52 WORLD POLITICS this interpretation,competent governments strive to signal their type to voters by successfully implementing inflation-reducing exchange rate- based stabilizations.25 If prices are sticky in the real economy,exchange- rate overshooting models imply strongly expansionary effects in the short to medium run from such policies,even if rational expectations imply new classical policy neutrality in the long run.Thus the combination of falling inflation and a real expansion distinctive of the ERBS pattern can arise in a competence framework even with fully rational forward- looking agents.Either way,governments have an incentive to engineer preelection booms via the exchange rate;we can safely remain agnostic about the appropriate variant for our eighteen Latin American countries. Nonetheless,while competence models advance one theoretical ra- tionale for our account,we prefer a more straightforward explanation based on the assumption that voters in middle-and low-income coun- tries with macroeconomic disequilibria sharply discount future con- sumption.Under such circumstances,it is plausible to expect fully informed rational voters to prefer the intertemporal transfer of income represented by risky ERBS policies instead of the unappealing certain- ties of inaction or MBS.26 Our intuition is that economic agents maxi- mize the consumption opportunities available during the boom phase of the cycle,particularly of durable goods:27 voters,that is,will be dis- inclined to penalize the incumbent government by electing a challenger More precisely,in a separating equilibrium competent governments successfully signal their type by achieving stabilization,whereas in a pooling equilibrium,incompetent governments mimic compe- tent ones in attempting stabilization.The main difference from standard competence models of politi- cal business cycles is,as shown by Persson and Tabellini (fn.23),that the signal is inflation rather than output;voters observe inflation,but not debt,before the election.Along these lines,Stein and Streb (fn.20)model stabilization policies in a competence framework,although they do not test their model against data.F.van der Ploeg establishes that stabilizations can have expansionary real effects even with rational,forward-looking agents able to anticipate future economic events;van der Ploeg,"Opti- mal Government Policy in a Small Open Economy with Rational Expectations,"International Eco- nomic Review 28(June 1987).We thank John Freeman for bringing these arguments to our attention. 26On competence models,see Stein and Streb(fn.20).Economists have developed a variety of theoretical models producing the real effects associated with ERBS;for a recent survey,see Fisher,Ratra, and Vegh(fn.12).Fisher(fn.12)and Carlos Rodriguez have focused on sticky prices in the real econ- omy;see Rodriguez,"The Argentine Stabilization of December 20th,"World Development 10(Sep- tember 1982).De Gregorio,Guidotti,and Vegh have focused(fn.13)on intertemporal shifts in durable goods purchase arising from consumers who follow inventory-type rules;Calvo (fn.2)and Calvo and Vegh(fn.2)focus on intertemporal shifts in consumption resulting from a lack of policy credibility;and Rebelo and Vegh(fn.13)and Lahiri(fn.13)on supply-side responses unleashed by distortions removed by stabilization.While the jury is still very much out on which of these best ac- counts for the data,models emphasizing intertemporal transfers in consumption and sticky prices are both compatible with our favored interpretation and enjoy some empirical support. 2 De Gregorio,Guidotti,and Vegh(fn.13)present evidence that large increases in the consump- tion of durables drive the boom phase of the cycle,a conclusion reaffirmed even by recent studies skep- tical of many of the stylized facts about ERBS,for example,by Hamman(fn.16).This finding suggests that ERBS is particularly attractive in societies where the majority of the population is historically ex- cluded from access to this type of goods
this interpretation, competent governments strive to signal their type to voters by successfully implementing inflation-reducing exchange rate– based stabilizations.25 If prices are sticky in the real economy, exchangerate overshooting models imply strongly expansionary effects in the short to medium run from such policies, even if rational expectations imply new classical policy neutrality in the long run. Thus the combination of falling inflation and a real expansion distinctive of the ERBS pattern can arise in a competence framework even with fully rational forwardlooking agents. Either way, governments have an incentive to engineer preelection booms via the exchange rate; we can safely remain agnostic about the appropriate variant for our eighteen Latin American countries. Nonetheless, while competence models advance one theoretical rationale for our account, we prefer a more straightforward explanation based on the assumption that voters in middle- and low-income countries with macroeconomic disequilibria sharply discount future consumption. Under such circumstances, it is plausible to expect fully informed rational voters to prefer the intertemporal transfer of income represented by risky ERBS policies instead of the unappealing certainties of inaction or MBS. 26 Our intuition is that economic agents maximize the consumption opportunities available during the boom phase of the cycle, particularly of durable goods:27 voters, that is, will be disinclined to penalize the incumbent government by electing a challenger 52 WORLD POLITICS 25More precisely, in a separating equilibrium competent governments successfully signal their type by achieving stabilization, whereas in a pooling equilibrium, incompetent governments mimic competent ones in attempting stabilization. The main difference from standard competence models of political business cycles is, as shown by Persson and Tabellini (fn. 23), that the signal is inflation rather than output; voters observe inflation, but not debt, before the election. Along these lines, Stein and Streb (fn. 20) model stabilization policies in a competence framework, although they do not test their model against data. F. van der Ploeg establishes that stabilizations can have expansionary real effects even with rational, forward-looking agents able to anticipate future economic events; van der Ploeg, “Optimal Government Policy in a Small Open Economy with Rational Expectations,” International Economic Review 28 ( June 1987). We thank John Freeman for bringing these arguments to our attention. 26 On competence models, see Stein and Streb (fn. 20). Economists have developed a variety of theoretical models producing the real effects associated with ERBS; for a recent survey, see Fisher, Ratra, and Végh (fn. 12). Fisher (fn. 12) and Carlos Rodriguez have focused on sticky prices in the real economy; see Rodriguez, “The Argentine Stabilization of December 20th,” World Development 10 (September 1982). De Gregorio, Guidotti, and Végh have focused (fn. 13) on intertemporal shifts in durable goods purchase arising from consumers who follow inventory-type rules; Calvo (fn. 2) and Calvo and Végh (fn. 2) focus on intertemporal shifts in consumption resulting from a lack of policy credibility; and Rebelo and Végh (fn. 13) and Lahiri (fn. 13) on supply-side responses unleashed by distortions removed by stabilization. While the jury is still very much out on which of these best accounts for the data, models emphasizing intertemporal transfers in consumption and sticky prices are both compatible with our favored interpretation and enjoy some empirical support. 27 De Gregorio, Guidotti, and Végh (fn. 13) present evidence that large increases in the consumption of durables drive the boom phase of the cycle, a conclusion reaffirmed even by recent studies skeptical of many of the stylized facts about ERBS, for example, by Hamman (fn. 16). This finding suggests that ERBS is particularly attractive in societies where the majority of the population is historically excluded from access to this type of goods. v56.1.043.schamis 3/2/04 4:29 PM Page 52
POLITICAL CYCLES/STABILIZATION 53 who,in addition to the uncertainty associated with the long term of ERBS,might increase policy uncertainty in the short term.In other words,what may appear to some as a propensity of the electorate to get fooled is to us just rational behavior under significantly shortened time horizons,such as those characteristic of high-inflation economies with relatively new and often ineffective democratic institutions.In these settings the option"consumption today/recession tomorrow"under ERBS appears preferable to the option"recession today/uncertainty to- morrow"typical of MBS. Another possibility,compatible with this account,is that aside from the real effects of ERBS,the nominal effects of an attempt to peg pre- dominate both in the motivations of politicians and in the responses of voters.Precisely because of the high and often chronic inflation con- text,political and monetary institutions exhibit low credibility among voters and economic agents;as a result,orthodox pronouncements (such as traditional MBS programs)fail repeatedly.Under such circum- stances,pegging provides an attractive option because it anchors policy to a more credible institution-a foreign currency-and features greater transparency and verifiability(by virtue of its simplicity and visibility) than orthodox policies.28 For these reasons,moving toward a more fixed regime has more likelihood of success in quickly producing disinflation. Accordingly,it is plausible that as elections near,politicians will try to adopt pegs and gain a political advantage. Our revised political-business cycle argument merits some additional considerations.Note that in a typical Nordhaus cycle,the economy ex- pands in the first phase while inflation emerges with a slight lag.After the election,however,achieving price stability has recessionary effects. In the modified version of the cycle,the introduction of a nominal an- chor achieves quick stabilization/falling inflation while avoiding the contractionary effects;in fact,led by a consumption boom,output in- creases and"all good things go together."After the election,however,if a bust phase of the cycle results,"all bad things go together,"as devalu- ation leads to a balance-of-payment crisis and possibly recession and reignited inflation.The moral of the story,then,is that,following the logic of political-business cycle arguments,a most extreme version of the self-interested,opportunistic politician appears in an exchange rate-based stabilization. See J.Lawrence Broz,"Political System Transparency and Monetary Commitment Regimes,"In- ternational Organization 56(March 2002);and Jeffrey Frankel,Sergio Schmukler,and Luis Serven, "Verfiability and the Vanishing Intermediate Exchange-Rate Regime,"NBER Working Papers 7901 (2000).We thank an anonymous reviewer for calling our attention to this issue
who, in addition to the uncertainty associated with the long term of ERBS, might increase policy uncertainty in the short term. In other words, what may appear to some as a propensity of the electorate to get fooled is to us just rational behavior under significantly shortened time horizons, such as those characteristic of high-inflation economies with relatively new and often ineffective democratic institutions. In these settings the option “consumption today/recession tomorrow” under ERBS appears preferable to the option “recession today/ uncertainty tomorrow” typical of MBS. Another possibility, compatible with this account, is that aside from the real effects of ERBS, the nominal effects of an attempt to peg predominate both in the motivations of politicians and in the responses of voters. Precisely because of the high and often chronic inflation context, political and monetary institutions exhibit low credibility among voters and economic agents; as a result, orthodox pronouncements (such as traditional MBS programs) fail repeatedly. Under such circumstances, pegging provides an attractive option because it anchors policy to a more credible institution—a foreign currency—and features greater transparency and verifiability (by virtue of its simplicity and visibility) than orthodox policies.28 For these reasons, moving toward a more fixed regime has more likelihood of success in quickly producing disinflation. Accordingly, it is plausible that as elections near, politicians will try to adopt pegs and gain a political advantage. Our revised political-business cycle argument merits some additional considerations. Note that in a typical Nordhaus cycle, the economy expands in the first phase while inflation emerges with a slight lag. After the election, however, achieving price stability has recessionary effects. In the modified version of the cycle, the introduction of a nominal anchor achieves quick stabilization/falling inflation while avoiding the contractionary effects; in fact, led by a consumption boom, output increases and “all good things go together.” After the election, however, if a bust phase of the cycle results, “all bad things go together,” as devaluation leads to a balance-of-payment crisis and possibly recession and reignited inflation. The moral of the story, then, is that, following the logic of political-business cycle arguments, a most extreme version of the self-interested, opportunistic politician appears in an exchange rate–based stabilization. POLITICAL CYCLES/STABILIZATION 53 28See J. Lawrence Broz, “Political System Transparency and Monetary Commitment Regimes,” International Organization 56 (March 2002); and Jeffrey Frankel, Sergio Schmukler, and Luis Serven, “Verfiability and the Vanishing Intermediate Exchange-Rate Regime,” NBER Working Papers 7901 (2000). We thank an anonymous reviewer for calling our attention to this issue. v56.1.043.schamis 3/2/04 4:29 PM Page 53
54 WORLD POLITICS IV.ELECTIONS AND EXCHANGE RATES:DATA AND A FIRST CUT AT ASSESSING THE RELATIONSHIP To evaluate our argument about electoral cycles and the incentives for governments to attempt an exchange rate-based stabilization,we collected quarterly data on exchange rate arrangements and elections for eighteen Latin American countries from 1970 to 1999.29 Since we are interested in movements toward a less flexible exchange rate,time periods in which the exchange rate was less than fully fixed are most relevant for testing our hypotheses.For this reason,we created two samples:one omitting all time periods when the exchange rate was less than fully fixed and one including all observations.In practice,this means that in the first sample most observations earlier than 1973 drop out,since prior to that year most developing countries participated in the Bretton Woods exchange rate system and pegged their currencies to the U.S.dollar,leaving them little room to take further steps toward less flexibility.30 Although we emphasize results from the first,more theoretically relevant sample,we ran all tests on both samples and briefly describe the latter when discussing robustness checks. EXCHANGE RATE REGIMES Governments have a variety of choices for managing their currency's ex- change rate,ranging from a free float to a currency board,31 with a vari- ety of intermediate options.To capture this range of options-and to evaluate the robustness of our findings to different operationalizations- we conducted all of our tests using,in turn,both narrow definitions fo- cusing only on polar cases of fixed versus floating regimes and broader definitions allowing for more fine-grained identification of intermedi- ate regimes.For both indicators,we base our classifications primarily on information available in the International Monetary Fund's Annual Report on Exchange Rate Arrangements and Exchange Restrictions.32 The eighteen countries are Argentina,Bolivia,Brazil,Chile,Colombia,Costa Rica,Ecuador,El Salvador,Guatemala,Guyana,Honduras,Mexico,Nicaragua,Panama,Paraguay,Peru,Uruguay,and Venezuela.This is the entire population of Latin American countries with a population of at least one million for which data on exchange rate regimes,elections,and our principle control variables are readily available. They could have adopted a currency board or dollarized the economy,but with the exception of Panama these were not commonly discussed policy options until recent years. 31Under a currency board,the central bank is required to maintain liquid international reserves equivalent to (almost)100 percent of the monetary base.As a consequence,monetary policy is directed solely at securing the exchange rate,abandoning (for the most part)the possibility of adjusting the monetary aggregate for macroeconomic stabilization purposes. The descriptions that appear in the country reports of the IMF volumes provide information about timing of policy changes and allow a consistent coding (or reclassification of categories)of arrangements,neither of which is available from the summary tables in the appendixes.Besides lacking
IV. ELECTIONS AND EXCHANGE RATES: DATA AND A FIRST CUT AT ASSESSING THE RELATIONSHIP To evaluate our argument about electoral cycles and the incentives for governments to attempt an exchange rate–based stabilization, we collected quarterly data on exchange rate arrangements and elections for eighteen Latin American countries from 1970 to 1999.29 Since we are interested in movements toward a less flexible exchange rate, time periods in which the exchange rate was less than fully fixed are most relevant for testing our hypotheses. For this reason, we created two samples: one omitting all time periods when the exchange rate was less than fully fixed and one including all observations. In practice, this means that in the first sample most observations earlier than 1973 drop out, since prior to that year most developing countries participated in the Bretton Woods exchange rate system and pegged their currencies to the U.S. dollar, leaving them little room to take further steps toward less flexibility.30 Although we emphasize results from the first, more theoretically relevant sample, we ran all tests on both samples and briefly describe the latter when discussing robustness checks. EXCHANGE RATE REGIMES Governments have a variety of choices for managing their currency’s exchange rate, ranging from a free float to a currency board,31 with a variety of intermediate options. To capture this range of options—and to evaluate the robustness of our findings to different operationalizations— we conducted all of our tests using, in turn, both narrow definitions focusing only on polar cases of fixed versus floating regimes and broader definitions allowing for more fine-grained identification of intermediate regimes. For both indicators, we base our classifications primarily on information available in the International Monetary Fund’s Annual Report on Exchange Rate Arrangements and Exchange Restrictions.32 54 WORLD POLITICS 29The eighteen countries are Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Guyana, Honduras, Mexico, Nicaragua, Panama, Paraguay, Peru, Uruguay, and Venezuela. This is the entire population of Latin American countries with a population of at least one million for which data on exchange rate regimes, elections, and our principle control variables are readily available. 30 They could have adopted a currency board or dollarized the economy, but with the exception of Panama these were not commonly discussed policy options until recent years. 31 Under a currency board, the central bank is required to maintain liquid international reserves equivalent to (almost) 100 percent of the monetary base. As a consequence, monetary policy is directed solely at securing the exchange rate, abandoning (for the most part) the possibility of adjusting the monetary aggregate for macroeconomic stabilization purposes. 32The descriptions that appear in the country reports of the IMF volumes provide information about timing of policy changes and allow a consistent coding (or reclassification of categories) of arrangements, neither of which is available from the summary tables in the appendixes. Besides lacking v56.1.043.schamis 3/2/04 4:29 PM Page 54