The exchange rate is the most important price in any economy, since it affects all other prices. Exchange rates are set, either directly or indirectly, by government policy. Exchange rates are also central to the global economy, for they profoundly influence all international economic activity. Despite the critical role of exchange rate policy, there are few definitive explanations of why governments choose the currency policies they do. Filled with in-depth cases and examples, Currency Politics presents a comprehensive analysis of the politics surrounding exchange rates.
Identifying the motivations for currency policy preferences on the part of industries seeking to influence politicians, Jeffry Frieden shows how each industry's characteristics--including its exposure to currency risk and the price effects of exchange rate movements--determine those preferences. Frieden evaluates the accuracy of his theoretical arguments in a variety of historical and geographical settings: he looks at the politics of the gold standard, particularly in the United States, and he examines the political economy of European monetary integration. He also analyzes the politics of Latin American currency policy over the past forty years, and focuses on the daunting currency crises that have frequently debilitated Latin American nations, including Mexico, Argentina, and Brazil.
With an ambitious mix of narrative and statistical investigation, Currency Politics clarifies the political and economic determinants of exchange rate policies.
An integrated world economy requires cooperation among major economic powers. Without determined cooperation among the principal powers, globalization is unlikely to survive the inevitable shocks to which it is subjected.
The world faces a difficult adjustment to reduce the macroeconomic imbalances that were a major cause of the current crisis. This means reducing the surpluses of the major surplus countries in East Asia and Europe, and reducing the deficits of the major deficit countries in North America and Europe. Both processes require substantial domestic economic changes; economies and people will be tempted to turn inward, and governments will be tempted to reduce the priority they give to their external ties. This increases the risks of a breakdown in international cooperation.
Historical precedent is instructive. During the interwar period, a global macroeconomic imbalance was a major cause of the eventual economic catastrophe. During the 1920s, Germany borrowed heavily from the United States. But when a crisis hit, it turned out that neither country was politically prepared to maintain cooperative policies. Americans, focused on domestic concerns, were unwilling to help work out a cooperative resolution of the crisis. Germany exploded into social and political unrest and ended up in the hands of rabid nationalists and protectionists. The problem was political: a lack of domestic support for the sacrifices necessary to maintain international cooperation.
As the crisis winds down and post-crisis adjustment begins, major governments will be challenged to work together to support a well-functioning international economy. They will need to address the concerns of constituents who will chafe at the economic changes forced upon them. Governments that can build domestic political support for international economic engagement will be in a stronger position to work to sustain an integrated global economy.
Two acclaimed political economists explore the origins and long-term effects of the financial crisis in historical and comparative perspective.
Welcome to Argentina: by 2008 the United States had become the biggest international borrower in world history, with almost half of its 6.4 trillion dollar federal debt in foreign hands. The proportion of foreign loans to the size of the economy put the United States in league with Mexico, Pakistan, and other third-world debtor nations. The massive inflow of foreign funds financed the booms in housing prices and consumer spending that fueled the economy until the collapse of late 2008.
The authors explore the political and economic roots of this crisis as well as its long-term effects. They explain the political strategies behind the Bush administration's policy of funding massive deficits with the foreign borrowing that fed the crisis. They see the continuing impact of our huge debt in a slow recovery ahead. Their clear, insightful, and comprehensive account will long be regarded as the standard on the crisis.
The Treasury can cry foul all it wants, but the decision by Standard & Poor’s to downgrade America’s credit rating by one notch last
Friday, and the subsequent plunge in the stock market, are serious
symptoms of a loss of confidence—an assessment that is fundamentally
political, not economic.
There is little question about the technical ability of America to make
good on its debts—but there are grave questions about the political
system’s ability to resolve our nation’s financial problems.
The debt-ceiling deal between President Obama and Congressional
Republicans merely staved off a crisis of confidence for the moment. It
does not address our immediate need to avoid falling back into
recession, or our longer-term need to raise enough revenue to pay for
the social spending Americans want.
Moreover, the deal sidesteps the fundamental challenge the country now
faces: who will pay to fix what was broken during the past decade by
irresponsible tax cuts, ruinously expensive wars, failures of regulation
and the resulting housing and financial booms and busts?
In the short term, the plan cuts a bit of discretionary nondefense
spending, a category that in fact has not grown particularly rapidly.
This is a mistake. With unemployment at 9.1 percent, and long-term
joblessness at record levels, we need more spending, not less. But the
agreement all but rules out new spending to boost the economy, at a
dangerous time. The chances of a double-dip recession are growing—and a
further slowdown will increase, not reduce, the budget deficit.
The longer-term spending and revenue commitments are no better.
Certainly spending, in particular on Medicare and Medicaid, needs to be
restrained. But the deficits cannot be reined in without tax increases,
and the “framework” does little or nothing in this regard. The S. &
P. decision to downgrade reflects, in large part, the expectation that
Republicans will not allow the Bush tax cuts to expire.
The recent skirmishes all dance around the central issue: the United
States is in the midst of the world’s largest debt crisis. The Treasury
now owes the public almost $10 trillion, including $4.5 trillion to
foreigners—and that doesn’t include what households and companies owe.
For decades to come, Americans will face the core problem of every
heavily indebted nation: who will bear the burden of adjustment?
Countries borrow for many purposes: canals and railroads in the 19th
century, factories and highways in the 20th, and in the last decade, a
housing and financial boom in Europe and America. When the projects
don’t pan out and the debtor country falls into crisis, what happens to
the accumulated debts? Who pays? Creditors or debtors? Workers or
investors? Rich or poor? The European Union is tearing itself apart over
this question, which divides creditor nations from debtor nations and
which divides groups within nations. The American variant of this
conflict is just beginning.
Perhaps, some Americans believe, we can shunt the adjustment costs onto
foreigners. Indeed, our creditors worry that the United States will
reduce its debt burden the old-fashioned way, by inflating it away. A
few years of moderate inflation, and a weaker dollar, would
significantly lessen the real cost of servicing the country’s debts—at
our creditors’ expense.
But adjusting to the reality of America’s accumulated debts will
inevitably require sacrifices at home. The battle over who will be
sacrificing has already begun, albeit under veils of rhetoric. The
Republicans seem unconcerned about stimulating recovery, and primarily
concerned that none of the long-term costs of balancing our budget be
paid by upper-income taxpayers. No surprise: unemployment among the
one-third of Americans with the highest incomes is barely 4 percent,
while for the lowest third it is more than four times that level.
The Democrats, for their part, seem content to insist that the
adjustment burden not fall on beneficiaries of government spending,
whether public employees or recipients of social spending. This reflects
their base in the labor movement, the public sector and the poor.
We lost the first decade of the 21st century by squandering our wealth
and borrowing as if there was no tomorrow. We risk losing this decade to
an incomplete recovery and economic stagnation.
An economically responsible, politically feasible distribution of the
costs of working our way out of the crisis will require higher taxes, a
more efficient tax code, and restrained growth of social spending,
particularly Medicare. To ignore these realities, and the contentious
choices they entail, is merely to postpone the inevitable day of
reckoning—and probably to make it worse.
This new introduction to world politics by three leading scholars offers a contemporary analytical approach based on the way political scientists study international relations today. Each chapter begins with an intriguing empirical or theoretical puzzle that sets up the chapter's analysis, and "Controversies" boxes throughout the text provide insights into some of the most compelling current policy debates.
Offering an approach that is closely in line with the way that political scientists study international relations today, this framework is used consistently in every chapter to help students understand the basic topics in international relations.
Each chapter begins with an intriguing empirical or theoretical puzzle to draw students in and set up the chapter’s analysis. Thoughtful pedagogy reinforces key points.
If the crisis turns into a new Great Depression, it will most likely be due to a breakdown of cooperation among the major economies. But sustaining international cooperation requires domestic support; ignoring the demands of poor and middle-class citizens for relief will inflame more extreme anti-globalisation views, making international cooperation much more difficult.
If the current crisis turns into a disaster on the order of the Great Depression, it will most likely be due to a breakdown of cooperation among the major economies. The history of the modern world economy—and especially of its collapse in the 1930s—makes clear that the principal powers have to work together if they are to maintain an integrated international economic order.
International cooperation needs domestic support for openness
Yet governments are only able to make the sacrifices necessary to sustain international cooperation if they can rely, in turn, on domestic political support for an open world economy. National publics unconvinced of the value of international integration will not back policies—often costly and difficult policies—to maintain it. This can lead—again, as in the 1930s—to a perverse process in which global economic failure undermines support for economic openness, which leads governments to pursue uncooperative policies, which further weakens the global economy.
On both dimensions, international and domestic, we are in trouble. So far, despite high-sounding internationalist rhetoric, governments have responded to the crisis with policies that take little account of their impact on other nations. And the crisis has dramatically reduced domestic public support for globalisation, and for national policies to sustain it.
Why reasonable governments do unreasonable things
On the international dimension, the threat is not so much of explicit protectionism but rather of nationally specific policies that impose costs on others, directly or indirectly.
These beggar-thy-neighbour policies are not normally the result of some inexplicable bloody-mindedness on the part of venal governments, or of purposeful antagonism toward rivals. They are, instead, desperate attempts to defend national economies from gathering storms. But they impose negative externalities on other countries, and in so doing can provoke hostile reactions that can drag all parties concerned into bitter conflict.
Not out of arrogant nationalism but out of domestic desperation
Domestic constituents demand action, and governments have to respond, even at the expense of international cooperation. This can easily lead down a path toward conflict. Financial intervention to restore liquidity or solvency to the banking system can come at the expense of financial partners, sucking funds out of neighbours.
The early-October Irish blanket deposit guarantee, implemented with the perfectly understandable goal of avoiding a bank panic in a small and vulnerable economy, nearly induced a run on British banks as British depositors rushed to transfer funds from British to Irish banks. The current American financial bailout is drawing capital from the rest of the world—including from emerging markets that urgently need it—not out of arrogant nationalism but out of domestic desperation. And the buy-American provisions of the current stimulus package demonstrate the ease with which well-intentioned policies can turn into uncooperative predation.
The range of policies of this type—sincere national initiatives with counter-productive international implications—is virtually endless.
Negative externalities galore
Support for troubled national firms can turn into anti-competitive subsidies to national champions. Currency depreciation, a common recommendation for difficult times, can put competitive pressure on trading partners, leading to round after round of "competitive devaluations." Debt-averse governments can limit the size of their fiscal stimulus, thereby free riding on the deficit spending of neighbours. Countries with intolerable foreign debt burdens can seek debt write-downs that further cripple creditor-country financial markets. And all of these can interact to create powerful protectionist pressures. One country’s fiscal stimulus can "leak" into a neighbour, draw in a surge of imports from the neighbour, and provoke a bitter protectionist backlash.
Even with the best of intentions, governments can act in ways that drive wedges among countries, block cooperative responses to the crisis, and ultimately make everyone worse off. And despite today’s flowery rhetoric, there is little evidence that national policymakers are willing or able to take into account the international implications of their actions.
If this pattern continues, it will be a major obstacle to a rapid recovery.
Will anyone speak for the rest of the world?
National governments rarely consider global consequences, because their constituents are domestic and national publics are very skeptical about the contemporary world economy.
Even before the crisis hit, there had been real erosion in popular support for globalisation. Economic integration has come to be associated with job losses, competitive pressures, and a worsening of income distribution in developed and developing countries alike. Nearly universally, the lower registers of the income distribution are most dubious about the benefits of international economic integration, and these doubts are particularly widespread in more unequal societies.
The crisis has heightened suspicion of a world economy that appears to be the source of much of our current predicament. There is increasing resentment that the expansion of the past ten years primarily helped the wealthy, while the poor and middle classes are being asked to sacrifice to deal with the hangover of the binge. This is coupled with similar resentment that governments appear to privilege the concerns of international banks and corporations. There is an advancing popular view that insulation will help reinforce national attempts to deal with the crisis.
National publics will increasingly resist making national sacrifices in order to honour international economic obligations. Meanwhile, concentrated interests who support globalisation—such as the international financial and corporate sectors—have been undermined by international economic weakness. Broad popular sentiment is increasingly widespread and powerful that national responses to the crisis must take priority over international obligations.
Attention must be paid: Crisis’s impact on income distribution
The impact of the crisis on income distribution cannot be ignored, for it will determine much of the politics of government responses to the crisis. Ignoring the demands of poor and middle-class citizens for relief will inflame more extreme anti-globalisation views, making international cooperation that much more difficult.
These two dimensions, the international and the domestic, are closely interrelated. The less domestic support there is for globalisation, the harder it will be for national governments to reach cooperative agreements with partners. The less international cooperation there is, the greater the likelihood of a deterioration in the global economy. As in the 1930s, beggar-thy-neighbour policies, distributional conflicts, and international economic stagnation could feed on each other in a downward dance.
Into the maelstrom?Governments have to act consciously to counteract this dismal possibility
At the domestic level, governments need to work out an equitable and politically sustainable allocation of austerity across the population. This means ensuring that those sectors of society hit hardest by the crisis are not also the ones asked to bear the stiffest sacrifices. Societies with existing social safety nets will have to expand them and make sure they work for wider segments of the population than they were planned. Countries with weak or non-existent social programs for the victims of crises such as this will have to create them, and quickly. By the same token, basic principles of equity—and even more basic political realities—demand that those who received the main benefits of the boom have to bear their share of the costs of the bust. Governments that ignore the social and distributional implications of the crisis are likely to find themselves either driven toward extreme and counter-productive policies, or swept away.
Even sustaining existing social programs is extraordinarily difficult in such hard times. This is true of all governments, which face powerful fiscal pressures as tax revenues dry up and demands for spending soar. The difficulties are especially challenging for developing countries, many of which have lost whatever access they may have had to external sources of capital. Yet governments that do not provide effective relief to those hardest hit by the crisis face the prospect of dramatically increased social and political strife, which will only deepen the disaster.
At the international level, governments need to work just as consciously to coordinate not just words, but actions. This will not happen of its own accord. So far, the solidarity of OECD central bankers has been impressive. However, this builds upon a long-standing tradition of the solidarity of central bankers, and upon decades of institutionalised collaboration, and can only take us a very short part of the way. There is nothing analogous on other dimensions.
The free interplay of government policies will not spontaneously bring forth international cooperation
Collaboration among governments has to be intended, designed, and monitored. This almost certainly requires some international institutional framework, some set of agreed-upon rules and ways of enforcing them. The governments of the major economic centers need to consult regularly on the international dimensions of the crisis, and of its resolution. They need to hold each other to account, and they need some reasonably independent mechanism to identify policies that risk driving governments toward conflict rather than mutual assistance. Other foreign policy goals can and should be linked to supportive efforts on the economic front.
If governments do not pay real attention to the domestic distributional impact of the emergency, and to the international implications of their national policies, the current calamity will feed on itself. The Great Depression of the 1930s was more a failure of national policy, and of international cooperation, than it was a failure of markets. Success in confronting the current crisis will similarly depend on socially responsive and viable national policies, and on globally responsive and viable international cooperation.
Editors' note: This column is a Lead Commentary on Vox's Global Crisis Debate page; see further discussion on Vox’s Global Crisis Debate page.
Is there a valid argument for international cooperation, and some form of international governance structure, in the international monetary realm? On the purely economic front, the argument is not strong. Yet a broader political economy approach concludes that national currency policy can in fact impose non-pecuniary externalities on partner nations. This is especially the case with major policy-driven misalignments, which cannot easily be countered by other governments. For example, one country’s substantially depreciated currency can provoke powerful protectionist pressures in its trading partners, so that exchange rate policy spills over into trade policy in potentially damaging ways. Inasmuch as one government’s policies create these sorts of costs for other countries, and for the world economy as a whole, there is a case for global governance. This might include some institutionalized mechanism to monitor and publicize substantial currency misalignments. While there appears to be little global political attention to such a mechanism now, there have been initiatives along these lines at the regional level, and the current crisis may have stimulated more general stirrings of interest.
Exchange rates powerfully affect cross-border economic transactions. Trade, investment, finance, tourism, migration, and more are all profoundly influenced by international monetary policies. Many developing-country governments have searched for alternatives to the uncertainty that can prevail on international currency markets. Policy entrepreneurs have rushed to peddle currency nostrums, urging a turn toward dollarization, managed floating, nominal anchors, target bands, or other options.
There are both theoretical and empirical reasons to expect globalization to heighten the importance of the exchange rate. Theoretically, open-economy macroeconomic principles imply that capital mobility profoundly affects exchange rate policy choices. As Robert Mundell showed more than forty years ago, the government of a financially integrated economy faces a choice between monetary policy autonomy and a fixed exchange rate (Mundell 1963). If the government opts for a fixed rate, capital mobility makes impossible a monetary stance different from that of the anchor currency; alternatively, if the government opts to sustain an independent monetary policy, it must allow the currency to move. These constraints mean that the economics and politics of monetary and exchange rate policy are likely to be very different in an economy that is financially open than in an economy that is not. By the same token, inasmuch as international economic integration involves increased exposure to international financial and commercial flows, it heightens the concerns of those involved in or exposed to international trade and finance. In a relatively closed economy, few economic actors care about currency movements. But as economies become “globalized” more firms, investors, and workers find their fortunes linked to the exchange rate, and to its impact on trade and financial flows. This concentrates attention on the exchange rate.
We show that political economy factors play an important role in shaping the exchange rate policies of transition economies. We argue, among other things, that tradables producers prefer a floating rate to allow active exchange rate policy to affect their competitiveness, while internationally exposed sectors prefer a fixed rate to provide currency stability. We carry out a quantitative analysis of the de facto exchange rate behavior of 21 countries over the period 1992-2004. We find support for our arguments, along with some counter-intuitive results, for example associating democracy with a pegged currency and trade concentration with a floating currency. Our empirical results serve as the basis for predictions regarding the adoption of the euro in the EU accession countries and other countries in Central and Eastern Europe.
International trade at unprecedented levels, millions of people migrating yearly in search of jobs, the world's economies more open to one another than ever before Such was the global economy in 1900. Then as now, many people considered globalization to be inevitable and irreversible. Yet the entire edifice collapsed in a few months in 1914.
Globalization is a choice, not a fact. It is a result of policy decisions and the politics that shape them. Jeffry A. Frieden's insightful history explores the golden age of globalization during the early years of the twentieth century, its swift collapse in the crises of 1914?45, the divisions of the Cold War world, and the turn again toward global integration at the end of the century. His history is full of character and event, as entertaining as it is enlightening. It deepens our understanding of the century just past and sheds light on our current situation.
Analyses of the political economy of exchange-rate policy posit that firms and individuals in different sectors of the economy have distinct policy attitudes toward the level and the stability of the exchange rate. Most such approaches hypothesize that internationally exposed firms prefer more stable currencies, and that tradables producers prefer a relatively depreciated real exchange rate. Sensible as such expectations may be, there are few direct empirical tests of them. We offer micro-level, cross-national evidence on sectoral attitudes over the exchange rate. Using firm-level data from the World Bank’s World Business Environment Survey (WBES), we find systematic patterns linking sector of economic activity to exchange-rate policy positions. Owners and managers of firms producing tradable goods prefer greater stability of the exchange rate: in countries with a floating currency, manufacturers are more likely to report that the exchange rate causes problems for their business. With respect to the level of the exchange rate, we find that tradables producers—in particular manufacturers and export producers—are more likely to be unhappy following an appreciation of the real exchange rate than are firms in non-tradables sectors (services and construction). These findings confirm theoretical expectations about the relationship between economic position and currency policy preferences.
The analysis of the political economy of currency policy has focused on two sets of questions. The first is global, and has to do with the character of the international monetary system. The second is national, and has to do with the policy of particular governments towards their exchange rates. These two interact. National policies, especially of large countries, have an impact on the international monetary system. By the same token, the global monetary regime influences national policy choice. For ease of analysis, however, it is useful to separate analyses of the character of the international monetary system from analyses of the policy choices of national governments.
Government exchange rate regime choice is constrained by both political and economic factors. One political factor is the role of special interests: the larger the tradable sectors exposed to international competition, the less likely is the maintenance of a fixed exchange rate regime. Another political factor is electoral: as an election approaches, the probability of the maintenance of a fixed exchange rate increases. We test these arguments with hazard models to analyze the duration dependence of Latin American exchange rate arrangements from 1960 to 1999. We find substantial empirical evidence for these propositions. Results are robust to the inclusion of a variety of other economic and political variables, to different time and country samples, and to different definitions of regime arrangement. Controlling for economic factors, a one percentage point increase in the size of the manufacturing sector is associated with a reduction of six months in the longevity of a country?s currency peg. An impending election increases the conditional likelihood of staying on a peg by about 8 percent, while the aftershock of an election conversely increases the conditional probability of going off a peg by 4 percent.
Many Europeans support common European Union (EU) representation in international institutions. But such a pooling international political influence raises complex and controversial issues. A common European foreign policy position implies compromise among EU members. The pooling international representation thus requires, as with many internal EU policies, that member states weigh the potential benefits of a common policy against the potential costs a policy not to their liking. There can be a trade–off between the advantages of scale and the disadvantages overriding heterogeneous preferences. Simple spatial models help to make this point, to clarify the circumstances in which a common European international representation is most likely, and to explain who is most likely to support or oppose a pooling of European foreign policies.
The future of dollarization will be determined by political economy considerations. Existing scholarship on the political economy of fixed exchange rates indicates factors of potential importance at both the domestic and international levels. At the domestic level the role of stabilizing currencies to encourage trade, and devaluing for competitive purposes, dominates the politics of these decisions. Greater commercial and financial integration with the United States increase the likelihood of dollarization. Internationally-oriented economic agents (financial institutions, borrowers, international firms) are more likely to want dollarization; tradables producers, especially import competers, are more likely to oppose it.
At the international level, dollarization will implicate regional integration agreements. Countries party to such agreements (such as Mercosur) are more likely to dollarize together than separately. Where such agreements are with the United States, or where they increase the level of commercial and financial integration with the United States, they will also tend to increase the likelihood of dollarization. On the other hand, dollarization is likely to put pressure on countries to harmonize financial regulation with the United States, and to require the implicit or explicit approval of American monetary and financial authorities.
Exchange rates have been central to the course of economic development in Latin America from the heyday of import substitution to the rapid expansion of foreign debt in the 1970s, and from the debt crisis and its troubled aftermath to renewed growth and borrowing in the 1990s.
Why do governments choose the currency policies they do, and how do economic and political factors affect these policies? Although currency policy is made by governments operating in a political environment, there has been little study of the political economy of exchange rate policy. The Currency Game looks to fill this void by examining the range of potential determinants of currency choices by Latin American governments. While purely economic factors (especially economic structure, trade patterns, and exogenous economic conditions) are of course important to these choices, the book focuses on the political and political economy considerations that have typically been underrepresented in the literature. These include the effects of interest groups, electoral competition, and the timing of elections on exchange rate decisions.
Since exchange regimes are adopted for reasons as diverse as inflation control, reduced volatility and improved competitiveness, the book also features a cross-country analysis of national exchange rate policies, as well as case studies of Argentina, Brazil, Chile, Colombia and Peru.
In an initial attempt to fill the previous void in the economic literature, this paper summarizes a series of studies, undertaken as part of a larger project sponsored by the Inter–American Development Bank, on the role of political economy factors in the making of exchange rate policy. While these factors are, of course, examined in conjunction with economic and macroeconomic variables, they have previously received little attention in their own. These political economy factors most notably include the role of interest groups, electoral competition, and election timing. This paper presents some simple analytical arguments, then summarizes evidence contained in other papers in this project.
The structure of international monetary relations has gained increasing prominence over the past two decades. Both national exchange rate policy and the character of the international monetary system require explanation. At the national level, the choice of exchange rate regime and the desired level of the exchange rate involve distributionally relevant tradeoffs. Interest group and partisan pressures, the structure of political institutions, and the electoral incentives of politicians therefore influence exchange rate regime and level decisions. At the international level, the character of the international monetary system depends importantly on strategic interaction among governments, driven by their national concerns and constrained by the international environment. A global or regional fixed–rate currency regime, in particular, requires at least coordination and often explicit cooperation among national governments.