across country, and its impact on policy is a function of national political institutions. Analyses of the politics of exchange rate policy evaluate both special and masspolitical interests, and the institutions within which they are expressed, and have found strong evidence of interest group and election cycle effects on policy. One research frontier is the role of exchange rate policy as a substitute for other policies (and vice versa). For example, currency policy and trade policy are close substitutes: a 10 per cent real depreciation is equivalent to a 10 per cent import tax plus a 10 per cent export subsidy.Hence, the tradeables sector can organize on an industryby- industry basis to seek trade barriers or export subsidies, or as a whole to attempt to obtain a depreciation. This requires careful consideration of the organizational, political institutional, and other factors that might lead private actors to pursue one policy or the other, and public policy-makers to use one policy or the other. Exchange rate policies are similarly closely related to policies toward capital flows, financial regulation, and many other arenas. A full analysis of the political economy of exchange rate policy requires consideration of its alternatives. Another research challenge is to integrate the external regime environment into analyses of the domestic politics of exchange rate levels. The character of the extant regional or international exchange rate regime may condition national policy decisions on whether to appreciate or depreciate the currency. On the one hand, an external regime with explicit rules and sanctions regarding members’ exchange rate policies can make it difficult for a nation pressured by weak-currency interests to depreciate for competitive purposes. On the other, regime rules and monitoring mechanisms may limit the ability of national politicians to manipulate exchange rates for electoral purposes, especially if such manipulations impose costs on other governments..
