Democratic Institutions and Exchange Rates 75 institutions on exchange-rate commitments during the interwar period.16 He finds no systematic relationship between proportional representational systems and exchange- rate regime choice.Instead,the severity of societal cleavages affected the ability of the state to maintain its commitment to the gold standard. One reason that the relationship between domestic political institutions and exchange-rate commitments is unclear stems from the fact that these arguments do not focus explicitly on politicians'incentives.Politicians and parties face political incentives-in particular,reelection-that condition their choice of exchange-rate arrangement.These political incentives,in turn,reflect the configuration of domestic political institutions.Domestic electoral and legislative institutions strongly influ- ence how politicians balance their own needs with the demands of economic and societal actors in the choice of exchange-rate regime.Consequently,we predict a relationship between the configuration of domestic political institutions and the choice of exchange-rate arrangement,even after controlling for international systemic and economic influences. Domestic Political Institutions and Exchange-rate Arrangements We argue that domestic political institutions influence politicians'incentives over the choice of an exchange-rate regime.We begin with the assumption that politicians in the governing party(ies)have an interest in maintaining their position in office.By serving in office,the governing party(ies)have the ability to control both public policy and particularistic policies,which,in turn,enhance their reelection fortunes. An exchange-rate commitment,although it may help stabilize the external trading environment or achieve certain macroeconomic policy goals,limits politicians'dis- cretion over monetary policy,especially in an era of capital mobility.The configura- tion of domestic political institutions affects the willingness of governing party(ies) to give up discretion over macroeconomic policy.In particular,we argue that the electoral system and legislative institutions condition the choice of exchange-rate regime. First,the decisiveness of the electoral system influences the need of the governing party(ies)to maintain discretion over macroeconomic policy.Majoritarian electoral systems tend to"manufacture"single-party majority governments.17 In these sys- tems changes in a relatively small number of votes can actually lead to large swings in the distribution of legislative seats and,potentially,a change in the governing party.Consequently,politicians in the governing party(ies)will wish to maintain full control over any policy instrument that may help to secure their electoral majority.In particular they want to retain the ability to manipulate monetary policy in the run-up to an election or to appeal to key swing constituents.Since an exchange-rate commit- 16.Eichengreen 1992b. 17.Lijphart 1984
Democratic Institutions and Exchange Rates 75 institutions on exchange-rate commitments during the interwar period.16 He finds no systematic relationship between proportional representational systems and exchangerate regime choice. Instead, the severity of societal cleavages affected the ability of the state to maintain its commitment to the gold standard. One reason that the relationship between domestic political institutions and exchange-rate commitments is unclear stems from the fact that these arguments do not focus explicitly on politicians' incentives. Politicians and parties face political incentives-in particular, reelection-that condition their choice of exchange-rate arrangement. These political incentives, in turn, reflect the configuration of domestic political institutions. Domestic electoral and legislative institutions strongly influence how politicians balance their own needs with the demands of economic and societal actors in the choice of exchange-rate regime. Consequently, we predict a relationship between the configuration of domestic political institutions and the choice of exchange-rate arrangement, even after controlling for international systemic and economic influences. Domestic Political Institutions and Exchange-rate Arrangements We argue that domestic political institutions influence politicians' incentives over the choice of an exchange-rate regime. We begin with the assumption that politicians in the governing party(ies) have an interest in maintaining their position in office. By serving in office, the governing party(ies) have the ability to control both public policy and particularistic policies, which, in turn, enhance their reelection fortunes. An exchange-rate commitment, although it may help stabilize the external trading environment or achieve certain macroeconomic policy goals, limits politicians' discretion over monetary policy, especially in an era of capital mobility. The configuration of domestic political institutions affects the willingness of governing party(ies) to give up discretion over macroeconomic policy. In particular, we argue that the electoral system and legislative institutions condition the choice of exchange-rate regime. First, the decisiveness of the electoral system influences the need of the governing party(ies) to maintain discretion over macroeconomic policy. Majoritarian electoral systems tend to "manufacture" single-party majority governments." In these systems changes in a relatively small number of votes can actually lead to large swings in the distribution of legislative seats and, potentially, a change in the governing party. Consequently, politicians in the governing party(ies) will wish to maintain full control over any policy instrument that may help to secure their electoral majority. In particular they want to retain the ability to manipulate monetary policy in the run-up to an election or to appeal to key swing constituents. Since an exchange-rate commit- 16. Eichengreen l992b. 17. Lijphart 1984
76 International Organization ment limits their policy discretion,potentially hurting their ability to retain office, politicians in a majoritarian system will prefer to let the currency float. In contrast,elections in proportional representation systems usually do not result in single-party majority governments.Instead,bargaining between parties deter- mines the composition of the government.Consequently,a party may lose a few votes in an election but retain the possibility of participating in the government. Since small vote swings do not necessarily have dramatic consequences for the com- position of the government,politicians in these systems may be less reticent to relin- quish discretionary control over monetary policy by fixing the exchange rate.More- over,a fixed exchange rate might actually help in coalition bargaining by providing a focal point for parties with diverse interests over monetary and economic policy.A pegged exchange rate is a "transparent"policy rule-that is,it can be observed at any time and is not subject to the long lags inherent in obtaining inflation and money supply data from the government.18 Parties in a coalition government might agree on a fixed exchange-rate focal point simply as a way to settle conflicts about policy. Additionally,a fixed exchange rate allows parties in the coalition government to monitor the policy activities of the party that holds the ministry of finance.19 In proportional representation systems where coalition or minority governments are common,therefore,politicians are more likely to fix their exchange rate. Second,the costs of serving in the opposition affect the incentives of the govern- ing party(ies)over the exchange-rate regime.In some systems opposition parties are excluded from the legislative policy process.Legislative committees may lack the resources to formulate policy or oversee the policy implementation.20 The governing party(ies)may also dominate committee membership or leadership positions,limit- ing the possibility of challenges to the government.21 Finally,the government may possess strict control over the legislative agenda,preventing committees from bring- ing issues to the legislative floor.In these systems,opposition legislators lack the ability to influence policy or to distribute particularistic policies to their constituents Politicians in the governing party(ies),therefore,have strong incentives not to risk their position in office.Consequently,they will not want to limit their policy discre- tion with a fixed exchange-rate arrangement. In other systems opposition parties play a larger role in the policy process.Legis- lative committee membership and leadership positions,rather than being dominated by the governing party(ies),are distributed across parties in proportion to their strength 18.See Aghevli,Khan,and Montiel 1991:and Bernhard 1997. 19.Parties in a coalition government bargain over both policy and the distribution of cabinet portfolios. See Laver and Schofield 1990;and Laver and Shepsle 1996.Although constrained by the coalition agree- ment,the party that controls the ministry of finance possesses institutional and informational advantages in the development and implementation of macroeconomic policy-advantages that the party could ex- ploit to enhance its own fortunes at the expense of its coalition partners.Bernhard 1998.A fixed exchange- rate commitment can help limit this potential for abuse by providing coalition partners with a clear stan- dard to monitor and evaluate the macroeconomic policy choices made by the party holding the finance portfolio. 20.See Krehbiel 1991;and Lupia and McCubbins 1994. 21.Strom 1990a
76 International Organization ment limits their policy discretion, potentially hurting their ability to retain office, politicians in a majoritarian system will prefer to let the currency float. In contrast, elections in proportional representation systems usually do not result in single-party majority governments. Instead, bargaining between parties determines the composition of the government. Consequently, a party may lose a few votes in an election but retain the possibility of participating in the government. Since small vote swings do not necessarily have dramatic consequences for the composition of the government, politicians in these systems may be less reticent to relinquish discretionary control over monetary policy by fixing the exchange rate. Moreover, a fixed exchange rate might actually help in coalition bargaining by providing a focal point for parties with diverse interests over monetary and economic policy. A pegged exchange rate is a "transparent" policy rule-that is, it can be observed at any time and is not subject to the long lags inherent in obtaining inflation and money supply data from the government.18 Parties in a coalition government might agree on a fixed exchange-rate focal point simply as a way to settle conflicts about policy. Additionally, a fixed exchange rate allows parties in the coalition government to monitor the policy activities of the party that holds the ministry of finance.19 In proportional representation systems where coalition or minority governments are common, therefore, politicians are more likely to fix their exchange rate. Second, the costs of serving in the opposition affect the incentives of the governing party(ies) over the exchange-rate regime. In some systems opposition parties are excluded from the legislative policy process. Legislative committees may lack the resources to formulate policy or oversee the policy implementati~n.~~ The governing party(ies) may also dominate committee membership or leadership positions, limiting the possibility of challenges to the go~ernment.~~ Finally, the government may possess strict control over the legislative agenda, preventing committees from bringing issues to the legislative floor. In these systems, opposition legislators lack the ability to influence policy or to distribute particularistic policies to their constituents. Politicians in the governing party(ies), therefore, have strong incentives not to risk their position in office. Consequently, they will not want to limit their policy discretion with a fixed exchange-rate arrangement. In other systems opposition parties play a larger role in the policy process. Legislative committee membership and leadership positions, rather than being dominated by the governing party(ies), are distributed across parties in proportion to their strength 18. See Aghevli, Khan, and Montiel 1991; and Bemhard 1997. 19. Parties in a coalition government bargain over both policy and the distribution of cabinet portfolios. See Laver and Schofield 1990; and Laver and Shepsle 1996. Although constrained by the coalition agreement, the party that controls the ministry of finance possesses institutional and informational advantages in the development and implementation of macroeconomic policy-advantages that the party could exploit to enhance its own fortunes at the expense of its coalition partners. Bemhard 1998. A fixed exchangerate commitment can help limit this potential for abuse by providing coalition partners with a clear standard to monitor and evaluate the macroeconomic policy choices made by the party holding the finance portfolio. 20. See Krehbiel 1991; and Lupia and McCubbins 1994. 21. Strom 1990a
Democratic Institutions and Exchange Rates 77 in the legislature.Committees have the resources,including research capabilities and access to the legislative agenda,to offer alternatives to the government's proposals and to monitor the government's policy choices.Since politicians can influence policy even while serving in opposition,politicians in the governing party(ies)will be less unwilling to lose some policy discretion with a fixed exchange rate. To test the role of electoral decisiveness and opposition influence over policy,we classify systems based on their electoral and committee systems.22 For the electoral system,we distinguish between majoritarian or proportional systems based on the work of Arend Lijphart.23 To examine opposition influence over policy,we classify systems according to the "strength"and "inclusiveness"of legislative committees, using a classification developed by G.Bingham Powell and Guy Whitten and Kaare Strom.24 The presence of a strong and inclusive committee system indicates that opposition parties have the ability to influence policy.Strong committee systems possess at least two of the three following characteristics:more than ten committees, specialization to match the government bureaucracy,and limitations in the number of committee memberships held by legislators.Inclusive committee systems require that committee chairmanships be distributed proportionally among all parties,regard- less of their participation in government. We combined these two measures to characterize different systems:majoritarian- low opposition influence,proportional-low opposition influence,and proportional- high opposition influence.25(There were no cases of majoritarian-high opposition influence.)26 We then included dummy variables for majoritarian-low opposition systems and proportional-low opposition systems in our analysis.We expect that the majoritarian-low opposition influence systems will be least likely to participate in a fixed exchange-rate regime,that proportional-low opposition influence systems will be somewhat more likely to fix the exchange rate,and that proportional-high opposi- tion influence systems will be most likely to participate in a fixed exchange-rate regime. We contend that another feature of electoral systems also affects the incentives of the governing party(ies)over the exchange-rate regime:the exogeneity of electoral timing.In most parliamentary systems the governing parties have the discretion to call for an election at any time,up to a specified maximum term.The government 22.See Powell 1989:and Strom 1990b. 23.Lijphart 1984. 24.See Powell and Whitten 1993:and Strom 1990a. 25.Majoritarian-low opposition influence systems include Australia,Canada,France,New Zealand, the United Kingdom,and the United States.Proportional-low opposition influence systems include Ire- land,Israel,Italy,Japan,and Spain.Proportional-high opposition influence systems include Austria,Bel- gium,Denmark.Finland,Germany.Netherlands,Norway.Sweden,and Switzerland. 26.It could be argued that the United States should be classified as a majoritarian-high opposition influence system.Congressional committees are relatively strong vis-a-vis the executive,but since the majority party dominates leadership posts,they fail to meet Powell and Whitten's inclusiveness criteria. The possibility of divided government,however,means that the party that controls the presidency (that is, the government)does not necessarily hold leadership positions in the committee system.As a check on the influence of the U.S.case,we reran our analysis without the United States in the majoritarian-low opposi- tion influence category.Dropping the U.S.case from this category did not substantially affect the results
Democratic Institutions and Exchange Rates 77 in the legislature. Committees have the resources, including research capabilities and access to the legislative agenda, to offer alternatives to the government's proposals and to monitor the government's policy choices. Since politicians can influence policy even while serving in opposition, politicians in the governing party(ies) will be less unwilling to lose some policy discretion with a fixed exchange rate. To test the role of electoral decisiveness and opposition influence over policy, we classify systems based on their electoral and committee systems.22 For the electoral system, we distinguish between majoritarian or proportional systems based on the work of Arend Lij~hart.~~ To examine opposition influence over policy, we classify systems according to the "strength" and "inclusiveness" of legislative committees, using a classification developed by G. Bingham Powell and Guy Whitten and Kaare Str~m.~~ The presence of a strong and inclusive committee system indicates that opposition parties have the ability to influence policy. Strong committee systems possess at least two of the three following characteristics: more than ten committees, specialization to match the government bureaucracy, and limitations in the number of committee memberships held by legislators. Inclusive committee systems require that committee chairmanships be distributed proportionally among all parties, regardless of their participation in government. We combined these two measures to characterize different systems: majoritarianlow opposition influence, proportional-low opposition influence, and proportionalhigh opposition influence.25 (There were no cases of majoritarian-high opposition infl~ence.)~~ We then included dummy variables for majoritarian-low opposition systems and proportional-low opposition systems in our analysis. We expect that the majoritarian-low opposition influence systems will be least likely to participate in a fixed exchange-rate regime, that proportional-low opposition influence systems will be somewhat more likely to fix the exchange rate, and that proportional-high opposition influence systems will be most likely to participate in a fixed exchange-rate regime. We contend that another feature of electoral systems also affects the incentives of the governing party(ies) over the exchange-rate regime: the exogeneity of electoral timing. In most parliamentary systems the governing parties have the discretion to call for an election at any time, up to a specified maximum term. The government 22. See Powell 1989; and Strom 1990b. 23. Lijphart 1984. 24. See Powell and Whitten 1993; and Strom 1990a. 25. Majoritarian-low opposition influence systems include Australia. Canada, France. New Zealand, the United Kingdom. and the United States. Proportional-low opposition influence systems include Ireland, Israel, Italy, Japan. and Spain. Proportional-high opposition influence systems include Austria, Belgium, Denmark. Finland. Germany, Netherlands. Norway. Sweden, and Switzerland. 26. It could be argued that the United States should be classified as a majoritarian-high opposition influence system. Congressional committees are relatively strong vis-a-vis the executive, but since the majority party dominates leadership posts, they fail to meet Powell and Whitten's inclusiveness criteria. The possibility of divided government, however, means that the party that controls the presidency (that is, the government) does not necessarily hold leadership positions in the committee system. As a check on the influence of the U.S. case, we reran our analysis without the United States in the majoritarian-low opposition influence category. Dropping the U.S. case from this category did not substantially affect the results
78 International Organization will often attempt to optimize the timing of the election based on its standing in the polls,economic conditions,and so on-that is,electoral timing is endogenous to the government's political calculations.In these systems politicians do not need to ma- nipulate monetary policy to insure an economic boom at a prespecified election time. Instead,politicians may manipulate the timing of the election to coincide with oppor- tune economic conditions.In these systems politicians in the governing parties will be less opposed to a fixed exchange rate. In other systems electoral timing is exogenous.Politicians stand for election at a predetermined time,regardless of political and economic conditions.In these sys- tems politicians in the governing parties have more incentive to manipulate policy to produce good economic conditions for the election period.A fixed exchange rate not only limits their discretion over policy but also makes domestic economic conditions (and their electoral consequences)vulnerable to external shocks.Consequently,poli- ticians in systems with exogenous timing will prefer a floating exchange. In our empirical analysis we include a dummy variable for countries with exog- enous electoral timing:Israel,Norway,Sweden,Switzerland,and the United States. We expect these countries to be more likely to adopt a floating exchange arrange- ment,even after other factors are taken into account. International and Domestic Influences on Exchange-rate Choice In addition to domestic political institutions,other factors have an important influ- ence on the choice of exchange-rate arrangement.This section identifies four sets of variables that affect this choice:international systemic factors,domestic macroeco- nomic conditions,domestic political factors,and policy inertia. International Systemic Variables According to the optimal exchange-rate literature,a country's structural position in the world economy strongly influences the decision to fix or float.The literature emphasizes three systemic factors:trade dependence,vulnerability to macroeco- nomic shocks,and capital mobility. Trade Dependence The literature on optimal currency areas argues that a country's dependence on exter- nal trade strongly affects the choice of exchange-rate arrangement.Countries that rely heavily on trade are more likely to fix the exchange rate.A fixed exchange rate decreases exchange-rate risk.With a predictable external environment,trading agents
78 International Organization will often attempt to optimize the timing of the election based on its standing in the polls, economic conditions, and so on-that is, electoral timing is endogenous to the government's political calculations. In these systems politicians do not need to manipulate monetary policy to insure an economic boom at a prespecified election time. Instead, politicians may manipulate the timing of the election to coincide with opportune economic conditions. In these systems politicians in the governing parties will be less opposed to a fixed exchange rate. In other systems electoral timing is exogenous. Politicians stand for election at a predetermined time, regardless of political and economic conditions. In these systems politicians in the governing parties have more incentive to manipulate policy to produce good economic conditions for the election period. A fixed exchange rate not only limits their discretion over policy but also makes domestic economic conditions (and their electoral consequences) vulnerable to external shocks. Consequently, politicians in systems with exogenous timing will prefer a floating exchange. In our empirical analysis we include a dummy variable for countries with exogenous electoral timing: Israel, Norway, Sweden, Switzerland, and the United States. We expect these countries to be more likely to adopt a floating exchange arrangement, even after other factors are taken into account. International and Domestic Influences on Exchange-rate Choice In addition to domestic political institutions, other factors have an important influence on the choice of exchange-rate arrangement. This section identifies four sets of variables that affect this choice: international systemic factors, domestic macroeconomic conditions, domestic political factors, and policy inertia. International Systemic Variables According to the optimal exchange-rate literature, a country's structural position in the world economy strongly influences the decision to fix or float. The literature emphasizes three systemic factors: trade dependence, vulnerability to macroeconomic shocks, and capital mobility. Trade Dependence The literature on optimal currency areas argues that a country's dependence on external trade strongly affects the choice of exchange-rate arrangement. Countries that rely heavily on trade are more likely to fix the exchange rate. A fixed exchange rate decreases exchange-rate risk. With a predictable external environment, trading agents
Democratic Institutions and Exchange Rates 79 will have more stable expectations,and,as a consequence,cross-border trade and investment will increase.27 Floating exchange rates,according to these arguments, lead to higher exchange-rate variability and,hence,to greater uncertainty and risk.In countries that are less dependent on trade,stabilizing the exchange rate will not be a priority.Instead,governments will want to use macroeconomic policy for domestic policy objectives. We measure a country's dependence on trade with an openness variable composed of imports plus exports as a percentage of GDP.Countries with higher levels of openness-that is,higher dependence on trade-will be more likely to fix their ex- change rates.In alternative specifications we disaggregated the openness variable into its component parts:imports as a percentage of gross domestic product(GDP), exports as a percentage of GDP,and the trade deficit as a percentage of GDP.The alternative measures did not substantially alter the results.28 Vulnerabiliry to Shocks Recent research in economics argues that a country's vulnerability to macroeco- nomic shocks conditions the optimal exchange-rate arrangement.The theoretical and empirical literatures conclude that a country faced with adverse shocks emanating from the real (that is,tradable)sector will be better able to insulate the domestic economy by adopting a floating exchange arrangement.29 A fixed exchange arrange- ment,on the other hand,is more desirable if the country experiences domestic(nomi- nal)disturbances. Following Michael Melvin and Andreas Savvides,we operationalize a country's vulnerability to shocks in several ways.30 The first variable,designed to capture do- mestic shocks,measures the variability in the growth rate of domestic credit over the course of a year,again based on quarterly data.Greater variability in the monetary sector makes a fixed exchange-rate arrangement more likely.To measure real shocks we include a measure of trade openness (discussed earlier)and a measure of the yearly rate of economic growth(discussed later).31 27.Frankel and Rose argue that,even where exchange-rate variability has been high.its effect on trade has been low.Frankel and Rose 1996.They suggest,however,that the exchange-rate variability argument "still carries some weight.It looms large in the minds of European policy-makers and business-people. Promoting trade and investment in Europe was certainly a prime motivation for the European Monetary System and for the planned E.M.U." 28.Including either exports or imports led to very similar empirical results-with the exception of the sign change.Including both indicators at the same time caused both variables to be statistically insignifi- cant because the correlation between imports and exports in our sample is 0.96. 29.For example,Fischer 1977;Melvin 1985:and Savvides 1990. 30.See Melvin 1985:and Savvides 1990. 31.In alterative specifications,we also included a measure of a country's economic size.based on its GDP in constant dollars,as a proxy of a country's vulnerability to shocks.Presumably,larger countries will be less vulnerable to exogenous shocks and,consequently,more likely to choose a floating exchange- rate arrangement.The economic size variable,however,was collinear with measures of openness and interational capital mobility
Democratic Institutions and Exchange Rates 79 will have more stable expectations, and, as a consequence, cross-border trade and investment will increase.27 Floating exchange rates, according to these arguments, lead to higher exchange-rate variability and, hence, to greater uncertainty and risk. In countries that are less dependent on trade, stabilizing the exchange rate will not be a priority. Instead, governments will want to use macroeconomic policy for domestic policy objectives. We measure a country's dependence on trade with an openness variable composed of imposts plus exposts as a percentage of GDP. Countries with higher levels of openness-that is, higher dependence on trade-will be more likely to fix their exchange rates. In alternative specifications we disaggregated the openness variable into its component parts: imposts as a percentage of gross domestic product (GDP), exports as a percentage of GDP, and the trade deficit as a percentage of GDP. The alternative measures did not substantially alter the results.28 Vulnerability to Shocks Recent research in economics argues that a country's vulnerability to macroeconomic shocks conditions the optimal exchange-rate arrangement. The theoretical and empirical literatures conclude that a country faced with adverse shocks emanating from the real (that is, tradable) sector will be better able to insulate the domestic economy by adopting a floating exchange a~angement.~~ A fixed exchange arrangement, on the other hand, is more desirable if the country experiences domestic (nominal) disturbances. Following Michael Melvin and Andreas Savvides, we operationalize a country's vulnerability to shocks in several ways.30 The first variable, designed to capture domestic shocks, measures the variability in the growth rate of domestic credit over the course of a year, again based on quarterly data. Greater variability in the monetary sector makes a fixed exchange-rate arrangement more likely. To measure real shocks we include a measure of trade openness (discussed earlier) and a measure of the yearly rate of economic growth (discussed late^).^' 27. Frankel and Rose argue that, even where exchange-rate variability has been high. its effect on trade has been low. Frankel and Rose 1996. They suggest, however. that the exchange-rate variability argument "still canies some weight. It looms large in the minds of European policy-makers and business-people. Promoting trade and investment in Europe was certainly a prime motivation for the European Monetary System and for the planned E.M.U." 28. Including either exports or imports led to very similar empirical results-with the exception of the sign change. Including both indicators at the same time caused both variables to be statistically insignificant because the correlation between imports and exports in our sample is 0.96. 29. For example. Fischer 1977; Melvin 1985: and Savvides 1990. 30. See Melvin 1985; and Savvides 1990. 31. In alternative specifications. we also included a measure of a country's economic size. based on its GDP in constant dollars, as a proxy of a country's vulnerability to shocks. Presumably, larger countries will be less vulnerable to exogenous shocks and, consequently, more likely to choose a floating exchangerate arrangement. The economic size variable. however. was collinear with measures of openness and international capital mobility