《国际政治经济学》文献资料（Political Economy of Money and Finance：Monetary System and Exchange Rate）Political Cycles and Exchange Rate-Based Stabilization

m PROJECT MUSE' Political Cycles and Exchange-Rate-Based Stabilization Hector E.Schamis Christopher Way WORLD World Politics,Volume 56,Number 1,October 2003,pp.43-78(Article) POLITICS Published by Cambridge University Press D0l:10.1353/wp.2004.0007 hm6Nmn】l31 For additional information about this article http://muse.jhu.edu/journals/wp/summary/v056/56.1schamis.html Access provided by Shanghai Jiao Tong University(24 Jun 2013 04:28 GMT)

Political Cycles and Exchange-Rate-Based Stabilization Hector E. Schamis Christopher Way World Politics, Volume 56, Number 1, October 2003, pp. 43-78 (Article) Published by Cambridge University Press DOI: 10.1353/wp.2004.0007 For additional information about this article Access provided by Shanghai Jiao Tong University (24 Jun 2013 04:28 GMT) http://muse.jhu.edu/journals/wp/summary/v056/56.1schamis.html

POLITICAL CYCLES AND EXCHANGE RATE-BASED STABILIZATION By HECTOR E.SCHAMIS and CHRISTOPHER R.WAY I.INTRODUCTION INCE the 1980s,but especially in the 1990s,the spread of currency and financial crises has been singled out as the most important source of instability across emerging markets.It has been widely recog- nized that the adoption of fixed exchange rate regimes is at the root of many of those crises.Whether to increase credibility and attract foreign investment or as an alternative approach to stabilization policy in high- inflation economies,fixing the exchange rate,it has been shown,can lead to undesirable outcomes in the medium to long term,even as it can be successful in expanding economic activity and correcting infla- tion in the short term.Especially in the developing world,though not only there,this currency arrangement tends to produce boom/bust cy- cles.1 This appears to be the record of several exchange rate-based stabi- lization experiments.In describing the life cycle of the boom/bust process that often follows the adoption of a nominal anchor,2 a wealth of literature has documented the dangers of attempts to fix the currency 'We thank Robert J.Franzese,John Freeman,Jeffry Frieden,Kurt Taylor Gaubatz,Hyeok Kwon, Susan Pratt,Andres Velasco,participants in seminars at Cornell,Northwestern,and Yale Universities, and three anonymous reviewers from World Politics for helpful comments and suggestions.Marci Brooks,Ana Frischtak,and Sharon Sprayregen provided valuable research assistance. This happened in the OECD countries,for example,during the ERM crisis of September 1992.See Willem Buiter,Giancarlo Corsetti,and Nouriel Roubini,"Excessive Deficits:Sense and Nonsense in the Treaty of Maastricht,"Economic Policy 16(April 1993);and Barry Eichengreen and Charles Wyplosz,"The Unstable EMS,"Brookings Papers on Economic Activity 1(1993). 2For example,Guillermo Calvo,"Temporary Stabilization:Predetermined Exchange Rates,"ou nal of Political Economy 94 (December 1986);Guillermo Calvo and Carlos Vegh,"Exchange-Rate- Based Stabilization under Imperfect Credibility,"International Monetary Fund Working Papers 91/77 (1991);Miguel Kiguel and Nissan Liviatan,"The Business Cycle Associated with Exchange Rate- Based Stabilizations,"World Bank Economic Review 6(May 1992);Alexander Hoffmaister and Carlos Vegh,"Disinflation and the Recession-Now-Versus-Recession-Later Hypothesis:Evidence from Uruguay,"International Monetary Fund Working Papers 95/99(1995);Aaron Tornell and Andres Ve- lasco,"Fixed versus Flexible Exchange Rates:Which Provides More Fiscal Discipline?Journal of Monetary Economics 45 (April 2000). World Politics 56(October 2003),43-78

World Politics 56 (October 2003), 43–78 POLITICAL CYCLES AND EXCHANGE RATE–BASED STABILIZATION By HECTOR E. SCHAMIS and CHRISTOPHER R. WAY* I. INTRODUCTION SINCE the 1980s, but especially in the 1990s, the spread of currency and financial crises has been singled out as the most important source of instability across emerging markets. It has been widely recog￾nized that the adoption of fixed exchange rate regimes is at the root of many of those crises. Whether to increase credibility and attract foreign investment or as an alternative approach to stabilization policy in high￾inflation economies, fixing the exchange rate, it has been shown, can lead to undesirable outcomes in the medium to long term, even as it can be successful in expanding economic activity and correcting infla￾tion in the short term. Especially in the developing world, though not only there, this currency arrangement tends to produce boom/bust cy￾cles.1 This appears to be the record of several exchange rate–based stabi￾lization experiments. In describing the life cycle of the boom/bust process that often follows the adoption of a nominal anchor,2 a wealth of literature has documented the dangers of attempts to fix the currency * We thank Robert J. Franzese, John Freeman, Jeffry Frieden, Kurt Taylor Gaubatz, Hyeok Kwon, Susan Pratt, Andrés Velasco, participants in seminars at Cornell, Northwestern, and Yale Universities, and three anonymous reviewers from World Politics for helpful comments and suggestions. Marci Brooks, Ana Frischtak, and Sharon Sprayregen provided valuable research assistance. 1This happened in the OECD countries, for example, during the ERM crisis of September 1992. See Willem Buiter, Giancarlo Corsetti, and Nouriel Roubini, “Excessive Deficits: Sense and Nonsense in the Treaty of Maastricht,” Economic Policy 16 (April 1993); and Barry Eichengreen and Charles Wyplosz, “The Unstable EMS,” Brookings Papers on Economic Activity 1 (1993). 2For example, Guillermo Calvo, “Temporary Stabilization: Predetermined Exchange Rates,” Jour￾nal of Political Economy 94 (December 1986); Guillermo Calvo and Carlos Végh, “Exchange-Rate￾Based Stabilization under Imperfect Credibility,” International Monetary Fund Working Papers 91/77 (1991); Miguel Kiguel and Nissan Liviatan, “The Business Cycle Associated with Exchange Rate￾Based Stabilizations,” World Bank Economic Review 6 (May 1992); Alexander Hoffmaister and Carlos Végh, “Disinflation and the Recession-Now-Versus-Recession-Later Hypothesis: Evidence from Uruguay,” International Monetary Fund Working Papers 95/99 (1995); Aaron Tornell and Andrés Ve￾lasco, “Fixed versus Flexible Exchange Rates: Which Provides More Fiscal Discipline?” Journal of Monetary Economics 45 (April 2000). v56.1.043.schamis 3/2/04 4:29 PM Page 43

44 WORLD POLITICS as part of a stabilization strategy.Adopting a nominal anchor as part of a stabilization effort generally leads to an appreciation of the real ex- change rate and a falling real interest rate,thus feeding a consumption boom of imports,a burst of investment,and a gradual deterioration of the current account.Under an open capital account,inflows of capital can finance the trade deficit in the short term.However,because the burgeoning current account deficit is unsustainable in the medium term,it often induces inconsistent fiscal policies,which in turn affect the credibility of the peg.At this point the sustainability of the regime itself comes into question:runs on the currency become widespread, usually with important losses in foreign-exchange reserves(as the gov- ernment tries to defend the parity)and,inevitably,a departure from the fixed exchange rate arrangement with a subsequent devaluation. This rendition conforms to the stylized facts of a balance-of-payment crisis as outlined in Krugman's seminal article.3 Moreover,it is also con- sistent with the main attributes of many exchange-rate and financial crises seen in much of the developing world:the Southern Cone of Latin America in the 1980s,Mexico,Asia,Russia,and Brazil in the 1990s,Turkey in 2001,and Argentina's explosive termination of the currency board in 2002(accompanied by the default on its external debt),to name a few prominent examples.If these boom/bust cycles appear with some frequency as a result of exchange rate-based stabi- lizations,the appeal of such programs-and,more generally,the nom- inal anchor approach to the exchange rate-appears puzzling.Why do governments implement policies that generate a short-term boom but are prone to collapse later in a sequence of devaluation and inflation that results in a severe balance-of-payment crisis and potentially poor economic performance? The literature on the political economy of exchange rates has left this question unanswered.The various contributions,including Krugman's, have showed how exchange rate crises unfold but not why govern- ments repeatedly choose those policies,exposing themselves to known risks.We embark on this discussion with a political economy explana- tion based on the notion of a self-interested government for which short-term stabilization is attractive in the face of incentives posed by the electoral cycle.If the election coincides with the boom phase, incumbent governments increase their likelihood of winning re- election-as the bust phase will develop,if at all,only after the contest. 3Paul Krugman,"A Model of Balance-of-Payments Crises,"Journal of Money,Credit,and Banking 11(August1979)

as part of a stabilization strategy. Adopting a nominal anchor as part of a stabilization effort generally leads to an appreciation of the real ex￾change rate and a falling real interest rate, thus feeding a consumption boom of imports, a burst of investment, and a gradual deterioration of the current account. Under an open capital account, inflows of capital can finance the trade deficit in the short term. However, because the burgeoning current account deficit is unsustainable in the medium term, it often induces inconsistent fiscal policies, which in turn affect the credibility of the peg. At this point the sustainability of the regime itself comes into question: runs on the currency become widespread, usually with important losses in foreign-exchange reserves (as the gov￾ernment tries to defend the parity) and, inevitably, a departure from the fixed exchange rate arrangement with a subsequent devaluation. This rendition conforms to the stylized facts of a balance-of-payment crisis as outlined in Krugman’s seminal article.3 Moreover, it is also con￾sistent with the main attributes of many exchange-rate and financial crises seen in much of the developing world: the Southern Cone of Latin America in the 1980s, Mexico, Asia, Russia, and Brazil in the 1990s, Turkey in 2001, and Argentina’s explosive termination of the currency board in 2002 (accompanied by the default on its external debt), to name a few prominent examples. If these boom/bust cycles appear with some frequency as a result of exchange rate–based stabi￾lizations, the appeal of such programs—and, more generally, the nom￾inal anchor approach to the exchange rate—appears puzzling. Why do governments implement policies that generate a short-term boom but are prone to collapse later in a sequence of devaluation and inflation that results in a severe balance-of-payment crisis and potentially poor economic performance? The literature on the political economy of exchange rates has left this question unanswered. The various contributions, including Krugman’s, have showed how exchange rate crises unfold but not why govern￾ments repeatedly choose those policies, exposing themselves to known risks. We embark on this discussion with a political economy explana￾tion based on the notion of a self-interested government for which short-term stabilization is attractive in the face of incentives posed by the electoral cycle. If the election coincides with the boom phase, incumbent governments increase their likelihood of winning re￾election—as the bust phase will develop, if at all, only after the contest. 44 WORLD POLITICS 3Paul Krugman, “A Model of Balance-of-Payments Crises,” Journal of Money, Credit, and Banking 11 (August 1979). v56.1.043.schamis 3/2/04 4:29 PM Page 44

POLITICAL CYCLES/STABILIZATION 45 We thus suggest a modified version of the traditional political business cycle.In the original formulation,a government facing reelection re- duces unemployment via expansionary monetary or fiscal policy prior to the election,although at the cost of increasing inflation after the election.+Corrective contractionary measures will then be introduced once the election has taken place,resulting in recession.In the cycle as- sociated with fixed exchange rates(with or without stabilization goals), a government facing reelection times the introduction of a nominal an- chor carefully-hoping for the boom to kick in before the election and for the election to occur before the potential difficulties associated with financing the current account deficit point to the possibility of a deval- uation.Viewed from the standpoint of opportunistic office-seeking governments,the political rationality of exchange rate-based stabiliza- tion explains its attractiveness despite its questionable appeal as an eco- nomic policy. The rest of the article proceeds as follows.In Section II we review the political economy literature on choice of exchange-rate arrange- ment.Taking the variant of this literature emphasizing domestic polit- ical incentives as our point of departure,we argue in Section III that the peculiar macroeconomic dynamics of exchange rate-based stabi- lizations provide democratic governments with powerful incentives to adopt such policies precisely when their time horizons are shortest: prior to elections.Section IV marshals data on decisions to fix the ex- change rate and on election timing in eighteen Latin American coun- tries from 1970 to 1999 and presents preliminary plausibility probes of our argument,whereas Section V analyzes these cycles with time- series/cross-sectional logistic regression models and describes several robustness tests.By way of conclusion,the final section discusses the implications of our findings for the broader literature on stabilization and electoral cycles. II.EXCHANGE RATE CHOICE:THE DEBATE The growing interest in recent exchange rate policies can hardly be ex- aggerated.A vast literature on the subject has addressed different +As espoused by William Nordhaus,"The Political Business Cycle,"Review ofEconomic Studies 42 (April 1975);and Edward Tufte,Political Control of the Economy (Princeton:Princeton University Press,1978).Later contributions along these lines have substituted fully rational voters for the myopic electorate of the original versions,relying instead on voters'imperfect information about government competence to drive the models.See,for example,Alex Cukierman and Alan Meltzer,A Positive Theory of Discretionary Policy,the Cost of Democratic Government,and the Benefits of a Constitu- tion,"Economic Inguiry 24(July 1986);and Kenneth Rogoff and Anne Sibert,"Elections and Macro- economic Policy Cycles,"Review ofEconomic Studies 55 (January 1988)

We thus suggest a modified version of the traditional political business cycle. In the original formulation, a government facing reelection re￾duces unemployment via expansionary monetary or fiscal policy prior to the election, although at the cost of increasing inflation after the election.4 Corrective contractionary measures will then be introduced once the election has taken place, resulting in recession. In the cycle as￾sociated with fixed exchange rates (with or without stabilization goals), a government facing reelection times the introduction of a nominal an￾chor carefully—hoping for the boom to kick in before the election and for the election to occur before the potential difficulties associated with financing the current account deficit point to the possibility of a deval￾uation. Viewed from the standpoint of opportunistic office-seeking governments, the political rationality of exchange rate–based stabiliza￾tion explains its attractiveness despite its questionable appeal as an eco￾nomic policy. The rest of the article proceeds as follows. In Section II we review the political economy literature on choice of exchange-rate arrange￾ment. Taking the variant of this literature emphasizing domestic polit￾ical incentives as our point of departure, we argue in Section III that the peculiar macroeconomic dynamics of exchange rate–based stabi￾lizations provide democratic governments with powerful incentives to adopt such policies precisely when their time horizons are shortest: prior to elections. Section IV marshals data on decisions to fix the ex￾change rate and on election timing in eighteen Latin American coun￾tries from 1970 to 1999 and presents preliminary plausibility probes of our argument, whereas Section V analyzes these cycles with time￾series/cross-sectional logistic regression models and describes several robustness tests. By way of conclusion, the final section discusses the implications of our findings for the broader literature on stabilization and electoral cycles. II. EXCHANGE RATE CHOICE: THE DEBATE The growing interest in recent exchange rate policies can hardly be ex￾aggerated. A vast literature on the subject has addressed different POLITICAL CYCLES/STABILIZATION 45 4As espoused by William Nordhaus, “The Political Business Cycle,” Review of Economic Studies 42 (April 1975); and Edward Tufte, Political Control of the Economy (Princeton: Princeton University Press, 1978). Later contributions along these lines have substituted fully rational voters for the myopic electorate of the original versions, relying instead on voters’ imperfect information about government competence to drive the models. See, for example, Alex Cukierman and Alan Meltzer, “A Positive Theory of Discretionary Policy, the Cost of Democratic Government, and the Benefits of a Constitu￾tion,” Economic Inquiry 24 ( July 1986); and Kenneth Rogoff and Anne Sibert, “Elections and Macro￾economic Policy Cycles,” Review of Economic Studies 55 ( January 1988). v56.1.043.schamis 3/2/04 4:29 PM Page 45

46 WORLD POLITICS aspects involved in the choice of one type of exchange rate arrangement over another.Early literature in economics built on the optimal cur- rency area literature,emphasizing that different exchange rate regimes might be appropriate for countries with different economic characteris- tics.Recent approaches have shifted the focus to credibility arguments, suggesting that governments can gain anti-inflationary credibility by fixing to a nominal anchor currency of a low-inflation country.5 For the most part,however,the economics literature does not problematize the preferences of policymakers and generally treats them as fixed and ex- ogenous,tending to assume a government that is a benevolent social welfare maximizer.As we highlight above,however,to the extent that a nominal anchor to the exchange rate is prone to boom-bust cycles,its adoption cannot be explained solely on the basis of considerations of efficiency. Recent research on globalization,by contrast,has emphasized the role of the integration of transnational economic actors and the pene- tration of market forces into the national space in diminishing the au- tonomy of national states.Arguably,nowhere is this trend more visible than in the area of monetary and exchange rate policy.Confronted with fully mobile financial capital and rapid technological change,the argu- ment goes,states find it increasingly difficult to implement domestic policy that deviates from the externally induced norm.As a result and regardless of domestic conditions,the adoption of rules and institu- tional configurations aimed at signaling to foreign investors the au- thorities'commitment to exchange rate and price stability emerges as a logical response.? For all its merits,much of the literature on globalization reduces government to a passive actor merely reactive to international condi- tions.Because of this,a domestic reading of the process leading to the adoption of exchange rate policy is more in tune with our take on the subject.Demand-side approaches have,in turn,viewed the adoption of exchange rate policies in terms of the response of governments to in- s See Robert Mundell,"A Theory of Optimal Currency Areas,"American Economic Review 51(Sep- tember 1961);Ronald McKinnon,"Optimum Currency Areas,"American Economic Review 53(Sep- tember 1963);George S.Tavlas,"The Theory of Monetary Integration,"Open Economies Review 5 (April 1994). Francesco Giavazzi and Marco Pagano,"The Advantage of Tying One's Hands:EMS Discipline and Central Bank Credibility,"European Economic Review 32 (June 1988). Benjamin J.Cohen,"Phoenix Risen:The Resurrection of Global Finance,"World Politics 48 (Jan- uary 1996);Jeffry Frieden and Ronald Rogowski,"The Impact of the International Economy on Na- tional Policies:An Analytical Overview,"and Stephan Haggard and Sylvia Maxfield,"The Political Economy of Financial Liberalization in the Developing World,"both in Robert Keohane and Helen Milner,eds.,Internationalization and Domestic Politics(Cambridge:Cambridge University Press, 1996);and Susan Strange,Mad Money (Ann Arbor:University of Michigan Press,1998)

aspects involved in the choice of one type of exchange rate arrangement over another. Early literature in economics built on the optimal cur￾rency area literature, emphasizing that different exchange rate regimes might be appropriate for countries with different economic characteris￾tics.5 Recent approaches have shifted the focus to credibility arguments, suggesting that governments can gain anti-inflationary credibility by fixing to a nominal anchor currency of a low-inflation country.6 For the most part, however, the economics literature does not problematize the preferences of policymakers and generally treats them as fixed and ex￾ogenous, tending to assume a government that is a benevolent social welfare maximizer. As we highlight above, however, to the extent that a nominal anchor to the exchange rate is prone to boom-bust cycles, its adoption cannot be explained solely on the basis of considerations of efficiency. Recent research on globalization, by contrast, has emphasized the role of the integration of transnational economic actors and the pene￾tration of market forces into the national space in diminishing the au￾tonomy of national states. Arguably, nowhere is this trend more visible than in the area of monetary and exchange rate policy. Confronted with fully mobile financial capital and rapid technological change, the argu￾ment goes, states find it increasingly difficult to implement domestic policy that deviates from the externally induced norm. As a result and regardless of domestic conditions, the adoption of rules and institu￾tional configurations aimed at signaling to foreign investors the au￾thorities’ commitment to exchange rate and price stability emerges as a logical response.7 For all its merits, much of the literature on globalization reduces government to a passive actor merely reactive to international condi￾tions. Because of this, a domestic reading of the process leading to the adoption of exchange rate policy is more in tune with our take on the subject. Demand-side approaches have, in turn, viewed the adoption of exchange rate policies in terms of the response of governments to in- 46 WORLD POLITICS 5See Robert Mundell, “A Theory of Optimal Currency Areas,” American Economic Review 51 (Sep￾tember 1961); Ronald McKinnon, “Optimum Currency Areas,” American Economic Review 53 (Sep￾tember 1963); George S. Tavlas, “The Theory of Monetary Integration,” Open Economies Review 5 (April 1994). 6 Francesco Giavazzi and Marco Pagano, “The Advantage of Tying One’s Hands: EMS Discipline and Central Bank Credibility,” European Economic Review 32 ( June 1988). 7Benjamin J. Cohen, “Phoenix Risen: The Resurrection of Global Finance,” World Politics 48 ( Jan￾uary 1996); Jeffry Frieden and Ronald Rogowski, “The Impact of the International Economy on Na￾tional Policies: An Analytical Overview,” and Stephan Haggard and Sylvia Maxfield, “The Political Economy of Financial Liberalization in the Developing World,” both in Robert Keohane and Helen Milner, eds., Internationalization and Domestic Politics (Cambridge: Cambridge University Press, 1996); and Susan Strange, Mad Money (Ann Arbor: University of Michigan Press, 1998). v56.1.043.schamis 3/2/04 4:29 PM Page 46