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Political Economy in Macroeconomics I Allan Drazen account libcralization as a signal of commitmcnt to economic reform. Wc also summarizc thc empirical rcscarch on political determinants of capital Political Economy in controls. Another major issue in open-economy macroeconomics is sovereign Macroeconomics debt, that is, the debt owed by a government to foreign creditors. hsucs of sovereign debt arc substantially different than those concerning nonsovereign debt and arc inherently political. For example, since it is oWed by the government, repayment decisions are not connectcd with any question of the ability to repay. With few exceptions, a borrower country has the technical ability to repay the debt, so that non-repayment is a ALLAN DRAZEN political issue. In Section 12.8, we analyze basic models of sovereign ,c,, borrowing and its repayment, especially the role of penalties in enforcing repayment. We also consider the importance of political versus nonpoliti­ cal penalties in the decision of whether to issue debt at home or abroad. Copyright © 2000 by Princeton University Press The final topic considered is foreign assistance, especially lending by Published by Princeton University Press, 41 William Street, governments and international financial organizations to developing coun­ Princeton, New Jersey 08540 tries for the purpose of structural adjustment. Our point of departure is In the United Kingdom: Princeton University Press, the strikingly disappointing results that foreign aid programs have had in Chichester, West Sussex alleviating poverty and stimulating growth in the recipient countries, a All Rights Resm;ed failure that we argue reflects the political nature of aid. Foreign assistance is inherently political for a number of reasons. First, the incentives of the donors may be political, not only in the obvious sense that aid is often given for strategic political reasons, but also because the nature of aid (and Library of Congress Cataloging-in-Publication Data especially its ineffectiveness) often reflects political and bureaucratic con­ flicts within the donor organizations. Second, the ineffectiveness of aid is Drazen, Allan. also very much attributed to misappropriation by the recipients, where this Political economy in macroeconomics I Allan Drazen. is widely believed to reflect political factors. There are a number of models p. em. which formalize the role of political factors, as well as much empirical Includes bibliographical references and index. work detailing the role of political factors in explaining the ineffectiveness ISBN 0-691-01670-4 (cl: alk. paper) of aid. Macroeconomics. 2. Decision making. 3. Policy sciences. 4. Economics. I. Title. HB172.5.D73 2000 339-dc21 99-41735 PART I-EXCHANGE-RATE ARRANGEMENTS 12-2. FIXED VERSUS FLEXIBLE EXCHANGE RATES The choice of optimal exchange rate arrangements has long been a key issue in open-economy macroeconomics. From an economic point of view, the general question may be put simply: which exchange rate arrangement is best for economic performance? The choice of the optimal regime from PRINCETON UNIVERSITY PRESS a, purely economic point of view is beyond the scope and purpose of this chapter. Hence, we will simply review thc key issues, suggesting that PRINCETON, NEW JERSEY readers interestt.:d in the primarily economic arguments refer to the voluminous literature. The brief discussion of issues that arc primarily economic is meant simply as a prelude to a discussion of political issues. C II A I' T 1i N T H' I·, I. I' 1,· 530 T II /c,' I N T ,,. R N A 1' I 0 N A I. E C 0 N 0 M I' 531 · · f· f fi d aminal exchange rates is Tl 1 e main economic argument m avor o xe n . Pegging the Exchange Rate to Gain Credibility . d d transactiOn. costs f or mterna· . t.10na · 1 trade that they Imply.. t he re uce - · 1 · re uncertam Floating exchange rates arc seen as more volat1 1e, Imp ymg mo . Taken together with the economic arguments for flexible exchange rates, 1 This uncertainty may reduce the volume of mterna- rea I exc h a nge rates· · · · T · f · t pegging the exchange rate to gain credibility for a low-inflation policy can tiona! trade, discourage investment, and reduce the poss1b1 1t1es_ or m er- be thought of as an application of the question of commitment versus national diversification of risks. The role of fixed exchange rates m ~nco~r­ flexibility introduced in Section 4.6 of Chapter 4 and further discussed in a ing trade may extend to trade arrangements. In the Europea~ Umon, or Chapter 5. Giavazzi and Pagano (1988) were perhaps the first to make e~ample a fixed-rate system (or, more precisely, monetary umon) IS ~-ee? explicit the argument for pegging the exchange rate to gain credibility. as maxi~izing the gains from unified goods and labor ~arkets a~d e Imi­ They consider a policymaker who has the same incentives towards surprise nating the changes in competitiveness between countn~s stemmmg fr?m inflation that we first introduced in Chapter 4-unanticipated inflation ersistent exchange rate movements, the latter tendmg to u_ndermme may lower unemployment or may reduce the real value of the stock of ~u ort for a single market. This last argument sugg~sts an_ Important outstanding debt. A social welfare-maximizing policymaker therefore has PJftical argument for fixed exchange rates, namely, as mcreasmg sup~ort the temptation to engineer a surprise inflation; since this incentive to for cooperative arrangements more ~eneral~y. We explore connectiOns time-inconsistent behavior is understood by the public, the resulting equi­ between monetary and political union m Section 12.~. , librium implies lower welfare than if he could commit himself to zero Another argument often made for fixed rates IS that ~e~mg. one s inflation. The problem is how to make such a commitment credible. at of a low-inflation country will help to restram mflat10nary cy to th Giavazzi and Pagano suggest joining an exchange rate mechanism with curren ed rates are seen as providmg· · d'ISCip · 1·me t o e nable a pressures. Hence ' fix . r . v· .ng fixed but adjustable parities as a way to do so. They use the example of the government to resist the temptation to follow mflat10nary _po ICies. Iewi f European Monetary System (EMS), which we take as a representative of a fixed rates as a commitment device brings us back to precisely the IS~~~~ro fixed exchange rate system simply for expositional convenience? With a commitment discussed in Chapter 5. We discuss th~s lfl?e of ~re I _IIty fixed nominal exchange rate, inflation in excess of the EMS average ar ument below. A number of the issues discussed will mmor dis~uss~~ns translates into an appreciation of the real exchange rate, a real apprecia­ in g Cha ters 4, 5, and 6, so that we rely at points on ~ more mtmtive tion that would not occur if domestic inflation induced an equal nominal discussion, referring the reader who wants a more techmcal treatment to depreciation. The real exchange rate implications of high inflation thus those chapters. change the governments' incentives to inflate. The main argument in favor of a flexible exchange_ ~ate IS th_e monetary One interesting aspect of the analysis is that it gives a specific real-world policy independence it allows, implying a greater abihty to adJust to bot~ structure to the question of institutional commitment first raised in Chap­ domestic (or country-specific) and to foreign disturban~es. T~~ co_sts ? ter 5. The specific structure raises some new issues. For example, since ivin u monetary sovereignty for purposes of econ?~uc ~tabihz_atiOn m inflation differentials between countries generally still exist in a fixed ~he f~c/of country-specific shocks are considered explicitly m Secuon 12.4{ exchange rate system such as the EMS, fixing the exchange rate will imply Mussa (1979) and Marston (1985) present good surveys ~f the role. o a continually appreciating real exchange rate for the relatively high-infla­ exchange rate regimes in optimal response to both domestic and foreign tion countries. Though inflation differentials may be far lower for these disturbances arguing that though flexible rates are generally presumed ~-o countries than if they did not join the EMS and let their exchange rates provide bett~r insulation against foreign shocks, there are cases where t IS float, the flip side of the fixity of the nominal exchange rate is real need not be true. h t overvaluation. If the cumulative real appreciation gets large enough, a We now turn to primarily political aspects of the chOice of exc ange ra e realignment will be necessary, so that the welfare implications of commit­ arrangements, which will be our focus. ment may be less clear. Giavazzi and Pagano consider a continuous-time model in which the domestic policymaker in the EMS chooses a level of inflation 7r1 to maximize the welfare of the representative individual, where welfare 2 I A key point to note i~ that fixing the exchange r~tc need not real~y red,uce .ex,eh,an~~ r:.le There is a distinction between unilaterally pegging the exchange rate in the attempt to risk, but simply greatly alter the form of the probabihty dJstnbullon o~ exch~n~c .:,::~c r~t~~;ct:; achieve anti-inflation credibility versus joining a multilateral fixed exchange rate system. As from continuous but small change~ to infrequent JUmps m the exchange rate. our main focus is on fixed rates as an anti-inflation device, we downplay this distinction here, but return to it in later sections. this below in considering currency crises. I' II F I .\' I' 1; ll ;\' A I' I 0 ·' I /. 1; (' (} :V 0 M l C II A I' r f: II 'f 11· li I.
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