The International Political Economy Of Exchange Rate Policy
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 their currencies 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 monetary free-for-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 franc zone of the African Financial Community, or “CFA franc zone,” ties the currencies of fourteen 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 US dollar. European monetary integration began with a limited regional agreement, evolved into a Deutschmark 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. Analyses of international monetary regimes treat nation states as decision-making units (like “firms” in microeconomics) and consider how these units deal with standard coordination and cooperation problems. Coordination entails interaction among governments to converge on a focal point—for example, linking national currencies to gold or to the dollar. This implies the existence of a Pareto improving equilibrium (often more than one), such as is the case in an assurance game, in which each actor wants to choose the same strategy as other actors. In this case, each country wants to choose the same currency regime as other countries—nobody wants to be the only country on gold, or the only country to float—but may disagree over which one to choose. Cooperation among nation states involves the adjustment of national policies to support the regime—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 prisoner’s 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 EuropeanMonetary System, has important characteristics of a focal point around which national choices can be coordinated (Meissner 2005; Frieden 1993). Such a fixed rate system can be self-reinforcing: the more countries that were on gold, or pegged to the Deutschmark, the greater the benefits to other countries of also choosing to go along. 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 the case of the pre-1914 gold standard, which owed its start to gold-standard Britain’s centrality to the nineteenth-century international economy, and its eventual global reach to the accession of other nations to the British-led system. European monetary integration also progressed in this manner, as the Deutschmark zone of Germany, Benelux, and Austria gradually attracted more European members. The focal nature of a fixed rate system can lead to a “virtuous circle” as more and more countries sign on, but the unraveling of the regime can lead to a “vicious circle.” The departure of important countries from the systemcan reduce its centripetal pull, as with the collapse of the gold standard in the 1930s: British exit began a stampede which led virtually the rest of the world off gold within a couple of years. We have illustrated coordination problems by reference to fixed rate regimes, but similar problems arise in floating rate regimes. Members of a floating regime can benefit—individually and jointly—by committing to a common standard on payments and exchange restrictions (Simmons 2000). A focal point in this respect is the voluntary standard on payments restrictions embodied in the International Monetary Fund’s Articles of Agreement. The IMF standard proscribes governments from rationing or limiting access to foreign exchange when citizens request it to pay for imports or service a foreign debt.
This promotes international trade, which benefits all members. Simmons (2000) finds strong evidence of regional diffusion effects, suggesting that the gains of adopting the standard increase with the number of nations in a region that do so. Cooperation in international monetary relations. International monetary relations may require the resolution of problems of cooperation. A fixed rate system may give governments incentives to “cheat,” such as to devalue for competitive purposes while taking advantage of other countries’ commitment to currency stability. Even a system as simple as the gold standard sometimes relied on agreements among countries to support each others’ monetary authorities in times of difficulty.
An enduring monetary system, in this view, requires explicit cooperation among its principal members. The welfare gains associated with interstate collaboration in the international monetary realm are several. First, reduced currency volatility almost certainly increases international trade and investment. Second, fixed rates tend to stabilize domestic monetary conditions, so that international monetary stability reinforces domestic monetary stability. Third, predictable currency values can reduce trade conflicts: a rapid change in currency values often leads to an import surge, protectionist pressures, and commercial antagonism. These joint gains may be difficult to realize because they can require national sacrifices. Supporting the fixed rate system may require painful adjustment policies to sustain a country’s commitment to its exchange rate. Governments may be forced to raise interest rates to high levels in order to defend an overvalued currency, and the domestic economic and political consequences can lead to conflict over the international distribution of adjustment costs.
For example, under Bretton Woods and the European Monetary System, one country’s currency served as the system’s anchor. This forced other countries to adapt their monetary policies to the anchor country, and led to pressures on the key-currency government to bring its policy more in line with conditions elsewhere. Under Bretton Woods, from the late 1960s until the system collapsed, European governments wanted the United States to implement more restrictive policies to bring down American inflation, while the US government refused. In the EMS in the early 1990s, governments in the rest of the European Union wanted Germany to implement less restrictive policies to combat the European recession, while the German central bank refused. Generally speaking, the better able countries are to agree about the distribution of the costs of adjustment, the more likely they are to be able to create and sustain a common fixed rate regime. Historically, intergovernmental cooperation has been crucial to the durability of fixed rate monetary systems. Barry Eichengreen (1992) argues that credible cooperation among the major powers before 1914 was the cornerstone of the classical gold standard, while its absence explains the interwar failure to revive the regime.
Many regional monetary unions, too, seem to obey this logic: where political and other factors have encouraged cooperative behavior to safeguard the common commitment to fixed exchange rates, the systems have endured, but in the absence of these cooperative motives, they have decayed (Cohen 2001). Two recent regional ventures, Economic and Monetary Union in Europe (EMU) and dollarization in Latin America, illustrate these international factors. Dollarization appears largely to raise coordination issues, as national governments consider independent choices to adopt the US dollar. The principal attraction for dollarizers is association with dollar-based capital and goods markets; the more countries dollarize, the greater this attraction will be. The course of EMU from 1973 to completion did have features of a focal point, especially in the operation of the European Monetary System as a Deutschmark bloc, but the transition to EMU went far beyond this. Participants bargained over the structure of the new European Central Bank, the national macroeconomic policies necessary for membership in the monetary union, and a host of other issues. These difficult bargains were unquestionably made much easier by the small number of central players, the institutionalized EU environment, and the network of policy linkages between EMU and other European initiatives. Despite the importance of international factors, international monetary cooperation and coordination rest on the foundation of national currency policies, which are subject to an array of political economy pressures..
