The Political Economy of Monetary Institutions an International Organization Reader Edited by William T

T he Political Economy of Monetary Institutions

The Political Economy of Monetary Institutions An International Organization Reader edited by William T. Bernhard, J. Lawrence Broz, and William Roberts Clark Recent analysis by political economists of monetary institution determinants in different countries has been limited by the fact that exchange rate regimes and central bank institutions are studied in isolation from each other, without examining how one institution affects the costs and benefits of the other. By contrast, the contributors to this volume analyze the choice of exchange rate regime and level of central bank independence together; the articles (originally published in a special issue of International Organization) constitute a second generation of research on the determinants of monetary institutions. The contributors consider both economic and political factors to explain a country’s choice of monetary institutions, and examine the effect of political processes in democracies, including interest group pressure, on the balance between economic and distributional policy. William Bernhard is Associate Professor of Political Science at the The Political University of Illinois at Urbana-Champaign. J. Lawrence Broz is Assistant Professor in the Department of Political Science at the University of California, San Diego. William Roberts Clark is Assistant Professor in the Department of Politics at New York University. Economy of

Bernhard, Monetary Broz,

and Clark, Institutions editors

IO International Organization Reader An International Organization Reader

edited by William T. Bernhard,

The MIT Press 0-262-52414-7 J. Lawrence Broz, and Massachusetts Institute of Technology Cambridge, Massachusetts 02142 http://mitpress.mit.edu ,!7IA2G2-fcebei!:t;K;k;K;k William Roberts Clark The Political Economy of Monetary Institutions

THE POLITICAL ECONOMY OF MONETARY INSTITUTIONS

edited by William Bernhard, J. Lawrence Broz, and William Roberts Clark

A special issue of International Organization

The MIT Press Cambridge, Massachusetts and London, England The contents of this book were ﬁrst published in International Organization (ISSN 0020-8183), a publication of the MIT Press under the sponsorship of the IO Foundation. Except as otherwise noted, copyright in each article is held jointly by the IO Foundation and the Massachusetts Institute of Technology.

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Library of Congress Cataloging-in-Publication Data

The political economy of monetary institutions / edited by William Bernhard, J. Lawrence Broz, William Roberts Clark. p. cm. “A special issue of International organization.” Includes bibliographical references. ISBN 0-262-52414-7 (pbk. : alk. paper) 1. Financial institutions. I. Bernhard, William (William T.) II. Broz, J. Lawrence. III. Clark, William Roberts. IV. International organization.

HG173.P65 2003 332.1—dc21 2003051314

10987654321 International Organization Volume 56, Number 4, Autumn 2002

Preface xiii

The Political Economy of Monetary Institutions William 1 Bernhard, J. Lawrence Broz, and William Roberts Clark

Partisan and Electoral Motivations and the Choice of Monetary 33 Institutions Under Fully Mobile Capital William Roberts Clark

Checks and Balances, Private Information, and the Credibility of 59 Monetary Commitments Philip Keefer and David Stasavage

Veto Players and the Choice of Monetary Institutions Mark 83 Hallerberg

Political Parties and Monetary Commitments William Bernhard 111 and David Leblang

Real Sources of European Currency Policy: Sectoral Interests and 139 European Monetary Integration Jeffry A. Frieden

Political System Transparency and Monetary Commitment 169 Regimes J. Lawrence Broz

Competing Commitments: Technocracy and Democracy in the 197 Design of Monetary Institutions John R. Freeman

Contributors

William Bernhard is Associate Professor of Political Science at the University of Illinois at Urbana-Champaign. He can be reached at [email protected].

J. Lawrence Broz is Assistant Professor in the Department of Political Science at the University of California, San Diego, California. He can be reached at [email protected].

William Roberts Clark is Assistant Professor in the Department of Politics at New York University. He can be reached at [email protected].

John R. Freeman is McKnight University Professor and Chair of the Depart- ment of Political Science at the University of Minnesota. He can be reached at [email protected].

Jeffry A. Frieden is Professor of Government at Harvard University. He can be reached at [email protected].

Mark Hallerberg is Assistant Professor in the Department of Political Science at the University of Pittsburgh. He can be reached at [email protected].

Philip Keefer is Lead Research Economist in the Development Research Group at the World Bank. He can be reached at [email protected].

David Leblang is Associate Professor of Political Science at the University of Colorado, Boulder, Colorado. He can be reached at [email protected].

David Stasavage is Lecturer in the Department of International Relations at the London School of Economics. He can be reached at [email protected].

Abstracts

The Political Economy of Monetary Institutions by William Bernhard, J. Lawrence Broz, and William Roberts Clark In recent decades, countries have experimented with a variety of monetary institutions, including alternative exchange-rate arrangements and different levels of central bank independence. Political economists have analyzed the choice of these institutions, emphasizing their role in resolving both the time-inconsistency problem and dilemmas created by an open economy. This “ﬁrst-generation” work, however, suffers from a central limitation: it studies exchange-rate regimes and central bank institutions in isolation from one another without investigating how one monetary institution affects the costs and beneﬁts of the other. By contrast, the contributors to this volume analyze the choice of exchange-rate regime and central bank independence together and, in so doing, present a “second generation” of research on the determinants of monetary institutions. The articles incorporate both economic and political factors in explaining the choice of monetary institutions, investigating how political institutions, democratic processes, political party competition, and interest group pressures affect the balance between economic and distributional policy objectives.

Partisan and Electoral Motivations and the Choice of Monetary Institutions Under Fully Mobile Capital by William Roberts Clark Central bank independence and pegged exchange rates have each been viewed as solutions to the inflationary bias resulting from the time inconsistency of discretionary monetary policy. While it is obvious that a benevolent social planner would opt for such an institutional solution, it is less obvious that a real-world incumbent facing short-term partisan or electoral pressures would do so. In this article, I model the choice of monetary institutions from the standpoint of a survival-maximizing incumbent. It turns out that a wide range of survival- maximizing incumbents do best by forfeiting control over monetary policy. While political pressures do not, in general, discourage monetary commitments, they can influence the choice between fixed exchange rates and central bank independence. I highlight the importance of viewing fiscal policy and monetary policy as substitutes and identify the conditions under which survival-maximizing incumbents will view fixed exchange rates and central bank independence as substitutes. In so doing, I provide a framework for integrating other contributions to this volume. Checks and Balances, Private Information, and the Credibility of Monetary Commitments by Philip Keefer and David Stasavage In this article, we argue that the effectiveness of central bank independence and exchange-rate pegs in solving credibility problems is contingent on two factors: political institutions and information asymmetries. However, the impact of these two factors differs. We argue that the presence of one institution—multiple political veto players—should be crucial for the effectiveness of central bank independence, but should have no impact on the efficacy of exchange-rate pegs. In contrast, exchange-rate pegs should have a greater anti-inflationary impact when it is difficult for the public to distinguish between inflation generated by policy choice and inflation resulting from exogenous shocks to the economy. Such information asymmetries between the public and the government, however, do not increase the efficacy of central bank independence. Empirical tests using newly developed data on political institutions provide strong support for our hypotheses.

Veto Players and the Choice of Monetary Institutions by Mark Hallerberg I argue that two types of veto players matter in the choice of monetary institutions: party veto players and subnational governments, which are strong in federal systems but weak in unitary systems. A crucial issue is whether voters can readily identify the manipulation of the economy with party players. A second issue concerns the national party veto player’s ability to control either fiscal or monetary policy. In one-party unitary governments identification and control are clear; parties where such governments are common prefer flexible exchange rates and dependent central banks. In multiparty coalition governments in unitary systems, identification is traditionally difficult, and the ability to target benefits to specific constituencies under fiscal policy makes fiscal policy autonomy more attractive for coalition governments. Such governments prefer central banks that are politically independent but that finance government debt. Under federalism, parties that constitute the central government have less control over fiscal policy and they prefer flexible exchange rates. Subnational governments do not support a dependent central bank that gives more power to the central government.

Political Parties and Monetary Commitments by William Bernhard and David Leblang Increased levels of economic openness in the industrial democracies have heightened the potential for intra-party and intra-coalition policy conflicts, hurting the ability of parties to win and retain office. We argue that politicians can use monetary commitments to help manage these conflicts and improve cabinet durability. To determine the political value of these commitments, we test the effect of fixed exchange rates and central bank independence on cabinet durability using a set of 193 cabinets in sixteen parliamentary democracies across the period 1972–98. The results indicate that monetary commitments are associated with higher cabinet durability, particularly for coalition governments. We then use the results of our statistical models to generate expected cabinet durability under alternative institutional configurations. By comparing these expected values, we show that actual monetary reforms in the industrial democracies have helped (or at least not hurt) the ability of political parties to remain in office. Real Sources of European Currency Policy: Sectoral Interests and European Monetary Integration by Jeffry A. Frieden In the thirty years before Economic and Monetary Union was achieved, European currency policies varied widely among countries and over time. In this article, I argue that the sectoral impact of regional exchange-rate arrangements, in particular their expected real effects on European trade and investment, exerted a powerful influence on the course of European monetary integration. The principal benefitoffixing European exchange rates was facilitation of cross-border trade and investment within the European Union (EU); the principal cost of fixed rates was the loss of national governments’ ability to use currency policy to improve their producers’ competitive position. Empirical results indeed indicate that a stronger and more stable currency was associated with greater importance of manufactured exports to the EU’s hard-currency core, while depreciations were associated with an increase in the net import competition faced by the country’s producers. This suggests a powerful impact of real factors related to trade and investment, and of private interests concerned about these factors, in determining national currency policies.

Political System Transparency and Monetary Commitment Regimes by J. Lawrence Broz Central bank independence (CBI) and fixed exchange rates are alternative monetary commitments that differ in transparency. While CBI is opaque and difficult to monitor, a commitment to a fixed exchange rate is easily observed. Political systems also vary in terms of transparency. I argue that the transparency of monetary commitments and the transparency of political systems are substitutes. Where political decision making is opaque (autocracies), governments must look to a commitment that is more transparent and constrained (fixed exchange rates) than the government itself. The transparency of the monetary commitment substitutes for the transparency of the political system to engender low inflation. Where the political process is transparent (democracies), a formal commitment to CBI can produce lower inflation because private agents and the political opposition are free to detect and punish government interference with the central bank. Statistical results indicate that (1) autocracies are more likely to adopt exchange-rate pegs than democracies, and (2) CBI is effective in limiting inflation in nations with high levels of political transparency.

Competing Commitments: Technocracy and Democracy in the Design of Monetary Institutions by John R. Freeman In this article, I refine and expand the agenda for research on monetary institutions. First, I evaluate the analyses and research designs presented in this special issue of International Organization. Out of this evaluation, several ideas about how to produce a “third generation” of research on this topic emerge. Specific ideas include how to: create a better synthesis with certain branches of economics, such as information economics; broaden the welfare criteria on which institutional choices are made; deepen the analyses of coalitional and other political processes on which the choice of institutions are based; and strengthen the tests that are offered in support of these choices. In the second part of this article, I explore questions of how popular sovereignty over economic policy and institutional choice are achieved. I show that the institutional regimes proposed in the special issue are, in a sense, democratic as long as the public’s “perceived consensus” about economic policies and macroeconomic outcomes is real. However, if, as new work suggests, there is genuine dissensus about policy and macroeconomic objectives, it is no longer clear that the regimes proposed in the special issue are democratic. In the conclusion, I briefly discuss a possible crisis of imagination in institutional design. Preface

Over the past twenty years, the field of international political economy has changed dramatically. Once dominated by neo-Marxist critiques of the world capitalist system and concept-laden interpretative discourses, recent scholarship is now firmly anchored in the theoretical frameworks and methodological techniques of main- stream economics. Today, for example, both political scientists and economists who analyze monetary policy in open economies start with the time-inconsistent nature of monetary policymaking and/or optimal currency area considerations. The contributors to this volume are no exception. Each author, however, progresses beyond these simple, yet powerful, models of the open economy by bringing a sophisticated understanding of politics to bear on monetary decision-making. Indeed, the explicit attention to the role of political and electoral institutions is the comparative advantage of this volume. Moreover, the methodological strategy of this new scholarship is rigorously formal and quantitative in the evaluation of alternative theories. In short, these common theoretical frameworks and empirical strategies have helped rejuvenate international political economy, creating a dynamic cross-fertilization between political science and economics and providing a more insightful understanding of open economy politics. Substantively, this volume investigates the political economy of monetary institutions: central banks and exchange rate regimes. Collectively, the studies owe much to Jeffry Frieden’s pioneering 1991 International Organization article on the distributive consequences of capital mobility, which set the research agenda for the study of exchange rate politics. One motivation for this volume was to assess the progress on that agenda after a decade of research. Another was to embed Frieden’s distributional arguments in an institutional context, whereby politicians make decisions on the basis of incentives created not only by constituency pressures but also by extant political and electoral structures. Together, the articles collected here show that the choice of monetary regime reflects the motives and strategies of both politicians and economic agents. The origins of this volume date to early 1999, when the three co-editors discovered a shared interest in understanding the remarkably diverse set of monetary regimes in the world. While other scholars had identified some important consequences of alternative monetary institutions, we were caught up in the effort to xiv International Organization explain the choice of institutions. We organized a conference entitled “Explaining Monetary Commitment Technologies: The Political Foundations of EMU,” in At- lanta on 1 September 1999 to bring together students of international monetary policy to examine the issue. We thank the European Union Center of the University System of Georgia and the Sam Nunn School of International Affairs at the Georgia Institute of Technology for their generous support of that event. We are grateful to the conference participants, including David Andrews, Benjamin J. Cohen, Vladimir Kliouev, Michael G. Hall, Kathleen McNamara, Robert Franzese, Thomas Oatley, and Thomas Willett for comments throughout the evolution of this project. We also thank Lucy Goodhart for her involvement in the early stages of the project. Com- ments and suggestions from discussants, fellow panelists, and audience members at the American Political Science Association Meeting in Atlanta and Washington, D.C. in 1999 and 2000 led to further improvements in the papers in this collection. Over time a lively intellectual interplay arose between the contributors to this volume. Each author provided extensive comments on the papers, not only improving the individual articles, but also producing a volume that, to a large degree, speaks with one voice. We hope this project has strengthened a research community that will continue to thrive in the future. We are deeply indebted to the editors of International Organization, Lisa Martin, Peter Gourevitch, and David Lake, for guiding us through the process and providing critical and constructive comments. In addition, we thank two anonymous reviewers for detailed and very helpful criticism. Lastly, we thank Rebecca Webb and Lynne Bush for their extraordinary efforts in producing this volume. The Political Economy of Monetary Institutions William Bernhard, J. Lawrence Broz, and William Roberts Clark

Introduction

Why do national governments choose the monetary institutions they do? While this question has long interested political economists, previous literature on the topic suffers from a central limitation: the choices of exchange-rate regime and central bank independence (CBI) have been analyzed in isolation from one another. This is surprising given that prominent arguments from this literature portray these institutions as solutions to the same problem—the time-inconsistency of monetary policy, or the inability of policymakers to commit credibly to staying the course on an announced policy. Time-inconsistency means that policymakers have an incentive to announce low inflation policies and then renege on that promise to achieve short-term improvements in real economic outcomes—growth and employment. Since private actors anticipate this behavior, attempts to create inflationary surprises will be frustrated, producing no additional growth and higher inflation. The best the policymaker can hope for is to make the promise of low inflation credible. CBI and fixed exchange rates have each been held out as ways of increasing the credibility of ex ante policy announcements and thereby reducing the inflationary bias of monetary policy. Both institutions insulate monetary policy from the direct control of those actors thought to have the greatest incentive to increase growth through ex post opportunism— incumbent politicians.

The authors wish to thank the European Union Center of the University System of Georgia and the Sam Nunn School of International Affairs at The Georgia Institute of Technology for their kind support of a conference entitled “Explaining Monetary Commitment Technologies: The Political Foundations of EMU” that took place in Atlanta on 1 September 1999. The seeds of the current volume, and a number of the included papers, were planted at that conference. We are also grateful to conference participants and the contributors to this volume, particularly David Andrews, Benjamin Cohen, Kathleen McNamara, Robert Franzese, and Thomas Willett for the comments then and during the evolution of this project. In addition, we thank the current and past editors, Lisa Martin, Peter Gourevitch, and David Lake, and two anonymous reviewers for their helpful comments.

The argument that these institutions are chosen as a response to the same economic problem raises several issues about how we analyze the determinants of monetary institutions. First, while the inflationary bias of discretionary policy creates the need for credible commitment mechanisms, it does not explain why some countries address the problem with fixed exchange rates, some choose independent central banks, some both, and some neither. Even if exchange rate anchors and central bank rules were unproblematic solutions to the inflationary bias in monetary policy, we still must explain how nations choose between the two solutions. Second, we are not likely to understand the conditions under which exchange rate or central bank anchors are adopted if we study the choice of each institution in isolation. To learn whether CBI and fixed exchange rates are institutional substitutes (where the presence of one negates the need for another) or complements (where each reinforces the effect of the other), we must develop an approach that considers their joint determination. Modeling the choice of one monetary commitment without an explicit consideration of the benefits and costs of the other does not shed light on this important question. Third, it may be the case that the time-inconsistency framework does not capture how political actors evaluate the benefits and costs of different monetary arrangements. The choice of these institutions may have less to do with fighting inflation than with the desire to redistribute real income to powerful constituents, assemble an electoral coalition, increase the durability of cabinets, or engineer economic expansions around elections. While the time-inconsistency framework informs much of the work in this volume, we may need to move beyond it to incorporate factors that influence the opportunity costs of adopting alternative monetary institutions. The contributors to this volume respond to these challenges. They explicitly analyze the choice of both exchange-rate regime and central bank institutions together. They emphasize how political factors, such as electoral, partisan, or sectoral pressures, influence the combination of monetary institutions that governments adopt. They seek to determine how politics conditions the opportunity costs of different configurations of monetary commitments. By analyzing the choice of both exchange rate regime and central bank institutions, they identify the conditions under which these institutions function as substitutes or complements. Finally, the contributors not only build on the time-inconsistency framework, but also confront its assumptions and implications, giving us a better understanding of the motivations of different actors in the process of choosing monetary commitments. In the next section, we summarize the range of institutional outcomes to be explained, highlighting those factors that would be difficult to explain from a pure time-inconsistency framework. We then show that the logic of time-inconsistency is nonetheless the analytical thread uniting the disparate work on central banking and exchange-rate regimes in the existing economics literature, justifying our treatment of the institutions as jointly determined. In the following section, we review “first- generation” explanations for these outcomes—explanations that incorporate both economic and political factors but look at CBI and exchange-rate regimes as The Political Economy of Monetary Institutions 3 isolated, independent decisions. We then highlight ways in which the “second- generation” contributors to this volume gain explanatory advantages by analyzing both sets of institutions concurrently. While each contributor has a slightly different approach, argument, and evidentiary strategy, each examines the choice of monetary institutions in combination. In the final section, we present our conclusions.

Monetary Institutions Since Bretton Woods

Over the past thirty years, countries have pursued a variety of monetary arrangements and commitments. These experiments involve two distinct types of monetary institutions: central banks and exchange-rate regimes. Central banks are the bureaucratic institutions charged with managing the supply of credit to the economy. The institutional structure of central banks—that is, their degree of independence from direct government control—varies across systems and over time. When a central bank is completely “dependent,” its institutional structure permits the government to determine monetary policy directly. With a fully independent central bank, by contrast, the government delegates monetary policy to an agent—typically the central bank’s governing board—and is restricted by statute from interfering with the agent’s freedom of action in the monetary domain. Countries have also adopted a variety of exchange rate arrangements, ranging from a purely floating-exchange-rate system, where market forces determine currency values, to an irrevocable exchange-rate peg or common currency among countries.1 While exchange-rate regimes are usually distinguished by the degree of flexibility in the arrangement (from a free float to an immutable fix), regime choice also involves a delegation decision not unlike that which governments face when setting the level of CBI. When a nation fixes its currency’s value to that of another nation, it is, to a large extent, delegating monetary policy to a foreign central bank. The pegging nation not only forgoes exchange-rate flexibility as a policy tool, but it also subordinates its monetary policy to that of the foreign central bank. Notwithstanding important differences between the two institutions, exchange- rate pegs and CBI can be thought of as alternative forms of monetary delegation. Indeed, as we shall discuss, a purely economic logic of monetary delegation, derived from the problem of time-inconsistent policy pronouncements, applies with roughly equal force to both CBI and pegging. In practice, countries often adopt intermediate institutions that fall between the extremes: cases of completely independent or dependent central banks are as rare as cases of pure floating or perfectly fixed exchange-rate regimes. Political economists have employed a variety of methods to measure the level of CBI and the degree of flexibility in exchange-rate arrangements. The most common indicators are based on formal or legal characteristics. With CBI, this typically entails an examination of

1. Broz and Frieden 2001. 4 International Organization central bank statutes, with an emphasis on restrictions of the government’s policy influence. Common legal indicators of independence include procedures for the appointment, term duration, and dismissal of central bank directors; budgetary autonomy for the central bank; government veto power over monetary policy; explicit policy goals; performance incentives for bank directors; limitations on monetary financing of budget deficits; and control over monetary instruments.2 Most indices combine these factors to produce a one-dimensional scale of CBI. Although each scale emphasizes slightly different factors, they are often in relative agreement about the ranking of CBI across systems.3 Indicators of exchange-rate arrangements are usually based on nations’ formal commitments, as reported to, or observed by, the International Monetary Fund (IMF). As with CBI, these arrangements fall along a continuum. Indeed, the IMF’s Exchange Arrangements and Exchange Restrictions recognizes no fewer than nine different types of exchange-rate regimes, varying according to the degree of flexibility in the arrangement. Formal and legal measures, although readily observable, may not capture a nation’s actual institutional commitments. For example, a statutorily independent central bank may be subject to extensive informal pressures from government. Recognition of this problem has propelled research on the “behavioral” independence of central banks and on the actual adherence to exchange-rate commitments. Alex Cukierman, for example, developed a behavioral measure of CBI based on the average term of office of central bank governors.4 According to Cukierman’s logic, a high “turnover rate” in central bank leadership reflects an absence of independence. However, a number of scholars have pointed out that a subservient central banker might be able to stay in office forever. With respect to exchange-rate regimes, there also appears to be a gap between formal commitments and the extent to which these commitments are honored in practice. Many countries that purport to float intervene heavily on foreign exchange markets.5 Likewise, many countries that formally maintain fixed regimes do in fact make frequent adjustments to exchange parities.6 Although the measurement of actual monetary commitments remains a problem, available data indicate that countries’ commitments are extremely varied, both across countries and over time. This holds for levels of CBI, the propensity to fix exchange rates, and various combinations of these two institutions. We now discuss some stylized facts that remain unexplained from a simple time-inconsistency perspective.

2. See Alesina 1988; Alesina and Summers 1993; Burdekin and Willett 1991; Cukierman 1992; Cukierman, Webb, and Neyapti 1992; Eijfﬁnger and de Haan 1996; and Grilli, Masciandaro, and Tabellini 1991. 3. Eijfﬁnger and de Haan 1996. 4. Cukierman 1992. 5. Calvo and Reinhart 2001. 6. Obstfeld and Rogoff 1995. 6 2 .42 .78 .24 .63 .14 .52 Index of legal CBI (4) (1989–1998) Transition economies 3 2 .69 Estonia .25 Ukraine .16 .37 .34 Kyrgyz Republic .52 Index of legal CBI Country (3) Developed countries 9 .51 Germany .25 Italy .10 .33 .12 Morocco, Spain .14 Azerbaijan .40 United States .48 Slovenia .36 Iceland Index of legal CBI Country (2) Developing countries Malaysia, Ethiopia Venezuela 24 .69 Egypt .25 South Africa .12 .43 Argentina, Lebanon, .34 .12 Poland Index of legal CBI Country (1) All countries Country Turkey Cross-national comparison of legal central bank independence (1950–89) Columns 1–3 same as Figure 1. Column 4 same as Figure 2. Sources: TABLE 1. Max. Upper quartile Ireland, Philippines, Std. Dev. Mean Median Australia, Ghana .36 Chile, Lower quartile Hungary N7 Min. 6 International Organization

FIGURE 1. Distribution of legal indices of central bank independence in developed and developing countries Source: Cukierman, Webb, and Neyapti 1992

Variation in Central Bank Independence From a naively benevolent view of government decision making, one might expect little variation in CBI. If CBI yields universally desired outcomes, it should be adopted by all nations. The available evidence suggests that it is not. Table 1 provides rankings of legal CBI for seventy-two countries for the period from 1950 through 1989, based on the comprehensive and widely used scale developed by Cukierman, StevenWebb, and Bilin Neyapti.7 Column 1 provides summary statistics for the full sample, columns 2 and 3 divide the sample into developing and developed countries, respectively, and column 4 extends the sample to transition economies. It is immediately obvious that there is enormous variation in levels of formal CBI in this period. Among developed countries, the central banks of Germany and Spain are, respectively, the most and least independent central banks. Iceland is positioned at the median of the developed country sample. There is also evidence of substantial variance in legal CBI in the developing world. The outcomes range from minimal legal independence in Poland to Egypt, the developing country with the most independent central bank. Figure 1 presents the distribution of CBI for the developed and developing subsamples. While there is a wide range of CBI in both subsamples, the developing countries tend to be clustered around the center of the scale more than the developed countries. While the cross-national variance in CBI between 1950 and 1989 is considerable, changes in CBI in this period were not very common. Less than half the countries in the Cukierman, Webb, and Neyapti sample experienced a change in legal independence during the period. Of the countries that reformed their central bank laws, twelve underwent a net decrease in CBI, while thirteen increased the

7. Cukierman, Webb, and Neyapti 1992. See the discussion of this and other scales in Eijfﬁnger and de Haan 1996. The Political Economy of Monetary Institutions 7 independence of their central banks. Furthermore, the magnitude of average decreases was about as large as the magnitude of average increases (between seven and eight points on the legal index, respectively). There is little evidence of a trend toward greater independence in the period between 1950 and 1989, an outcome that might be expected if benevolent governments came to recognize the social welfare advantages of the institution. More recently, however, such a trend may be under way. Although indices of CBI have not been systematically updated, many countries have moved to increase the independence of their central banks since the early 1990s. Among the industrial democracies, Italy and New Zealand made the earliest moves to grant their central banks more independence. The Maastricht Treaty required members of the Euro- pean Union (EU) to grant their central banks formal independence as a precondition to participating in Economic and Monetary Union (EMU). France, Belgium, Spain, and other member-states quickly complied with this obligation. Outside the Euro- zone, Britain (1997) and Japan (1998) also increased the independence of their central banks. The reform trend also seems to extend beyond the industrial democracies. Cukierman, Miller, and Neyapti document high levels of legal independence in twenty-six former socialist economies after post-transition reforms.8 Column 4 of Table 1 provides some illustrative comparisons. Note that the median case (Kyrgyz Republic) has a higher degree of legal independence (0.52) than the U.S. Federal Reserve—widely considered one of the most independent central banks in the world. Indeed, eight of these newly created central banks “possess levels of aggregate legal independence which exceeds that of the highly independent Bundes- bank during the 1980s.”9 While legal independence measures for the 1990s in other regions are not readily available, Sylvia Maxﬁeld reports regional averages that suggest that the increase in CBI is not unique to Eastern Europe. The regional averages for Latin America and Western Europe, for example, are 0.55 and 0.46 respectively.10 Mexico and Chile, for instance, both increased the formal independence of their central banks.11 If the central banks of the former Soviet states are any indication, however, the apparent recent trend toward CBI does not necessarily constitute cross-national convergence on a particular institutional form. As Figure 2 illustrates, while the level of independence in the former Soviet states is relatively high, there is still considerable cross-national variance in the degree of independence. Given that CBI has become a nearly ubiquitous policy prescription for economists, international agencies, and policymakers interested in improving economic performance, this variation requires explanation. In addition, the potential gap between legal and behavioral independence suggests that it is important to try to determine whether these recent increases

8. Cukierman, Miller, and Neyapti 2001. 9. Cukierman, Miller, and Neyapti 2001, 4. 10. Maxﬁeld 1997, 51. 11. Boylan 1998. 8 International Organization

FIGURE 2. Distribution of legal central bank independence in twenty-six former Soviet economies Source: Cukierman, Miller, and Neyapti 2001

in independence produce equilibrium institutions by examining the conditions associated with CBI in the recent past.

Variation in Exchange-Rate Regimes At the end of World War II, Allied leaders established a set of international monetary institutions to promote global economic prosperity and international stability. A fixed exchange-rate system, where participating nations pegged their exchange rate to the U.S. dollar, was at the heart of these institutions. The United States, in turn, pledged to redeem gold for dollars at the rate of $35 an ounce. The “Bretton Woods” system worked well in the 1950s, as the United States injected liquidity into the world economy and promoted economic recovery. But strains appeared in the 1960s, reflecting both the gold overhang—U.S. gold reserves were inadequate to cover all the dollars circulating in the world economy—and lax U.S. macroeconomic policies. European nations and Japan bridled under the regime because it tied their monetary conditions to the inflationary policies of the United States. In the early 1970s, the system collapsed as the United States declared it would no longer honor its commitment to exchange dollars for gold. The Political Economy of Monetary Institutions 9

FIGURE 3. Percentage of countries adhering to ﬁxed exchange rates Source: Ghosh et al. 1997

The breakdown of the Bretton Woods system ushered in an era of unprecedented variety in exchange rate regimes. The currencies of the largest industrial economies (the United States, Germany, Japan, and Britain) floated against each other, and several medium-sized developed countries also floated independently (for example, Canada, Switzerland, Australia, New Zealand). In contrast, European nations quickly attempted to limit exchange rate variability in the region, first pursuing exchange rate cooperation under the European Exchange Arrangement (Snake) and later, in the European Monetary System (EMS). At the same time, some European countries outside the EMS—for example, Austria and Sweden—maintained tight pegs to the deutsche mark. Through the 1980s, the EMS hardened into a quasi-fixed exchange-rate regime for EU member states. In 1991, EU member states signed the Maastricht Treaty, committing themselves to the adoption of a single currency by 1999. For developing countries and, later, the transition economies of the former Soviet Union, a mixture of exchange-rate regimes has prevailed, with a growing tendency for many of these countries to adopt flexible exchange-rate arrangements. Mexico, Brazil, and several Asian economies shifted toward floating exchange rates to deal with the complications of an open capital account. In contrast, other Latin American countries rigidly tied their currencies to the U.S. dollar. Argentina, for instance, established a currency board that forced domestic monetary policy to follow in lockstep the policies of the U.S. Federal Reserve. Ecuador and El Salvador have gone so far as to adopt the U.S. dollar as their national currencies—an extreme case of delegation to a foreign monetary authority. Figure 3 shows the distribution of formal exchange-rate commitments over time, 10 International Organization

FIGURE 4. Time on fixed exchange rates, developed and developing countries, 1970–1989 Source: Ghosh et al. 1997 as the IMF reports. About 60 percent of the 167 countries in this sample have had fixed exchange rates since 1973. In the industrial democracies, the propensity to fix has been fairly constant; in the developing world, the trend is toward flexible exchange rates. This trend may itself obscure important regional differences. While there is a decreased propensity to peg in recent years in Latin America, Asia, Africa, and former Soviet States, countries in the Caribbean, Middle East, or the Pacific Islands have maintained fixed exchange-rate regimes.12 Further, countries have experimented with different exchange-rate arrangements over time. While many countries had fixed exchange rates for the entire sample period and other countries never made such a commitment, it was also common for countries to go on and off a peg. Figure 4 shows that the share of time a country spent with a fixed exchange rate varies considerably across countries. While the majority of countries spent the entire observation period with a commitment to a fixed exchange rate, and a fair number of countries are coded as having a “flexible” exchange rate for the entire period, many countries maintained a fixed exchange-rate arrangement for only a part of the of the post–Bretton Woods period.

Combination of Monetary Commitments While there is considerable variation in the choice of individual monetary institutions, the central focus of this volume is to explain the combination of monetary institutions chosen. If CBI and ﬁxed exchange rates represent solutions to the problem of time-inconsistency in monetary policy, one might expect some type of correlation in the propensity to adopt these institutions. For example, if these institutions are substitutes, countries that have chosen one commitment mechanism

12. It is likely that the continued propensity to peg the exchange rate in these regions is due to Optimal Currency Area (OCA) considerations. For more on the OCA framework, see the following section. The Political Economy of Monetary Institutions 11

TABLE 2. Monetary regimes after 1973

Share of time with a pegged exchange rate

Central bank independence Below median Above median

Above median 16 countries including Switzerland, 19 countries including Austria, United States, Mexico, and South Netherlands, Taiwan, and Malaysia Africa (22.2 percent of sample) (26.4 percent of sample)

Below median 20 countries including United 17 countries including Belgium, Kingdom, Japan, Brazil, and South Sweden, Venezuela, and Thailand Korea (27.8 percent of sample) (23.6 percent of sample)

Note: Countries were classiﬁed as “above median” in central bank independence if they were below the developing country sample median in turnover rate or above the developed country sample median in legal independence. Countries were classiﬁed as above the sample median (.60) in share of time with a pegged exchange rate.

may be less inclined to adopt the other. On the other hand, if each of these institutions mitigates, but does not definitively solve, the time-inconsistency problem, we might expect countries that had one commitment mechanism to also choose the other. In the former case, we would expect the adoption of these institutions to be negatively correlated; in the latter, we would expect them to be positively correlated. In fact, variations in the pattern of monetary commitments support neither case. Table 2 provides a sense of this variation in a sample of seventy-six countries since 1973. Each cell contains the number of countries that conformed to a particular combination of monetary institutions, a few representative examples, and the fraction of the sample in each category. A glance at the table shows the combination of monetary institutions varies widely. Countries with a dependent central bank have allowed the exchange rate to float throughout much of the period (for example, the United Kingdom or Brazil) and have fixed the exchange rate for long periods (for example, Sweden or Thailand). Countries that delegated policy to an independent central bank have also pursued a variety of exchange rate options; Switzerland, the United States, Mexico, and South Africa have floating exchange rates, while Austria, the Netherlands, Taiwan, and Malaysia pegged their exchange rates for long periods of the sample. The cell percentages indicate that the combination of monetary commitments is distributed almost equally across all four categories. Table 2 is a cross-sectional snapshot of the combination of monetary institutions. There is also considerable intertemporal variation in the paths of monetary reform across countries. That is, countries have moved from one set of monetary institutions to a different combination of monetary institutions in a variety of patterns and 12 International Organization at very different times. A few examples illustrate these different processes. During the 1970s and 1980s, Britain had a dependent central bank and a floating exchange rate; the Conservative government declined to join the EMS when it was founded in 1979. After renewed inflation in the late 1980s, Britain experimented with fixed exchange rates by joining the EMS in 1990. That commitment, however, soon became untenable, and Britain was forced to allow the pound to float after the September 1992 currency crisis. In 1997, British politicians granted the Bank of England substantially more autonomy in setting interest rate policy. Starting from a similar combination of monetary institutions in the 1970s, France followed a different path. France was a founding member of the EMS. As that exchange-rate commitment hardened in the 1980s, France moved to support the single currency and also granted its central bank independence in 1993. While substantial declines in legal CBI have been exceedingly rare in recent years, an examination of turnover rates in developing countries suggests that it would be wrong to infer that there has been a worldwide increase in de facto independence. For example, South Korea, which frequently floated its currency, and Egypt, which frequently maintained a peg, both exhibit evidence of a decline in behavioral CBI during the 1980s. Both countries had turnover rates well below the developing country median in the earlier period, but in the 1980s, they changed central bank heads about once every two (Korea) or three years (Egypt). In contrast, Greece, which has allowed its currency to float for much of the period, and Honduras, which maintained a peg for almost the entire period, cut their turnover rates in half in the same period—doubling the “life expectancy” of the central bank head. Such variance in outcomes is difficult to explain if these institutions are implemented simply as a mechanism for producing universally desired economic outcomes. The combination of the different reforms remains a puzzle to be explained. Why do some countries choose both CBI and fixed exchange rates? Why do some countries adopt neither commitment device? Of those countries that do adopt a single commitment device, what explains why some countries choose an external constraint, while others choose a domestic one? In the following section, we review economic explanations for the choice of monetary institutions, emphasizing that these questions cannot be adequately addressed unless the analyst is willing to examine both institutions simultaneously. In one way or another, each contributor to this volume attempts to do just that.

The Economics of Monetary Institutions

An established literature examines the beneﬁts and costs of monetary institutions from the perspective of a benevolent social planner. However, normative analyses of central bank and exchange-rate institutions have evolved as largely separate ﬁelds of study, resulting in two highly specialized and distinct literatures on optimal monetary institutions. In this section, we abstract from the differences to illustrate The Political Economy of Monetary Institutions 13 the common theoretical elements that bind the literatures together. In so doing, we make a case for treating the two institutions as jointly determined.

Time-Inconsistency and the Logic of Delegation Since price instability (high inflation and inflation variability) generates a variety of welfare-reducing distortions, the maintenance of price stability is one of the core desiderata of normative macroeconomics.13 A surprising result in modern macroeconomics is that even benevolent social planners have difficulty producing price stability when they have direct control of monetary policy. The reason is grounded in the time-inconsistency problem.14 Dynamic inconsistency arises when a policy announced for some future period is no longer optimal when it is time to implement the policy. The problem occurs in monetary policy when policy is set with discretion and wages and prices are not fully flexible. Under these conditions, a policymaker may try to fool private actors by inflicting an inflationary surprise after these actors have locked into wage and price contracts on the basis of expectations of low future inflation. The policymaker’s incentive to do so ex post lies in her preference for raising output and employment above its natural level, which is possible at least temporarily when wages and prices are sticky.15 Failure to do so would not be rational given the utility function of the policymaker. However, when private agents are equally rational and forward-looking, they anticipate this incentive and take it into account when forming their ex ante inflationary expectations. Rational expectations thus introduce an inflationary bias into wage bargaining and price setting at an earlier stage of the game. Consequently, when the policymaker adopts surprise inflation, the equilibrium outcome is higher inflation but not higher output and employment. Frustrated in the effort to engineer a boost in output, the best the policymaker can hope for is to attain a low inflation goal. But to do so requires a credible commitment to refrain from the attempt to stimulate output after wages and prices are set. Delegation schemes constitute important institutional devices to enhance credibility. Delegating monetary policy to an independent central bank staffed with officials that are more averse to inflation than the government can be a source of credibility.16 If the private sector believes that the central banker is conservative (that is, places a greater weight on low inflation than on output and employment) and independent of government (that is, cannot be pressured to depart from its prean- nounced policy of low inflation), then inflationary expectations are kept in check and

13. Garfinkel 1989. 14. See Kydland and Prescott 1977; and Barro and Gordon 1983. 15. The “natural” rate of employment is the rate that would occur in the absence of monetary disturbances. The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is a related concept. Monetary surprises may have temporary “real” effects—that is, effects on output and employment— when the inflation generated exceeds the nominal growth fixed in wagesetters’ and pricesetters’ contracts. 16. Rogoff 1985; and Neumann 1991. 14 International Organization actual inflation is on average lower and more stable than in the discretionary equilibrium. Delegating monetary policy to a conservative foreign central bank via a pegged exchange rate is another way to enhance credibility.17 While the traditional case for stable exchange rates hinges on the benefits of increased foreign trade and investment (see following), recent analyses tend to place more emphasis on credibility issues and the role of fixed regimes in stabilizing inflation expectations.18 With roots in the rational expectations literature, this work builds on the same time-inconsistency problem described previously. Pegging the exchange rate to the currency of a low-inflation nation provides a strong constraint on the conduct of domestic monetary policy, thereby enhancing the credibility of the government’s commitment to price stability.19 With a fixed regime, monetary policy must be subordinated to the requirements of maintaining the peg, effectively “tying the hands” (eliminating the discretion) of the domestic policymakers. By pegging, the nation adopts the monetary policy of the foreign central bank, and in so doing “borrows” its credibility to supplement its own. Both forms of institutional delegation can in theory help resolve the time-inconsistency problem.20 But this alone does not explain the conditions under which these institutions are chosen because both institutions require trade-offs between increased price stability and other economic policy goals. In light of these trade-offs, the choice of these institutions is a political question— even if the primary motivation is to solve the technocratic sounding problem of time-inconsistent monetary policy. One important trade-off shared by both institutions is between credibility and flexibility. In principal, CBI and pegged exchange rates can each be effective in enhancing the credibility of governments’ commitment to low inflation. This is an important benefit to national welfare, but the benefit comes with a reduction in the capacity of policymakers to stabilize the domestic economy. Delegation to a conservative central bank, for example, forces a trade-off between lower inflation and output stabilization; the more conservative the central banker, the less she stabilizes output in the face of unanticipated disturbances, especially supply shocks like oil crises.21 Indeed, a central bank can be too conservative in fighting inflation, causing excessive volatility in economic activity.22 But efforts to increase the flexibility of monetary policy may compromise the very credibility of the central bank’s commitment to low inflation. This is because wagesetters have difficulty

17. Giavazzi and Giovannini 1989. 18. For example, Canavan and Tommasi 1997; and Giavazzi and Pagano 1988. 19. Mishkin 1999. 20. Empirically, the evidence is stronger with respect to the credibility effects of fixed exchange rates. Ghosh et al. 1997 analyzed 136 countries over a 30-year period and found that pegging is indeed associated with lower inflation. The evidence on the effect of CBI on inflation is less consistent. See also de Haan and Kooi 2000; and Eijffinger and de Haan 1996. These inconsistent findings may be due to the fact that the effectiveness of CBI in lowering inflation is conditioned by the political environment in which it is found—a theme developed systematically in this volume. 21. For example, Lohmann 1992. 22. Debelle and Fischer 1994. The Political Economy of Monetary Institutions 15 disentangling a “legitimate” stabilization effort from an act of opportunism, given the wide array of factors that affect money demand and velocity and the various lags through which monetary policy is transmitted to the economy. Although various solutions to the problem have been proposed, the trade-off remains an important consideration in delegating policy to a domestic central bank.23 Pegging the exchange rate poses a similar trade-off. To gain the benefits of greater credibility, governments must sacrifice their capacity to run an independent monetary policy. The “unholy trinity” principle explains that, where capital is internationally mobile, a fixed rate and monetary independence are not simultaneously attainable.24 Instead, a country must give up one of three goals: exchange-rate stability, monetary independence, or financial market integration. When capital is mobile internationally, domestic interest rates cannot long differ from world interest rates, as capital flows induced by arbitrage opportunities quickly eliminate the differential. A fixed exchange rate with international capital mobility renders monetary policy ineffective, meaning that there is no leeway to use monetary policy for demand management or balance of payments adjustment. This constraint poses a trade-off between the competing values of credibility and flexibility not unlike that which arises with CBI.

Exchange-Rate Commitments and Optimal Currency Areas Fixing the exchange rate can be a substantial benefit for economies that have had difficulty controlling inflation. Exchange-rate stability can also yield gains for economies that are heavily internationalized. This is the principal insight of the OCA approach to exchange-rate regime choice.25 From this perspective, the main advantage of a fixed rate regime is to lower the exchange-rate risk and transaction costs that can impede international trade and investment.26 Volatile exchange rates create uncertainty about international transactions, adding a risk premium to the costs of goods and assets traded across borders. While it is possible to hedge against this risk in derivatives markets, hedging invariably involves costs that increase with the duration of the transaction. And recent experience indicates that there is a great deal of unexplained volatility in currency markets, which makes hedging particularly difficult for small countries’ currencies. By opting to stabilize the currency, a government can reduce or eliminate exchange-rate risk, and so encourage greater

23. In Lohmann 1992, the government, at a cost, can overrule the conservative central banker. This accountability produces a superior policy in which the central banker responds more strongly to large shocks than to small ones. This partially resolves the trade-off problem because it leaves room for policy to perform a stabilization role. In a similar vein, Walsh 1993 and 1995 shows that a “contract” between the government and the central bank tying the central banker’s remuneration to inflation performance can attain efficiency. The contract removes the inflationary bias of policy but still allows the central banker’s counter-cyclical policy to be optimally active. The incentive for political principals to enforce such a contract, however, remains open to question. 24. Mundell 1962 and 1963. 25. See Tavlas 1994; and Eichengreen 1995. 26. See Mundell 1961; McKinnon 1962; and Kenen 1969. 16 International Organization trade and investment—a desirable objective quite distinct from the credibility gains of pegging. Going the next step to a currency union does away with the remaining transaction costs, providing an even stronger impetus to economic integration.27 But what unites the credibility and the OCA approaches is the elemental trade-off in economic goals: pegging means foregoing domestic monetary flexibility. Achiev- ing exchange-rate stability at the expense of such flexibility can be a substantial cost for countries that face severe shocks to which monetary policy might be the appropriate response. Indeed, the advantages of floating reduce to the single crucially important property that it allows a government to have its own independent monetary policy. Under a full float, demand and supply for domestic currency against foreign currency are balanced in the market. There is no obligation or necessity for the central bank to intervene. Therefore, domestic monetary aggregates do not need to be affected by external flows, and a monetary policy can be pursued that is independent of, and does not need to have regard for, monetary policy in other countries. This policy autonomy is valuable since it provides flexibility to accommodate foreign and domestic shocks, including changes in the external terms of trade and interest rates. More generally, floating allows monetary policy to be set autonomously, as deemed appropriate in the domestic context (for example, for stabilization purposes), and the exchange rate becomes a residual, following whatever path is consistent with the stabilization policy. A related advantage of floating is that it allows the exchange rate to be used as a policy tool. This flexibility is valuable when real appreciation, caused by inertial inflation or rapid capital inflows, harms international competitiveness and threatens to generate a balance of payments crisis—this is a common syndrome in developing and transition economies that use a fixed exchange rate as a nominal anchor for credibility purposes.28 When residual inflation generates an inflation differential between the pegging country and the anchor, it induces a real appreciation that, without compensating productivity gains, leads to balance-of-payments problems. A more flexible regime allows policymakers to adjust the nominal exchange rate to ensure the competitiveness of the tradable goods sector. However, the more flexible the regime, the smaller the credibility gains. The trade-off between credibility and competitiveness is particularly relevant in countries where inflation has been a persistent problem.29 Table 3 summarizes the relevant trade-offs as they relate to delegation via CBI and fixed exchange rates. The credibility/flexibility trade-off underpins the social welfare approach to both central banking and exchange rate institutions: CBI and pegging both yield credibility but require reductions in the ability to stabilize output

27. Time-series studies of the relationship between exchange-rate volatility and trade or investment typically ﬁnd small, weak negative effects. Frankel 1995. However, much stronger effects are evident in cross-sectional evaluations; countries that share a common currency (or have a long-term peg) trade more than three times as much as comparable countries that have separate currencies. See also Rose 2000. 28. Edwards and Savastano 1999. 29. Frieden, Ghezzi, and Stein 2001. The Political Economy of Monetary Institutions 17

TABLE 3. Welfare effects of alternative monetary delegation schemes

Beneﬁts Costs

Central bank • Credibility f lower inﬂation • Monetary inﬂexibity f less stabilization independence

Fixed exchange • Credibility f lower inflation • Monetary inflexibility f less stabilization rates • Exchange rate stability f more trade • Exchange rate inflexibility f difficulties and capital flows with competitiveness

and employment. This trade-off poses a theoretical puzzle; why do some countries opt to delegate domestically to a conservative central bank while others utilize pegs to a foreign currency (or some other fixed regime) for credibility purposes? OCA considerations relate only to exchange-rate regime choice and raise the caution that credibility is not the only, or perhaps not even the most important, factor influencing the choice of monetary institutions.30 Indeed, for very small, highly trade-dependent economies such as the island nations of the Caribbean, the decision to peg is over-determined by OCA considerations.31 For these countries, enhanced credibility is merely a by-product of the force of such factors. Yet for economies that are neither so small nor so open that pegging is the obvious option, the question as to the choice of monetary institutions remains salient. For example, the regions of the EMU do not satisfy OCA criteria, and few suggest that Argentina belongs in a currency union with the United States. Credibility motivations evidently swamp OCA considerations in certain contexts. Untangling the relative explanatory importance of these forces is a central concern of many contributors to this volume. From the perspective of welfare economics, which institution is best for a particular country is largely a matter of the economic characteristics of the country. The trade-off between the credibility of monetary policy pronouncements and the flexibility to stabilize output may be steeper in countries with a greater exposure to output shocks. The trade-off between exchange-rate stability and trade shocks will be steepest in economies that depend heavily on trade in a small number of goods markets. Since large numbers of countries with similar economic characteristics have chosen different combinations of monetary institutions, however, such an explanation is unsatisfying. Consequently, the authors in this volume stress the ways political factors influence the choice and combination of institutions. Some do so by emphasizing the ways the economic trade-offs discussed previously are politically and institutionally conditioned. Others relax the assumption that institutions are chosen by a benevolent social planner and argue that they are chosen for primarily

30. Frieden 2002. 31. Obstfeld and Rogoff 1995. 18 International Organization political reasons but are conditioned by factors highlighted by the time-inconsistency or OCA frameworks.

First- and Second-Generation Work on Monetary Institutions

The economic logic of monetary delegation is explicitly apolitical. That is, the classic time-inconsistency problem is analyzed from the perspective of a benevolent planner whose objectives coincide with maximizing social welfare. The temptation to engineer an inflationary surprise comes from the desire to raise national income and, thereby, increase social welfare. While this makes a “hard case” for the existence of time-inconsistency problems, it also makes the decision to adopt an institutional fix trivial. Because benevolent social planners also care about reducing inflation, they would obviously adopt an institution that allows them to overcome the time-inconsistency problem. But political actors who possess goals that need not be consistent with the good of society make decisions about monetary policy institutions. A body of positive political economy research that we label the “first generation” departs from the benevolent social planner assumption and incorporates various political incentives and constraints that shape governments’ decisions on monetary institutions. However, this work follows the economics literature by considering CBI and exchange-rate regimes as isolated, unrelated outcomes. In this next section, we briefly review these first-generation approaches to the choice of monetary institutions. We also demonstrate how the second-generation contributions of this volume highlight and extend these different approaches. While each contribution emphasizes a different mechanism to explain the pattern of monetary commitments, each explicitly considers the simultaneous choice of CBI and exchange-rate regime. Political economy arguments to explain the choice of monetary institutions fall into two broad classes: those that focus on “policy suppliers”—politicians and political parties—and those that focus on “policy demanders”—interest groups, economic sectors, and voters. Within each of these approaches, political economists have developed a number of mechanisms to explain either CBI or the exchange rate regime. But almost without exception, analysts have chosen to examine the choice of these institutions in isolation. Whether the focus has been on policy suppliers or policy demanders, political economists have not explored the conditional or con- current choice of these two institutions.

Policy Suppliers and the Choice of Monetary Commitments Politicians in office obviously do not have to delegate monetary policy authority to a conservative central bank, domestic or foreign. When they do so, it is because delegation serves their purposes. The credibility/flexibility trade-off provides a simple framework for analyzing how politicians weigh the benefits and costs of The Political Economy of Monetary Institutions 19 granting more independence to a central bank.32 Delegation to an independent and inflation-averse central bank at home or abroad serves as a commitment device to circumvent the time-inconsistency problem and resulting inflationary bias. The most prominent cost is that the government in office loses monetary policy flexibility. The incumbent government has less capacity to engage in stabilization policy via monetary instruments. When politicians consider this trade-off, they do so within constraints imposed by their political environment. Five arguments potentially link the incentives of policy suppliers to exchange-rate regimes and CBI: welfare gains, constraining future governments, policymaking capabilities, electoral opportunism, and government partisanship. The articles in this volume draw on the latter three mechanisms to analyze the choice of monetary commitments.

Social welfare benefits. One strand of literature suggests that monetary commitments will provide greater social welfare gains where political pressures discourage responsible monetary and fiscal policies. In situations where governments face pressures to adopt lax macroeconomic policies, the value of these monetary commitments—in terms of superior economic outcomes—is higher. As a result, politicians who face inflationary pressures will be more likely to adopt a fixed exchange rate as a nominal anchor33 or an independent central bank.34 This type of argument suggests that countries with weak and unstable governments will be more likely to adopt monetary commitments, since these governments are unable to carry out stabilization programs.35 High public debt and high levels of unemployment also increase the inflationary pressures on governments and, according to this logic, increase the propensity to adopt monetary commitments. Tests of these hypotheses produce only mixed results. Using a sample of the industrial democracies, Jakob De Haan and Gert Jan Van’t Hag for example, find no relationship between CBI and government turnover, public debt, or the equilibrium employment rate.36

Constraining future governments. Another set of arguments contends that political actors recognize how monetary commitments can lock in the policy preferences of the enacting coalition, tying the hands of future politicians.37 Susanne

32. For example, Cukierman 1994; and Broz and Frieden 2001. 33. See Flood and Isard 1989; Giavazzi and Pagano 1988; and Rogoff 1985. 34. See Franzese 1999; de Haan and Van’t Hag 1995; Alesina 1988; and Cukierman 1992. Other research indicates that the macroeconomic consequences of monetary commitments depend on labor market organization. See Hall and Franzese 1998; Franzese 1999 and 2002; Iversen 1999 and 1998; and Soskice and Iversen 1998. According to the literature, monetary commitments reduce inﬂation most where wage bargaining is least coordinated. These commitments tend to increase unemployment, but at a diminishing rate where wage bargaining is more highly coordinated. These arguments suggest that the overall beneﬁts of a monetary commitment may be greatest when wage bargaining is moderately coordinated. 35. See Alesina 1987; and Cukierman 1992. 36. de Haan and Van’t Hag 1996. 37. McCubbins, Noll, and Weingast 1989. 20 International Organization

Lohmann, for instance, argues that political parties were engaged in a “turf battle” during the Bundesbank’s founding, trying to choose institutions that would protect their ability to affect policy in the future.38 John Goodman argues that politicians will choose an independent central bank to insulate policy from future opposition governments, especially from parties with a high-inflation policy program.39 Delia Boylan identifies conditions under which outgoing autocrats will attempt to constrain the policy choices of democratic successors by enhancing the independence of the central bank.40 These types of arguments imply a government will choose a monetary commitment if subsequent governments are likely to possess different policy priorities. In systems where policy change is incremental across governments, politicians have fewer incentives to make an institutional commitment since they can trust subsequent governments to pursue similar policies. In a cross-national test of CBI, William Bernhard finds no support for such an argument.41

Political capacity. A third set of arguments focuses on the policymaking capabilities of the government to explain monetary commitments: policymakers will not adopt a monetary institution unless they have the ability to ensure the success of that commitment. Weak or unstable governments may lack the ability to implement the difficult domestic adjustments often necessary to sustain a fixed exchange rate.42 Strong, durable governments are able to pursue the policies required to maintain the exchange rate and, therefore, are more likely to adopt an exchange-rate commitment. Related arguments suggest that politicians will adopt an independent central bank only where they can credibly commit to maintaining that institutional arrangement. Since the existence of many veto players in the policy process will help prevent politicians from overturning the policy actions of an independent central bank, these arguments suggest that independent central banks will be more likely in systems with many veto players. In contrast, CBI can be overturned easily in systems with few veto players.43 Consequently, politicians will be less likely to pay the short-term costs of adopting an independent central bank. In the current volume, the papers by Philip Keefer and David Stasavage and by Mark Hallerberg make extensive use of the veto-player framework.44 Keefer and Stasavage investigate how the number of veto players affects the credibility of monetary commitments. They argue that delegation to an independent central bank will be more credible than low-inflation-policy pronouncements when multiple governmental veto players are present. Any low-inflation policy implemented by an independent central bank can be overridden by a single veto player. In contrast, low-

38. Lohmann 1998 and 1994. 39. Goodman 1991. 40. Boylan 2001. 41. Bernhard 1998. 42. See Eichengreen 1992; and Simmons 1994. 43. Moser 1999. 44. See Keefer and Stasavage 2002; and Hallerberg 2002. The Political Economy of Monetary Institutions 21 inflation policies may survive the displeasure of a subset of political principals if at least one veto player prefers the banks’ policy to the policy that would be enacted by a government with discretionary power over monetary policy. Keefer and Stasavage argue that this logic does not extend to exchange-rate commitments because the policy outcome expected under a peg to a low-inflation currency is likely to be seen as prohibitively austere by even the most hawkish domestic actors. Instead, they argue that exchange-rate pegs reduce inflation because they help solve the problem of asymmetric information in monetary policy. By analyzing the choice of both monetary institutions in a common framework, they reach the conclusion that these institutions are not alternative solutions to the same problem, but rather solve two different problems faced by incumbents. As such, their study demonstrates the advantage of a “second-generation” approach. Hallerberg also emphasizes the role of veto players in the choice of monetary commitments, but he is not primarily interested in their effect on the credibility of commitments. Instead, he argues that the existence of veto players influences the identifiability and controllability of monetary and fiscal policy. Identifiability and controllability determine whether incumbents will choose to use monetary or fiscal policy for electoral purposes, which—in a world of mobile capital—influences their assessments of the various possible combinations of exchange-rate regime and CBI. For example, Hallerberg argues that the existence of subnational veto players in federal systems makes controlling fiscal policy difficult. As a consequence, actors in these systems will shun pegged exchange rates in an attempt to preserve monetary policy autonomy. Conversely, the divisibility of fiscal policy makes it more attractive than monetary policy as a political instrument in the hands of multiparty coalitions. Consequently, governments comprised of many partisan veto players are more likely to peg the exchange rate than single-party governments. This last result is consistent with Bernhard and David Leblang’s45 finding of a link between proportional representation and an increased propensity to peg, but is potentially at odds with Keefer and Stasavage’s assertion that increasing the number of veto players appears to decrease the credibility of pegged exchange rates.46

Political opportunism. A standard assumption in political science is that politicians and parties are office-seeking, that is, that they desire to remain in office. Politicians, then, may use monetary policy surprises to generate temporary expansions in employment and growth just prior to an election.47 Delegating monetary policy to an independent central bank or fixing the exchange rate, however, limits politicians’ discretion over monetary policy. Indeed, William Clark and Usha Reichert48 find that these monetary commitments limit opportunistic political business cycles.49

45. Bernhard and Leblang 1999. 46. Keefer and Stasavage 2002. 47. Nordhaus 1975. 48. Clark and Reichert 1998. 49. See also Clark and Hallerberg 2000. 22 International Organization

Drawing on these insights, political economists have argued that the “electoral value” of monetary policy will shape the choice of monetary institutions. Where the control of monetary policy may strongly shape electoral outcomes, politicians will be less likely to sacrifice flexibility by adopting an independent central bank or a fixed exchange rate. The electoral value of monetary policy will reflect the time horizon of politicians50 or the configuration of domestic political institutions.51 According to Bernhard and Leblang, in systems where the costs of losing an election are high or if small shifts in voter support can lead to large swings in the distribution of seats, politicians will be reluctant to give up control over any policy instrument that can help them win elections. Consequently, they will be less likely to adopt a fixed exchange rate (or, by implication, an independent central bank). In systems where the costs of being in opposition are lower or where a small loss in votes does not necessarily lead to exclusion from government, politicians may be more likely to adopt a monetary commitment. In contrast, Clark argues that, if incumbents can use fiscal policy to respond to electoral pressures, monetary commitments need not frustrate their attempt to use the macroeconomy for political purposes.52 Clark’s contribution to this volume examines whether politicians subject to electoral pressures have as much incentive to find a cure for the inflationary bias of discretionary monetary policy as the benevolent social planners in the standard time-inconsistency setup.53 He finds that, to a large extent, they do. In addition, he shows that the magnitude of such pressures can play an important role in determining whether incumbents will solve the problem by pegging the exchange rate or by delegating policy monetary policy to an independent central bank. The credibility of the independent central bank also influences the rate of substitution between these monetary institutions. Clark argues that the extent to which survival-maximizing incumbents view fiscal policy as a close substitute for monetary policy is also likely to influence the choice between monetary institutions.

Government partisanship. Other analysts examine how government partisanship affects the choice of monetary commitments. According to the partisanship literature, parties have different policy objectives, which reflect the interests of their key supporters.54 Left parties appeal to the working class and, thus, emphasize employment and wealth redistribution as policy goals. Reflecting business and middle-class interests, Right parties are more concerned with controlling inflation. Assuming that an independent central bank and an exchange-rate peg provide enhanced anti- inflation credibility, the most straightforward link implies that Right parties will be

50. See Goodman 1991; and Cukierman and Webb 1995. 51. See Bernhard and Leblang 1999; and Leblang 1999. 52. Clark forthcoming. 53. Clark 2002. 54. See Alesina and Sachs 1989; Hibbs 1977 and 1987; and Havrilesky 1987. The Political Economy of Monetary Institutions 23 more likely to support these commitments.55 In contrast, other authors turn this logic on its head. Left parties may recognize that they lack anti-inflation credibility and, in turn, favor monetary commitments as a way to demonstrate their commitment to responsible economic policies.56 Since Right parties already have a reputation for price stability, they have little need to support these monetary commitments to gain credibility and prefer to see discretionary monetary policy remain grounds for political competition with the Left. Tests of the partisan arguments on the choice of monetary commitments have produced only mixed results. Bernhard finds no relationship between partisanship and the cross-national variation of CBI in the 1970s and 1980s.57 Moreover, both Right and Left parties initiated central bank reform in the 1980s and 1990s.58 A number of authors find that Left parties were more likely to support exchange commitments, both during the interwar years59 and in the EMS experience.60 Another study of developed countries in the post–Bretton Woods period, however, found no relationship between partisanship and exchange-rate regime choice.61 Political parties, however, can use the political credibility of an independent central bank to appeal to constituents with diverse policy preferences and to prevent any intra-party disputes over monetary policy from precipitating a cabinet collapse.62 These types of arguments suggest that monetary commitments will be more likely in systems where political parties must maintain diverse electoral and legislative coalitions. The contribution by Bernhard and Leblang provides a test of this argument.63 The authors contend that increased economic openness in the industrial democracies has heightened the potential for intra-party conflicts over economic and monetary policy, hurting the ability of parties to remain in office. Monetary commitments can help manage these policy conflicts and keep parties in office. They test the effect of CBI and exchange-rate commitments on cabinet durability in sixteen parliamentary democracies. The results indicate that these monetary institutions can increase cabinet durability, especially for coalition governments. By exploring the choice of both exchange-rate regime and CBI in a single paper, they are able to examine the relative effectiveness of alternative monetary institutions in solving the survival problems faced by incumbents.

55. See, for example, Goodman 1991 on central banks; Simmons 1994; and Oatley 1997 on exchange- rate commitments. 56. See Milesi-Ferritti 1995; and Garrett 1995. 57. Bernhard 1998. 58. Bernhard 2002. 59. See Simmons 1994; and Eichengreen 1992. 60. See Garrett 1995; and Oatley 1997. 61. Bernhard and Leblang 1999. 62. Bernhard 2002. 63. Bernhard and Leblang 2002. 24 International Organization

Policy Demanders and the Choice of Monetary Commitments The second approach to explaining the variation in monetary institutions focuses on policy demanders: sectoral interests, interest groups, and voters. This approach is premised on the idea that monetary institutions have distributional implications— what is optimal for a country as a whole may not be optimal for particular groups within a country. The distributional consequences of these institutions, therefore, represent part of the explanation of their causes.

Anti-inflation interests. The array of anti-inflation interests in society might include retirees on non-indexed fixed incomes, institutional bondholders, elements of the financial sector, and even the mass public in situations where hyperinflation or sustained high inflation remains part of the collective consciousness.64 Adam Posen, for instance, argues that the demands and organization of such societal interests will determine the level of CBI.65 He contends that central banks will take a strong anti-inflation stance only when there is a coalition of interests politically capable of protecting it. The behavior of the central bank depends on the existence of a coalition of inflation hawks in society politically capable of supporting the central bank when it faces informal (non-statutory) pressures to inflate. There is some support for the hypothesis that central banks are more independent in countries where anti-inflationary social interests are powerful.66 Broz’s argument about the choice of monetary institutions echoes a similar logic.67 He begins with the assumption that all societies contain low-inflation constituencies; what varies is the extent to which these actors are able to verify a government’s commitment to a credibility-enhancing monetary institution. In democracies, low-inflation actors are relatively able to monitor governmental activities, which enhances the credibility of a monetary commitment. But in autocracies, the lack of political-system openness undermines the monitoring capabilities of inflation hawks; governmental promises are less verifiable and, therefore, less credible. Monetary commitments also differ in terms of verifiability.68 Broz expects credibility-seeking autocratic governments to opt for fixed exchange rates because fixing offers the verifiability that autocratic promises lack. Democracies, by contrast, are likely to find legal CBI credible. Even though it is a less verifiable commitment, anti-inflationary interests have the capacity to detect and punish informal (non-legislative) governmental efforts to violate the independence of the central bank in democracies. Indirect monitoring by inflation hawks thereby enhances credibility. The structure of political institutions, therefore, conditions the choice of monetary institutions.

64. See Hibbs 1982, 1985; and Issing 1993. 65. Posen 1995. 66. See Posen 1995; and de Haan and Van ’t Hag 1995. 67. Broz 2002. 68. For example, Frankel, Schmukler, and Serven 2000. The Political Economy of Monetary Institutions 25

Broz’s argument shares some aspects of the political capacity approach: governments chose monetary institutions with an eye toward their effectiveness in resolving the time-inconsistency problem. Broz’s contribution, however, illustrates the links between political system characteristics, the incentives and actions of demand- side social actors, and the effectiveness of alternative monetary institutions. Broz also demonstrates the value of a second-generation approach. First-generation scholars posited an unconditional relationship between the goals of anti- inflation social actors and the demand for CBI or fixed exchange rates. Broz shows that anti-inflationary interests benefit from CBI only when political institutions are sufficiently transparent. When this is not the case, social actors that benefit from price stability are likely to pin their hopes on fixed exchange rates.

Economic sectors. Other authors emphasize the distributional consequences across economic sectors to account for different monetary commitments. In an influential article, Jeffry Frieden identifies how social groups align on the trade-off between global integration and monetary-policy flexibility in the choice of exchange-rate regime.69 Groups heavily involved in foreign trade and investment (producers of exportables, foreign direct and portfolio investors, and international merchants) should favor fixed exchange rates, since currency volatility makes their business riskier and more costly. By contrast, groups whose economic activity is confined to the domestic economy benefit from a floating regime due to the monetary flexibility that floating allows. Producers in the nontradables sector (for example, services, construction, and transport) belong in this camp because they are largely insulated from foreign markets but are highly sensitive to domestic macroeconomic conditions. Building on this argument, Frieden develops a demand-side account of exchange- rate regime choice by focusing on the movement toward monetary integration in the EU.70 Frieden argues that the trade-off between greater trade and investment (lower left cell in Table 3, above) and lost currency flexibility (lower right cell in Table 3) was critical in animating interest groups on the issue of stabilizing European exchange rates. With modest refinements to earlier arguments, Frieden posits that cross-border investors and exporters of specialized manufactured goods should be strong advocates of fixed rates; import competers, on the other hand, should oppose fixing since this sector suffers from the loss of ability to adjust currency values to enhance competitiveness. Frieden takes pains to develop reasonable proxies for interest-group variables to test the argument statistically—an important achievement given the difficulty of measuring group preferences and political influence. Frieden’s contribution represents an explicit challenge to the credibility arguments that dominate the rest of this volume (as well as to the OCA arguments that are common in the literature on Europe). Regime choice, Frieden cautions, may

69. Frieden 1991. 70. Frieden 2002. 26 International Organization have more to do with the politics of real outcomes (trade and investment) than purely monetary goals. The empirical results in his contribution consolidate the ﬁrst- generation research program and point the way for second-generation work on the sectoral determinants of the choice of monetary institutions. An examination of how the institutional demands of inﬂation-averse actors interact (Broz) with demands for particular exchange-rate regimes by sectoral actors concerned primarily about their international competitiveness (Frieden) would be a promising future extension of this work.

Conclusion

We have sought to accomplish three goals in our introduction to this volume. First, we described the range of institutional outcomes that the contributors of the volume hope to explain. Since the breakup of Bretton Woods, countries have been confronted with the choices of whether to peg their exchange rates and whether to grant their central banks independence. Decisions along these two dimensions produce four ideal typical regimes (see Table 2), and countries in both the developed and developing world have sustained institutional combinations that approximate each ideal type. Second, we reviewed the argument that CBI and pegged exchange rates represent alternative solutions to the problem of time-inconsistent monetary policy. We argue that, while time-inconsistency is certainly a key factor in the choice of monetary institutions, the wide variety of combinations of monetary institutions observed cannot be simply explained as technological solutions to the inflationary bias inherent in discretionary monetary policy. Why are monetary commitment “technologies” not universally adopted? And if they were, what determines which solution would be chosen in a particular context? Finally, we have sought to summarize the answers provided to these questions by the contributors to this volume. Briefly, the authors in this volume argue that the particular political context influences the extent to which (1) politicians are induced to pursue goals that compete with price stabilization or (2) they are inhibited from successfully implementing monetary commitments. Electoral, partisan, or sectoral pressures may loom larger than price stabilization goals for incumbents. Political institutions may condition the extent to which these pressures influence incumbents. These political institutions may also inhibit or facilitate the ability of incumbents to convey credible commitments to CBI or pegged exchange rates. In sum, the authors in this volume argue that, even if adopting pegged exchange rates or granting CBI is desirable because it reduces the inflationary bias of discretionary policy, an explanation of the range of observed institutional outcomes requires an inquiry into the price paid for their adoption. In particular, if fixed exchange rates and CBI are potential substitutes, it is vital that we gain an understanding of their relative prices. For this reason, the contributors simultaneously consider the determinants of both types of monetary commitments. In doing The Political Economy of Monetary Institutions 27 so, they offer new answers to existing questions and provoke debates that open up vistas for future research. The benefits of this “second-generation” approach include the following:

● Clark identifies the ways in which the magnitude of political pressures and the credibility of monetary commitments interact to influence the rate of substitution between CBI and fixed exchange rates.

● Keefer and Stasavage show that domestic veto players inﬂuence the credibility of commitments to CBI, but not the credibility of commitments to pegged exchange rates.

● Hallerberg ﬁnds that federalism reinforces commitments to CBI, but not to pegged exchange rates.71

● Bernhard and Leblang demonstrate that, in a world of global capital mobility, CBI and exchange-rate commitments are alternative means that coalition governments can use to address the problem of political survival.

● By ﬁnding that CBI may make it easier for governments to sustain a pegged exchange rate, Frieden suggests these institutions may be complements.

● Broz shows that, when the absence of transparency reduces the credibility of CBI, it increases the propensity to peg the exchange rate, suggesting that these institutions are substitutes. Clearly, there is much second-generation work to be done, but the contributors in this volume get the research program off to a roaring start. In the volume’s conclusion, John Freeman highlights important features of the papers and sets an agenda for a “third generation” of research into the politics of monetary commitments.72 Freeman notes that the contributions to the volume share a common assumption about the important role of monetary technocracy in shaping economic performance. He argues that, as a whole, the volume begins to show how democratic institutions can be designed to “create and protect” a sphere for socially benign technocratic expertise in the management of monetary policy. The authors show how democracy “fits” with allegedly “undemocratic” monetary commitments. He states that the articles in the volume represent a significant contribution in that they emphasize the interaction of political and economic forces in theoretically sophisticated and nuanced ways. At the same time, however, Freeman challenges the field of international political economy to start work on a new generation of theoretical models and empirical tests that will uncover new facts about the relationships among democratic processes, institutions, and economic performance. This new generation of research should encompass work on the microfoundations of economic and political equilibria, a

71. In fact, federal countries with multiparty systems are less likely to peg than unitary systems. 72. Freeman 2002. 28 International Organization broader understanding of the welfare criteria used to evaluate institutional arrangements, and a deeper analysis of the economic consequences of political information. The contributors to this volume do not reach a consensus regarding the factors that determine the choice of monetary institutions. While they agree that political factors are crucial, important differences remain about the precise mechanisms by which politics affects the choice of monetary institutions. Readers must evaluate the logic and evidence for the competing claims. It is our hope that this work is a consolidation, rather than the culmination, of a program for theoretically informed, empirically grounded research on the determinants of monetary institutions.

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Partisan and Electoral Motivations and the Choice of Monetary Institutions Under Fully Mobile Capital William Roberts Clark

According to the time-inconsistency literature in monetary economics, even a benevolent social planner has an incentive to announce, and then renege on, a commitment to a low-inflation policy, because an inflationary surprise can result in an increase in national income. Market actors, however, should see through this plan and form inflationary expectations that will make surprise unlikely. As a result, inflation, but not income, should be higher under a discretionary regime than under a regime where credible commitments are possible.1 As the editors of this volume point out, central bank independence and fixed exchange rates have both been put forward as solutions to the benevolent social planner’s problem.2 If central bank independence and fixed exchange rates are effective institutional fixes for the time- inconsistency problem in monetary policy, it is easy to see why they would be adopted. Despite its impeccable logical foundations, there are a number of reasons why the time-inconsistency framework may have limited ability to explain the choice of monetary regimes. I concentrate on three. First, and most importantly, while it is easy to see why a benevolent social planner would adopt an institutional fix that would enhance social welfare, it is less obvious why the elected officials who are responsible for the choice of monetary institutions would do so.3 Second, while the desire to solve the time-inconsistency problem might explain why designers of institutions might want to limit monetary discretion, it does not

The author thanks William Bernhard, Lawrence Broz, John Duggan, Mark Fey, John Freeman, Jude Hays, Mark Hallerberg, Randall Stone, and the participants of the International Relations Seminar at Yale, the World Politics Seminar at the University of Michigan, and the Game Theory seminar at New York University for helpful comments on this paper or earlier drafts. He also gratefully acknowledges help, advice, and support from Youssef Cohen, Michael Gilligan, Joseph Gochal, Marek Kaminski, Helena McGahagan, and Shanker Satyanath. 1. See Kydland and Prescott 1977; and Barro and Gordon 1983. 2. See Rogoff 1985; Walsh 1995; and Giavazzi and Pagano 1988. 3. See Bernhard, Broz, and Clark 2002; and Frieden, Ghezzi, and Stein 2001.

International Organization 56, 4, Autumn 2002, pp. 725–749 © 2002 by The IO Foundation and the Massachusetts Institute of Technology 34 International Organization explain which institutional fix they choose. Finally, a focus on the time- inconsistency problem leads to a focus on the consequences of institutional choice related to monetary policy. In a world of highly mobile capital, however, the choice of the exchange-rate regime also has important consequences for the effectiveness of fiscal policy. In this article, I present a pair of models designed to address these concerns. Specifically, I model the choice of institutions by a survival-maximizing incumbent who chooses a set of monetary institutions that can include an independent central bank, a fixed exchange rate, neither, or both. It turns out that, like benevolent social planners, survival-maximizing incumbents often do better by forfeiting control over monetary policy. While political pressures—thought of as either electoral or partisan pressures—do not, in general, discourage monetary commitments, they can influence the choice between fixed exchange rates and central bank independence. Thus, I identify the conditions under which fixed exchange rates and central bank independence will be viewed as institutional substitutes. Most discussions of the political economy of monetary institutions ignore an important fact: while monetary commitments may frustrate the ability of incumbents to use monetary policy for political purposes, fiscal policy may serve as a viable substitute for monetary policy. Failure to consider the possibility that incumbents might accomplish their goals through fiscal policy may lead analysts to overstate the reluctance of incumbents to forfeit the control of monetary policy. I argue that policy substitution (in this case the potential for incumbents to achieve their political goals with either fiscal or monetary policy) is likely to be an important factor in the choice of monetary institutions.4 To gauge the importance of policy substitution, I compare a model in which monetary policy is the only instrument relevant to the control of the economy with a model in which fiscal policy is also potentially useful. In model 1 (in which fiscal policy is not an option), it is possible to identify the conditions under which survival-maximizing incumbents view a fixed exchange rate as a close substitute for an independent central bank with a floating exchange rate. In model 2, where it is possible for the incumbent to substitute the use of fiscal policy for monetary policy, an independent central bank with a floating exchange rate is never a close substitute for a fixed exchange rate. Thus if policy substitution is not possible, the incumbent’s choice of regimes depends on contextual factors such as the magnitude of political pressures or inflationary expectations. In contrast, if the incumbent can freely substitute fiscal policy for monetary policy in an attempt to achieve political goals, choosing a fixed exchange rate is a dominant strategy.

4. See Jankowski and Wlezien 1993 on policy substitution in macroeconomic policy. Partisan and Electoral Motivations and Monetary Institutions 35

Model 1: Choosing Monetary Institutions when Monetary Policy Is the Only Instrument Preferences The incumbent’s preferences are captured in the following loss function:

n 2 2 Li ϭ ͑y Ϫ y k͒ ϩ ␣͑␲ Ϫ ␲*͒ (1) where y is the growth rate, ␲ is the inflation rate, and ␲* is the incumbent’s ideal rate of inflation. Political pressure is captured by its effect on the policymaker’s ideal point for growth. Specifically, the incumbent’s growth target is ynk, where yn is the natural rate of growth (normalized so that yn ϭ 1) and k is a parameter equal to one in the absence of political pressure to push growth above the natural rate and proportionally greater than one in the presence of such pressure. The weight policymakers place on hitting their inflation target relative to their growth target is captured by ␣. Normalization results in the following loss function:

2 2 Li ϭ ͑y Ϫ k͒ ϩ ␣␲ (2)

The central banker’s loss function is identical to the policymaker’s, except when the central bank is independent. When the central banker is granted independence, the central banker is insulated from political pressures and so, in the ideal typical case, of total independence (k ϭ 1). Otherwise the government and central banker have the same growth target. The political pressures mentioned above can be usefully thought of as deriving from either of two sources. First, the pressure to push growth above the natural rate (and accept the consequent short-term rise in inﬂation) could be thought of as pressure from constituencies on the Left of the political spectrum. This captures the intuition behind Douglas Hibbs’ argument about the distribution of macroeconomic preferences in society and the notion that parties can be differentiated on the basis of which set of voters they seek to satisfy with their policies.5 Second, political pressure (felt by incumbents of all stripes) can be thought of in terms of short-term pressures to push growth above the natural rate in the period just prior to elections, regardless of long-term inﬂationary consequences.6

Control of the Economy The central banker controls the economy via an expectations-enhanced short-term Phillips curve:

y ϭ yn ϩ ␮͑␲ Ϫ ␲e͒ (3)

5. Hibbs 1977. 6. Nordhaus 1975. 36 International Organization where y is the growth rate, yn is the natural rate of growth (normalized so that yn), ␲ is the inflation rate, and ␲e is expected inflation. The central banker chooses the rate of inflation, and ␮ captures the transmission of inflationary surprises into changes in the growth rate. According to the Mundell-Fleming model, the effectiveness of monetary policy depends on the exchange rate for the following reasons.7 A monetary expansion by reduction in interest rates will lead to an outflow of capital, resulting in downward pressure on the price of the local currency. If a government is committed to a fixed exchange rate, it will have to purchase local currency to “defend the exchange rate.” It will do so until the consequent monetary tightening returns interest rates to their original level. The degree of capital mobility determines the speed at which the original drop in interest rates results in a capital outflow and, therefore, the time elapsed between the monetary intervention and a restoration of the original interest rate. When capital is fully mobile, a drop in interest rates would lead to an instantaneous outflow of capital. Consequently, monetary policy would not have even temporary effects. The effect of a monetary expansion is quite different under a flexible exchange rate. Now, when a drop in interest rates leads to a capital outflow, the government is no longer committed to purchasing local currency to defend the exchange rate, and the currency will be allowed to depreciate. The ensuing increase in competitiveness leads to an increase in the demand for exports, which reinforces the monetary expansion. Thus, under fully mobile capital, monetary policy is fully effective when the exchange rate is flexible and ineffective when the exchange rate is fixed. Since I assume that capital is fully mobile, ␮ ϭ 0 when the exchange rate is fixed, and ␮ ϭ 1 when the exchange rate is flexible.8

Order of Moves

The incumbent moves ﬁrst and chooses the relationship between the central bank and the government (independent or dependent) and the exchange-rate regime (ﬁxed

7. Foundational statements of this approach can be found in Mundell 1962 and 1963; and Fleming 1962. See Kenen 1994 for a particularly clear textbook statement. Frieden 1991 is the first attempt to examine the political implications of the Mundell-Fleming model. 8. To focus attention on the effect of political motivations on the choice of monetary regimes, I choose to model their choice under fully mobile capital. Two other alternatives are zero capital mobility and partially mobile capital. The former is clearly at odds with the experience of most, if not all, countries since the early 1970s. The Mundell-Fleming model’s conclusions about the effect of partially mobile capital on the effectiveness of monetary and fiscal policies are qualitatively similar to those of fully mobile capital. For example, since capital flows respond more slowly when capital is partially mobile than when it is fully mobile, monetary policy can be effective in the short run when the exchange rate is fixed, but capital outflows will eventually return interest rates to their original level. Consequently, partial capital mobility reduces, but does not eliminate, the effectiveness of monetary policy when the exchange rate is fixed. While empirical evidence suggests that predictions drawn from a model based on fully mobile capital fit the data on the political control of the macroeconomy—Clark and Hallerberg 2000; Hallerberg, de Souza, and Clark 2002; and Clark forthcoming—an examination of the effects of partially mobile capital would be a worthwhile extension of the current model. Partisan and Electoral Motivations and Monetary Institutions 37 or floating). The central banker then sets monetary policy by choosing the rate of inflation.

k Ϫ e 1 PROPOSITION 1: If ␲ Ն the incumbent chooses a ﬁxed exchange rate ␣ ϩ 1 ͱ␣͑4␣ ϩ 1͒ 2 (with either an independent central bank or a dependent central bank) and the central k Ϫ 1 banker sets monetary policy so that ␲ ϭ 0. If ␲e Յ , the incumbent ␣ ϩ 1 ͱ␣͑4␣ ϩ 1͒ 2 chooses a ﬂexible exchange rate with a dependent central bank and sets monetary policy 1 so that ␲ ϭ ͑k Ϫ 1 ϩ ␲e͒. 1 ϩ ␣

PROOF: See appendix 1.

Discussion

Proposition 1 says that, if inflationary expectations under a discretionary regime are sufficiently high, a survival-maximizing incumbent will choose to forfeit national monetary policy autonomy by adopting a pegged exchange rate.9 Otherwise, it will choose a flexible exchange rate and a dependent central bank. In neither case will it choose an independent central bank with a flexible exchange rate. The result in Proposition 1 is driven by the effect of monetary institutions on the incumbent’s ability to use monetary policy to respond to political pressures. As (3) shows, when the exchange rate is flexible and the central bank is not independent, the incumbent can freely choose the rate of inflation that minimizes its loss function—given exogenously determined inflationary expectations and magnitudes of political pressure. The trade-off between inflation and growth embodied in the Phillips curve, however, means that the incumbent cannot hit both its inflation and growth targets when the latter is not equal to the natural rate. Instead, it must accept some non-zero inflation rate to push growth closer to its ideal point. Losses mount under a fully discretionary regime because the policymaker’s willingness to accept non-zero inflation ratchets up inflationary expectations, which in turn requires the incumbent to adopt an even higher rate of inflation than expected if progress is to be made in pushing growth above its natural rate. This familiar dynamic is the “problem” part of the time-inconsistency problem. Any progress an incumbent can make toward hitting its growth target comes at the expense of large deviations from his inflation target. It is, therefore, clear that the inflationary bias in discretionary monetary policy is just as much of a problem for survival-maximizing incumbents

9. In the context of the models in this article, a fixed exchange-rate regime with a dependent central bank turns out to be equivalent to a fixed exchange rate with an independent central bank. Consequently, I refer to a “fixed exchange-rate regime” to mean a combination of fixed exchange rates with either an independent or a dependent central bank. 38 International Organization

FIGURE 1. The effect of expected inﬂation on the incumbent’s loss under a ﬁxed exchange rate and a fully discretionary monetary regime when k ϭ 2, ␣ ϭ 1

as it is for benevolent social planners. And so, to the extent that hitting its inflation target matters, the incumbent is drawn away from efficient goal attainment to the extent that it is responsive to political pressures. Consequently, it is not hard to imagine why the incumbent might want to give up control of monetary policy by pegging the exchange rate. When capital is mobile and the exchange rate is fixed, monetary policy is ineffective, and the incumbent will miss its growth target and be forced to accept the natural rate of growth.10 Since the growth rate is independent from monetary policy when capital is mobile and the exchange rate is fixed, there is no temptation to engineer an inflationary surprise and, therefore, no inflationary bias. It is in this sense that a pegged exchange rate is said to be a solution to the time-inconsistency problem. Whether a survival-maximizing incumbent would actually prefer this

10. When monetary policy is ineffective, the Phillips curve (3) reduces to y ϭ yn. Partisan and Electoral Motivations and Monetary Institutions 39

FIGURE 2. Critical levels of expected inﬂation as a function of political pressures when ␣ ϭ 1

solution to a discretionary regime depends on the rate of expected inflation under the discretionary regime and the weight placed on hitting one’s inflation target. For the moment, assume that hitting one’s growth target is as important as hitting one’s inflation target (␣ ϭ 1) and that political pressures are such that the incumbent wants to produce a growth rate two times the natural rate (k ϭ 2). Figure 1 shows that, when expected inflation under a discretionary regime is zero, the incumbent does better when the central banker is free to adjust monetary policy to hit its growth target. Under these circumstances, adopting a fixed exchange rate means forfeiting a politically useful instrument, and a survival-maximizing incumbent would not do so willingly. But how realistic is this scenario? If equilibrium monetary policy for a dependent central bank is to adopt an inflationary monetary policy, why would inflationary expectations equal zero? It is more plausible to assume that at least some positive inflation would be anticipated, and, once this is true, the time- inconsistency problem is present in full force. For policymakers to increase growth above the natural rate, they must implement a policy that is more expansionary than expected. Knowledge of this causes societal actors to increase their inflationary expectations, which starts the process over again. Without endogenizing beliefs in a more complex dynamic model, it is impossible to say where this will end, but it is clear that the process would lead to inflationary expectations substantially above zero. The current model demonstrates that expected inflation does not have to increase very much before the incumbent would be better off pegging the exchange rate and giving up on its attempt to hit its growth target. In the example in Figure 40 International Organization

1, expected inflation does not have to reach one half of one percent before the incumbent would opt for a fixed exchange rate commitment. The critical level of expected inflation identified in proposition 1, however, is a function of both political pressures and the weight placed on hitting the inflation target. Figure 2 plots the critical level of expected inflation as a function of political pressures, while holding the weight placed on hitting the inflation target constant. When the actors place the same weight on hitting their growth target as they do on hitting their inflation target, they are indifferent between a fixed exchange rate and a discretionary regime whenever the combination of political pressures and expected inflation falls on the plotted line. If the combination of political pressures and expected inflation falls to the northwest of the plotted line, however, the incumbent chooses a fixed exchange rate. Finally, if the combination of political pressures and expected inflation falls to the southeast of the plotted line, the incumbent chooses a flexible exchange rate with a dependent central bank. Figure 3 relaxes the assumption that the actors place equal weights on hitting their two macroeconomic targets. As actors place more weight on hitting their inflation target (that is, as ␣ increases), the level of expected inflation required for the incumbent to prefer pegging decreases. When actors place four times the weight on hitting their inflation target as they do on hitting their growth target (␣ ϭ 4), for example, almost any amount of expected inflation is enough to encourage the incumbent to choose a fixed exchange rate. In contrast, when actors place four times as much weight on hitting their growth targets as they do on hitting their inflation targets (␣ ϭ 0.25), there is a larger set of expected inflations under which incumbents would retain a discretionary regime. Thus, survival-maximizing incumbents choose a fixed exchange rate over a fully discretionary regime unless expected inflation under the discretionary regime is low relative to the amount of political pressure on the incumbent to produce growth outcomes above the natural rate. The weight actors place on hitting their inflation target relative to their growth target changes the point at which incumbents will choose a fixed exchange rate over a discretionary regime. When actors care more about hitting their inflation target than they do about hitting their growth target, they will peg under nearly every plausible combination of political pressures and expected inflation. Specifically, they will peg unless political pressures are several times the rate of expected inflation—a condition that is implausible since increased political pressures are likely to be a key determinant of increased inflationary expectations. In contrast, when actors care more about hitting their growth target than hitting their inflation target, incumbents may be willing to retain a discretionary regime unless expected inflation is large compared to political pressures. Recall, however, that when actors care more about hitting their growth target than hitting their inflation target, a dependent central bank is more responsive to both political pressures and inflationary expectations. This responsiveness should fuel inflationary expectations. Thus, while there are many combinations of expected inflation and political pressure below the relevant line in Figure 3 when ␣ is small, there are good reasons to believe that inflationary expectations will be high, relative to political Partisan and Electoral Motivations and Monetary Institutions 41

FIGURE 3. Critical levels of expected inflation as a function of political pressures under various target weights pressures, under these conditions. Thus, as long as actors place some nontrivial weight on hitting their inflation target, survival-maximizing incumbents will choose a pegged exchange rate over a discretionary regime under virtually all plausible conditions. Proposition 1 also implies that incumbents will choose fixed exchange rates over a flexible exchange rate with an independent central bank. To understand why, it is worthwhile to consider the determinants of monetary policy under an independent central bank and a flexible exchange rate. First, let us consider equilibrium monetary policy when the central banker is fully independent and able to communicate a preference for a zero-inflation policy. Such a signal should be credible since, if it is believed and expected inflation equals zero, the central banker can only hit its growth and inflation targets by sticking to its announced plan. It is in this sense that central bank independence does away with the time-inconsistency of monetary policy. Under such conditions, an independent central bank with a flexible exchange rate will produce exactly the same policy outcome as a fixed exchange-rate regime—zero inflation and the natural rate of growth. Consequently, the incumbent is indifferent between a pegged exchange rate and an independent central bank with a flexible exchange when the expected rate of inflation under the latter is equal to zero. Contributors to this volume, however, point out that there are circumstances under which a nominally independent central bank may have difficulty signaling its commitment to a low-inflation policy in a fully credible manner.11 When this is the case, inflationary expectations are not likely to be precisely zero. An independent

11. See Broz 2002; Keefer 2002; and Stasavage 2002. 42 International Organization

FIGURE 4. The effect of expected inflation on the incumbent’s loss under a fixed exchange rate and a flexible exchange rate with a dependent central bank when k ϭ 2, ␣ ϭ 1 central bank will not respond to political pressures but will loosen monetary policy in response to positive inflationary expectations. Failure to do so would lead to a rate of growth below the central banker’s target—the natural rate (see appendix). Given positive inflationary expectations, therefore, an independent central bank will accept some increase in inflation in exchange for a growth outcome closer to its ideal point. The incumbent anticipates the central banker’s response to inflationary expectations and its consequences for inflation and growth outcomes and is, therefore, able to compare the losses anticipated under a range of inflationary expectations in light of the pressure it feels to push growth above the natural rate. Figure 4 plots the losses experienced by the incumbent as a function of expected inflation under a flexible exchange rate and an independent central bank. When an independent central bank presides over zero expected inflation, the incumbent is indifferent between fixed exchange rates and a flexible exchange rate with an independent central bank. As stated above, both these institutional combinations produce a zero inflation rate and a growth rate equivalent to the natural rate. But positive Partisan and Electoral Motivations and Monetary Institutions 43 inflationary expectations result in an increase in losses for the incumbent. Consequently, the incumbent prefers a pegged exchange rate when expected inflation under a flexible exchange rate with an independent central bank is greater than zero. While the graph in Figure 4 is specific to the case where actors place the same amount of weight on their growth target as their inflation target and when the incumbent is under political pressure to produce a growth rate twice the natural rate, the story is essentially the same for all relevant values of these other parameters. Since the incumbent does not control an instrument that is responsive to political pressures under either institutional combination, its losses are proportional to the amount of political pressure under both institutional combinations.12 Similarly, a change in the value of ␣ influences the rate at which losses mount under a flexible exchange rate with an independent central bank as expected inflation increases, but a pegged exchange rate still produces a smaller loss for all nonzero inflationary expectations. According to model 1, therefore, a survival-maximizing incumbent has the same incentives to adopt a fixed exchange rate as a benevolent social planner. An incumbent can anticipate smaller losses under a fixed exchange rate than under a flexible exchange rate with a dependent central bank unless expected inflation in the latter case is low relative to the political pressures on the incumbent. More surprisingly, the model suggests that an incumbent can always anticipate smaller losses under a fixed exchange rate than under a flexible exchange rate with an independent central bank. Thus incumbents should favor the “international” to the “domestic” solution to the time-inconsistency problem. In neither case can the incumbent manipulate monetary policy in response to political pressures, and a fixed exchange-rate regime eliminates the inflationary bias of monetary policy entirely, but an independent central bank does not.

Model 2: Choosing Monetary Institutions when Fiscal Policy Exists as a Possible Substitute

The model introduced above analyzes the strategic interaction between an incumbent who designs monetary institutions and a central banker who—given a set of institutions—attempts to use monetary policy to influence the macroeconomy. In this framework, the incumbent cannot influence the macroeconomy directly, but merely chooses the institutional context in which the central banker will operate. Under such conditions, the incumbent must accept a trade-off between accepting the natural rate of growth and zero inflation or adopting a flexible exchange rate that will allow a central bank it does not control to try to implement a policy that may produce a growth outcome more to its liking but at the cost of nonzero inflation outcome. William Clark and Mark Hallerberg argue that, while pegging the

12. The magnitude of political pressures (k) changes the intercept of both lines but does not alter their slope. 44 International Organization exchange rate or granting the central bank independence may curtail the political use of monetary policy, it does not necessarily discourage the political use of fiscal policy.13 This argument is potentially important for attempts to examine the effects of partisan or electoral incentives on the choice of monetary institutions. If the incumbent can use fiscal policy to respond to political pressures, monetary institutions may not have a constraining effect on incumbent behavior. As a consequence, incumbents with strong incentives to manipulate the economy may be no less likely to make monetary commitments than incumbents without such incentives. Consequently, in this section I allow the incumbent to influence the macroeconomy through fiscal policy. The game is identical to the one presented in the previous section with the following exceptions. First, after the incumbent chooses a combination of monetary institutions, it adopts a budget that influences the economy in a direct manner. Specifically, Equation (3) is replaced by:

y ϭ yn ϩ ␮͑␲ Ϫ ␲e͒ ϩ ␾g (4) where g is net government spending and ␾ is a parameter that captures the rate at which changes in net government spending are transformed into changes in the growth rate. Following the standard Mundell-Fleming setup, assume that, given fully mobile capital, fiscal policy is effective (␾ ϭ 1) when the exchange rate is fixed, but not when the exchange rate is allowed to fluctuate (␾ ϭ 0). To understand why, consider first the effect of a fiscal expansion under a fixed exchange rate. An increase in net spending will lead to an increase in interest rates and, therefore, an inflow of capital. The capital inflow will put upward pressure on the price of the local currency. A government committed to a fixed exchange rate will, therefore, need to sell domestic currency to prevent an appreciation. As a consequence, fiscal expansions under fixed exchange rates will be accompanied by a reinforcing monetary expansion. Next, consider the effect of a fiscal expansion under a flexible exchange rate. As before, an increase in net spending leads to an increase in interest rates and, therefore, a capital inflow that puts upward pressure on the exchange rate. In the absence of exchange-rate intervention, an appreciation will occur. The consequent loss in competitiveness in turn reduces the demand for exports— counteracting the expansionary effects of the fiscal expansion. As in model 1, monetary policy is assumed to be effective (␮ ϭ 1) when the exchange rate is flexible and ineffective (␮ ϭ 0) when the exchange rate is fixed.

PROPOSITION 2: The incumbent chooses a pegged exchange rate and chooses a budget g ϭ k Ϫ 1, and the central banker responds by choosing ␲ ϭ 0.

PROOF: See appendix 2.

13. See Clark and Hallerberg 2000; and Clark forthcoming. Partisan and Electoral Motivations and Monetary Institutions 45

Discussion

Proposition 2 states that, when the assumptions of model 2 are true, a survival- maximizing incumbent will choose a fixed exchange rate. The fixed exchange rate renders monetary policy ineffective, making the central banker’s commitment to a zero-inflation policy credible. Under these conditions, the incumbent and the monetary authority both achieve their shared goal of zero inflation. In addition, the incumbent is free to use fiscal policy to achieve its growth target. Outcomes under flexible exchange rates are identical to model 1 because, when fiscal policy is ineffective, a model with both fiscal and monetary policy reduces to a model with just monetary policy. Outcomes are markedly different under flexible exchange rates when policy substitution is possible. In contrast to model 1, the incumbent does not have to accept the natural rate of growth as the outcome under fixed exchange rates. While monetary policy is ineffective, the incumbent can increase net government spending and, therefore, achieve its growth target. Since monetary policy is ineffective, monetary policy is set to zero inflation, and inflationary expectations are beside the point. The combination of hard-wired zero inflation and the ability to use fiscal policy to achieve its growth goal means that the incumbent’s loss under a fixed exchange rate is reduced to zero. This outcome is not achievable under alternative institutional combinations. Consequently, an incumbent that can freely substitute fiscal policy for monetary policy will always prefer a fixed exchange rate to a flexible exchange rate with an independent central bank. The above results depend crucially on the implicit assumption that increases in net spending lead to increased growth without a corresponding change in the inflation rate. Deficit spending will be inflationary if borrowing from the central bank finances it, but not if it is financed by borrowing from the general public, because the former expands the money supply and the latter does not. Since the former requires the consent of the central bank and operates through the expansion of the money supply, in the context of the current model, the inflationary consequences of deficit spending (should there be any) should be thought of as the result of monetary policy. Since the goal of this model is to examine the choice of monetary institutions in light of the strategic interaction between fiscal and monetary authorities, fiscal and monetary functions must be separated as much as possible. Consequently, if increases in net spending require financing, they should be thought of as being financed by the general public, not the central bank.14 In addition, the attractiveness of a fixed exchange rate to a survival-maximizing incumbent depends on the availability of a low-inflation nominal anchor currency to peg to. If no such currency is available, the incumbent faces the same trade-off between hitting its growth and inflation targets under a fixed exchange rate as it does under a flexible exchange, only now the inflation rate is outside of its control. This

14. The author wishes to thank Jude Hays and an anonymous reader for their thoughts on the issues raised in this paragraph. 46 International Organization was, in fact, the complaint of many countries in the later part of the Bretton Woods era. The perception was that expansionary macroeconomic policies in the United States meant that countries pegged to the dollar were forced to ”import” inflation. The breakup of Bretton Woods and the creation of the European Monetary System can be viewed as a decision by European countries to trade the dollar for the deutsche mark as the anchor currency. The need for a low-inflation nominal anchor also raises the familiar degrees-of-freedom problem. If a set of countries pegs their currencies to a nominal anchor, the currency to which they peg is, effectively, forced to accept a floating exchange rate. The United States and Germany, for example, have both experienced prolonged periods in which they had de facto flexible exchange rates.

Empirical Implications

The two models produce a number of interesting implications about monetary and ﬁscal policy, macroeconomic outcomes, and the choice of monetary institutions. I now compare the predictions of the two models and, where appropriate, suggest tests capable of distinguishing between them.

Choice of Monetary Institutions The two models presented here have interesting implications for the role political pressures should play in the choice of monetary institutions. Both models suggest that survival-maximizing incumbents will choose fixed exchange rates under a wide range of circumstances. But, while model 2 predicts that incumbents will choose a fixed exchange rate over a flexible exchange rate regardless of the magnitude of political pressure, model 1 identifies conditions under which an increase in political pressure can lead a survival-maximizing incumbent to abandon a fixed exchange rate. This latter result is consistent with William Bernhard and David Leblang’s suggestion that incumbents with strong incentives to manipulate the economy to stay in office ought to be the most reluctant to forfeit monetary-policy autonomy by pegging.15 Model 1, however, qualifies Bernhard and Leblang’s claim. Specifically, if model 1 is the appropriate model, the effect of political pressures on the choice between domestic and international monetary commitments is conditioned by the expected rate of inflation under an independent central bank with a flexible exchange rate and the weights actors attach to hitting their growth and inflation targets. The rate of institutional substitution depends on the relationship between these parameters. Recall from figure 2 that when expected inflation is low, and the actors place the same weight on hitting both their targets all incumbents would choose a

15. Bernhard and Leblang 1999. Partisan and Electoral Motivations and Monetary Institutions 47

flexible exchange rate because the condition for retaining a discretionary regime is met for all political pressures (that is, whenever 1 Ͻ k). Conversely, whenever inflationary expectations under a discretionary regime are very high, a wide range of incumbents will choose to peg. This is so because the condition for adopting an “international” solution to the time inconsistency problem is met for all but those incumbents facing the most severe political pressures. In a more moderate range of inflationary expectations, some incumbents (those facing strong political pressures) will want to peg and some (those facing modest political pressures) will want to float.16 Consequently, while the propensity to peg is strictly increasing in the political pressures facing the incumbent, as Bernhard and Leblang suggest, the estimated causal effect of an increase in political pressures should be greatest when expected inflation under a discretionary regime would be modest. The hypothesized relationship between political pressures and the propensity to peg also depends on the degree of central bank independence. Model 1 suggests that survival-maximizing incumbents will choose a fixed exchange rate over a flexible exchange rate with an independent central bank unless expected inflation under an independent central bank is exactly zero. When expected inflation under an independent central bank is zero, the incumbent is indifferent between the two institutional combinations. In either case, the degree of political pressure is never a factor in the incumbent’s decision between a fixed exchange rate and a flexible exchange rate with an independent central bank. To summarize, according to model 1, political pressures can be expected to have a significant effect on the propensity to peg only when expected inflation under a discretionary regime is low enough and the central bank is not independent. Otherwise, the incumbent will choose a fixed exchange rate regardless of the magnitude of political pressures. In contrast, model 2 implies that there is no connection between political pressures and the propensity to peg the exchange rate. Since fiscal policy can be used to respond to political pressures, the propensity to peg is inelastic with respect to such pressures. To determine which of the two models presented is more consistent with observed experience, therefore, I examine the relationship between political pressures and the propensity to fix. The absence of a relationship between the propensity to fix and the magnitude of political pressures would lend support for model 2. In contrast, the existence of a conditional relationship between political pressures and the propensity to fix would lend support to model 1. As noted, the pressure to push growth above the natural rate could come from either electoral or partisan sources. If the political pressures are partisan in nature, some governments (those elected by left-wing constituents) should experience greater political pressures to produce growth than others should. If political pressures are electoral, then all governments that must stand for election might

16. Recall from Figure 3 that the weight actors attach to hitting their inflation targets determines the rate at which political pressures increase the critical level of expected inflation. 48 International Organization experience roughly similar amounts of political pressure. Bernhard and Leblang have identified a set of institutions that, they argue, should heighten electoral pressures on incumbents.17 Consequently, one could test the implications of the models in two ways. Under the assumption that the partisan model is the appropriate model of the political control of the economy, one might examine the historical record to determine if there is a relationship between the ideological orientation of government and the propensity to peg. Conversely, under the assumption that the electoral model is the appropriate model of the political control of the economy, along with the auxiliary assumption that Bernhard and Leblang have correctly identified institutions that heighten the electoral incentives of the incumbent, one could examine whether there is a correlation between the existence of such institutions and the propensity to peg. Because the current model suggests that a relationship between political pressures and the propensity to peg exists only in the absence of central bank independence and when the rate of expected inflation under a discretionary regime is sufficiently low, such a re-examination should be conditional. While not uncontroversial, measures of central bank independence are widely used in the literature. Controlling for the modifying effect of inflationary expectations would be more difficult. Fortunately, two of the contributors to the current volume provide some help in this area. Lawrence Broz argues that commitments to central bank independence will not be effective in lowering inflationary expectations in the absence of a high degree of transparency.18 Such transparency will allow financial sector actors to determine whether politicians are making good on their promise not to interfere with the conduct of monetary policy. Broz argues that the necessary transparency is most likely to be present in democracies. Philip Keefer and David Stasavage argue that the credibility of central bank independence is related to the existence of legislative veto players.19 They argue that (1) commitments to low inflation policies will be more credible in the presence of multiple veto players (such as in Germany) and (2) when there is only one veto player (as is typical in the United Kingdom), central bank independence is expected to be no more credible than an incumbent’s low-inflation promises. This suggests that expected inflation under an independent central bank with a flexible exchange rate will be negatively correlated with the number of veto players. The connection between these findings and the models presented above is complicated, however. According to model 1, if the incumbent’s commitment to an independent central bank is credible enough to reduce inflationary expectations to zero, the incumbent is indifferent between a fixed exchange rate and a flexible exchange rate with an independent central bank. Otherwise, the incumbent will choose a fixed exchange rate and an independent central bank. Either way, the amount of political pressure is beside the point. But since Broz and Keefer and

17. Bernhard and Leblang 1999. 18. Broz 2002. 19. Keefer and Stasavage 2002. Partisan and Electoral Motivations and Monetary Institutions 49

Stasavage have identified factors that may help independent central banks reduce inflationary expectations, their results may, nevertheless, be relevant to the question of the propensity to peg. Specifically, an independent central bank may be able to reduce inflationary expectations to the point where the incumbent is indifferent between this institutional combination and a fixed exchange rate when political transparency and the number of veto players are high. Consequently, incumbents are more likely to opt for an international solution to the time-inconsistency problem when the domestic conditions for central bank credibility are not met. Broz’s result, for example—that nondemocracies are more likely to peg their exchange rates—and Tamar Asadurian’s20 finding—that the propensity to peg decreases with the number of veto players—can each be interpreted as support for model 1. Evidence in support of model 1 would support the idea that the effect of political pressures on institutional substitution is key to understanding the choice of monetary institutions. Evidence in support of model 2 would support the idea that the existence of close policy substitutes requires us to fundamentally rethink the way political pressures influence the choice of monetary institutions.21

Monetary and Fiscal Policies As noted, both models yield the same predictions about monetary policy, and model 1 is mute on fiscal policy. Since the policy subgame of model 2 is identical to the model in Clark and Hallerberg, their empirical test is relevant here.22 The model predicts that monetary policy will be tied to political pressures if and only if the exchange rate is flexible and the central bank is not independent. The model also predicts that fiscal policy will be tied to political pressures if and only if the exchange rate is fixed. Consistent with the two dominant models of the political control of the economy, Clark and Hallerberg examine both partisan and electoral pressures to push growth above the natural rate. In the former case, we would expect to find a context-dependent correlation between policy instruments and the ideological orientation of government. In the latter case, we should expect to find a context-dependent correlation between policy instruments and elections. Using time-series cross-sectional data from Organization for Economic Cooperation and Development (OECD) countries, Clark and Hallerberg and Clark find a link between elections and the money supply when the exchange rate is flexible and the central bank is not independent (an institutional combination found in the United Kingdom for much of the post–Bretton Woods period). There is no link when the central bank is independent (as in the United States or Germany) or when the exchange rate is fixed (which has been the case in most Western European and developing countries in the post-War era).23 They do, however, find a link between elections and

20. Asadurian 2002. 21. Hallerberg 2002. 22. Clark and Hallerberg 2000. 23. See Clark and Hallerberg 2000; and Clark forthcoming. 50 International Organization government spending when the exchange rate is fixed. Hallerberg et al. find very similar results using time-series cross-sectional data from a set of Eastern European countries.24 In sharp contrast, Clark and Hallerberg find no evidence of context- dependent partisan cycles in monetary and fiscal policies in OECD countries.25 Clark argues that there is little evidence of partisan differences in monetary and fiscal policy—context-dependent or otherwise.26 Together these results suggest that the relevant political pressures with respect to monetary and fiscal policy probably operate similarly on incumbents of all political stripes and are most keenly felt in the period just prior to elections. Governments respond to this pressure by adopting expansionary policies before elections whenever the combination of monetary institutions leaves at least one policy instrument in their hands. Evidence that incumbents use monetary policy for electoral purposes under some institutional arrangements and fiscal policy under others suggests that they view these policy instruments as substitutes.

Macroeconomic Outcomes Models 1 and 2 yield somewhat different predictions about the effects of the equilibrium policies on macroeconomic outcomes. Model 1 predicts that economic growth should be tied to political pressures if and only if the exchange rate is flexible and the central bank is independent. Model 2, in contrast, predicts that, since fiscal policy can be substituted when incumbents lose control of monetary policy, political pressures should influence macroeconomic outcomes except when the incumbent controls neither macroeconomic policy instrument. This is the case when the exchange rate is flexible and the central bank is independent (as in the United States). Clark evaluates empirical predictions equivalent to those derived from the policy subgames of both of the presented models.27 Note that the models differ most with respect to their predictions about the effects of political pressures on growth when the exchange rate is fixed. Model 1 predicts that the loss of national monetary policy autonomy that occurs under fixed exchange rates and mobile capital is sufficient to sever the link between political pressures on incumbents and macroeconomic outcomes. In contrast, model 2 predicts that the link between political pressures and macroeconomic outcomes is maintained under fixed exchange rates because elected officials can use fiscal policy to respond to such pressures (as is the case in the member countries of the Economic and Monetary Union in Europe). Clark presents evidence that is more consistent with model 2.28 Consistent with both models, he finds evidence of a link between growth and unemployment and the electoral calendar when the exchange rate is flexible and the central bank is

24. See Hallerberg, Vinhas de Souza, and Clark 2002. 25. Clark and Hallerberg 2000. 26. Clark forthcoming. 27. Clark forthcoming. 28. Clark forthcoming. Partisan and Electoral Motivations and Monetary Institutions 51 dependent. But consistent only with model 2, he finds evidence of a tighter link between the electoral calendar and macroeconomic outcomes when the exchange rate is fixed than when it is allowed to fluctuate. Echoing Clark and Hallerberg’s results for policy instruments, Clark finds very little systematic evidence of a link between the ideological orientation of government and macroeconomic outcomes.

Conclusion

A standard argument for the benefits of fixed exchange rates and/or central bank independence is that these institutions help policymakers overcome the time- inconsistency problem, which creates an inflationary bias when monetary policy is under the discretionary control of policymakers. Policymakers in such circumstances are unable to resist the temptation to enact a policy that is inconsistent with their optimal plan. An institutional fix is the only way out of this intertemporal dilemma. A mechanism, much like the ropes that bound Ulysses to the mast and the wax that shielded the ears of his oarsmen from the song of the sirens, must be constructed to force the policymaker to implement the optimal plan. What standard economic treatments do not explain, however, is why the ex ante existence of such a rule would change the ex post behavior of the policymaker. These institutional fixes are reasonable responses to the time-inconsistency problem as originally formulated, but the original formulation of the problem contained a key assumption, the relaxation of which calls into question the feasibility of each of the institutional fixes. To establish the generality of the time-inconsistency problem, Finn Kydland and Edward Prescott, and others that followed, started with the assumption that the policymaker in question has precisely the same goals as society in general. In effect, they were saying, “even if we found ourselves in the enviable position of having leaders that wanted only what was best for us, discretionary policy could not produce optimal outcomes.” While this made for a “hard case” for the existence of time-consistency problems, it made for an “easy case” for their solution. If the existing institutional arrangement leads the benevolent dictator to behave in a suboptimal manner, it is reasonable to expect the benevolent dictator to design an institution that removes such “perverse” incentives. If central bank independence or fixed exchange rates can be conceived as embodying, or at least facilitating, such institutional fixes, their occurrence can be explained as a rational response to the time-consistency problem. However, if the designers of institutions are not benevolent social planners but rather survival-maximizing politicians, and solutions for the time-inconsistency problem of monetary policy require these politicians to forfeit control of monetary policy instruments that can help them survive in office, it is not obvious that they would ever choose to increase central bank independence or peg the exchange rate. But both models presented in this paper agree that, under a wide range of conditions, incumbents would choose to forfeit their control over monetary policy in at least one of these ways. Model 1 predicts that a wide range of incumbents will choose to peg 52 International Organization the exchange rate in order to avoid the inflationary consequences of politically motivated monetary policy. In a narrower range of circumstances, incumbents may choose to delegate monetary policy to an independent central bank. Model 2 predicts that all incumbents will choose to peg the exchange rate to use fiscal policy to hit their growth targets. In addition, model 2 produces a number of hypotheses related to the effect of political pressure on macroeconomic policy and outcomes that are consistent with existing observations based on the electoralist model. One other implication of these models is worth mentioning. In both models, incumbents use whatever instruments they have available to manipulate the economy for survival-maximizing reasons. Both models also point to instances where incumbents would prefer to forfeit their ability to act in this way. Thus, even though incumbents are willing to forfeit instruments that allow them to control the economy in a politically motivated manner at the institutional design stage, they aggressively use these instruments if they inhabit institutions that allow them to do so. This result strongly suggests that institutions are not merely endogenous to the preferences incumbents hold—in truth, they have an independent effect on incumbent behavior.

Appendix 1: Derivation of Proposition 1

The game is solved by backwards induction. The central banker observes the incumbent’s choice of monetary institutions and chooses an inﬂation rate that minimizes its loss function. The central banker’s loss function is:

͑y Ϫ k͒2 ϩ ␣␲2 ϭ ͭ if Dependent Lcb ͑y Ϫ 1͒2 ϩ ␣␲2 if Independent (5)

And the short-term Phillips curve depends on the incumbent’s choice of exchange-rate regime. Speciﬁcally:

yn ϩ ␮͑␲ Ϫ ␲e͒ ϭ ͭ if Flexible y yn if Fixed (6)

Equilibrium policy is determined by plugging the appropriate Phillips curve into the appropriate loss function, differentiating with respect to ␲, setting equal to zero, and solving for ␲. Table A.1 displays the resulting, context-dependent, monetary policies. The incumbent chooses a set of monetary institutions that is a combination of the exchange-rate regime (ﬁxed, ﬂexible) and the relationship between the central bank and the government (independent, dependent) so as to minimize its loss function:

2 2 Li ϭ ͑y Ϫ k͒ ϩ ␣␲ (7)

The incumbent does so by anticipating the growth and inﬂation outcomes implied by the context-dependent equilibrium monetary policies in Table A.1. Inﬂation is determined Partisan and Electoral Motivations and Monetary Institutions 53

TABLE A.1. Equilibrium monetary policies under alternative monetary institutions

Exchange rate is: Flexible Fixed

Central bank is: Independent 1 ␲ ϭ 0 ␲ ϭ ␲e 1 ϩ ␣ 1 Dependent 1 ␲ ϭ 0 ␲ ϭ ͑k Ϫ 1 ϩ ␲e͒ 1 ϩ ␣

directly by monetary policy; substituting equilibrium inflation rates in Table A.1 into the appropriate context-dependent Phillips curve produces growth outcomes (Table A.2). Substituting these outcomes into the incumbent’s loss function provides the incumbent’s evaluation of inflation and growth outcomes. For the reader’s convenience, Table A.3 lists the loss incurred by the incumbent under each combination of context-dependent inflation and growth outcomes. Note that the losses generated under a fixed exchange rate and an independent central bank are identical to those generated under a fixed exchange rate with a dependent central bank. Consequently, the incumbent will always be indifferent between these two institutional combinations. The incumbent’s choice comes down to a choice, effectively, between three institutional combinations: a flexible exchange rate with a dependent central bank (combination A), a flexible exchange rate with an independent central bank (combination B), or a fixed exchange rate regime (combination C). I refer to the losses associated with each of these combinations as LA,LB, and LC, respectively. A fixed exchange rate is chosen when it produces a smaller loss than a flexible exchange Ͻ rate with a dependent central bank, LC LA, and a smaller loss than a flexible exchange rate

TABLE A.2. Equilibrium growth outcomes under alternative monetary institutions

Exchange rate is: Flexible Fixed

␣ Central bank is: Independent y ϭ 1 Ϫ ␲e y ϭ 1 1 ϩ ␣ 1 1 y ϭ 1 Dependent y ϭ (␣ ϩ k Ϫ ␣␲e) 1 ϩ ␣ 54 International Organization

TABLE A.3. Incumbent’s equilibrium losses under alternative monetary institutions

Exchange rate is: Flexible Fixed

Central bank is: Independent ␣ 2 1 2 (1 Ϫ k)2 ͩ 1 Ϫ k Ϫ ␲eͪ ϩ ␣ͩ ␲eͪ 1 ϩ ␣ 1 1 ϩ ␣ I

Dependent ␣ 2 1 2 (1 Ϫ k)2 ͩ ͑1 Ϫ k Ϫ ␲e͒ͪ ϩ ␣ͩ ͑k Ϫ 1 ϩ ␲e͒ͪ 1 ϩ ␣ 1 ϩ ␣

Ͻ with an independent central bank, LC LB. From Table A.3, the ﬁrst of these two conditions is met when

␣ 2 1 2 ͑1 Ϫ k͒2 Ͻ ͩ ͑1 Ϫ k Ϫ ␲e͒ͪ ϩ ␣ͩ ͑k Ϫ 1 ϩ ␲e͒ͪ (8) 1 ϩ ␣ 1 ϩ ␣

k Ϫ 1 which is the case whenever ␲e Ն . The second condition is satisﬁed ␣ ϩ 1 ͱ␣͑4␣ ϩ 1͒ 2 when

␣ 2 1 2 ͑1 Ϫ k͒2 Ͻ ͩ 1 Ϫ k Ϫ ␲eͪ ϩ ␣ͩ ␲eͪ (9) 1 ϩ ␣ I 1 ϩ ␣ I

Ϫ Ͻ ␲e Ͼ ␲e Յ which is satisﬁed only if 2(1 k) I, and since, by assumption, k 1 and I 0, this is always true.

Appendix 2: Derivation of Proposition 2

The actor’s loss functions are the same as in model 1. The crucial difference between the models is that fiscal policy, as well as monetary policy, can influence the growth rate in model 2. The incumbent moves first by choosing institutions, as above, and then choosing a fiscal policy (thought of as a change in net government spending). The central banker responds by setting monetary policy. Specifically, the context-dependent, expectations-enhanced Phillips curve becomes:

yn ϩ ␮͑␲ Ϫ ␲e͒ ϭ ͭ if Flexible y yn ϩ ␾g if Fixed (10)

Once again, the game is solved by backwards induction. The central banker chooses an equilibrium monetary policy as in model 1, except that now it is also a response to ﬁscal Partisan and Electoral Motivations and Monetary Institutions 55

TABLE A.4. Equilibrium monetary and ﬁscal policies under alternative structural conditions

Exchange rate is: Flexible Fixed

Central bank is: Independent g ϭ 0 g ϭ k Ϫ 1 1 ␲ ϭ 0 ␲ ϭ ␲e 1 ϩ ␣ Dependent g ϭ 0 g ϭ k Ϫ 1 1 ␲ ϭ 0 ␲ ϭ ͑␲e ϩ k Ϫ 1͒ 1 ϩ ␣

policy. The incumbent anticipates this response when formulating its ﬁscal policy. In general, the incumbent sets ﬁscal policy equal to:

1 ϭ ͓ n͑ Ϫ ͒ Ϫ ␮͑␲ Ϫ ␲e͔͒ g ␾ y k 1 (11)

and the central banker responds by setting inﬂation at:

1 ␲ ϭ ͓␮␲ ϩ n͑ Ϫ ͒ Ϫ ␾ ͔ ␣ y k 1 g (12) ␮ ϩ ␮

These policies, of course, depend on the institutional context. Accordingly, Table A.4 lists the context-dependent equilibrium policies.

TABLE A.5. Equilibrium growth outcomes under alternative structured conditions

Exchange rate is: Flexible Fixed

␣ Central bank is: Independent y ϭ 1 Ϫ ␲e y ϭ k 1 ϩ ␣ I

1 y ϭ k Dependent y ϭ 1 ϩ (k Ϫ 1 Ϫ ␣␲e) 1 ϩ ␣ 56 International Organization

TABLE A.6. Incumbent’s equilibrium losses under alternative monetary institutions

Exchange rate is: Flexible Fixed

Central bank is: Independent ␣ 2 1 2 0 ͩ 1 Ϫ k Ϫ ␲eͪ ϩ ␣ͩ ␲eͪ 1 ϩ ␣ I 1 ϩ ␣ I

Dependent ␣ 2 1 2 0 ͩ ͑1 Ϫ k Ϫ ␲e͒ͪ ϩ ␣ͩ ͑k Ϫ 1 ϩ ␲e͒ͪ 1 ϩ ␣ 1 ϩ ␣

Substituting context-dependent equilibrium policies into the Phillips curve determines growth outcomes, as summarized in Table A.5. Consequently, the incumbent anticipated the context-dependent losses displayed in Table A.6. It is readily apparent that the incumbent is able to achieve both of its targets under a fixed exchange rate. Thus, unless it can reduce its loss to zero under one of the flexible exchange- rate regimes, the incumbent always does better under a peg. And, since its loss under a flexible exchange rate with either a dependent or an independent central bank could equal zero only if 1 Ϫ k ϭ 0, this is never the case.29 The incumbent always does better with a peg if it can supplement its choice of the combination of monetary institutions with a fiscal policy of its choosing.

References

Asadurian, Tamar A. 2002. “Exchange Rate Commitments and the Role of Veto Players” Manuscript, Department of Politics, New York University. Barro, Robert, and David B. Gordon. 1983. Rules, Discretion, and Reputation in a Model of Monetary Policy. Journal of Monetary Economics 12 (1):101–21. Bernhard, William, and David Leblang. 1999. Democratic Institutions and Exchange-Rate Commitments. International Organization 53 (1):71–97. Bernhard, William, J. Lawrence Broz, and William Roberts Clark. 2002. The Political Economy of Monetary Institutions: An Introduction. International Organization 56 (4):693–723. Broz, J. Lawrence. 2002. Political System Transparency and Monetary Commitment Regimes. Interna- tional Organization 56 (4):861–87. Clark, William Roberts. Forthcoming. Capitalism, Not Globalism: Capital Mobility, Central Bank Independence, and the Political Control of the Economy. Ann Arbor: University of Michigan Press. Clark, William Roberts, and Mark Hallerberg. 2000. Mobile Capital, Domestic Institutions, and Electorally-Induced Monetary and Fiscal Policy. American Political Science Review. 94 (2):323–46. Fleming, J. Marcus. 1962. Domestic Financial Policies Under Fixed and Floating Exchange Rates. IMF Staff Papers 3 (9):369–79.

29. Since k Ͼ 1 by assumption, 1 Ϫ k ϭ 0 cannot be true. Partisan and Electoral Motivations and Monetary Institutions 57

Frieden, Jeffry A. 1991. Invested Interests: The Politics of National Economic Policies in a World of Global Finance. International Organization 45 (4):425–51. Frieden, Jeffry A., Pierro Ghezzi, and Ernesto Stein, 2001. Politics and Exchange Rates: A Cross- Country Approach. In The Currency Game: Exchange Rate Politics in Latin America, edited by Jeffry Frieden and Ernesto Stein, 21–64. Washington, D.C.: Inter-American Development Bank. Giavazzi, Francesco, and Marco Pagano. 1988. The Advantage of Tying One’s Hands: EMS Discipline and Central Bank Credibility. European Economic Review 32 (5):1055–82. Hallerberg, Mark. 2002. Veto Players and the Choice of Monetary Institutions. International Organiza- tion 56 (4):775–802. Hallerberg, Mark, Lucios Vinhas de Souza, and William Roberts Clark. 2002. Monetary and Fiscal Cycles in EU Accession Countries. European Union Politics 3 (2):231–50. Hibbs, Douglas A., Jr. 1977. Political Parties and Macroeconomic Policy. American Political Science Review 71 (4):1467–87. Jankowski, Richard, and Christopher Wlezien. 1993. Substitutability and the Politics of Macroeconomic Policy. Journal of Politics 55 (4):1060–80. Keefer, Philip, and David Stasavage. 2001. Checks and Balances, Private Information, and the Credibility of Monetary Commitment. International Organization 56 (4):751–74. Kenen, Peter B. 1994. The International Economy. New York: Cambridge University Press. Kydland, Finn E., and Edward C. Prescott. 1977. Rules Rather Than Discretion: The Inconsistency of Optimal Plans. Journal of Political Economy 85 (3):473–86. Mundell, Robert A. 1962. The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability. IMF Staff Papers 9 (1):70–9. ———. 1963. Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates. The Canadian Journal of Economics and Political Science 29 (4):475–85. Nordhaus, William D. 1975. The Political Business Cycle. Review of Economic Studies 42 (2):169–90. Rogoff, Kenneth. 1985. The Optimal Degree of Commitment to an Intermediate Monetary Target. Quarterly Journal of Economics 100 (4):1169–90. Walsh, Carl E. 1995. Optimal Contracts for Central Bankers. American Economic Review 85 (1):150–67.

Checks and Balances, Private Information, and the Credibility of Monetary Commitments Philip Keefer and David Stasavage

Introduction

Positive models of monetary policy have focused on the fundamental difficulty that governments can encounter in establishing the credibility of their policy commitments. After governments have announced their monetary policy and the public has taken actions that rely on that policy, such as signing wage contracts, governments may have an incentive to increase the rate of inflation ex post. Two information asymmetries complicate attempts to solve this credibility problem. First, the public may have little information about policymaker preferences and therefore about the incentives of policymakers to renege on any policy commitments they make. Second, because the public may not be able to observe policymaker actions, they have more difficulty detecting whether policymakers have adhered to an announced policy. Considerable research has investigated the use of central bank independence and exchange-rate pegs as instruments that governments might use to establish policy credibility. In this article, we address two related puzzles that have received less attention in the literature: Why is it more costly for politicians to revoke central bank independence or fixed exchange rates than to abandon more simple commitments, such as a promise to maintain a specific rate of inflation? And why does the presence of an independent central bank or a pegged exchange rate deliver more information to the public than simple policy announcements? To answer these questions, we first investigate whether the presence of multiple veto players in government makes it more difficult for governments to renege on exchange-rate pegs or central bank independence. We next consider whether the public finds it easier to observe government policy actions when an exchange-rate peg or central bank independence has been adopted. We find that the effectiveness of central bank independence in solving credibility problems depends on the

We have beneﬁted from the generous advice of Bill Bernhard, Lawrence Broz, Bill Clark, Peter Gourevitch, Mark Hallerberg, David Lake, David Leblang, Tom Willett, and two anonymous referees.

International Organization 56, 4, Autumn 2002, pp. 751–774 © 2002 by The IO Foundation and the Massachusetts Institute of Technology 60 International Organization presence of multiple veto players in government. Following earlier contributions, we show that independent central banks enhance the credibility of monetary policy to the extent that there are multiple veto players in government.1 However, we argue that central bank independence does not improve the public’s ability to observe policymaker actions. In contrast, we suggest that the effectiveness of exchange-rate pegs in solving credibility problems does not depend on the number of veto players in government. Instead, following arguments made by Chris Canavan and Mariano Tommasi and by Berthold Herrendorf, we argue that the primary contribution of exchange-rate pegs is to make it easier for the public to judge whether a policymaker has deviated from a previously announced commitment.2 In other words, they help reduce the information asymmetries between government and the public. Exchange-rate pegs should therefore have a larger anti-inflationary effect in contexts where it would otherwise be difficult for the public to observe policymaker actions.3 Our empirical results strongly support these propositions; they are robust to alternative specifications emphasizing the effect of democratic institutions more generally on monetary commitments. These findings are also general—we obtain them using a sample of seventy-eight developed and developing countries over the period from 1975 to 1994. Our investigation has direct implications for the question posed by William Bernhard, Lawrence Broz, and William Clark: If commitment mechanisms like central bank independence unambiguously improve general welfare, why do all countries not adopt them?4 One possible answer is that the social welfare function assumed in the literature incompletely reflects the social tradeoffs between inflation and economic growth. If institutional reforms such as central bank independence reduce social welfare in some countries, governments would be naturally reluctant to embrace them. The institutional and information hypotheses that we analyze offer a different answer to the question: even if central bank independence increases social welfare, commitment mechanisms like central bank independence may simply not work. We organize the remainder of this article as follows. We first consider the conditions under which central banks and exchange-rate pegs will increase credibility of monetary policy in a world of complete information. We then consider the conditions under which these two instruments provide more information about the preferences of policymakers than do the underlying policies enacted by policymakers. The influence of political institutions is analyzed in both sections. We then

1. See Lohmann 1998; Moser 1999; and Keefer and Stasavage 2000. 2. See Canavan and Tommasi 1997; and Herrendorf 1999. 3. On the idea that exchange rate pegs provide a more transparent form of commitment, see also Broz 2002. 4. Bernhard, Broz, and Clark 2002. See also Bernhard 1998; Maxfield 1997; Broz 2002; Clark and Maxfield 1997; and Bernhard and Leblang 1999. The Credibility of Monetary Commitments 61 present cross-country empirical tests of several propositions and evaluate the robustness of our findings.

Political Institutions and Monetary Commitments Central Bank Independence and Political Institutions In the canonical contribution on central bank independence, Kenneth Rogoff argued that delegation to an independent central bank might solve the time consistency problem in monetary policy and be welfare-improving.5 The crucial implicit assumption in this work is that the central bank acts with irreversible, full autonomy. If, however, central bank decisions are no more difficult for political actors to override than are economic policies themselves, independent central banks may do little to prevent ex post reneging on inflation commitments. Instead of solving the time-consistency problem, central bank independence would merely displace it, as governments would have an incentive to first announce central bank independence and subsequently renege on this commitment. Central bank independence could be protected from override by constitutional guarantees. Susanne Lohmann clarifies the precise effect of constitutional guarantees: legal central bank independence is likely to make a difference for policy outcomes if a larger number of veto players is required to revise a central bank’s statute than would be required to make a change in monetary policy if the government had regained discretionary control over policy.6 For example, if the executive alone set monetary policy under discretion, but revisions of the central bank charter required the agreement of both the executive and the legislature, delegation to an independent central bank could increase the credibility of monetary policy.7 However, it is not evident in practice that a greater number of political actors is required to consent to changes in a central bank charter than is required to change monetary policy in the absence of an independent central bank. The central bank charters of most countries are laws voted by legislatures rather than inscribed in constitutions; thus central banks are no less vulnerable, in principle, to having their actions or independence overturned by political authorities than would be other types of legislation. Moreover, as the literature on legislative control of bureaucratic institutions emphasizes, failure to observe frequent changes in central bank statutes is an unreliable indicator of independence, since if the threat of a statutory revision

5. Rogoff 1985. 6. Lohmann 1998. More generally, comparative research on political institutions and policymaking has demonstrated that it is more difficult to pass laws in countries where decision making is divided among multiple veto players, whether a separate executive and legislature in the case of presidential systems or multiple parties within a coalition government within parliamentary systems (for a recent comprehensive discussion, see Tsebelis 2002). 7. Whether or not credibility increases also depends on the preferences of the different veto players. 62 International Organization is credible, central banks will face incentives to modify their policies to avoid revision.8 It might be argued that only the executive, rather than the executive and legislature, has full control of monetary policy if there has been no decision to delegate. However, this is not always accurate. In a coalition government, the party controlling the finance ministry may nominally have full control of monetary policy, but in practice, other coalition members can threaten to leave the coalition when confronted with finance ministry actions to which they are strongly opposed. Likewise, in a presidential system, the legislature also exerts influence on monetary policymaking to the extent that there are spillovers from fiscal policy to monetary policy. Thus in practice, a similar number of actors may be required to consent to changes in central bank laws as would be required to consent to changes in monetary policy in the absence of an independent central bank. The important question that remains, therefore, is how delegation of policymaking authority to an independent agency can make a difference for policy when the number of veto players required to overturn delegation and to change monetary policy is the same. In earlier work, we address this question by comparing the effects of delegation under a variety of institutional arrangements.9 We expand the classic Barro-Gordon model to investigate how monetary policy outcomes depend on the number of veto players in a political system and on whether there has been a prior decision to delegate to an independent central bank. In the case where there has not been a prior decision to delegate and monetary policy is set directly by government, the order of moves in the game is as follows: first the public establishes its inflation expectations, then a random supply shock occurs, then monetary policy is chosen. If there is only one veto player, then that veto player sets policy unilaterally. If there are two veto players, then one of the two players is assumed to have the agenda power to make a “take it or leave it” offer to the other player. If the offer is refused, then the default outcome is determined by the wage contracts signed by the public. In earlier work we have shown that the policy the veto players select depends on whether the more inflation-averse or less inflation-averse veto player has agenda control.10 It also depends on whether expected inflation is higher than the preferred inflation outcome of the less inflation-averse political actor, lower than the preferred inflation of the most inflation-averse actor, or between the two, each case resulting in the two actors agreeing to a different inflation outcome. Outcomes may differ significantly if there has been a prior decision to delegate to a central bank. In this case the game proceeds as follows.

8. See, especially, Weingast and Moran 1983. 9. See Keefer and Stasavage 2000. Moser 1999 has also considered this question with a model that assumes policy outcomes, under checks and balances, with no delegation, are the result of a simple bargain among the veto players. The results then show that delegation by multiple political actors can lead to lower inﬂation expectations than would prevail in the absence of an independent central bank. 10. Keefer and Stasavage 2000. The Credibility of Monetary Commitments 63

1. The public establishes inflation expectations and signs wage contracts. 2. A random supply shock occurs. 3. The central bank chooses monetary policy. 4. The veto player(s) decide whether to override the central bank—a decision to which both must agree, by definition. If all veto player(s) do not agree to override, then the inflation rate chosen by the central bank prevails and the game ends. 5. If the veto player(s) decide to override the central bank, then they choose a new policy, as in the case where there is no central bank. In this model the central bank has agenda-setting power, yet unlike other models of monetary delegation, it is possible for politicians to override the central bank. As a result, the relationship between political actors and the central bank in our earlier work reflects the logic of “agency drift” models of legislative control over bureaucratic institutions.11 When there are two veto players, the key difference between monetary policy made under discretion (without central bank independence [CBI]) and monetary policy made under delegation (CBI) is the change in the default outcome that confronts the political decision makers. In the case without CBI, the default outcome is the rate of inflation that results from the price increases written into wage contracts by the private sector. Under delegation, in contrast, if veto players are unable to agree to override the central bank, the default outcome is the rate of inflation chosen by the central bank. Knowing this, the central bank has an incentive to choose a rate of inflation that is override-proof. More specifically, if we assume that the central bank is more averse to inflation than any veto player, then it will choose a rate of inflation that leaves the most inflation-averse veto player no worse off than if the two veto players overrode the central bank and subsequently agreed on a new rate of inflation. One of the core predictions from the model in our earlier work is that central bank independence can only have an effect on inflation outcomes if there are multiple veto players in government.12 To see this, consider first what options a central bank that has been granted control of monetary policy has in a political system with only one veto player. Any attempt to pursue a lower rate of inflation than that preferred by the single veto player would be overridden. As a result, when there is only one veto player in government, inflation outcomes will be identical regardless of whether there has been a prior decision to delegate. In contrast, when political power is divided between multiple veto players, then a prior decision to delegate to an independent central bank can have a significant impact on inflation outcomes. Provided that veto players do not share the same preferences, the central bank can now successfully implement a policy that one veto player would prefer to override,

11. See McCubbins, Noll, and Weingast 1987; and Epstein and O’Halloran 1999. 12. Keefer and Stasavage 2000. 64 International Organization as long as a second veto player would refuse to override. The end result is that the inflation outcome will be different from the outcome in the case where there has not been a prior decision to delegate, and veto players must bargain over the inflation rate. This leads to our first main proposition.

PROPOSITION 1: Central bank independence is more effective as an anti-inﬂation- ary device when there are multiple veto players in government.

This basic result, that the effect of central bank independence will be greater when there are multiple veto players, would also hold under a variety of assumptions different from those used in our earlier work.13 For example, if we assumed that veto players bore some exogenous political cost from deciding to override, then delegation to a central bank could have an effect on outcomes even when there was only one veto player, but the effect of CBI would still be larger when there are multiple veto players in government. In the second half of the article, we present tests of the proposition that emerges from this discussion.14

Exchange-Rate Pegs and Political Institutions

Exchange-rate pegs are widely believed to serve as a form of credible commitment, because adopting a peg reduces the ability of a government to conduct an independent monetary policy. As is well known, to the extent that foreign assets are substitutable for domestic assets, a country’s money supply—and hence its inflation rate—are exogenously determined from the point of view of the policymaker. All a government need do to establish such a peg is to declare that it is willing to sell foreign currency for domestic currency at a fixed rate. If private actors believed that the exchange-rate peg were immutable, their domestic inflation expectations would then simply equal expected world inflation. As Maurice Obstfeld shows, however, if a policymaker has a standard Barro-Gordon model loss function, then she would have an ex post incentive to devalue—to abandon the peg—to generate a higher rate of inflation.15 Obstfeld suggests that exchange-rate pegs may nonetheless increase monetary policy credibility if devaluation imposes additional political costs on governments. To model this possibility, he simply adds a parameter to the policymaker’s utility function representing the exogenous costs the policymaker confronts if she abandons the peg.16 This solution parallels the assumption made by Rogoff regarding the

13. Keefer and Stasavage 2000. 14. In our empirical tests, we assume, as is conventional, that central bankers on average have conservative preferences with regard to output-inflation tradeoffs. 15. Obstfeld 1996. 16. Inclusion of this additional parameter also generates the possibility of multiple equilibria, an issue we do not discuss here. The Credibility of Monetary Commitments 65 irrevocability of central bank independence.17 As with that assumption, it is not clear why governments that abandon exchange-rate pegs suffer larger political costs than governments that renege on simpler policy pledges to maintain a specific rate of inflation or to maintain a specific rate of money growth.18 Since institutional factors appear to be a crucial foundation of the efficacy of central bank independence, one might first ask whether the presence of multiple veto players in government also ensures the effectiveness of a pegged exchange rate in reducing expected inflation. Three examples suggest that this is unlikely to be the case. First, it is common in the literature to assume that countries peg their currencies to the currencies of foreign countries with inflation much lower than their own. This pegging strategy implies that domestic inflation under the exchange-rate peg could be lower than the minimum level of inflation acceptable to even the most inflation- averse domestic government veto player. Following the logic in our earlier model, such inflation outcomes would be overturned by domestic political veto players, no matter how many veto players there are.19 Under these conditions, a peg would fail to serve as a form of credible commitment, regardless of whether there are checks and balances in government. A second crucial point is that pegs are often established by the executive branch alone, without legislative approval. If abandoning a peg is also a matter only of executive discretion, we reach a similar conclusion: no matter how many veto players are present in government, the peg will not reduce inflation expectations because the decision to abandon the peg will be the prerogative of a single veto player. Third, even if foreign inflation outcomes are not extremely low and the introduction of a peg is a decision of both the legislature and the executive branch, checks and balances may still not improve the efficacy of the peg. In fact, they may detract from it by making it more difficult for government to respond to shocks that threaten the peg. Take a case where economic circumstances are such that government intervention is necessary to avoid de facto devaluation and abandonment of the peg. Under these circumstances, the default outcome under a peg—de facto devaluation—converges to that under a flexible exchange rate (where the same circumstances would lead to a depreciation). A peg could come under threat whenever economic circumstances trigger an outflow of foreign reserves and those reserves are scarce. Any exogenous shock that increases domestic inflation would trigger such an outflow. Under these conditions, if foreign reserves are scarce and a country is exposed to inflationary shocks, a pegged exchange rate leads to nearly the same outcome as a flexible exchange rate in the absence of countervailing government action. Under these conditions, even in the

17. Rogoff 1985. 18. See the observation by Persson and Tabellini 1994, 17. 19. Keefer and Stasavage 2000. 66 International Organization presence of checks and balances, the pegged exchange rate will do little to “tie the hands” of policymakers.20 We have omitted several institutional variations from the foregoing discussion. Their introduction does not fundamentally change the analysis, however. For example, what if the responsibility for defending an exchange-rate peg is assigned to an independent central bank, or, even more stringently, what if a currency board arrangement is established by law? In this case, it would be the independence of the bank or the legal status of the currency board that provides the commitment and not the peg itself.21 Similarly, it is sometimes the case that governments attempt to make pegs credible by giving a central bank the right to refuse a request by the government for monetary financing of a fiscal deficit. This makes it difficult for government to entertain fiscal policies that would trigger a loss of foreign exchange under a peg. Again, in this case it would be the presence of central bank independence that secures policy credibility and not the peg, per se. These arguments therefore suggest a second testable hypothesis that emerges from this analysis.

PROPOSITION 2: Exchange-rate pegs are not more effective as anti-inﬂationary devices when there are multiple veto players in government.

Monetary Commitments and Information Asymmetries

Attempts by governments to establish credibility for their monetary policies are further complicated by asymmetric information. First, the public may be uncertain about the relative importance that government veto players attach to inflation stabilization versus output stabilization and, therefore, government incentives to renege on their monetary policy commitments. Second, the public may observe policymaker actions imperfectly, because policymakers have incomplete control of inflation.22 In particular, the public may find it difficult to determine the extent to which observed inflation results from deliberate governments actions versus the realization of exogenous shocks that are beyond government control. Uncertainty about preferences creates incentives for policymakers to take actions that “signal” their preferences to the public. Imperfect control of inflation makes these signals more difficult for the public to interpret. The literature has identified both central

20. We do not consider the possibility that a government would deal with a problem of scarce reserves by imposing exchange controls because we restrict our attention to the case of exchange-rate pegs with full convertibility. This option might preserve a peg, but since it would also allow the government to regain control of the domestic money supply, it would also imply that the peg was no longer effective as a commitment device. 21. In many cases where independent central banks have operational responsibility for managing a peg, the decision whether to maintain or abandon the peg remains the prerogative of the ﬁnance ministry. We thank an anonymous referee for alerting us to this consideration. 22. See Canzoneri 1985. The Credibility of Monetary Commitments 67 bank independence and pegged exchange rates as tools that governments can use to send more reliable signals about their policy preferences and actions.

Central Bank Independence and Private Information Sylvia Maxfield has argued that many recent efforts to increase central bank independence can be explained as attempts by governments to signal policy preferences.23 The government announces the creation of an independent central bank and claims that it is staffed by inflation-averse individuals. If the public subsequently observes high inflation, it understands that this cannot be consistent with the planned inflation of a conservative central bank. The public is therefore likely to believe that high inflation is due to meddling by the government. This could make the adoption of an independent central bank a potentially valuable signal. The difficulty with this logic is that it does not clearly demonstrate why central bank independence has greater signaling value than do other types of policy announcements. The government could just as easily announce a particular inflation or monetary growth target at the beginning of the period, and the public could draw the same conclusions after observing final inflation. One reply to this argument is that central bank independence might make it easier for the public to observe political interference in monetary policy decisions. However, Broz argues that it is the transparency of a political system that makes such actions observable, not central bank independence per se.24 Just as importantly, governments do not need to undertake the very visible action of revoking the charter of a central bank or replacing a central bank governor to pressure central banks to pursue a more generous monetary policy. They can instead exercise subtler and less visible forms of pressure, ranging from reducing the resources of the central bank to social ostracism of the central bank leadership. It might also be the case that central bank independence improves the problem of imperfect observability of policy. Here, however, recent literature has suggested that it is not independence that improves observability of policy, but rather the extent to which central banks, independent or not, are transparent in their operations and procedures.25 It might finally be the case that, within some institutional frameworks, central bank independence has more signaling value than in others.26 We know from the earlier argument that government interference in central bank decision making is more difficult in the presence of checks and balances. However, the key issue in a signaling context is whether, under checks and balances, meddling with central bank decisions is easier for the public to detect. There are a number of reasons to suspect

23. Maxfield 1997. 24. Broz 2002. 25. See Faust and Svensson 2001; Chortareas, Stasavage, and Sterne forthcoming; and Stasavage 2001. 26. Clark and Maxfield 1997 also emphasize the importance of examining the institutional context. 68 International Organization that this might be the case. For example, override of a central bank may require a legislative act that is more public than would be a simple instruction from a president to a dependent central bank. Competing political actors inside government may have a greater incentive to register public complaints about the treatment of the central bank when it has been granted legal independence. We leave the more rigorous exploration of this issue to further work, however. Still, even in these cases, it would be difficult to argue that the effectiveness of central bank independence derives primarily from such signaling benefits rather than from the straightforward notion that multiple veto players hinder excessive meddling in central bank decisions. Central bank independence is likely, then, to be a weak response to the problems of asymmetric information in monetary policy. Whether or not asymmetric information is severe should therefore have little impact on the efficacy of central bank independence in reducing inflation, giving rise to our third testable proposition.

PROPOSITION 3: Central bank independence will not be more effective in reducing inﬂation when it is more difﬁcult for the public to observe policymaker actions.

Exchange-Rate Pegs and Private Information Because deviation from exchange-rate pegs is transparent, pegging can potentially be more effective than central bank independence in overcoming problems of private information in monetary policy.27 In particular, abandonment of a peg may be a more transparent indicator of inflationary government practices than either a high rate of growth of the money supply (which may be generated by an unanticipated change in the money multiplier) or a high rate of inflation (which may result from a shock to money demand). Pegging the exchange rate can avoid the uncertainties surrounding the connection between unobserved government policy and observed final inflation, allowing the public to better infer the preferences and actions of government actors.28 Canavan and Tommasi and Herrendorf have formalized this argument using somewhat different models.29 Both models provide a rigorous explanation of previous empirical findings showing that countries that have adopted fixed exchange-rate pegs have lower inflation than others. However, the specific predictions of these models have not been empirically tested. The basic conclusion of both is

27. See Broz 2002. 28. The principal exception to this argument concerns devaluations that are triggered by circumstances such as herd behavior by investors or other actions beyond the control of governments. Such factors might reduce the extent to which exchange-rate pegs provide a transparent indicator of government actions. Also, while exchange-rate pegs may be transparent, intermediate exchange-rate regimes such as those that allow the exchange rate to fluctuate within a band are less likely to be so. Frankel, Schmukler, and Serven 2000 have shown that in practice it may take considerable time for markets to distinguish between these intermediate regimes and a float. 29. See Canavan and Tommasi 1997; and Herrendorf 1999. The Credibility of Monetary Commitments 69 that pegging should be more effective in environments in which it is difficult for the public to distinguish the contribution of government policy to inflation. Canavan and Tommasi show that inflation should be lower the greater the precision with which the public can observe the contribution of the government’s policy action to final inflation. Since, in their model, the point of pegging the exchange rate is to increase this precision, if precision is high to begin with (in the absence of a peg), we would expect the peg to have little impact on inflation. As with central banks, we can also ask whether the effect of pegs in solving problems of private information depends on the presence of multiple veto players in government. It is evident that abandoning a peg that was previously established is as visible to the public when there are multiple veto players as when there is only one. The signaling value of the peg does not, therefore, change. The question of whether pegs are more or less likely to be adopted under checks and balances is the more important and complex one, exceeding the bounds of this article.30 This argument, then, yields our fourth and final proposition, that pegged exchange rates are likely to reduce inflation rates because they reduce information asymmetries. They should therefore have their greatest impact on inflation when the public has the greatest difficulty discerning government policy contributions to inflation outcomes, due for example to volatility of money demand. We test all four propositions in the following section.

PROPOSITION 4: Exchange-rate pegs are more effective in reducing inﬂation when it is more difﬁcult for the public to observe policymaker actions.

Empirical Tests

To test our propositions, we examine economic and political determinants of inflation in a sample of seventy-eight countries covering the period 1975–1994. We chose the end of the Bretton Woods era to determine this time period, and determined sample size by data availability. Our empirical tests follow the specifications used in recent papers investigating the effect of monetary institutions on inflation outcomes.31 Because the institutional variables with which we are concerned change relatively infrequently, we follow the majority of recent papers in the literature by investigating period averages. We report results both from cross- section regressions (averaging values for each country over the entire period) and from cross-section time-series regressions where variables are averaged across five-year time periods.

30. See Bernhard and Leblang 1999. 31. See Franzese 1999; Hall and Franzese 1998; Campillo and Miron 1996; and Cukierman, Webb, and Neyapti 1992. 70 International Organization

Presentation of Data

We use inflation as our dependent variable, following the logic that where the inflation bias due to time-consistency problems is higher, so also is average inflation. To control for the effect of countries with extremely high levels of inflation, we use the log of the inflation rate.32 To measure central bank independence, we use the index developed by Alex Cukierman, Steven Webb, and Bilin Neyapti,33 since this is the one indicator that covers a sample of both Organization for Economic Cooperation and Development (OECD) and non-OECD countries. It is based on sixteen different characteristics of central bank statutes, such as provisions for monetary policy decisions, resolution of conflicts between central bank and government, and provisions for replacing the central bank governor. While Cukierman, Webb, and Neyapti’s original data set runs only up to 1989, more recent studies have compiled updated information on central bank independence and, in some cases, data on new countries.34 The International Monetary Fund’s Annual Report on Exchange Arrangements and Exchange Restrictions presents information on exchange-rate pegs.35 We classified countries according to those that adopt some form of a nominal exchange- rate peg (peg ϭ 1) and those that do not. This covers countries that peg their currency to a single other currency and those that peg to a basket of currencies. Countries that allow a very limited amount of nominal exchange-rate flexibility (for example, the European Monetary System) are also classified as having pegged regimes. We opt for this binary classification (peg versus no peg) because economic theory does not offer firm predictions about the extent to which some types of pegs might be more effective than others.36 In this study, we also use newly developed cross-country data on political institutions. Philip Keefer developed a measure of checks and balances in government based on objective indicators assembled by Thorsten Beck et al.37 The index counts the number of veto players present in a political system, including both what George Tsebelis has called “constitutional” veto players as well as “partisan” veto 38 players. For presidential systems, the variable CHECKS counts the number of veto players, counting the executive and legislative chamber(s) separately only if they are controlled by different parties. For parliamentary systems, CHECKS counts the

32. Based on CPI data from the International Monetary Fund (IMF), International Financial Statistics. 33. Cukierman, Webb, and Neyapti 1992. 34. See, in particular, Cukierman, Miller, and Neyapti 1998. The de facto indicator of central bank independence that they have developed—rates of central bank governor turnover—is not appropriate for our tests, since we are precisely interested in the extent to which legal prescriptions prevent this sort of intervention. 35. See Ghosh et al. 1995. We have updated this data set to cover the period 1990–94. 36. Though, as previously mentioned, economic theory does offer reasons to believe that these pegs might be more effective anti-inflationary devices than regimes where the exchange rate is allowed to fluctuate within a wider band. 37. See Keefer 2002; and Beck et al. 2001. 38. Tsebelis 2002. The Credibility of Monetary Commitments 71 number of parties in the government coalition, based on the assumption that individual coalition members will enjoy veto power over policy. The index is modified to take into account the effect that certain electoral rules (closed list versus open list) have on the cohesiveness of governing coalitions.39 The probability that at least one actor prefers the status quo increases with the number of veto players counted by CHECKS. However, the rate of increase is lower at higher levels of CHECKS. We therefore use a log version of check, LOG CHECK, in our regressions. Testing the informational propositions 3 and 4 requires variables that capture the public’s difficulty in distinguishing between inflation generated by government policy and inflation generated by exogenous shocks. We use several different proxy measures for the public’s uncertainty, achieving significant results with all of them. The first measure we use to proxy for the degree of uncertainty about the policymaker’s intended rate of inflation is instability in a country’s money multiplier, as suggested by both Canavan and Tommasi and by Herrendorf. We use the variable VOLATILITY M2/M0, the standard deviation of the ratio of broad money (M2) to base money (M0), as our first measure of uncertainty about the policymaker’s intended rate of inflation. The idea is that the government or central bank controls base money directly, but inflation outcomes also depend upon changes in broad money that are in part beyond the central bank’s control. When the money multiplier is volatile, the public faces a larger challenge in inferring monetary policy intentions from inflation outcomes.40 The second measure of the noise that interferes with the public’s ability to infer government policy is the volatility of the terms of trade. The variable VOLATILITY TOT measures the standard deviation of the annual change in a country’s capacity to import as a share of national income.41 The capacity of a country to purchase imports out of its exports can increase either because the world prices of a country’s imported goods have fallen relative to those of its exports, or because a country has experienced a positive supply or income shock so that it can afford more imports (for example, if its costs of production have exogenously declined). Under a flexible exchange rate, both shocks have implications for domestic prices. Consequently, the larger the VOLATILITY TOT measure, the larger the shocks that make it difficult to

39. For presidential systems, CHECKS is the sum of 1 for the president and 1 for each legislative chamber. The value is increased by one if an electoral competition index developed is greater than four (out of a possible seven). Also, in closed-list systems where the president’s party is the first government party, the legislature is not counted. For parliamentary systems, CHECKS is the sum of 1 for the prime minister and 1 for each party in the governing coalition. If elections are based on a closed-list system and the prime minister’s party is the first government party, then this sum is reduced by one. As for presidential systems, the value of CHECKS is modified upwards by one if the value of the index for electoral competition is greater than four. 40. In discussing the robustness of our results, we also ask whether including volatility in the money multiplier as an explanatory variable creates a simultaneity bias in our regressions. 41. World Development Indicators CD-ROM. The terms-of-trade adjustment variable that we use equals capacity to import less exports of goods and services. Data are in constant local currency. We preferred this to a more standard terms-of-trade measure (price of exports/price of imports) largely because of data availability, but also because the extent to which terms-of-trade shocks affect domestic inflation depends not only on the size of the shocks, but also on the degree of openness of an economy. 72 International Organization judge a policymaker’s intended rate of inflation, and the larger the impact that we would expect the introduction of a peg to have on inflation.42 The third proxy we use to gauge the public’s difficulty in observing planned inflation is the quality of a country’s economic data. As Herrendorf argues, when a country’s consumer price statistics are known to include frequent errors, it is more difficult for the public to assess the true rate of inflation and therefore more difficult to extract the intended rate of inflation from the officially reported rate of inflation.43 The introduction of a peg has a greater impact on the precision with which the public can assess government policy when consumer price index (CPI) data are of poor quality; therefore, peg introduction should have a larger downward impact on inflation. The quality of a country’s CPI data cannot be measured directly, but there are indicators available that are designed to measure the overall quality of a country’s economic statistics. The Penn World Tables data set includes a measure of data quality, GRADE, which is based on results of United Nations surveys. A higher value for GRADE indicates more reliable data. In addition to the institutional and informational variables, the regressions include three further variables to control for determinants of inflation that are unrelated to our theoretical arguments. First, there are both strong theoretical and empirical reasons to believe that political instability is causally linked with inflation. To measure political instability with improved precision, we developed a new variable, POLITICAL INSTABILITY, based on information in the database reported in Beck et al., which measures, for each country and each period, the fraction of all veto players who were replaced from the period earlier. In authoritarian systems with only one veto player, this amounts to measuring the rate of government turnover. In systems with more than one veto player, however, this variable captures the possibility that although governments might frequently change, some coalition partners might be present in several successive governments. Following David Romer, we also include a measure of openness based on the argument that incentives for policymakers to generate surprise inflation should be 44 weaker in countries that are more open to trade. The variable OPENNESS is measured in the standard manner as the sum of exports plus imports, divided by a country’s gross domestic product (GDP). We also include the log of real GDP per capita as a control variable. Poorer countries tend to have less well-developed tax systems, and under these conditions governments have an increased incentive to rely on seignorage for revenue. A further rationale is that some of our institutional variables are highly correlated with levels of income. Including LOG GDP in the specification addresses concerns that our

42. It is interesting to note here that governments with volatile terms of trade will face an acute dilemma. If exchange-rate pegs have a greater anti-inflationary impact in countries with more volatile terms of trade, governments that peg will also find it more difficult to achieve real exchange-rate adjustments, and this cost will be greater the more volatile are the terms of trade. 43. Herrendorf 1999. 44. Romer 1993. The Credibility of Monetary Commitments 73

TABLE 1. Summary statistics

Variable No. obs. Mean Std. dev. Min. Max.

LOG INFLATION 277 Ϫ2.02 1.43 Ϫ5.39 3.90 CBI 297 0.35 0.13 0.10 0.82 LOG CHECK 293 0.95 0.48 0 2.08 PEG 297 0.53 0.41 0 1 GRADE 266 2.43 1.04 1 4 VOLATILITY M2/M0 226 1.07 2.45 0.02 27 VOLATILITY TOT 258 0.02 0.03 0 0.16 POLITICAL INSTABILITY 289 0.15 0.14 0 0.68 OPENNESS 279 68.4 52.4 10 394 LOG GDP 275 8.06 1.62 4.57 10.7

political and informational variables are merely proxying for overall levels of development between countries.

Testing Propositions 1 and 2 We evaluate our ﬁrst and second propositions by using a model with interaction terms, which allows the marginal effect of central bank independence and exchange- rate pegs on inﬂation to vary with the extent of checks and balances. The general form of our regressions is as follows:

ϭ ␣ ϩ ␤ ϩ ␤ ϩ ␤ ϫ ϩ ␤ LOG INFLATION 1 CBI 2 PEG 3 CBI LOG CHECK 4PEG ϫ ϩ ␤ ϩ ␤ ϩ ␤ LOG CHECK 5 OPENNESS 6 INSTABILITY 7 LNGDP ϩ ␤ ϩ ⑀ 8 LOG CHECK

Proposition 1 predicts that the interaction term CBI ϫ LOG CHECK has a negative coefficient, while Proposition 2 predicts the interaction term PEG ϫ LOG CHECK to be ␤ ϩ ␤ ϫ insignificant. The net effect of central bank independence, given by 1 3 LOG CHECK, should be negative at high levels of checks and balances. In contrast, Proposition 2 does not deliver a firm prediction about whether the net effect of ␤ ϩ ␤ ϫ pegging, 2 4 LOG CHECK, should be positive or negative at high levels of checks and balances. Regressions 1 and 2 in Table 2 report results of baseline regressions that do not include interaction terms. In both regressions, the estimated anti-inflationary effect of adopting an exchange-rate peg is statistically and economically significant. In contrast, in both samples the coefficient on CBI is actually positive and significant, suggesting that higher central bank independence is actually associated with higher rates of inflation when one controls for other determinants. This is a strong 74 International Organization

TABLE 2. CBI, exchange-rate pegs, and political institutions

Depvar: log inﬂation (1) (2) (3) (4)

Constant 1.15 0.33 Ϫ0.33 Ϫ0.56 (0.91) (0.62) (1.61) (0.66) OPENNESS 0.001 Ϫ0.002 0.001 Ϫ0.003 (0.003) (0.002) (0.00) (0.002) LOG GDP Ϫ0.36 Ϫ0.27 Ϫ0.37 Ϫ0.26 (0.11) (0.12) (0.10) (0.11) POLITICAL INSTABILITY 1.52 1.34 0.43 1.21 (1.52) (0.40) (1.46) (0.41) CBI 2.14 1.84 10.3 5.15 (1.03) (0.48) (4.15) (1.75) PEG Ϫ2.07 Ϫ0.84 Ϫ4.50 Ϫ1.33 (0.61) (0.20) (1.11) (0.56) LOG CHECK Ϫ0.04 Ϫ0.36 1.73 0.54 (0.54) (0.19) (1.62) (0.51) CBI ϫ LOG CHECK ؊7.58 ؊3.20 (3.91) (1.50) PEG ϫ LOG CHECK 2.05 0.44 (0.95) (0.38) R2 0.40 0.29 0.46 0.30 N 78 258 78 258 p-value for Chi-sq. p Ͻ .01 p Ͻ .01 p Ͻ .01 p Ͻ .01

Note: OLS with White’s heteroskedastic consistent standard errors for Regressions 1 and 3 reported in parentheses. Regressions 2 and 4 are estimated using panel corrected standard errors.

indication that legal central bank independence on its own is, on average, unlikely to deliver anti-inflationary credibility. Regressions 3 and 4 test our propositions about the effect of political institutions on the credibility of monetary commitments. In both regressions, the coefficient on the interaction term CBI X CHECKS is negative and statistically significant at the five percent level. The substantive results of the regressions are also consistent with Proposition 1. Based on the estimates in Regression 3, in a parliamentary system with a three-party coalition (LOG CHECK ϭ 1.6), an increase of 0.2 in CBI (equivalent to moving from the twenty-fifth percentile to the seventy-fifth percentile in the sample) would be associated with a thirty-one percent decrease in the annual rate of inflation. The effect of the same increase in CBI in a parliamentary system with a single-party majority (LOG CHECK ϭ 1.1) would actually be an increase in inflation of forty-eight percent. To provide a graphical representation of our findings, Figure 1 shows the estimated effect on log inflation of a 0.2 increase in CBI at different levels of LOG CHECK (based on Regression 3). The solid line represents the estimated effect, the two dotted lines represent the boundaries of the ninety percent confidence interval, The Credibility of Monetary Commitments 75

FIGURE 1. Estimated effect of 0.2 increase in CBI (at different levels of log check)

and the horizontal line represents zero change in inflation.45 The evidence suggests that increased central bank independence has a negative effect on inflation only in the set of countries with relatively high levels of checks and balances (within the highest quartile of our sample). Regressions 3 and 4 in Table 2 suggest that exchange-rate pegs may actually be less, rather than more, effective as anti-inflationary commitments when there are multiple veto players in government. This result is consistent with Proposition 2. The interaction term PEG ϫ CHECKS is positive in both regressions and significantly in the case of the cross-sectional estimation. In both regressions, the estimated effect on inflation of adopting an exchange-rate peg is negative for nearly all sample values of checks and balances (the maximum value of LOG CHECK is 2.07). However, the magnitude of this effect is much smaller in countries where there are multiple veto players in government. Taken together, the above results provide support for the idea that the structure of political institutions plays an important role with regard to monetary commitments, and the idea that this effect varies dramatically depending upon the type of monetary commitment under consideration. While central bank independence is likely to have

␤ ␤ 45. Since the effect of a change in CBI here depends on both 1 and 3, we calculated the standard error of the effect using a formula that takes into account both the variance of each individual coefﬁcient and its covariance. 76 International Organization a bigger impact on credibility in political systems with multiple veto players, the opposite may well occur with exchange-rate pegs.

Testing Propositions 3 and 4 If central banks or exchange-rate pegs help governments credibly commit because they are transparent, then their anti-inflationary effects should be greatest in countries where it is particularly difficult for the public to distinguish between inflation attributable to deliberate government decisions and inflation attributable to exogenous shocks. We have argued that exchange-rate pegs should exhibit this characteristic, but that central bank independence is unlikely to be an informative signal. As with Propositions 1 and 2, these propositions can best be tested in a model with interaction terms, which follows the specification below. We use three different proxies for the ability of the public to distinguish the contribution of government policy to final inflation outcomes: the Summers and Heston grade for data quality (GRADE), instability of the money multiplier (VOLATIL- ITY M2/M0), and a variable capturing instability in terms of trade (VOLATILITY TOT). Based on Proposition 3, we predict that the interaction term PEG ϫ GRADE should have a positive sign (because data quality is higher in countries where the value of GRADE is high), while the interaction terms PEG ϫ VOLATILITY TOT and PEG ϫ VOLATILITY M2/M0 should be negative. We again report results from both cross-section regressions and from regressions based on five-year period averages.

ϭ ␣ ϩ ␤ ϩ ␤ ϩ ␤ ϫ LOG INFLATION 1 CBI 2 PEG 3 CBI LOG CHECK ϩ ␤ 4 INFORMATION VARIABLE ϩ ␤ ϫ ϩ ␤ 5 PEG INFORMATION VARIABLE 6 OPENNESS ϩ ␤ ϩ ␤ ϩ ␤ ϩ ⑀ 7 INSTABILITY 8 LNGDP 9 LOG CHECK

The results in Table 3 suggest that exchange-rate pegs are more effective as anti-inflationary commitments under conditions where data quality is poor and there is significant economic volatility, which makes it more difficult for the public to observe government policy choices. In Regressions 1 and 2, the interaction term PEG ϫ GRADE is positive and highly significant, as predicted. The economic significance of the peg effect is also quite large. Based on Regression 2, for a country with a Summers and Heston grade for data quality equivalent to the twenty-fifth percentile of the sample (1.7), adopting an exchange-rate peg is estimated to result in a sixty-two percent reduction in the annual rate of inflation. A country with a grade for data quality equivalent to the seventy-fifth percentile would, in contrast, be predicted to experience a forty-five percent increase in annual inflation. In Regressions 3–6, coefficients on the interaction terms for PEG ϫ VOLATILITY TOT and PEG ϫ VOLATILITY M2/M0 are negative as predicted and generally highly significant. Once again, these results are also substantively significant. For example, The Credibility of Monetary Commitments 77

TABLE 3. CBI, exchange rate pegs, and information

Depvar: log inﬂation (1) (2) (3) (4) (5) (6)

Constant Ϫ3.09 Ϫ2.17 Ϫ3.03 Ϫ1.68 Ϫ1.50 Ϫ1.52 (1.16) (0.47) (1.36) (0.70) (1.75) (1.01) OPENNESS Ϫ0.01 Ϫ0.01 Ϫ0.002 Ϫ0.004 0.002 Ϫ0.001 (0.002) (0.001) (0.002) (0.002) (0.004) (0.002) LOG GDP 0.26 0.18 Ϫ0.22 Ϫ0.19 Ϫ0.37 Ϫ0.29 (0.14) (0.03) (0.11) (0.09) (0.15) (0.12) POLITICAL INSTABILITY Ϫ0.43 0.82 0.87 1.16 0.43 1.14 (1.07) (0.44) (1.44) (0.33) (1.72) (0.44) CBI 10.2 6.56 10.2 5.12 10.2 6.15 (2.96) (1.45) (4.26) (2.13) (4.80) (1.46) PEG Ϫ3.37 Ϫ2.14 Ϫ1.43 Ϫ0.47 Ϫ2.04 Ϫ0.24 (0.93) (0.52) (0.63) (0.28) (1.16) (0.24) LOG CHECK 2.96 0.76 2.82 0.94 2.59 0.80 (1.15) (0.61) (1.39) (0.60) (1.82) (0.43) CBI ϫ LOG CHECK Ϫ7.37 Ϫ2.40 Ϫ8.20 Ϫ3.58 Ϫ7.73 Ϫ3.65 (3.20) (1.63) (4.01) (1.65) (4.64) (1.43) GRADE Ϫ1.20 Ϫ0.73 (0.49) (0.21) PEG ϫ GRADE 0.90 0.68 (0.27) (0.12) CBI ϫ GRADE ؊0.79 ؊1.26 (1.00) (0.48) VOLATILITY TOT 27.1 22.2 (22.0) (22.9) PEG ϫ VOLATILITY TOT ؊39.2 ؊24.0 (15.9) (10.9) CBI ϫ VOLATILITY TOT 14.1 ؊0.33 (78.5) (45.3) VOLATILITY M2/M0 0.15 0.72 (0.29) (0.23) PEG ϫ VOLATILITY ؊0.05 ؊0.55 M2/M0 (0.30) (0.18) CBI ϫ VOLATILITY ؊0.15 ؊0.42 M2/M0 (0.48) (0.47) R2 0.65 0.45 0.56 0.34 0.32 0.34 N 67 247 74 246 62 202 p-value for Chi-sq. p Ͻ .01 p Ͻ .01 p Ͻ .01 p Ͻ .01 p Ͻ .01 p Ͻ .01

Note: OLS with White’s heteroskedastic consistent standard errors for Regressions 1 and 3 reported in parentheses. Regressions 2, 4, and 6 are estimated using panel-corrected standard errors.

based on the estimates in Regression 6, adopting an exchange-rate peg would cause a thirty-two percent drop in inflation for a country with relatively low volatility in its money multiplier (0.27, the value for the twenty-fifth percentile); the effect for a country with high volatility (1.01, the value for the seventy-fifth percentile) would be a fifty-five percent drop in annual average inflation. Figure 2 illustrates the estimated effect of adopting an exchange-rate peg, showing the effect of a peg 78 International Organization

FIGURE 2. Estimated effect of an exchange-rate peg (at different levels of volatility)

(together with the estimated ninety-percent confidence interval) at different levels of money multiplier volatility (based on Regression 6 in Table 3). The horizontal line represents zero change in log inflation. In stark contrast with our results with regard to exchange-rate pegs, the effect of central bank independence does not seem to vary significantly with the extent of either terms-of-trade volatility or volatility in a country’s money multiplier. The coefficients CBI ϫ VOLATILITY M2/M0 and CBI ϫ VOLATILITY TOT are not statistically significant in Regressions 3–6. The results with regard to data quality are more mixed. While, as our theory predicts, the interaction term CBI ϫ GRADE is not significant in Regression 1, it is significant in Regression 2.

Robustness of Results

Several issues might affect the robustness of our results: our institutional variables may proxy for more general features of political systems; the significance of the results may be exaggerated by autocorrelation; and finally, the results may be biased by the endogeneity of central bank independence to inflation. The first problem is whether our institutional variables are measuring the phenomena we claim, or whether they might in fact be capturing more general features of political systems, such as levels of democracy or levels of income. The simple correlation between the variable DEMOCRACY from the Polity III data set and The Credibility of Monetary Commitments 79

TABLE 4. J-tests against alternative speciﬁcations

Regression Null hypothesis Alternative hypothesis p-value

Table 2(4) LOG CHECK DEMOCRACY p ϭ .00 DEMOCRACY LOG CHECK p ϭ .08 Table 3(2) GRADE DEMOCRACY p ϭ .54 DEMOCRACY GRADE p ϭ .00 Table 2(4) LOG CHECK LOG PER CAP. GDP p ϭ .00 LOG PER CAP. GDP LOG CHECK p ϭ .09 Table 3(2) GRADE LOG PER CAP. GDP p ϭ .00 LOG PER CAP. GDP GRADE p ϭ .00

our variable CHECKS is fairly high (0.52), and the simple correlation between our measure of data quality (GRADE) and DEMOCRACY is even higher (0.74). Similar conclusions might be drawn from the high correlation of GRADE and CHECKS with per capita income.46 The alternative hypothesis to test, then, would be whether the effects of central bank independence and of exchange-rate pegs vary with levels of democracy or income, instead of with the number of veto players or the extent of economic volatility. To test this alternative against our own propositions, we used the J-test methodology developed by Russell Davidson and James Mackinnon.47 This test involves estimating the two specifications to be compared and then re-estimating each specification while including the fitted values from the alternative model as an explanatory variable in each regression.48 The t statistic on the fitted values can be interpreted as a test of the null that the alternative specification (for example, the specification using DEMOCRACY or income) would not add explanatory power to the existing model. One can then repeat the test while reversing the variables, which are considered as the “null” and the “alternative.” It is common with J-tests comparing two specifications A and B to find that one rejects the null when A is the null and B is the alternative, but that one also rejects the null when B is the null and A is the alternative. In this case, one can conclude that each specification adds explanatory power to the other (or that neither specification encompasses the other). Table 4 reports results of J-tests where we tested Regression 4 from Table 2 and Regression 2 from Table 3 against two alternative specifications. The first alternative involved replacing the relevant institutional or informational variable with the

46. The simple correlations of our two other information variables, VOLATILITY TOT and VOLATILITY M2/M0, with either LOG GDP or DEMOCRACY, did not exceed 0.35. We do not consider the possibility that these speciﬁcations are picking up effects due to levels of GDP or democracy. 47. Davidson and MacKinnon 1981. 48. For an application of J-test methodology to compare alternative political economy hypotheses, see Franzese 1999. 80 International Organization

Polity III measure DEMOCRACY. The second alternative specification involved replacing the relevant institutional or informational variable with LOG PER CAPITA GDP. The test statistics are significant in most cases at the one percent level and in all but one case at the ten percent level of confidence. We find, first, that all of the specifications using our institutional and informational variables add explanatory power to regressions using only DEMOCRACY and LOG PER CAPITA GDP (using the ten percent level as a cutoff). We can therefore reject the hypothesis that our institutional and informational variables are simply proxies for more general phenomena. However, in three out of four cases, specifications using only DEMOCRACY or LOG PER CAPITA GDP also add explanatory power to our existing specifications from Tables 2 and 3. The exception here is Regression 2 from Table 3, where we clearly reject the hypothesis that DEMOCRACY adds explanatory power to the GRADE specification. These findings suggest that more general features of democracy or levels of income may also have an influence on the effectiveness of central bank independence or exchange-rate pegs as commitment mechanisms. We also considered whether our statistical tests might be affected by serial correlation of error terms. Standard Lagrange multiplier tests detected autocorrelation in our five-year period regressions. Using a Prais-Winsten regression rather than ordinary least squares (OLS) would be one way to deal with this problem. However, using this technique depends upon accepting the restriction that the autoregressive process influencing each of the variables in our regression is identical. Standard testing procedures strongly reject this restriction. As a result, we have chosen to retain our OLS estimates. Although autocorrelation is present and difficult to address in the five-year data, it is nevertheless the case that our cross-section results, by definition not subject to autocorrelation, are also significant. As a final robustness test, we also considered the possibility that there might be biases in our results due to the endogeneity of certain explanatory variables. This could involve the endogeneity of legal central bank independence to past levels of inflation. For central bank independence, Granger causality tests failed to establish that current levels of CBI were “Granger-caused” by lagged levels of log inflation. It could also involve simultaneity bias, such as that created by shocks that affect both CBI and LOG INFLATION within the same time period. Volatility in the money multiplier (VOLATILITY M2/M0) might also be subject to this problem. Logically, simultaneity bias is unlikely to be responsible for our results. For such biases to explain the results in Tables 2 and 3, for example, omitted variables or shocks would have to be such that they made the interaction of pegs and volatility, but not the interaction of central bank independence and volatility, significant. Similarly, they would have had to generate a significant estimate of the interaction of checks and central bank independence, but not of pegs and central bank independence. In any case, a Hausman specification test did not reject OLS estimates from Table 2 when compared with estimates that instrumented for current values of central bank independence with past values. For volatility in the multiplier VOLATILITY M2/M0,a Hausman specification test also failed to reject the consistency of the OLS estimates. The Credibility of Monetary Commitments 81

Conclusion

In this article, we have developed and tested several new hypotheses about the anti-inflationary effect of central bank independence and exchange-rate pegs across different institutional and informational contexts. Theory provides a strong reason to believe that, while central bank independence will prove more effective as a commitment mechanism in countries with multiple veto players in government, these multiple veto players will not increase the credibility of exchange-rate pegs. We reach an opposite conclusion with regard to the effect of central bank independence and exchange-rate pegs in different informational contexts. In economically volatile conditions, where it is more difficult for the public to distinguish inflation deliberately generated by government from inflation created by unanticipated economic shocks, the anti-inflationary effect of central bank independence will be unchanged, while the effectiveness of exchange-rate pegs will be significantly enhanced. Cross-country tests using newly developed data provide strong support for both our institutional and our informational propositions.

References

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It is indisputable that the government’s economic institutions are important. Schol- ars have focused considerable attention on the implications of exchange-rate regimes, the relative independence of central banks, open versus closed capital markets, and the inﬂuence of the structure of labor markets on economic policy and economic performance. An innovative body of literature in the last decade has moved beyond a consideration of the effects of economic institutions to consider why governments choose some institutional forms over others. That literature usually discusses the choices in isolation. The contributors to this volume present a second generation of scholarship that addresses the interaction of these institutional choices and, in particular, the joint choice of a level of central bank independence (CBI) and the exchange-rate regime.1 This article’s contribution is to present a veto-player argument for why industrialized countries select their levels of CBI and their exchange-rate regimes. Based largely on a Mundell-Fleming model expanded in William Clark and Clark and Mark Hallerberg,2 it considers circumstances under which governmental parties agree to delegate decisions on monetary decisions to an independent body and to choose a certain exchange-rate regime under full capital mobility. The model assumes only opportunistic behavior—that is, parties are ofﬁce-seekers—on the part of political parties. Differences in ideology play no role in the model. This focus on veto-player preference for monetary institutions differs from that of Philip Keefer and David Stasavage,3 who focus on how the number of veto players affects the effectiveness of central bank and exchange-rate commitments.

I would like to thank the following people for their comments and suggestions: David Bearce, Lawrence Broz, William Bernhard, Thilo Bodenstein, William Roberts Clark, Markus Crepaz, Robert Franzese, Steffen Ganghof, David LeBlang, Thomas Plu¨mper, and George Tsebelis. 1. See Bernhard and Leblang 2002; Broz 2002; and Clark 2002. 2. See Clark forthcoming 2003; and Clark and Hallerberg 2000. 3. Keefer and Stasavage 2002.

My results show that two types of veto players matter: subnational governments, which are strong in federal systems but weak in unitary systems, and party veto players. A crucial issue for party players is whether voters can readily attribute the benefits, and the costs, of their manipulation of the economy directly to them. A second issue concerns the veto player’s ability to control a given type of policy. Identifiability and controllability vary systematically across the four possible combinations of veto players. In one-party unitary governments, identification and control are clear, and parties where such governments are common prefer flexible exchange rates, and the monetary policy autonomy that accompanies them, as well as dependent central banks. In multiparty coalition governments in unitary systems, identification is traditionally difficult, and the ability to target benefits to specific constituencies under fiscal policy makes this option more attractive for coalition governments. Such governments also prefer politically independent central banks, although they do value banks that finance government debts. Under federalism, the predictions do not vary. The party(ies) that constitute the federal government have less control over fiscal policy because subnational governments compose much of total government involvement in the economy, and such subnational governments generally do not support a dependent central bank that gives more power to the federal government. The common expectation is a combination of flexible exchange rates and independent central banks. The first section of this article provides a brief overview of previous research on the choice of levels of CBI and exchange-rate regime. I consciously build upon William Bernhard, J. Lawrence Broz, and Clark and add material only where it is necessary to explain the argument.4 In the next section, I provide the model, and in the following section, I test the model empirically. The final section offers my conclusions.

Veto Players and Monetary Institutions

The number of veto players is a crucial variable in my analysis. While I will provide a more detailed theoretical discussion of why I think some types of veto players are relevant in my discussion of the model that follows, I offer a deﬁnition here so that the reader may compare my use of the term with other work in the ﬁeld. As George Tsebelis explains, in their simplest form, veto players are institutions, organizations, and/or individuals that have the power to block change from the status quo.5 Two different types of veto players are relevant when considering the joint choice of the level of CBI and exchange-rate regime—party veto players and subnational veto players. I count party veto players as the number of political parties whose assent is needed to change the status quo. In the theoretical section, I reduce

4. Bernhard, Broz, and Clark 2002. 5. Tsebelis 1995, 1999, and 2001. Veto Players and Monetary Institutions 85 the discussion to countries either with one party-veto player or with more than one. The second dimension is the relevance of subnational checks on central government action, which I simplify to a federalist-unitary dichotomous variable. The check on the central government is present in federalist systems but absent in unitary systems.6 In the remainder of this section, I brieﬂy review what the existing literature argues about the effects of veto players on monetary institutions.

Veto Players and Explanations of Central Bank Independence Several scholars argue that increasing the number of some type of veto player increases the discretion of the central bank to determine monetary policy.7 It simply becomes harder for the government to unite to overturn the decision of the central bank when there are more veto players. Who these veto players are, however, and the exact role that they play differ. Susanne Lohmann focuses on Germany, and she notes that the discretion of the Bundesbank increases when the government’s parties do not hold a majority of seats in the upper house of parliament, the Bundesrat.8 Discretion therefore increases when Germany experiences periods of divided government; the number of partisan players in government is not consequential. Bernhard considers a combination of institutional and partisan veto players. He codes countries with “strong bicameralism” and indicates that such states are more likely to have independent central banks.9 Bernhard also creates a “punishment index,” which includes polarization, parliamentary or congressional committee strength, and whether or not a country has a coalition or minority government. Increases in this index lead to greater independence. Neither variable matches completely the deﬁnition provided in this article—strong bicameral states are coded the same way whether one party or more than one party controls them, while the punishment index codes coalition governments and one-party minority governments the same way. But Bernhard’s results are consistent with the argument that increases in veto players increase independence of the bank. Peter Moser, in contrast, focuses on the level of institutional checks and balances for a cross-section of twenty-two Organization for Economic Cooperation and

6. This definition is broadly consistent with two uses of veto players in the literature—Tsebelis 1999 and 2001, which Clark 2002 uses, and Birchfield and Crepaz 1998 and Crepaz 2002. Here I dichotomize the number of party players, which would correspond to the cases for Tsebelis where the ideological distance is zero and greater than zero. The paper’s dichotomy of unitary and fiscal systems also is consistent with the Tsebelis 2001, chap. 6. With regard to Birchfield and Crepaz 1998 and Crepaz 2002, the discussion of party players parallels their consideration of “collective veto points,” although again I dichotomize the variable. The presence of federalism is similarly covered under their definition of “competitive veto points.” One difference is that they also consider upper chambers as additional veto players, while here they are relevant only if they have different partisan majorities than in the lower house. 7. See Lohmann 1998a; Bernhard 1998; Moser 1999 and 2000; and Keefer and Stasavage 2002. 8. Lohmann 1998a. 9. Bernhard 1998. 86 International Organization

Development (OECD) countries rather than partisan control. He creates dummy variables for countries with strong checks and balances, weak checks and balances, and no checks and balances.10 Note that Moser considers (in most cases) the potential for different partisan majorities to control bicameral legislatures, which makes the argument distinct from Tsebelis who counts only actual differences in partisan control.11 Moser produces results to argue that states with strong institutional checks and balances have more-independent banks and lower inflation rates than states without them, even controlling for the level of CBI.12 A final way of considering veto players is to contrast federal versus unitary political systems, which is the second definition used in this article. The idea is that there are additional subnational checks on changes from the status quo in federal systems that are lacking in unitary ones. Indeed, a consistent finding is that federalism is associated with CBI.13 The literature differs, however, on why this association exists. Adam Posen stresses that there is an increase in access points to decision-makers under federalism.14 The financial sector has more opportunities to voice its opposition to higher inflation, which leads to higher readings of CBI. In another article, Lohmann notes that countries where state governments appoint a part of the bank’s council in a federalist country like Germany are more likely to have councils with a significant proportion of members appointed by the current government’s political opponents.15 In sum, there are two fairly distinct ways of looking at veto players and central banks. One view emphasizes the importance of party veto players and insists that institutional veto players do not matter in practice if the same party controls them. The other view emphasizes institutional divisions of power regardless of the partisan control of those institutions, and the available evidence argues for a unitary- federalism dichotomy. In fact, the one exception that looks at checks and balances without partisan players and without federalism, which is Moser, may present as good a measure of federalism as of checks and balances in practice.16

10. Moser 1999 and 2000. 11. Tsebelis 1995 and 1999. Moser 2000 does look, in cases where the coding is unclear, at partisan control and rules a country as having no checks and balances if the same parties always control both houses. Moser codes three countries this way—Belgium, Italy, and Japan. 12. Moser has a problem with the way he formulates his regression equation. He includes CBI, two dummy variables for checks and balances (weak and strong dummies), and terms that interact CBI with the checks and balances dummies. But he does not include CBI alone in the regression. The structure of his regression equation therefore assumes that the effect of CBI on inflation in the absence of checks and balances is zero, and his results by themselves cannot be interpreted as evidence that independent banks are more effective with strong checks and balances. (Thanks to William Roberts Clark for helpful discussions on this issue.) 13. Lijphart 1999. 14. Posen 1993. 15. Lohmann 1998b. 16. Moser 1999 and 2000. The five states Moser classifies as having strong checks and balances are the same OECD states Lijphart 1999 classifies as truly federalist states. Yet one of them, Canada, should not be a case of “strong checks and balances” according to Moser’s own classification scheme, which emphasizes that chambers must have equal power and have different procedures to elect them for the Veto Players and Monetary Institutions 87

While the two types of veto players—party players and the federalism-unitary dichotomy—appear in the literature, there has been thus far no attempt to consider which of these types of veto players can explain more completely the presence or absence of CBI. Moreover, while the literature on the connection between federalism and CBI is fairly developed, less attention has been paid to how party-veto- player differences on their own translate into CBI differences. My discussion of the model in this article will address how different types of veto players lead to different types of CBI.17

Exchange-Rate Regime Choice The relationship between the number of veto players and exchange-rate regime choice is not as developed in the literature. One reason may be that economists have until recently been the predominant authorities on the topic. Exchange-rate regime choice is often considered fairly technical. Much of the work in economics concerns whether a given country would benefit from a change in regime type. Efficiency reasons clearly matter, which is especially the case for the largest and smallest states.18 Yet, as Bernhard, Broz, and Clark’s discussion makes clear, a theory based purely on efficiency grounds is not a sufficient predictor of why states make their exchange-rate regime choices.19 Some scholars do, however, argue that the number of party veto players matters. One group focuses on the ability of countries to maintain fixed exchange rates. Keefer and Stasavage discuss the ability of governments to bear the adjustment costs of maintaining a fixed exchange rate, and they contend that countries with fewer veto players are able to make the necessary adjustments, while countries with many veto players are not.20 Sebastian Edwards makes the same argument for developing countries.21 In a study of the inter-war period, Beth Simmons argues that states with more government instability are more likely to devalue.22 To the extent that

checks to be strong. As Bird and Tassonyi 2000, 11 note, “Canada appears to be unique among federations in the complete absence of any formal representation of provincial interests at the federal level,” and representatives that do sit in the upper house, the Senate, are appointed directly by the federal government. More generally, on Lijphart’s federalism scale from one to five, Moser’s “strong checks and balances” states all score a five, while the average of the remaining states is just 1.9. 17. I ignore here many of the nuanced implications of partial CBI and its interaction with the exchange rate regime; see Franzese 1999 and 2000. 18. Cohen 2003. 19. Bernhard, Broz, and Clark 2002. Another reason for a lack of scholarly attention to the impact of veto players on exchange-rate choice could be because there is no functional reason for multiple-veto- player states to choose a given regime in the first place. Keefer and Stasavage 2002 argue that increases in veto players should not make fixed exchange rates any more effective in fighting inflation. This would suggest that there is no a priori reason why countries with more veto players should be any more likely to adopt one type of exchange-rate regime over another. 20. Keefer and Stasavage 2002. 21. Edwards 1999. 22. Simmons 1994. 88 International Organization one-party governments are more stable than multiparty coalitions, states with one- party governments are more suitable for fixed exchange rates. Bernhard and Leblang make an opposing argument. They consider what is in the best interests of the government of the day.23 In states where the electoral costs of defeat are high, and where electoral timing is exogenous, governments do not want to give up the tool of monetary policy to influence the economy before elections. Conversely, in states where the electoral costs of defeat are low, and where the political opposition is influential in the making of policy, states opt for fixed exchange rates. Such rates allow coalition partners in proportional systems to agree on a focal point. The rates also imply that the government is giving up less when it agrees to fixed exchange rates in states where the influence of the political opposition is high. In practice, majoritarian/low-opposition-influence states, such as the United Kingdom, should opt for flexible exchange rates, while proportional/ high-opposition-influence states, such as Denmark, should opt for fixed exchange rates. In their empirical analysis, Bernhard and Leblang consider the exchange-rate- regime choices of OECD countries for the period 1974–95.

The Model General Framework In developing this model, I attempt both to build upon and to synthesize the two mostly separate literatures on CBI and exchange-rate regime choice (exceptions include the other articles in this volume). I begin with the focus in Bernhard and Leblang on the importance of government type. I also rely upon Bernhard and Leblang’s and Clark’s assumption that governments make choices to further their chances of electoral survival—they choose flexible exchange rates when they judge monetary policy to be the most optimal economic policy to further their reelection chances.24 Unlike Bernhard and Leblang, however, I argue that the choice in exchange rates is not between the use of monetary policy or no policy to manipulate the economy, but rather between monetary policy and fiscal policy. As Clark and Clark and Hallerberg illustrate, in a world of open capital mobility, governments may engage in opportunistic fiscal behavior before elections in countries with fixed exchange rates.25 I also use the broader discussion to consider the choice of an independent central bank. An independent central bank is a device to ensure that explicit political manipulation of the money supply does not occur. States have independent central banks when one or more key veto players stands to lose, or even expect to lose, from manipulation of the money supply and when the losing player can hurt the others.

23. Bernhard and Leblang 1999. 24. See Bernhard and Leblang 1999; and Clark 2002. 25. See Clark 2002 and forthcoming 2003; and Clark and Hallerberg 2000. Veto Players and Monetary Institutions 89

It should be noted that this argument is stronger than the traditional veto-player argument, which only addresses whether one can move from the status quo.

Assumptions about General and Distributional Effects of Monetary and Fiscal Policy

As the Mundell-Fleming model indicates, states can only maintain two of the following three policy options: monetary policy, fixed exchange rates, and open capital. An important corollary to this argument concerns fiscal policy: while monetary policy is effective only under flexible exchange rates when capital is mobile, fiscal policy is effective only under fixed exchange rates.26 This framework has important implications for the choice of the level of capital openness as well as for the exchange rate. A state that chooses to close its capital markets can maintain both fiscal and monetary policy autonomy. A move to mobile capital, however, increases the implications of the choice between flexible and fixed exchange rates. A choice of flexible exchange rates means the choice of effective monetary policy, while a choice of fixed exchange rates means the choice of effective fiscal policy. This discussion is assuming, of course, that states can choose both the level of openness of their capital markets as well as their exchange rate regime. Several authors argue that, after the collapse of the Bretton Woods system, there was a systemic change in the level of capital mobility. Because of new technologies that made it easier for individuals to evade government controls, the elimination of many legal barriers to trade, and the end of the Bretton Woods system, states may have lost the ability to control capital by 1973, if not earlier.27 It is also possible that capital controls simply became less and less effective as time progressed from the late 1960s. At some point, probably by the mid-1980s, capital controls in industrialized countries became ineffective. One can also debate the degree to which the exchange-rate regime was really a choice variable. But unlike the discussion of capital mobility, the question is whether the exchange rate regime was a choice variable before the collapse of Bretton Woods. Through the early 1970s, most OECD states maintained fixed exchange rates as part of the Bretton Woods system. There were, of course, occasional realignments, but in general, countries pledged to maintain fixed exchange rates. When the system collapsed, the type of exchange rate became a choice variable at roughly the same time that the capital mobility ceased to be a choice variable. The Mundell-Fleming model tells us that the type of macroeconomic policy that is effective, monetary or fiscal policy, became a choice variable as well.

26. See Mundell 1963; and Fleming 1962. 27. See Frieden 1991; and Andrews 1994; for an overview see Hallerberg and Clark 1997. 90 International Organization

Under capital mobility, states can no longer enjoy the macroeconomic benefits of manipulating both types of policy.28 Certain characteristics about how the two types of policy boost the economy provide guidance about why governments would prefer one policy type over another. First, it is more difficult to target monetary policy than fiscal policy to different groups. Looser monetary policy makes borrowing cheaper, and cheaper money leads to more spending and to an increase in economic growth. It therefore helps an incumbent by raising all boats and making content voters more likely to support them. Looser monetary policy does have clear distributional implications— domestic holders of capital receive lower returns from their holdings, while borrowers have to spend less—but parties are not able to focus the effects of looser money on different constituencies over different elections.29 In contrast, fiscal policy boosts the economy when the state consciously worsens the balance of the budget, and, in most cases, borrows money to pay for the temporary boost. How the government distributes the cash is largely up to it: it can cut taxes on everyone in the population with an across-the-board tax cut, or it can appeal to particular constituencies by cutting just sales taxes (an appeal to consumers) or taxes to particular income groups (the middle class). The same is the case for increases in spending. When the exchange rate is fixed, the government can target benefits to specific groups in society while at the same time boosting the economy, which results in spending for particular groups leading to a concomitant general boost to the economy. A second difference between the two policies is the legacy of their use. How these costs and benefits play out in the long run differs across the policy areas. Looser monetary policy leads to higher inflation, either just before the election or during some time period after it.30 Monetary contractions, with their concomitant reduction in economic growth, can correct the higher inflation. Higher budget deficits too can be corrected in a similar fashion, but there may be a temptation to allow the gross debt level to ratchet up. Presumably, the effects of higher inflation are more painful than the comparatively low movement upward in the gross debt burden. The absolute level of the debt is crucial here—the higher it becomes, the greater the restriction on the use of fiscal policy even for nonpolitical reasons. Yet before moving on, a key assumption in much of the opportunistic political business cycle literature about costs must be stressed—the country is a net loser

28. The emphasis on choice is not uncontroversial. McNamara 1998, 10, argues, for example, that there were no options other than monetary orthodoxy after the end of Bretton Woods. She emphasizes that states “must be willing to rule out the use of monetary policy as a weapon against broader societal problems, such as unemployment or slow growth. Instead, governments must be willing to stake their credibility on walking the plank of rigorous orthodoxy—support for exchange rate stability and inflation control above all other macroeconomic goals.” 29. Frieden 1994. 30. Standard models of opportunistic monetary cycles such as Nordhaus 1975 assume that inflation comes after the election. Alesina and Roubini 1997, however, express skepticism that inflation can be so easily delayed until after the election. Veto Players and Monetary Institutions 91 from such manipulation.31 Net costs in aggregate are higher than net benefits because of economic inefficiencies. On the monetary side, inflation is higher than it would be in the absence of political cycles. Borrowers pay higher interest rates than they should and make decisions that lower overall economic growth. The spike in inflation, however, can be relatively short-lived and is correctable with tighter monetary policy, albeit with some economic pain. On the fiscal side, expansive budgets in election years lead to higher government borrowing than would be the case in the absence of fiscal political business cycles. Higher government borrowing can have similar costs, but the nature of those costs differs. Short-term borrowing is not that problematic if it is repaid immediately after elections. Borrowing over a longer period of time, however, can ratchet up the overall debt burden. This increase in debt can make fiscal policy less effective over time. A country like Belgium, for example, must now maintain primary budget surpluses to pay interest costs and to pay down its large debt burden. A third dimension is jurisdiction. Monetary policy affects directly the economy where the money is circulated. A given currency has traditionally been restricted to national borders. There are, of course, important exceptions. Some countries adopt another country’s currency. If that country is small relative to the country whose currency it is adopting, the country does not serve as an effective veto player in its own right on the setting of monetary policy; examples include Panama’s use of the U.S. dollar or Monaco’s adoption of the French franc. In the case of the European Union (EU), jurisdiction of the euro extends across twelve countries as of 2001. Both the practice and the discussion of such multilateral regimes are expanding. Yet the more general point is clear—monetary policy has traditionally been a national policy tool, albeit one that is rapidly becoming deterritorialized.32 Monetary policy is also usually national, and not local, in terms of decision- making. This is practically true by definition—if regional banks are allowed to circulate their own currencies, as banks indeed did under the Zollverein in pre- unification Germany, then one cannot speak of a common currency. Yet there is one way that subnational governments can participate at least indirectly in the making of monetary policy. In some countries, such as in Germany, the state governments appoint a part of the governing council’s members. The relevant actors are therefore at the national level rather than the regional or state level, although it is possible that subnational governments appoint some or most of the governing board. In contrast, fiscal policy has different characteristics. Like monetary policy, it begins at the national level. The degree to which it is centralized, however, is in this case a variable. Some states centralize most spending and taxation decisions with the national government. Other states, in particular those in a federation, decentralize

31. An important exception in the literature about the nature of costs and political business cycles is Clark forthcoming. He argues that political business cycles could imply more economic expansions than elites may want, but that the expansions could beneﬁt the average voter. The welfare implications of having political business cycles are then not straightforward. 32. Cohen 1998 and 2003. 92 International Organization

TABLE 1. Key differences between monetary and ﬁscal policy

Monetary policy Fiscal policy

Targetability to particular groups Difficult Easy Effective in manipulating the economy Flexible Fixed exchange rate under capital mobility with costs Exchange rate Higher deficits, potentially Higher inflation Higher debt burden Jurisdiction National National, state, and local Decision-making National National, state, and local Ease of understanding, policymakers Difficult Easy

fiscal policy. This suggests that the level of decision-making on fiscal policy can also be a variable.33 The final difference is the ease of understanding of the two policies. Monetary policy can be rather arcane and requires much information to run effectively.34 Revenue and expenditure questions, in contrast, are less technical. Table 1 summarizes the key differences between fiscal and monetary policy. These characteristics affect the relative efficiency of using a given policy tool for political means. A national government that wants to target specific constituencies will generally find that fiscal policy is a more efficient tool than monetary policy. Similarly, a national government in a unitary system where subnational government spending is negligible will find that fiscal policy is a more efficient tool than in a state where subnational governments have significant budgetary authority. The following example illustrates this point. Consider two states that each have general governments that control approximately 40 percent of the national economy. One state’s central government has complete control over government spending, and it chooses to run a 2 percent deficit before an election to boost the economy. The second state’s central government, in contrast, controls just one-third of general government spending.35 It must run a 6 percent budget deficit to get the same “bang” for the economy. If one assumes that the marginal costs to a policy are constant, the fiscal expansion is three times as costly politically in the second state than in the first one. I return to these points in the next section after I discuss the relevant actors in the choice of monetary institutions.

33. It is not simply the ratio of central government to total government spending that is crucial. In some states, spending may be decentralized while decision-making is centralized. Denmark is an example. 34. Bernhard 1998. 35. This argument assumes that the translation of ﬁscal policy expansions into economic growth is roughly equal across countries. Veto Players and Monetary Institutions 93

Actors, Preferences, and Strategies On one end of the equation, the relevant actor set includes voters who elect governments. At the other end are actors who can veto changes in the two main policy instruments for manipulating the macroeconomy and monetary and fiscal policy. I focus on party veto players, and in particular party veto players at the national level. I also consider the absence or presence of subnational veto players. I begin with a discussion of voters. I take the standard assumption that voters are retrospective and that they reward the incumbent for good performance and punish the incumbent for poor performance. Following Guido Tabellini, I add the assumption that voters differ in their reservation utilities.36 Some voters are fairly easy to please and are likely to support the incumbent. Others, however, are more difficult to please and are unlikely to support the incumbent. While the government does not know the reservation utility of an individual, it does know the general distribution of the reservation utilities. Moreover, direct government appeals to specific groups can affect their decisions to support or oppose the government. These assumptions suggest, therefore, that government manipulation of the economy can sway some voters. The first assumption concerning party veto players is the common one that they are office-seeking.37 If they are in government, they want to stay in government. When the end of the Bretton Woods system forced them to choose between fixed and flexible exchange rates and, by implication, between effective fiscal or monetary policy, political parties were interested in the policy that was most likely to help them win elections. Similarly, parties will select a given level of CBI based on their assessment of how an independent central bank can further their election goals. When they consider the adoption of certain monetary institutions, parties want to maximize the net electorate benefits from using them. Two variables play an important role. First, ideally, parties would have voters identify their party as responsible for any benefits while identifying opponents as responsible for any 38 costs. Party IDENTIFIABILITY with outcomes is therefore crucial. Second, the parties care about their CONTROLLABILITY of a given policy area. Differences in both variables can be traced directly to the type of electoral system in place. Proponents of plurality systems have stressed for decades that an important advantage of such systems over proportional representation is that they guarantee a defined government and a defined opposition.39 In other words, voters can identify who is responsible for a given policy under plurality systems. There is a two-fold reason for this. First, plurality systems lead (more or less) to two competitive parties who compete with one another, and the presence of two major parties all but

36. Tabellini 2000, 11. 37. Mayhew 1974. 38. See Whitten and Powell 1993. Note that this concept is related to accountability, but is not the same thing. Voters may be able to identify a party with a given outcome but not be able to hold that party accountable at the polls. 39. See, for example, Independent Commission on the Voting System 1998. 94 International Organization guarantees regular one-party-majority governments.40 Second, voters cast votes for individuals, and they can defeat individuals whom they think perform poorly directly at the polls. In contrast, proportional representation systems often (but not always) have coalition governments composed of several parties. Voters have difficulty identifying which party is responsible for beneficial, and which party for costly, policies in a coalition government. Second, the traditional literature argues that voters have an easier time punishing parties under plurality than under proportional representation. With a clearly identified government and a clearly identified opposition, changes in voter support send clear messages. Because there are usually only around two parties that compete against one another, drops in seats below 50 percent usually translate into a change in government.41 In contrast, in coalition governments, the election results merely provide the parties with potential “shares” towards a majority in parliament (or, in some cases, with enough of a minority plus enough opposition tolerance that assures a government). After the elections, parties negotiate among themselves to determine what coalition of parties will become the next government. It is conceivable that all parties in a government could gain seats in an election, but that, for whatever reason, one of the parties is left out of the next government for one of the opposition parties. Conversely, the parties in government could all lose seats, but, by adding a new partner, remain in government. Finally, electoral systems shape the electoral strategies of parties, and these strategies have a direct bearing on identifiability. Torsten Persson and Tabellini argue that parties under plurality need to win only a majority of districts across the country.42 They therefore target marginal districts, and they provide narrowly focused goods to those districts. They hope to be identified with improving the economic conditions of marginal districts at election time. In contrast, under proportional representation, parties have little to gain from being identified with the improvement of specific districts. They do, however, have reason to target broad constituencies that are distributed across the country that can deliver votes. Focusing on the number of candidates per electoral district (or district magnitude), Gian Maria Milesi-Ferretti, Roberto Perotti, and Massimo Rastagno offer supporting empirical evidence in OECD countries.43 They find that transfer payments are higher in states with higher district magnitudes, while spending on goods that can easily be targeted to particularistic groups is higher in states with low district magnitudes. The positive relationship between district magnitude and the number of political parties in the legislature is well established.44 For my analysis, which is concerned with party veto players, the higher the number of effective parties, the lower the probability of one-veto-player governments. Coalition governments become the

40. Duverger 1954. 41. Duverger 1954, 42. Persson and Tabellini 2000. 43. Milesi-Ferretti, Perotti, and Rastagno 1999. 44. Taagapera and Shugart 1989. Veto Players and Monetary Institutions 95 norm. Note too that the crux of the broader debate between proponents of plurality and proportional representation usually focuses on the implications of the system for the voter. Yet the concern here is with how electoral systems structure party choices of monetary institutions. The logic becomes clear when we bring together the variable IDENTIFIABILITY and the second important variable, the CONTROLLABILITY of either fiscal or monetary policy. The concept of controllability is the ability of an incumbent political party to manipulate the economy with a given policy. The choice variables are as follows. With regard to the central bank, conceptually I rely upon the two types of independence discussed in Vittorio Grilli, Donato 45 Masciandaro, and Tabellini. POLITICAL independence measures the extent to which the bank can make decisions that are counter to the government’s wishes. Their measure of political independence includes items such as who appoints the governor and the board of directors, the length of their tenure, and statutory provisions that strengthen the power of the bank versus the government. DEFICIT-FINANCING independence considers the ability of the central bank to formulate its economic positions independently from the government. In the empirical section, I include five measures of the extent to which the bank must finance the government’s budget deficit; this is an abridged version of Grilli, Masciandaro, and Tabellini’s economic independence index. It is possible that a government prefers a politically independent, but deficit-financing dependent, central bank. With regard to the exchange rate, I follow Clark and Hallerberg and assume the dichotomous choice of either flexible or fixed rates.46 There are four potential configurations of party and subnational veto players, and I discuss their implications for monetary institutions in the following section.

One Party Player, Unitary System. This combination of veto players is common in plurality countries like the United Kingdom. Identifiability of economic outcomes with the government and controllability of the policy instrument suggest that such governments prefer monetary policy autonomy over fiscal policy autonomy. Voters can identify the party that does something, positive or negative, to the economy. Such states often have low district magnitudes, and monetary policy can be a useful tool to shift the location of the ideal marginal district. The fact that monetary policy cannot be targeted to specific groups is not problematic; so long as the economy is strong, the incumbent is likely to win. Keep in mind that flexible exchange rates do not rule out the use of fiscal policy to influence marginal districts with narrowly focused spending programs; flexible exchange rates only mean that spending on individual districts will not lead to an additional boost of the economy. Moreover, as Persson and Tabellini as well as Milesi-Ferretti, Perotti, and Rastagno suggest, the overall size of the public economy is smaller in countries with low district magnitudes for reasons discussed

45. Grilli, Masciandaro, and Tabellini 1991. 46. Clark and Hallerberg 2000. 96 International Organization earlier.47 This suggests that monetary policy would be a more efficient means of boosting the economy than fiscal policy. In terms of controllability, the party that controls the government has unambiguous control over monetary policy so long as the central bank is dependent upon the government. This discussion also has consequences for the independence of the central bank. A politically independent central bank would take away the monetary policy tool the government could use to manipulate the economy. There is therefore no reason for the government to support a politically independent central bank in such systems. Deficit-financing independence is less relevant in this case so long as the government can control the timing of monetary expansions.

Multiple Party Players, Unitary System. The classic example would be a country like the Netherlands. It has had no one-party majority governments in the postwar period. Unlike in the one-party case, the expectation is that multiparty coalition states will prefer fiscal policy to monetary policy. None of the electoral systems in place in OECD countries allows the electorate to vote for the coalition as a whole; instead, voters must decide which party, or candidate from a party, to support in the election. A general increase in the economic welfare may lead to an expectation that the coalition will benefit generally, but it is not at all clear that the parties will benefit equally. Voters may overly compensate the party that controls the finance minister, or the largest party, or whatever party has avoided recent scandals. Similarly, the distribution of “punishments” for higher inflation may not fall equally on all coalition partners.48 Moreover, even the timing of the punishment is more difficult to control—the withdrawal of a party from a coalition can cause early elections and force elections during the expected monetary contraction after the election.49 A second problem with the use of monetary policy under multiparty governments concerns controllability. Effective monetary policy requires both knowledge about the state of the economy, which can change fairly quickly, and an understanding of key economic fundamentals. It is therefore a difficult tool for any government to use based on regular cabinet decisions, and, consequently, if the government sets monetary policy largely on its own, decisions are usually made in one ministry (usually the finance ministry). Disagreements about the course of monetary policy within a coalition government where one party has the most information and/or expertise about policy can cause the coalition to fall.50

47. See Persson and Tabellini 2000; and Milesi-Ferretti, Perotti, and Rastagno 1999. 48. Goodhart 2000. 49. This argument takes a seemingly opposing view to Broz 2002. Broz argues that, where transparency is high, states opt for independent central banks and ﬂexible exchange rates. Yet the arguments are not on their face incompatible—for Broz 2002, transparency is important because of the credibility of the institution for keeping low inﬂation, and in practice the key difference between high and low transparency is between democracies and nondemocracies. 50. Bernhard 1998. Veto Players and Monetary Institutions 97

Fiscal policy autonomy, in contrast, offers coalition parties a chance to target spending increases and tax cuts on specific constituencies. The expected, somewhat untargeted, economic boost from a fiscal expansion will come too, but the focused tax cuts and/or increased spending can reduce the uncertainty about electoral consequences for political parties. Coalition governments should therefore prefer fixed exchange rates. This discussion also has implications for the desirability of an independent central bank. On the one hand, coalition partners are unlikely to trust one party player in the government with the task of maintaining monetary policy.51 This will be the case if there is any difference in inflation preferences among the party actors, even in the presence of fixed exchange rates. On the other hand, it may be useful for the bank to finance government budget deficits if larger deficits are expected. This suggests that political independence of the bank should be high, but deficit-financing independence should be low so that the bank supports the fiscal policy of the government.

One Party Player, Federal System. The combination of no effective upper chamber and a plurality electoral system in Canada leads to regular, one-party veto player governments in a federal system. The move to a federalist system, which entails a significant loss of the total amount of fiscal policy the central government controls, should make governments even warier about choosing effective fiscal policy over monetary policy. There are two reasons for this result. The first concerns the amount of extra spending/tax cuts needed to reach the same effect in a federal state. As the previous section shows, the central government must spend proportionately more of its budget in a federalist country than in a unitary one to have the same effect on the economy. A second, related problem is a possible substitution effect at the state and local level. Increased spending at the federal level could lead states and local governments to cut back their own spending. The costs of using fiscal policy to manipulate the economy would be even greater. In contrast, monetary policy is relatively effective across the country. In terms of CBI, there are two countervailing pressures. Like their one-party colleagues in unitary governments, national governments want a politically dependent bank. The lower levels of government, however, will suffer from the inevitable economic costs of the manipulation of the money supply. Remaining in a strict opportunistic behavior model, one would expect state governments to tolerate dependent banks only if (a) voters do not punish state governments for economic conditions in the state but vote on the basis of noneconomic criteria or (b) elections happen at the same time at all (relevant) levels of government. Examples of federalism do not generally fit into these categories. In Canada, provincial elections are not timed to coincide with national elections. In Germany, Land elections are

51. Bernhard 1998. 98 International Organization often seen as mandates for or against the federal government, and the economic conditions in a given Land are important. Most Land elections are not the same time as federal elections. In the United States, many gubernatorial elections do not coincide with presidential elections, and, while there is some reason to doubt that governors have much control over the economic conditions of their state, there is evidence that voters reward or punish governors based on the health of the economy.52 When considering deficit-financing independence, it is hard to see why either lower levels of government or, for that matter, central governments with flexible exchange rates, would want dependent banks. Lower levels of government generally lose if the central government runs budget deficits. For the central government’s part, there is little reason to use fiscal policy to influence the economy or to have the central bank support expansions through deficit financing. In sum, to the extent state governments have any say in the design of the central bank, they will opt for a politically independent bank that controls the opportunistic behavior of the national government. Given that the principal actors in designing a federal constitution are states themselves, it is likely that the states will prevail in establishing an independent central bank. So long as the national government maintains a floating-exchange-rate regime, deficit-financing dependence makes little sense.

Multiple Party Players, Federalist System. The use of proportional representation makes multiple party players the norm in Germany even without an upper legislative chamber, while the election of the President, House of Representatives, and the Senate according to plurality but across different types of constituencies makes “divided government” in the U.S. presidential system common. The prospects for effective fiscal policy are likely to become even drearier for countries in this category. Multiple institutional veto players can expect to control relatively less fiscal policy than monetary policy. It is often the case that the power of a given player is asymmetric—it is easier for a player to block additional spending than to generate new spending.53 Once again, central banks are likely to be strongly independent in such countries. The same reasons for political independence given in the one-party-player/federalism case remain. The increased discretion to maintain a given monetary policy in terms of deficit-financing independence also should increase so long as elections are again not at the same time and the approval of different institutional veto players is required to pressure the bank to initiate pre-electoral monetary expansions. Table 2 summarizes the predictions of the type of monetary institutions expected under the four possible combinations of party and institutional veto players. The expectation is that central banks will be most dependent in the one-party, unitary

52. Hansen 1999. 53. See Kiewiet and McCubbins 1988 for the U.S. case. Veto Players and Monetary Institutions 99

TABLE 2. Predictions from a veto player approach

Party veto players (one party vs. multiparty)

12ϩ

Subnational Players Unitary Dependent central banks Intermediate independent (Unitary vs. (low political, low central banks (high political, Federal Systems) deficit-financing), low deficit-financing), fixed flexible exchange rates exchange rates (Netherlands) (United Kingdom) Federal Intermediate independent Highly independent central central banks (low/high banks (high political, high political, high deficit- deficit-financing), flexible financing), flexible exchange rates (Germany) exchange rates (Canada)

Notes: “Political” refers to the ability of the government to control the central bank directly, while “Deficit-financing” refers to whether the central bank is required to finance government policy, specifically government debts.

case and most independent in multiparty, federal system case. The remaining combinations should prefer intermediate levels of independence. In terms of exchange-rate regimes, the only types of states expected to fix are found in the multiparty, unitary system case. Before continuing, it is important to discuss an alternative specification common in the political business cycle literature, which looks at the preferences of political parties themselves.54 The argument would be that Right parties prefer lower inflation and this difference with Left parties would translate into different monetary institutions. As Simmons argues for the interwar years, it could be that Right parties are more likely to defend exchange-rate pegs than Left parties.55 Similarly, central banks that Right parties established should be more independent to fight inflation than those that the Left established.56 As Clark argues, each of these arguments would presume that institutions constitute the “frozen” preferences of parties.57 Such an argument would have to assume that costs to changing the institution were high so that changes in the monetary institutions would not occur after every change in government. Determining the relevant party players at the time of the founding

54. Hibbs 1977. 55. Simmons 1994. See also Bearce 2002 for a similar argument about partisan effects under capital mobility. 56. On the connection between CBI and low inflation, see Bernhard, Broz, and Clark 2002 and the review in Berger, de Haan, and Eijffinger 2001. 57. Clark 2002. 100 International Organization of the central bank is beyond the scope of this article, but I will examine the partisan argument when considering exchange-rate choice. At the same time, even finding confirmation of a partisanship effect does not necessarily invalidate the argument made here. The veto-player approach may explain why some institutions are “stickier” than others.

Evidence

In this section, I compare the institutional choices most OECD countries made in the postwar period.58 I address whether there is any empirical support for the model I have developed. I make two crucial assumptions. First, costs to changing a given institution are nontrivial. It is difficult, and costly, to generate credibility either for fixed exchange-rate regimes or for independent central banks.59 Changes in institutions therefore take place but are fairly rare. Second, I assume that the creation and destruction of the Bretton Woods system are events exogenous to the model. The Bretton Woods arrangements were systematic; that is, they were imposed upon the industrialized world after World War II. This is not to say that states did not benefit from Bretton Woods or that divergent preferences led to the system’s collapse. Rather, the key assumption is simply that there was not a clear choice of exchange- rate regime for most countries until the Bretton Woods system was no longer present. In contrast, states chose a given level of CBI in the immediate postwar period or at some time before. They chose CBI in a period where capital was generally immobile. Governments were therefore deciding whether to forego monetary policy or to keep it, but fiscal policy remained autonomous because of generally closed capital. This situation changed with the collapse of the Bretton Woods system. As capital became mobile, states had to make a choice between fixed exchange rates, and the fiscal policy autonomy that came with them, and flexible exchange rates, and the monetary policy autonomy that could have accompanied them in the absence of an independent central bank. This discussion suggests that, as a first cut, one can compare the historical occurrence of party veto players and federalism after World War II and standard measures of CBI. Second, one can break down exchange-rate regime choice into two periods—the initial years after the collapse of Bretton Woods, or 1974–79, and the later years when capital was becoming increasingly mobile, or 1980–91. The beginning and end points correspond to the first year after the clear end of the Bretton Woods system and the year of the Treaty of Maastricht

58. Lack of consistent data on CBI makes it necessary to exclude Iceland, Luxembourg, Portugal, and Turkey. Spain is included only when it was a democracy. 59. Clark 2002. Veto Players and Monetary Institutions 101 signed by the twelve European countries that then belonged to the European Community.60 I divide the countries into the four possible veto-player combinations and compare the monetary institutions states had in place. I then consider the robustness of the argument when compared with other explanations. I introduce the veto-player variables as described here to the data sets and methodologies described in Bernhard for CBI and Bernhard and Leblang for exchange-rate regime choice.61

Central Bank Independence

I begin with a discussion of CBI. I first consider general measures of CBI common in the literature. The argument developed here suggests that there should be differences between political and deficit-financing independence, and I also break down the measure of CBI in Grilli, Masciandaro, and Tabellini according to these two categories.62 Table 3 displays the average CBI of OECD countries according to the two dimensions of one or more than two party-veto players and unitary or federal systems of government. The average CBI score is the one reported in Bernhard.63 He averages three popular indices developed in the early 1990s.64 The table indicates that increases in veto players generally increase CBI. The jump from unitary to federal systems, however, leads to greater independence than the change from one party-veto player to many players. One surprise is that there is little apparent difference between multiparty and one-party unitary states in these aggregate indices—the average score of 0.42 is only slightly higher than 0.39. It appears that the only difference in veto players comes from the move from unitary to federal forms of government. Yet this conclusion would be too dismissive. The average scores reported in Bernhard factor in many ways of measuring CBI. Table 4 breaks down measures of independence according to the two dimensions of political and deficit-financing independence derived from Grilli, Masciandaro, and Tabellini. Table 4a presents an ordinary least squares (OLS) analysis of political independence and deficit-financing independence on a zero-to-one scale according to the

60. The decision to move forward with Economic and Monetary Union for individual countries includes additional policy issues than the decision for a fixed or flexible exchange rate. The period after 1991 therefore does not represent a good test of the hypothesis developed here. 61. See Bernhard 1998 and Bernhard and Leblang 1999. I also considered the methodology provided in Moser. The correlation between his average measure of CBI and Bernhard’s 1998, however, is 0.95. 62. Grilli, Masciandaro, and Tabellini 1991. 63. Bernhard 1998, 312. 64. Those indices appear in Grilli, Masciandaro, and Tabellini 1991, Alesina and Summers 1993, and Cukierman 1992. Bernhard 1998 made a minor error in rescaling the GMT data, which is on a sixteen-point scale but which he divided through by fifteen. This slightly inflates the independence of central banks according to GMT. As a consequence, corrected figures for the average of the three indices used here are either 0.01 or 0.02 lower than Bernhard 1998, 312, reports. 102 International Organization

TABLE 3. Independence: Average central bank independence and the number of veto players

Party veto players (one party vs. multiparty)

12ϩ

Subnational players Unitary New Zealand (.24), Spain (.30), Italy (.31), Belgium (.38), (Unitary vs. Japan (.39), Norway (.39), France (.41), the Federal Systems) Sweden (.39), Britain (.4), Netherlands (.56) (.42) Ireland (.48), and Denmark (.53) (.39) Federal Australia (.46), Canada (.59) Austria (.59), Germany (.53) (.82), Switzerland (.81), US (.71) (.73)

Note: Data are averages of Grilli, Masciandaro, and Tabellini 1991, Alesina and Summers 1993, and Cukierman 1992, and are based on Bernhard 1998, 312. Higher ﬁgures indicate greater independence. Figures reported in parentheses in bold are averages for the countries in the given cell. Coun- tries that have a majority of one-party governments during the period 1960–90 are coded as having one veto player, while countries with two or more veto players are coded as 2ϩ. Opposing majorities are counted in second chambers where second chambers can block ﬁnancial legislation according to Tsebelis and Money 1997.

number of veto players.65 Table 4b provides the averages for each possible configuration of veto players. Both theoretical expectations are confirmed. One- party unitary governments easily have the most-dependent banks on the political scale, with an average measure of 0.21. Moreover, for both unitary and federal states, there is a clear jump when one moves from a one-party government to a multiparty government, and the party-veto-player variable is statistically significant at the p ϭ .04 level. In contrast, for the deficit measure, two-party unitary governments have the most-dependent central banks. It is also the only case where one would expect fiscal political business cycles. The main difference in this case is the move from unitary to federal systems, however, where states uniformly free their central banks from financing the (central) government deficit. This finding is consistent with the argument presented earlier that federal states have little reason to pursue fiscal political business cycles.

65. The political independence index is on a scale of one to eight, while the financing of the budget balance is on a scale of one to five. I focus on the financing of the budget only for the economic independence measure. This is done for two reasons; first, it is unclear how bank supervision requirements affect the government’s ability to force the bank to finance its deficit; and second, Grilli, Masciandaro, and Tabellini 1991 allow the bank supervision subindex to range from zero to two instead of zero to one, which overemphasizes its importance. There is no substantive difference in results when the full index is used instead of the independence from financing the deficit subindex. Veto Players and Monetary Institutions 103

TABLE 4A. Regression analysis using political and deﬁcit-ﬁnance independence as measures of central bank independence

Dependent variable: Dependent variable: independence from political independence ﬁnancing deﬁcit

Coefﬁcient Coefﬁcient (standard error) p (standard error) p

2ϩ Party Players .20* (.09) .04 Ϫ.09 (.11) .46 Federalist country .22 (.13) .11 .41* (.15) .02 Federalism Ϫ.04 (.17) .80 .04 (20) .18ءParty Constant .22** (.06) .002 .22** (.06) .002 N ϭ 20, F (3, 16) ϭ 4.92, p Ͼ N ϭ 18, F (3, 14) ϭ 6.47, p Ͼ .01, r-squared ϭ 0.48, Adj .006, r-squared ϭ 0.58, Adj R-squared ϭ 0.38. R-squared ϭ 0.49.

Note: Figures for political independence and financing the deficit are from Grilli, Masciandaro, and Tabellini 1991, 368–69. Grilli, Masciandaro, and Tabellini do not report figures for Norway and for Sweden. The comparison with Table 3 is therefore not exact. Moser 1999 provides data from Eijffin- ger, Sylvester, and van Keulen 1995 for Finland and Norway that is not included in Grilli, Mascian- daro, and Tabellini for the political independence regression that are included here.

A useful question to ask is how well this explanation compares with Bernhard.66 Unfortunately, it is not possible to include all of the relevant variables in a regression. There is a serious problem of multicollinearity—the correlation between Bernhard’s strong bicameralism and the federalism measure here is 0.76, for

66. Bernhard 1998.

TABLE 4B. Comparison of veto players with central bank political independence and independence from ﬁnancing the deﬁcit

Party veto players 1 2ϩ

Unitary states Political independence .21 .42 Debt-ﬁnancing independence .49 .4 Federal states Political independence .44 .59 Debt-ﬁnancing independence .9 .85

Note: The averages can be computed directly from the coefﬁcients from the regression in Table 4a. 104 International Organization example. In fact the only difference between the two variables is that I code Austria and Canada as a one, as federal countries, while Bernard codes those countries as not having a strong second chamber and, consequently, as a zero. Similarly, the Spearman rank correlation between multiple party veto players and Bernhard’s punishment index is a fairly high 0.56. Such correlations indicate serious problems when there are only eighteen countries in the data set.67 It may be that strong bicameralism is a result of federalism, for example, but one cannot dismiss with so few cases that what matters with federalism is that most federalist states have strong second chambers. Yet the results do indicate an answer to a question posed earlier in this article. The brief review of veto players and central banking indicated that there was not a consensus exactly on how veto players affected CBI. This section shows that different veto players have different effects on the bank. Where there is just one party-veto player, the bank is more likely to be politically dependent. Concerning the bank’s funding of the budget deﬁcit, however, federal systems are most likely to be most independent.

Exchange-Rate Regime Choice I begin with simple bivariate comparisons as in the previous section. I also, however, consider the usefulness of the argument in a multivariate setting based upon a comparison with Bernhard and Leblang.68 Table 5 compares eighteen OECD countries according to the two dimensions of party veto players and unitary-federalist forms of general government during the periods 1974–79 and 1980–91 for exchange-rate choice.69 States that the theory accurately predicts are printed in bold. For the period 1974–79, sixteen of eighteen countries have exchange-rate regimes consistent with the theory. The errors were for small European states that we expected to have flexible exchange rates but that had fixed rates—Austria and Norway. The results are similar for the period 1980–91. Capital mobility is presumably increasing during this period, which would make the choice between fiscal and monetary policy especially stark. Once again, correct predictions are in bold, and fifteen of eighteen states have exchange-rate regimes consistent with the argument. Two of the three misses are in the unitary one-veto-player box. They are also Scandinavian countries that had regular one-party minority governments in the

67. I did nonetheless perform the regression analyses. I included only Bernhard’s 1998 punishment index, which was not as correlated with the variables in the veto player regressions as the strong bicameral variable. The punishment index had no effect on the independence from financing the deficit index, but it was significant at the p Ͻ .08 level and it had the correct sign for the political independence index. This result is not surprising given the emphasis in Bernhard on concerns about delegating monetary policy to one player where the punishment index is high. 68. Bernhard and Leblang 1999. I am indebted to William Bernhard, David LeBlang, and Peter Moser for making their data sets available to me. 69. The categorization of fixed and flexible exchange rate regimes is from Clark and Hallerberg 2000. Veto Players and Monetary Institutions 105

TABLE 5. Veto players and exchange-rate regime choice 1974–79 and 1980–91

Party veto players (one party versus multiparty)

2؉ 1 Prediction: Flexible Prediction: Fixed

Subnational veto players 1974–79 1980–91 1974–79 1980–91

Unitary Britain, France, Britain, Belgium, Denmark, Belgium, Denmark, NewZealand, NewZealand, Finland, Ireland, Finland, France, Italy, Japan, Japan, Norway, Netherlands, Ireland, Italy, Norway Sweden, Spain Sweden Netherlands Prediction: Flexible Prediction: Fixed

Federal Australia, Canada Australia, Canada Austria, Germany, Austria, Germany, Switzerland, U.S. Switzerland, U.S.

Sources: Woldendorp, Keman, and Budge 1998, and Newman 1999. Note: Countries that appear in bold match expectations. Spain is excluded from 1974–79 because it did not become a democracy until 1977.

1980s. It may be that one-party minority governments cannot survive well under flexible exchange rates for two reasons. First, opposition parties do not like giving an identifiable tool like monetary policy autonomy to a one-party minority government. Second, fiscal policy spending can buy votes from the opposition while boosting the economy. Finally, the argument in the theoretical section focused especially on one-party states with low district magnitudes. Norway and Sweden had higher district magnitudes than the remaining states. Yet the results at this stage can only be suggestive. While they generally conform to expectation, there may be rival explanations that do a better job of explaining the patterns in the data. Bernhard and Leblang argue that, in political systems where the costs to electoral defeat are high and electoral timing is exogenous, governments are less willing to lose monetary policy autonomy through a fixed exchange rate. They measure states according to dummy variables for whether they are majoritarian-low opposition influence, proportional-low opposition influence, or proportional-high opposition influence, and whether they have exogenous timing of elections. They provide a sophisticated test of their argument that uses a battery of control variables. One explanation they consider is the effect of partisanship and including a measure for partisanship. Other variables include: economic openness; vulnerability to shocks; capital mobility; domestic macroeconomic conditions; and a set of political variables, election year, a legal definition of CBI, whether a country is European, and whether a country is a member of the European Community.70 They use both

70. For details about the expected effects of these variables, see Bernhard and Leblang 1999, 84. 106 International Organization

TABLE 6. Binomial logit of exchange-rate choice (1 ϭ ﬁxed exchange rate)

Variable Coefﬁcient (std error) Probability

FEDERAL STATE 1.40 (1.75) .421 MULTIPLE PARTY VETO PLAYERS 1.80 (.63) .004 FEDERAL ϫ MULTIPLE PARTY Ϫ5.90 (1.95) .003 CONDITIONAL COEFFICIENT: MULTIPLE PARTY Ϫ4.09 (1.80) .027 WHEN FEDERALISM ϭ 1 MAJORITARIAN-LOW OPPOSITION Ϫ5.00 (1.45) .000 PROPORTIONAL-LOW OPPOSITION Ϫ5.22 (1.48) .000 ELECTORAL TIMING Ϫ4.98 (1.23) .000 OPENNESS 6.70 (2.73) .014 DOMESTIC CREDIT SHOCK .00 (.001) .624 CAPITAL CONTROLS 1.77 (.70) .011 INTERNATIONAL CAPITAL MOBILITY 6.93e-06 (3.88e-06) .074 ECONOMIC GROWTH Ϫ99.42 (53.25) .062 PARTISANSHIP .26 (.58) .652 ELECTION YEAR .20 (.47) .671 EUROPE 4.11 (.86) .000 EC MEMBERSHIP 1.92 (1.06) .069

Notes: N ϭ 432, Log Likelihood ϭϪ99.27, Probability ϭ .0005. constrained multinomial logit and binomial logit to investigate their hypotheses. Because they reach broadly similar results with both methods and I categorize exchange rate regimes dichotomously, I investigate only their binominal logit. Their data set includes twenty-one OECD countries for the years 1974–95.71 Table 6 presents the logit results with the veto player variables introduced into Bernhard and Leblang’s full model.72 The logit provides supporting evidence for the theory I have developed. The insignificant value for the variable FEDERALISM indicates that a move from a unitary system to a federal system under a one-party-veto player has no effect, as one would expect from Table 2. The positive, and significant, value for MULTIPLE PARTY PLAYERS indicates that a move in unitary systems from one to multiple players increases the likelihood of a state adopting a fixed exchange rate. Finally, the conditional coefficient for party players in federal systems is significant and indicates that such systems are more likely to have flexible exchange rates. The analysis also has implications for other arguments. The results for Bernhard and Leblang’s original political variables remain—exogenous electoral timing as well as the division of states according to whether they are majoritarian or

71. I make only one change to their data set. They code Italy as pegged in 1993. I change this to ﬂoat; Italy was forced out of the European Monetary System in Fall 1992. 72. Stata 7.0 was used to calculate the results. Dummy variables for years were included but are not reported. Veto Players and Monetary Institutions 107 proportional and whether they have low- or high-opposition parliaments are significant. In contrast, there is no support in the results for partisan arguments. This reinforces the non-ﬁnding of the effects of partisanship reported by Clark and Hallerberg and Clark for political business cycles in the post–Bretton Woods era.73 It may be that differences between the political Left and the Right on exchange-rate policy, and on macroeconomic policy more generally, have diminished since the interwar years that Simmons considers.74

Conclusion: Comparison with Other Approaches and Implications for Europe

Benjamin Cohen notes recently in a discussion of state preferences for different types of exchange-rate regimes that “domestic politics obviously matters, but it is difficult to say just how.”75 In this article, I seek to answer this question through the development of a veto-player argument where politicians seek to remain in office. While I take no issue with Keefer and Stasavage’s contention that there are no functional grounds for a link between veto players and exchange-rate choice, I do provide a political rationale and empirical evidence to suggest that scholars should look at combinations of party and subnational veto players in the future.76 This research fits well with other recent work in the field; indeed it provides a unified theoretical framework to bring together different strands of literature. It is consistent with Bernhard and Clark.77 Bernhard’s punishment index, which tracks the ability of parties in government to be punished through committee strength, the presence of coalition governments, and the level of polarization, is positively correlated with CBI. This index is also positively correlated with the number of party veto players. Clark finds that CBI usually accompanies fixed-exchange-rate regimes, and he finds three outliers—Australia, Canada, and the United States. While Clark does not focus only on the effects of veto players, his discussion focuses on party veto players only, not subnational players; the three outliers are all federal states, and they fit the predictions of the model provided here. The discussion is also complementary to Bernhard and LeBlang.78 They find that coalition states that have both independent central banks and fixed exchange rates have coalitions that are less prone to break down. In another article, Bernhard and Leblang argue that countries with committee systems that have high opposition influence tend to fix their exchange rate, while those that have low opposition influence fear having no impact on monetary policy

73. See Clark and Hallerberg 2000; and Clark forthcoming 2003. 74. Simmons 1994. 75. Cohen forthcoming 2003. 76. Keefer and Stasavage 2002. 77. See Bernhard 1998; and Clark 2002. 78. Bernhard and LeBlang 2002. 108 International Organization and hence support flexible exchange rates.79 As I argue elsewhere,80 committee strength in parliamentary committees is largely a function of the number of party veto players and how those veto players form coalitions. While the results presented here in no way invalidate their findings, the argument does provide a more complete explanation. Some states choose fixed exchange rates because they would like to use fiscal policy for electoral purposes, while they argue that the choice is between using monetary policy to manipulate the economy and using no policy. A useful future exercise would be to examine in greater detail why high-opposition states are more likely to favor fiscal policy over monetary policy. This study also has some interesting implications for the future of monetary institutions in Europe. To the extent that the EU resembles a state with multiple institutional veto players and multiple party players, it should move to the lower right-hand corner of Table 1, or to an independent central bank and flexible exchange rates. Indeed, at the EU level, this is exactly what has happened. In the case of the United Kingdom, if Tony Blair truly wants to increase support for a fixed exchange rate in the form of the introduction of the euro, the implication of this study is that he should introduce proportional representation and, consequently, increase the number of domestic veto players. If he cares more about maintaining his party’s position in government, however, the continuance of a plurality electoral system remains the rational course to continue, but the euro may then remain only a dream for some British Europhiles.

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We argue that political parties will choose monetary institutions in order to help them win elections and retain office. Increased levels of economic openness in the industrial democracies have complicated the pursuit of office by altering the policy preferences of constituents and decreasing the ability of cabinet ministers to deliver promised economic outcomes. We contend that monetary commitments can help political parties manage diverse constituent interests, restore policy effectiveness, and, ultimately, maintain their position in office. Therefore, we expect that fixed exchange rates and central bank independence can improve cabinet durability, especially under conditions of economic openness. In the first section, we discuss how fixed exchange rates and central bank independence can insulate cabinets from the political shocks of increased economic openness. To determine the political value of these commitments, we then test the effect of exchange-rate commitments and central bank independence on cabinet durability in the second section. In the third section, we use the results of our statistical models to generate expected cabinet durability for the countries in our sample under alternative institutional configurations. By comparing the expected durabilities, we show that most monetary reforms have helped (or at least not hurt) expected cabinet durability.

Economic Internationalization, Monetary Commitments, and Governance

Over the past thirty years, the economies of the industrial democracies have become more integrated.1 Higher levels of economic openness have increased the potential for intra-party and intra-coalition conﬂicts over economic policy. In particular,

We thank Lawrence Broz, Bill Clark, Rob Franzese, Brian Gaines, Jim Granato, Torben Iversen, and Beth Simmons for helpful comments. We thank Dennis Quinn for sharing data. 1. See Milner and Keohane 1996; Quinn and Inclan 1997; Goodman and Pauly 1993; and Simmons 1999.

International Organization 56, 4, Autumn 2002, pp. 803–830 © 2002 by The IO Foundation and the Massachusetts Institute of Technology 112 International Organization changes in the patterns of electoral support for the main governing parties and decreases in the ability of cabinet ministers to deliver promised policy outcomes have hurt the ability of the main governing parties to win and retain ofﬁce.

Changes in Constituent Demands Increased economic openness changes constituent interests concerning economic policy.2 Further, economic internationalization affects the relative influence of different sectors over economic policy. Owners of internationally mobile assets—in particular, capital—can threaten to withdraw those assets if they are dissatisfied with the government’s policies. Therefore, politicians must respond to their demands if they wish to attract and retain these assets for their country, even if these sectors do not form part of the government’s electoral coalition.3 These developments have altered the socioeconomic coalitions underlying political parties in the industrial democracies over the past twenty years.4 There has been a diversification in the economic policy demands made by voters. New issues have become salient.5 New cleavages have emerged, reflecting divisions between exposed and sheltered sectors, manufacturing and service sectors, rising and declining industries, the private and the public sector, and owners of mobile and specific assets.6 The diversification of constituent preferences has increased the potential for intra-party and intra-coalition conflict over economic policy, making it more difficult for parties to attain and retain office.

Decreased Policy Effectiveness Since the 1970s, the ability of governments to deliver promised economic outcomes has also decreased substantially. The emergence of high public debt during the 1970s and early 1980s in many industrial democracies limited the flexibility of fiscal policy.7 As a result, government ministers faced a temptation to rely on monetary policy to manage the economy. At the same time, however, established monetary policy choices no longer produced predictable outcomes. Prior to the 1970s, monetary policy reflected the idea of the Phillips Curve, which predicted a relatively stable trade-off between inflation and unemployment. In the 1970s, however, both theoretical critiques8 and empirical evidence—stagflation in the industrial democracies—undermined confi-

2. See Franzese 2002; Frieden 1991; Frieden and Rogowski 1996; Iversen 1999; Keohane and Milner 1996; and Rogowski 1989. 3. See Frieden 1991; Maxfield 1997; and Keohane and Milner 1996. 4. For example, Pempel 1998. 5. For example, Inglehart 1997. 6. See Iversen 1996; Rosenbluth 1996; Franzese 2002; Iversen 1999; and Iversen and Cusak 2000. 7. See Franzese 2002; Roubini and Sachs 1989a and 1989b; and Hallerberg and von Hagen 1999. 8. See Friedman 1968; and Lucas 1972. Political Parties and Monetary Commitments 113 dence in the Phillips Curve. It became less clear how monetary policy affected overall economic performance—and what policies policymakers should pursue.9 During this period, the industrial democracies also became more exposed to the international economy, exacerbating the problems of policy management.10 Open- ness exaggerated the economic and social consequences of policy actions.11 Ad- vances in technology shortened the time lag between policy choices and policy outcomes. Policymakers, therefore, had to respond more quickly and more accurately to exogenous shocks to meet the demands of their constituents. Decreased policy effectiveness hurt the ability of cabinet ministers to achieve promised outcomes—with predictable political consequences. Poor economic performance led to sharp electoral losses for incumbents. Parties that were in office during the stagflation of the 1970s were exceptionally hard hit, losing their reputation for capable policy management.

Socioeconomic Change and Intra-Party Conflict The combination of diversified constituent demands and decreased policy effectiveness increased the possibility of intra-party conflict over economic policy during the 1980s and 1990s—conflicts that threatened the ability of the main governing parties to win and retain office. Indeed, intraparty conflicts occurred throughout the industrial democracies and across the ideological spectrum. In Left parties, traditional working-class constituents battled not only export interests, but also middle class postmaterialists and public sector workers for control of party programs.12 In Germany, the Social Democratic– led government of the 1970s and early 1980s collapsed, in part, due to conflicts between moderates and trade unionists over the best response to the second oil shock. In the wake of defeat in the 1979 elections, the British Labour party splintered, before pulling back toward the center in the 1990s. In France during the 1980s, Mitterrand’s decision to pursue economic rigueur involved sweeping changes to the Socialists’ constituent base, creating conflict and dissension within the party.13 In the United States, Democratic party centrists and trade unionists battled over trade and environmental issues.14 In Scandinavia, Social Democratic parties faced constituents with increasingly divided interests.15 Right parties endured similar conflicts. The Italian Christian Democrats suffered internal battles over the best response to union militancy and the economic shocks of the 1970s and early 1980s.16 In Britain, policy conflicts between Tory Wets and radical free-market Thatcherites divided the Conservative party during the 1980s

9. See Clarida, Galı´, and Gertler 1999; and Sargent 1999. 10. See Clark forthcoming; Oatley 1999; Clark and Hallerberg 2000; and Simmons 1994. 11. See Frieden 1991; and Franzese 2002. 12. Kitschelt 1994 and 1999. 13. See Frieden 1994; and Loriaux 1991. 14. Shoch 2001. 15. Iversen 1996. 16. For example, Goodman 1992. 114 International Organization and 1990s.17 In Japan, economic openness contributed to conflicts between the Liberal Democratic party’s main constituents—export-oriented industries favored more openness, while small business and agriculture wanted to maintain protection.18 On both sides of the political spectrum, these intra-party conflicts made governance more difficult and shortened cabinet durability.

Monetary Commitments Many studies contend that monetary commitments—such as a fixed exchange rate, participation in the European Monetary System (EMS), and an independent central bank—exacerbate these intra-party conflicts by forcing politicians to pursue unpopular policies and, as a result, reduce cabinet durability even further. Instead, we argue that these monetary commitments can, under certain circumstances, help prevent some intra-party and intra-coalition conflicts and extend cabinet durability. In particular, these institutions can help cabinet ministers balance the interests of constituents and legislators with diverse policy preferences and increase policy effectiveness. Monetary institutions can help party leaders facilitate agreement and cooperation among parties and legislators with diverse policy preferences in a number of ways. First, monetary commitments provide information about the behavior of policymakers to party legislators, potential coalition partners, markets, and the public. This information can facilitate trust between the cabinet, party legislators, and potential coalition partners and, in turn, increase cabinet durability. In a parliamentary system, parties delegate policy authority to the cabinet (that is, prime minister, minister of finance), allowing it to manage monetary policy. Ministers, however, enjoy informational advantages over backbench legislators and coalition partners: the cabinet often has a higher level of policy expertise or can obfuscate its policy intentions. These information asymmetries allow cabinet ministers to manipulate monetary policy for their own benefit, even if it means hurting the interests of party legislators or coalition partners. As a result, party legislators and coalition partners may be quick to withdraw their support from the cabinet over a monetary policy dispute. Monetary commitments, however, supply information about the cabinet’s policy behavior that can reassure party legislators and coalition partners. A fixed exchange rate, for example, 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.19 It provides a clear standard to monitor and evaluate the macroeconomic policy choices made by the party holding the finance portfolio. Deviation from that standard sends a signal about the policy choices of the finance minister. An independent central bank can also act as a watchdog over the cabinet’s policy actions, sounding alarms in the event of opportunistic policy manipulation.20

17. For example, Hall 1986. 18. Rosenbluth 1996. 19. See Broz 2002; Aghevli, Khan, and Montiel 1991; and Bernhard 1998a. 20. Bernhard 1998b and 2002. Political Parties and Monetary Commitments 115

Because it is not under the direct control of the cabinet, an independent central bank can draw attention to situations where cabinet ministers pressure the central bank—either directly or indirectly—to manipulate policy in ways that deviate from policy objectives. Second, these monetary commitments help policymakers justify difficult policy actions and defend certain outcomes. Party leaders may use monetary commitments to persuade backbench legislators, other parties, and the public that certain policy actions are necessary. With a fixed exchange rate, cabinet ministers may be able to rationalize painful policy measures in the name of defending the exchange rate. The fixed exchange rate allows politicians to frame sensitive policy choices in a manner that is more politically palatable. As one central banker in Europe noted, “It is always easier to sell the decision to defend the exchange rate than to raise interest rates. Unions understand the importance of the exchange rate.”21 An independent central bank can also provide credible verification that cabinet ministers had attempted to achieve certain outcomes, even if those policy choices unintentionally had consequences unacceptable to their legislative and coalition supporters. In both cases, party legislators and coalition partners, therefore, will be less likely to withdraw their support from the government in the face of negative outcomes. As a result, parties remain in office longer, even if party politicians have different incentives regarding monetary policy. Finally, monetary commitments can help parties manage intra-party and intra- coalition conflict by providing a basis for policy agreement and bargaining. A fixed exchange rate, for instance, may provide a focal point for parties with diverse interests regarding economic policy, particularly in an open economy.22 Politicians may simply agree to fix the exchange rate as a way to settle otherwise intractable policy conflicts. Or politicians may agree to delegate policy formation to an independent central bank with clear policy goals, such as price stability. These commitments, therefore, take monetary policy “off the table,” removing a potential source of conflict and allowing parties to focus on issues that unite them.23 Monetary commitments, therefore, can help political parties manage diverse coalitions.24 These commitments can also help restore policy effectiveness and

21. Personal interview with a central banker in Europe, Spring 1993. 22. Bernhard and Leblang 1999. 23. Bernhard 2002 suggests that the independence of the German Bundesbank helped the Social Democratic party and the liberal Free Democratic party form a coalition in the 1970s, despite their differences on economic policy. The Bundesbank’s ability to criticize the Social Democratic–led government would alert the Free Democrats to any attempts to manipulate monetary policy away from the coalition agreement. Similarly, strong monetary commitments in the Netherlands (a relatively independent central bank, a stable fixed exchange rate) may have facilitated an unlikely coalition between the Labor party (PvdA) and the Liberal party (VVD) in the 1990s by removing monetary policy as a potential source of conflict. 24. Monetary commitments also have distributive consequences. Recent literature on the real economic effects of monetary policy begins to identify the distributive consequences—the “winners” and “losers”—of different monetary arrangements. For example, Hall and Franzese 1998; Franzese 1999; Iversen 1998; and Soskice and Iversen 1998. Parties can use these commitments to benefit certain sectors, 116 International Organization improve economic performance. A fixed exchange rate helps stabilize the external trading environment by decreasing uncertainty surrounding the exchange rate and reducing transactions costs across countries. In addition, a fixed rate can provide a nominal anchor for macroeconomic policy. A more independent central bank also enhances monetary policy effectiveness. An independent central bank signals to economic agents that monetary policy will be insulated from excessive partisan and electoral manipulation.25 Consequently, economic agents will adjust their behavior more quickly, improving policy efficacy.26 Improved performance, in turn, can contribute to more cabinet stability. Monetary commitments, therefore, can help politicians manage intra-party and intra-coalition conflicts over monetary policy, helping these parties to remain in office. At the same time, however, a fixed exchange rate or an independent central bank does entail some political costs: the cabinet loses the ability to manipulate policy for short-term electoral or partisan gain.27 But where intra-party conflicts threaten the party’s ability to win and stay in office, the political benefits of a monetary commitment outweigh these costs. Therefore, we expect that monetary commitments enhance cabinet durability, especially under conditions of economic openness.

Economic Openness, Monetary Institutions, and Cabinet Durability

To determine the political value of monetary commitments, in this section we test the relationship between economic internationalization, monetary commitments, and cabinet durability. We expect that monetary commitments will be associated with higher levels of cabinet durability, particularly for open economies.

Independent Variables Economic Openness. We measure economic openness along two dimensions. The ﬁrst dimension reﬂects barriers to the movement of assets across borders. Increased internationalization implies fewer restrictions on the movement of capital

particularly inflation-averse sectors, while relying on other policies (for example, fiscal policy or welfare policy) to compensate the policy “losers.” Monetary commitments, therefore, may be able to help parties assemble and maintain diverse electoral coalitions. 25. See for example, Cukierman 1992; Grilli, Maciandaro, and Tabellini 1991; and Lohmann 1998. 26. Empirical evidence does not bear out this theoretical expectation. Several researchers have investigated how CBI affects the “costs” of disinflation in terms of lost output and increased unemployment. These studies show that the costs of disinflation are actually higher under an independent central bank. Posen 1998; and Walsh 1995a. 27. Further, a fixed exchange rate implies a loss of domestic monetary policy autonomy. See Mundell 1961. Without the ability to use monetary policy to counter localized economic shocks, countries may suffer unnecessary welfare losses in output or unemployment. Political Parties and Monetary Commitments 117 and traded goods across borders, including no capital controls, full convertability of currencies, no restrictions on the current account, and no tariff or non-tariff barriers to trade. As a proxy for this variable, we use a measure of RESTRICTIONS ON 28 INTERNATIONAL TRANSACTIONS compiled by Dennis Quinn. This variable measures both capital account and current account openness. It ranges from seven (high restrictions) to fourteen (no restrictions).29 The second dimension reflects the degree of exposure to the international economy. We measure this by the sum of imports and exports as a proportion of gross domestic product (GDP). This TRADE OPENNESS variable ranges from 18 percent to 148 percent of GDP. We expect both restrictions on international transactions and trade openness to have a negative effect on cabinet durability.

Exchange Rate Commitments. We include two variables to account for exchange-rate commitments. The ﬁrst dummy variable, FIXED EXCHANGE RATE,is coded one when a country had a pegged exchange rate or participated in the EMS after 1987,30 at the date of the cabinet’s installation. We included another dummy variable, POST-MAASTRICHT, from January 1993 until the end of the sample for governments that participated in the EMS during that time.31 Data are from Cobham, Gros and Thygesen, and the International Monetary Fund’s (IMF’s) Exchange Arrangements and Exchange Restrictions Annual Report.32 We interacted the exchange rate variables with the economic openness variables.

Central Bank Independence. We include a measure of central bank indepen- 33 dence (CBI) from Cukierman, Webb, and Neyapti. We update CENTRAL BANK INDEPENDENCE to reﬂect central bank reform in Belgium, France, Italy, and New Zealand during the sample period.34 We also interacted central bank independence

28. Quinn 1997. 29. In alternative specifications, we used (1) a dummy variable for capital controls from Leblang 1997 and (2) the measure of capital account openness developed by Quinn 1997. The results from all three measures were qualitatively similar, although at varying levels of statistical significance. 30. In preliminary analyses, we divided participation in the EMS into three periods: 1979–86, 1987–92, and 1993–98. Gros and Thygesen 1998. During the first period, the system underwent a series of realignments, ending in January 1987. Between 1987 and 1992, no devaluations occurred, and the EMS “hardened” into a quasi-fixed-exchange-rate regime until the September 1992 currency crisis. The third period, 1993–98, represents the runup to Economic and Monetary Union (EMU), which began in January 1999. The effects of these three periods on cabinet durability differed dramatically. In the first period, participation in the EMS did not have any effect on cabinet durability. Consequently, we coded participation in the EMS from 1979 to 1986 as a floating exchange rate. In the subsequent two periods, participation had a statistically significant effect on cabinet durability. Participation in the EMS after 1987, therefore, is coded as having a fixed exchange rate. 31. This includes Denmark and, after 1995, Sweden—countries that participated in the EMS until 1999 but then opted out of the single currency. Austria, Finland, and Sweden, countries that joined the European Union (EU) in 1995–96, are coded as participating in the EMS beginning in 1996. 32. See Cobham 1994; Gros and Thygesen 1998; and IMF, various years. 33. Cukierman, Webb, and Neyapti 1992. 34. The rankings of CBI for reformed central banks are based on Tavelli, Tullio, and Spinelli 1998, who used the Grilli, Masciandaro, and Tabellini 1991 criteria. We used the same criteria to compute the 118 International Organization with the trade and restrictions on international transactions variables as well as the fixed exchange rate and post-Maastricht variables.

Coalition and Party System Attributes. According to the political science literature, cabinet durability is a function of coalition attributes and party system attributes.35 Coalition attributes reﬂect the majority status of the government and the number of parties in the government. We distinguish three government types: SINGLE-PARTY MAJORITY GOVERNMENTS, MINIMUM-WINNING COALITIONS, AND MINORITY 36 GOVERNMENT OVERSIZE COALITIONS. We interacted these dummy variables with the economic internationalization and monetary commitment variables. The literature indicates that single-party majority governments tend to be most durable, minimum-winning coalitions slightly less durable, and oversize and minority governments least durable.37 Since single-party majority governments already tend to be durable, we expect the monetary commitment variables to have little effect on their durability. Instead, we expect ﬁxed exchange rates and CBI to have a larger impact on the cabinet durability of coalition governments. In each of the models, single-party majority governments are the omitted category. Party system attributes include fragmentation of the political system and political polarization. Political scientists argue that the more fragmented and polarized the political system, the shorter the expected cabinet duration. We include a variable for party system, FRACTIONALIZATION, which measures the number of effective political parties in the system.38 This variable should have a negative effect on cabinet 39 durability. POLARIZATION is measured by the electoral support for extremist parties. More support for extremist parties also implies shortened duration. We also include a dummy variable to capture EXOGENOUS ELECTORAL TIMING.In systems with exogenous electoral timing, cabinets are likely to last longer since party leaders know that they must work with the existing distribution of legislative seats. As a result, they may be less likely to withdraw their support from the government coalition. Table 1 contains summary statistics for all variables.

value for the reformed New Zealand central bank. We then used these updated rankings to impute the new values in the Cukierman, Webb, and Neyapti 1992 index. 35. See Alt and King 1994; King, Alt, Burns, and Laver 1990; Laver and Schofield 1990; and Warwick 1994. 36. We originally identified four government types: single-party majority, minimum-winning coalitions, oversize coalitions, and minority governments. Initial statistical analyses, however, indicated that the minority and oversize coalitions tend to have similar cabinet durabilities. As a result, we collapse them into one type. 37. For example, Lijphart 1999; and Laver and Schofield 1990. 38. Rae 1971. 39. According to Powell 1982, extremist parties exhibit one of the following characteristics: (1) a well-developed nondemocratic ideology; (2) a proposal to breakup or fundamentally alter the boundaries of the nation; or (3) diffuse protest, alienation, and distrust of the existing political system. We follow Powell’s classifications with the exception of including France’s National Front. Political Parties and Monetary Commitments 119

TABLE 1. Descriptive statistics

Standard Variable Mean deviation Minimum Maximum

CABINET DURABILITY 0.57 0.31 0.008 1.15 TIME UNTIL NEXT ELECTION 1181.18 443.06 76 1822 MINIMUM-WINNING COALITION 0.23 0.42 0 1 MINORITY/OVERSIZE COALITION 0.55 0.50 0 1 FRACTIONALIZATION 0.69 0.10 0.41 0.88 POLARIZATION 0.12 0.12 0 0.42 EXOGENOUS ELECTORAL TIMING 0.19 0.39 0 1 CENTRAL BANK INDEPENDENCE 0.33 0.14 0.17 0.69 FIXED EXCHANGE RATE 0.45 0.50 0 1 POST-MAASTRICHT 0.06 0.23 0 1 RESTRICTIONS ON INT’L TRANSACTIONS 11.20 1.79 7 14 TRADE 61.08 28.06 16.31 140.66

Sample, Dependent Variable, and Methodology Sample. The sample includes 193 cabinets from sixteen countries: Australia, Austria, Belgium, Britain, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, and Sweden.40 The sample extends from roughly 1972 to 1998. For each country, the sample begins with the ﬁrst cabinet installed after 1972 and ends with the last cabinet that dissolved by 1 January 1999. There are no censored data in the sample. The number of cabinets varies substantially across the countries in the sample. Austria, Britain, Canada, the Netherlands, and Germany had the fewest governments (eight each), while Italy and Japan had the most governments (twenty-four and twenty, respectively).

Dependent Variable. For the dependent variable, we could simply use the number of months that a cabinet is in office. Constructing the dependent variable in this manner, however, leads to complications that could bias the results. First, countries have different constitutionally mandated electoral terms—three, four, or five years—that define the maximum time a government can hold office. If the dependent variable is simply the number of months in office, we would not be able to discern whether a cabinet completed its maximum term or if the cabinet ended prematurely. Second, measuring the dependent variable as number of months in office obscures the durability of cabinets that do not form at the beginning of the electoral term. Consider two hypothetical cabinets in a system with a four-year electoral term. The first cabinet forms immediately after an election and serves two

40. Switzerland was excluded due to the permanent oversize status of its executive council. Other countries were excluded due to limitations in the availability of data. 120 International Organization years before collapsing. The second cabinet forms with only two years left before a mandated election and then serves out its maximum term. If the dependent variable were measured in months in office, both would be counted as two years, even though the latter served its maximum term. To overcome these issues, we construct a dependent variable that measures cabinet duration as the proportion of the maximum term available when the cabinet takes office (measured in days). That is, a cabinet that lasts three years (1,095 days) out of a possible four (1,460 days) would score a 0.75. A cabinet that formed only 365 days before constitutionally mandated elections and survived for that year is coded 1.41 We included a control variable, TIME TO ELECTION, measuring the maximum number of days that a government could potentially be in office.42 The longer the potential time a government can be in office, the greater the possibility that a government will collapse during its term. Consequently, we expect this variable to have a negative coefficient.

Methodology. We employ two estimation methods. Both the literature on cabinet formation and clear cross-national differences in cabinet duration suggest that country-speciﬁc factors—for example, similar political institutions or practices— will affect all cabinets in that country. As a consequence, there may be unequal variation in cabinet durability across countries. For example, cabinet duration in Italy may differ a great deal, while the length of cabinets in Germany is relatively similar. To address this issue, we perform ordinary least squares (OLS) regression with robust (Huber-White) standard errors. This method assumes that observations are independent across countries but not necessarily independent within countries. In the discussion, we use expected values from the model to evaluate different institutional reforms in the industrial democracies. The procedure to calculate those expected values, however, does not support OLS regression with robust standard errors. As a consequence, we rely on simple OLS regression for those calculations. OLS is a more conservative technique—the standard errors will be larger than the robust standard errors.43

41. Because the dependent variable is truncated, it is possible that the residuals will not be normally distributed. We performed a Jarque-Bera test for the normality of the residuals. For model III, the main model of interest, the chi-squared statistic of 0.0457 (p-value of .9974) did not allow us to reject the null hypothesis of normality. We also re-estimated the models in Table 2 using a variant of robust regression. See Welsch 1980; and Western 1995. This technique produces parameter estimates and standard errors that are “robust” to departures from normality. Results from the robust regression estimation did not substantively alter the estimated parameters and only attenuated the standard errors in a few cases. 42. In alternative specifications, we ran the analysis without this control variable. The results were similar. 43. We ran the model using two other methods: OLS Regression with Panel-Corrected Standard Errors and Panel-Specific AR(1) and a variant of robust regression. The panel-corrected standard errors and panel-specific AR(1) are designed to correct for potential serial correlation in the residuals. Beck and Katz 1995 and 1996. Robust regression helps minimize the influence of outliers or overly influential cases. See also Welsch 1980; and Western 1995. The results from both procedures were similar to the results obtained using OLS with robust standard errors (results available on request). Political Parties and Monetary Commitments 121

Results

Table 2 contains the results. Column entries are parameter estimates, and standard errors are in parentheses. Models 1, 2, and 3 are estimated using OLS with robust standard errors. Model 4 is estimated using OLS. Model 1 provides a baseline model of cabinet duration, based solely on attributes of the governing coalition and the party system. The model as a whole is statistically different from zero. Polarization and exogenous electoral timing are statistically significant and in the predicted direction. Consistent with the literature, the parameter estimate for polarization indicates that more heterogeneous party systems produce cabinets that survive for shorter times. On the other hand, cabinets in systems with exogenous electoral timing last longer.44 The other variables are not statistically different from zero, although each is in the predicted direction. Model 2 includes variables for central bank independence, fixed exchange rates, and participation in the post-Maastricht E.M.S. The polarization and exogenous electoral timing variables remain significant and in the predicted direction. The minority/oversize coalition variable becomes statistically significant. As the literature indicates, these types of governments do not last as long as single-party majority governments. The central bank variable is, as predicted, positive and significant. Systems with independent central banks have higher levels of cabinet durability. For a hypothetical government beginning a potential four-year term in office, increasing the level of central bank independence from 0.2 (about one-standard deviation below the mean) to 0.5 (about one standard deviation above the mean) increases expected durability by about 88 days—almost three months. The fixed exchange rate variable is also positive and attains a marginal level of statistical significance (p Ͻ .07). Countries with a fixed exchange rate appear to have higher levels of cabinet durability. For that same hypothetical government beginning a four-year term in office, the expected cabinet durability is 146 days more with a fixed exchange rate than without—an increase of nearly five months. The post-Maastricht variable is also positive, although not statistically significant. The results clearly indicate that monetary commitments can increase cabinet durability. But Model 2 does not tell us how these monetary commitments interact with a country’s economic and political attributes to affect cabinet durability. Model 3 adds variables capturing economic internationalization. Given the collinearity of the interaction terms, few of the variables are individually statistically distinguish- able from zero. As a result, we report a series of Wald tests for each set of variables. These results indicate that we can reject the null hypothesis that none of the sets of

44. This result may be an artifact of how we measure the dependent variable. With exogenous electoral timing, the last cabinet of an electoral term must serve its maximum term, potentially increasing the number of cabinets that have a value on the dependent variable equal to one. 122 International Organization

TABLE 2. Models of cabinet durability

Variables 1234

Constant 0.92* 0.78* Ϫ0.11 Ϫ0.11 (0.17) (0.16) (0.58) (0.57) TIME UNTIL NEXT ELECTION Ϫ0.00005 Ϫ0.00005 Ϫ0.00005 Ϫ0.00005 (0.00005) (0.00005) (0.00004) (0.00005) MINIMUM-WINNING COALITION Ϫ0.05 Ϫ0.13 Ϫ0.33* Ϫ0.33 (0.09) (0.08) (0.15) (0.20) MWC ϫ CBI 0.86 0.86 (0.47) (0.53) MWC ϫ FIXED EXCHANGE RATE Ϫ0.54 Ϫ0.54 (0.32) (0.36) MWC ϫ CBI ϫ FIXED 0.76 0.76 (0.67) (0.87) MWC ϫ CBI ϫ POST-MAASTRICHT Ϫ0.65 Ϫ0.65 (0.81) (2.30) MINORITY/OVERSIZE COALITION Ϫ0.13 Ϫ0.16* Ϫ0.23 Ϫ0.23 (0.08) (0.07) (0.16) (0.17) MIN/OVER ϫ CBI 0.26 0.26 (0.55) (0.51) MIN/OVER ϫ FIXED EXCHANGE RATE Ϫ0.01 Ϫ0.01 (0.28) (0.31) MIN/OVER ϫ POST-MAASTRICHT Ϫ0.04 Ϫ0.04 (0.35) (0.96) MIN/OVER ϫ CBI ϫ FIXED RATE Ϫ0.31 Ϫ0.31 (0.70) (0.83) FRACTIONALIZATION Ϫ0.22 Ϫ0.12 Ϫ0.10 Ϫ0.10 (0.27) (0.22) (0.31) (0.33) POLARIZATION Ϫ0.85* Ϫ0.79* Ϫ0.78* Ϫ0.78* (0.15) (0.16) (0.19) (0.24) EXOGENOUS ELECTORAL TIMING 0.21* 0.16* 0.15 0.15 (0.05) (0.05) (0.08) (0.08) CENTRAL BANK INDEPENDENCE 0.20* 3.72* 3.72* (0.09) (1.25) (1.53) FIXED EXCHANGE RATE 0.10 Ϫ0.21 Ϫ0.21 (0.05) (0.35) (0.38) POST-MAASTRICHT 0.08 Ϫ4.97* Ϫ4.97 (0.08) (0.95) (3.04) CBI ϫ FIXED EXCHANGE RATE Ϫ0.33 Ϫ0.33 (0.59) (0.71) CBI ϫ POST-MAASTRICHT Ϫ0.14 Ϫ0.14 (0.59) (2.22) RESTRICTIONS ON INT’L TRANSACTIONS 0.07 0.07 (0.05) (0.04) RESTRICTIONS ϫ CBI Ϫ0.24* Ϫ0.24* (0.10) (0.11) RESTRICTIONS ϫ FIXED EXCHANGE RATE 0.02 0.02 (0.03) (0.03) RESTRICTIONS ϫ POST-MAAS. 0.41* 0.41 (0.07) (0.24) TRADE 0.003 0.003 (0.001) (0.002)

(Continued) Political Parties and Monetary Commitments 123

Table 2. continued

Variables 1234

TRADE ϫ CBI Ϫ0.02* Ϫ0.02* (0.006) (0.007) TRADE ϫ FIXED EXCHANGE RATE 0.004 0.004 (0.002) (0.002) TRADE ϫ POST-MAASTRICHT Ϫ0.002 Ϫ0.002 (0.002) (0.004) R-Squared 0.26 0.30 0.39 0.39 MSE 0.2750 0.2697 0.2646 0.2646 Tests of Joint Signiﬁcance MODEL 56.28* 54.10* 137.42* 3.97* MINIMUM-WINNING COALITION 3.38* 2.19 MINORITY/OVERSIZE COALITION 1.80 1.48 CENTRAL BANK INDEPENDENCE 31.21* 1.73 FIXED EXCHANGE RATE 3.13* 1.71 POST-MAASTRICHT 13.27* 1.00 RESTRICTIONS 11.30* 2.23 TRADE 16.19* 2.20

N ϭ 193 for all models. Models I through III estimated via OLS regression with robust standard errors. Model IV estimated via OLS regression. *p Ͻ .05. Tests of Joint Significance are for combinations of the following variables: MODEL: all variables; MINI- MUM WINNING COALITION: Minimum Winning Coalition, MWC ϫ CBI, MWC ϫ Fixed Exchange Rate, MWC ϫ CBI ϫ Fixed Exchange Rate, MWC ϫ CBI ϫ Post-Maastricht; MINORITY/OVERSIZE COALITION: Minority/Oversize Coalition, Min/Over ϫ CBI, Min/Over ϫ Fixed Exchange Rate, Min/Over ϫ Post- Maastricht, Min/Over ϫ CBI ϫ Fixed Exchange Rate; CENTRAL BANK INDEPENDENCE: CBI, MWC ϫ CBI, MWC ϫ CBI ϫ Fixed Exchange Rate, Min/Over ϫ CBI, Min/Over ϫ CBI ϫ Fixed Exchange Rate, CBI ϫ Fixed Exchange Rate, CBI ϫ Post-Maastricht, CBI ϫ Restrictions, CBI ϫ Trade; FIXED EXCHANGE RATE: Fixed Exchange Rate, MWC ϫ Fixed Exchange Rate, MWC ϫ CBI ϫ Fixed Exchange Rate, Min/ Over ϫ Fixed Exchange Rate, Min/Over ϫ CBI ϫ Fixed Exchange Rate, CBI ϫ Fixed Exchange Rate, Fixed Exchange Rate ϫ Restrictions, Fixed Exchange Rate ϫ Trade; POST-MAASTRICHT: Post-Maastricht, MWC ϫ CBI ϫ Post-Maastricht, Min/Over ϫ Post-Maastricht, CBI ϫ Post-Maastricht, Post-Maastricht ϫ Restrictions, Trade ϫ Post-Maastricht; RESTRICTIONS: Restrictions, CBI ϫ Restrictions, Fixed Exchange Rate ϫ Restrictions, Post-Maastricht ϫ Restrictions; TRADE: Trade, CBI ϫ Trade, Fixed Exchange Rate ϫ Trade, Post-Maastricht ϫ Trade. variables, except minority/oversize coalitions, has any statistically significant influence on the cabinet durability at the .05 level.45 How do these results conform to our expectations about the influence of economic openness and monetary commitments on cabinet durability? We first note that the overall effects of trade levels and restrictions on international transactions are

45. As a robustness check, we re-ran the analysis deleting one country at a time. The sets of variables remained signiﬁcant throughout this procedure. 124 International Organization

FIGURE 1. Effect of central bank independence on expected cabinet durability for different government types, floating exchange rates negative, holding all other variables at their means and assuming a floating exchange rate. Increasing trade by one standard deviation from its sample mean leads to a reduction in cabinet durability by 0.03; however, this effect is not statistically significant. On the other hand, reducing the number of restrictions on international transactions from the sample mean of eleven by one standard deviation decreases cabinet durability by 0.14, a statistically significant effect. In other words, given an increase in the restrictions variable from eleven to thirteen, the expected duration of a hypothetical cabinet facing a four-year term would drop by about 200 days. We present the results for monetary commitments two ways. First, we graph the relationship between central bank independence and cabinet durability for different government types (Figure 1). Holding all other variables constant,46 we generated expected values of cabinet durability using the sample range of central bank independence.47 The X-axis represents the range of variation for central bank independence. The Y-axis represents the expected values of cabinet duration. The line marked “Effect of CBI for Single Party Majority Government” illustrates how CBI affects cabinet durability for single-party majority governments. The slope of this line is virtually horizontal. That is, CBI does not have much, if any, effect on cabinet durability for single-party majority governments. This is consistent with expectations—single-party majority governments should be relatively stable regard-

46. The restrictions and trade variables were held at their means. The exchange-rate and post-Maastricht variables were held at zero. In other words, these results are for ﬂoating exchange-rate regimes. 47. For ease of presentation, we do not report conﬁdence intervals around the expected cabinet durability. Political Parties and Monetary Commitments 125

FIGURE 2. Effect of central bank independence on expected cabinet durability for different government types, fixed exchange rate less of monetary commitments. For coalition governments, however, CBI has a positive effect on cabinet durability, particularly for minimum-winning coalitions. The line marked “Effect of CBI for Minimum-Winning Coalitions” is sharply positive, and the line “Effect of CBI for Minority Governments and Oversize Coalitions” is positive as well. For minimum-winning coalitions, in particular, CBI has a beneficial effect on cabinet durability. At high levels of CBI, minimum- winning coalitions outlast even single-party majority governments! How does an exchange-rate commitment interact with CBI to affect cabinet durability? Holding all other variables at their means, we examined the relationship between CBI and cabinet durability in systems with a fixed exchange rate (Figure 2). For single-party majority governments with an exchange-rate commitment, CBI has a slightly negative relationship with cabinet durability. Comparing Figures 1 and 2 shows that a fixed exchange rate does appear to provide slightly higher cabinet durability for single-party majority governments, particularly at low levels of CBI, but this effect is not statistically significant. For minimum-winning coalitions, CBI still has a sharp, positive relationship with cabinet durability, even under a fixed exchange rate. A comparison of Figures 1 and 2 indicates that, at low levels of CBI, a fixed exchange rate appears to depress expected cabinet durability, while at high levels of CBI, a fixed exchange rate appears to increase expected cabinet durability. In neither case, however, is the 126 International Organization difference statistically significant. An exchange-rate commitment, therefore, does not affect the cabinet durability of minimum-winning coalitions. Finally, with an exchange-rate commitment, CBI has a slightly negative effect on cabinet durability for minority and oversize coalition governments (Figure 2). At low levels of CBI, a fixed exchange rate provides a statistically significant increase in expected cabinet durability. At high levels of CBI, an exchange-rate commitment reduces cabinet durability, although the difference between a fixed and floating exchange rate is not statistically significant except for very high levels of CBI. With a dependent central bank, therefore, minority and oversize coalition governments benefit from a fixed exchange rate. That fixed exchange rate may provide a focal point for parties, helping to foster agreement about monetary policy. But how do monetary commitments and economic conditions interact to affect cabinet durability? The previous figures held economic conditions constant at their sample means. But economic conditions vary substantially across countries and over time. These conditions are likely to affect the relationship between monetary commitments and cabinet durability. To examine these interactions, we compared expected cabinet durabilities based on different configurations of monetary commitments and economic conditions. For each government type, we determined expected cabinet durability for different levels of openness, varying both restrictions on international transactions (from ten, high restrictions, to fourteen, few restrictions) and trade openness (from 20 percent of GDP to 100 percent of GDP). For each combination of economic openness, we then calculated expected cabinet durability for four different institutional configurations: a dependent central bank (CBI ϭ 0.20) and floating exchange rate; a dependent central bank and fixed exchange rate; an independent central bank (CBI ϭ 0.52) and floating exchange rate; and an independent central bank and fixed exchange rate.48 We then compared the expected values to determine which configuration of monetary institutions provided the highest cabinet durability for that level of openness.49 For single-party majority governments, cabinet durability is unaffected by the configuration of monetary institutions at moderate to low levels of economic openness. Each institutional combination provides a statistically similar expected cabinet durability. This result squares with our expectation that single-party majority cabinets will be uninfluenced by monetary commitments. At higher levels of openness (trade at eighty or above), a fixed exchange rate provides the highest cabinet durability. With an exposed economy, the economic benefits of a fixed exchange rate (for example, a more stable trading environment) may outweigh the political costs of losing the ability to manipulate monetary policy for electoral or partisan advantage. Interestingly, at high levels of openness, an independent central bank provides the lowest levels of expected cabinet durability.

48. Expected values and 95 percent conﬁdence intervals were calculated using procedures suggested by King, Tomz, and Wittenberg 2000. 49. Results are available on request. Political Parties and Monetary Commitments 127

The pattern is substantially different for minimum-winning coalitions. For all except the very highest levels of economic openness, an independent central bank provides the highest levels of cabinet durability. For the most part, the exchange rate regime does not matter for cabinet durability. Only at very high levels of trade does the effect of the fixed exchange rate appear to dominate the effect of an independent central bank. Finally, for minority and oversize coalition governments at low levels of openness, an independent central bank delivers the highest levels of cabinet durability. But at even modest levels of economic openness, a dependent central bank and a fixed exchange rate produce the highest cabinet durability. A fixed exchange rate provides a focal point for parties in these governments. That focal point becomes more important as more constituents are exposed to the international economy. Monetary commitments can improve cabinet durability, but the effect depends on both the level of economic openness and political circumstances. The tenure of single-party majority governments is, for the most past, unaffected by monetary commitments. Coalition governments, on the other hand, can benefit from fixed and exchange rates and CBI. These differences can help explain patterns of monetary and institutional reform in the industrial democracies.

Monetary and Institutional Reform in the Industrial Democracies

Over the past thirty years, the economies of the industrial democracies have become more open and integrated.50 Increased levels of economic internationalization have altered the political environment. Changes in both the policy preferences of constituents and the government’s policy efficacy have not only challenged parties to maintain their traditional constituents, but also provided them with opportunities to expand their electoral coalitions. Therefore, many political parties have modified their electoral strategies and policy priorities.51 Part of this strategic repositioning includes the support of institutional reforms (Table 3). Institutional reform can provide outlets for the representation of new interests, demonstrate policy commitment to affected constituents, or enhance policy effectiveness. Institutional reforms, therefore, can potentially help parties balance the interests of party politicians with divergent policy incentives, re-establish an electoral coalition, and preserve the party’s position in office. Political parties will pursue institutional reforms when it is in their interest to do so. Parties are, of course, interested in attaining and retaining office. If institutional reform can help the government survive longer, politicians are likely to pursue those

50. For the purposes of this paper, we assume that changes in the level and degree of economic openness are exogenous. While we recognize that governments can, to a certain degree, manipulate the level of economic openness, much of the increase in interactions across borders reﬂects technological advances in communication and transportation. 51. See Boix 1998; Kitschelt 1994; and Garrett 1998. 128 International Organization

TABLE 3. Institutional reform in the industrial democracies since 1979

Country Year Reform to electoral system, central bank, exchange rate

Australia 1983 Adopt Floating Exchange Rate Austria 1996 Join European Monetary System, Post-Maastricht Belgium 1979 Join European Monetary System 1991 Sign Maastricht Treaty 1993 Grant Central Bank More Independence Canada — — Denmark 1979 Join European Monetary System 1991 Sign Maastricht Treaty (Eventually opt-out of Euro) Finland 1996 Join European Monetary System, Post-Maastricht 1998 Grant Central Bank Independence France 1979 Join European Monetary System 1991 Sign Maastricht Treaty 1993 Grant Central Bank Independence Germany 1979 Join European Monetary System 1991 Sign Maastricht Treaty Ireland 1979 Join European Monetary System 1991 Sign Maastricht Treaty 1998 Grant Central Bank Independence Italy 1979 Join European Monetary System 1981 Grant Central Bank More Independence (Divorce) 1991 Sign Maastricht Treaty 1992 Leave European Monetary System 1992 Grant Central Bank Independence 1994 Electoral System Reform 1996 Return to European Monetary System Japan 1993 Electoral System Reform 1998 Grant Central Bank Independence New Zealand 1985 Adopt Floating Exchange Rate 1990 Grant Central Bank Independence 1992 Electoral System Reform Netherlands 1979 Join European Monetary System 1991 Sign Maastricht Treaty Norway 1992 Adopt Floating Exchange Rate 1994 Adopt Fixed Exchange Rate1 Sweden 1996 Join European Monetary System, Post-Maastricht 1998 Grant Central Bank Independence United Kingdom 1990 Join European Monetary System 1992 Leave European Monetary System 1997 Grant Central Bank Independence

1In 1994, Norway decided to manage the krone vis-a`-vis the ECU. While the monetary policy guidelines stated that monetary policy would be aimed at keeping the krone stable against the ECU, no commitment was made to defend a specific parity. reforms. If reforms will shorten the government’s tenure in office, politicians will not implement those institutional changes. Comparing the expected cabinet durabilities of different configurations of monetary commitments allows us to evaluate the political benefit or cost of different institutional options (in terms of cabinet durability) and predict which Political Parties and Monetary Commitments 129 reforms are more or less likely. The statistical results show that the durability of single-party majority governments is generally unaffected by monetary commitments. Assuming that the implementation of reform is costly, this implies that single-party majority governments will not often pursue monetary reform. Coalition governments, on the other hand, do benefit from monetary commitments. In particular, the duration of minimum-winning coalitions benefits from CBI, suggesting that those government types will pursue a more independent central bank. Minority and oversize coalition governments, on the other hand, benefit from CBI only at low levels of economic openness. At moderate levels of openness, a fixed exchange rate provides the highest levels of cabinet durability. As a result, we expect countries with minority and oversize coalition governments to make exchange rate commitments.

Institutional Change and Cabinet Durability To examine these predictions, we use the results of model 3 to generate expected values of cabinet durability based on counterfactual configurations of monetary institutions for each country at four different periods: 1979–81, 1984–86, 1989–91, and 1994–96. For each period, we used the actual values of trade exposure and restrictions on international transactions to capture changing levels of economic openness. We then compared the expected cabinet durability from the actual configuration of institutions with the expected cabinet durability from other potential institutional choices. In these simulations, we assumed a constant government type for each country across all four periods unless there was a major electoral reform. We calculated the percentage of time that each of the three government types—single-party majority, minimum winning coalition, and minority/oversize coalitions—served in office during the sample period. We used those proportions as each country’s assumed government type.52 If a country underwent a major electoral reform that changed the predominant government type, we changed the assumed government type in the subsequent simulation period. New Zealand, for instance, reformed its electoral system in the early 1990s, moving from a majoritarian electoral system to a mixed majoritarian-proportional representation system. Prior to the reform, New Zealand usually had single-party majority governments. Since the reform, minimum-winning coalitions have become the norm. The assumed values for New Zealand’s government type in 1994–96 reflect that change. We argue that politicians are not going to pursue any reforms that significantly hurt their ability to stay in office. In other words, we expect the predicted cabinet

52. In about half the countries, one government type held ofﬁce for more than 95 percent of the period. For example, Germany experienced only minimum-winning coalitions. In those countries, we assumed that particular government type for all the simulations. For the other countries, we used the proportion of different government types for the simulations. In Belgium, for example, minimum-winning coalitions were in place for about 65 percent of the period, while minority and oversize coalition governments constituted the other 35 percent. 130 International Organization

TABLE 4. Expected cabinet durabilities based on different institutional conﬁgurations

Cross- Exch. border rate Cab. E (cabinet durability) Country Period Trade restric. CBI reg. type in 1994–96 Difference

U.K. 1979–1981 52.8 11.2 0.27 Float S 0.66 (0.53, 0.81) 1994–1996 57.3 13 0.27 Float S 0.66 (0.53, 0.81) 0 Belgium 1979–1981 119.9 10 0.17 Float Mix 0.53 (0.30, 0.75) 1994–1996 128.9 13.8 0.47 EMU Mix 0.60 (0.29, 0.85) 0.07 France 1979–1981 44.0 11 0.24 Float Mix 0.56 (0.42, 0.70) 1994–1996 44.6 13 0.56 EMU Mix 0.63 (0.34, 0.93) 0.07 Germany 1979–1981 53.2 13.7 0.69 Float M 0.84 (0.67, 1.06) 1994–1996 46.6 14 0.69 EMU M 1.00 (0.73, 1.29) 0.16 Italy 1979–1981 47.7 10.5 0.25 Float C 0.23 (0.15, 0.30) 1994–1996 48.2 14 0.47 EMU C 0.95 (0.54, 1.34) 0.72* Neth’land 1979–1981 102.9 13 0.42 Float Mix 0.40 (0.30, 0.52) 1994–1996 98.8 14 0.42 EMU Mix 0.92 (0.74, 1.08) 0.52* Norway 1979–1981 79.1 8.5 0.17 Fix C 0.88 (0.73, 1.07) 1994–1996 71.1 13.5 0.17 Fix C 0.88 (0.73, 1.07) 0 Sweden 1979–1981 60.7 10.7 0.29 Fix C 0.89 (0.79, 0.98) 1994–1996 72.4 13 0.29 EMU C 0.91 (0.59, 1.28) 0.02 Canada 1979–1981 53.9 12 0.45 Float Mix 0.51 (0.39, 0.63) 1994–1996 72.4 14 0.45 Float Mix 0.51 (0.39, 0.63) 0 Japan 1979–1981 27.0 10.2 0.18 Float Mix 0.55 (0.44, 0.64) 1994–1996 17.7 11 0.18 Float Mix 0.46 (0.34, 0.63) Ϫ0.09 Denmark 1979–1981 68.4 10 0.44 Float C 0.31 (0.17, 0.44) 1994–1996 66.1 14 0.44 EMU C 0.79 (0.50, 1.05) 0.48* Finland 1979–1981 64.8 10.5 0.28 Fix C 0.90 (0.81, 1.01) 1994–1996 66.7 14 0.28 EMU C 1.33 (0.96, 1.79) 0.43* Ireland 1979–1981 108.9 10.5 0.44 Float Mix 0.27 (0.10, 0.43) 1994–1996 132.6 13.8 0.44 EMU Mix 0.81 (0.52, 1.09) 0.54* Australia 1979–1981 34.0 8.2 0.36 Fix Mix 0.74 (0.66, 0.82) 1994–1996 39.9 11.5 0.36 Float Mix 0.73 (0.65, 0.80) Ϫ0.01 New Zealand 1979–1981 62.1 7.3 0.24 Fix S 0.99 (0.78, 1.15) 1994–1996 58.7 13.2 0.42 Float M 0.73 (0.63, 0.83) Ϫ0.26* Austria 1979–1981 73.26 11.5 0.61 Fix Mix 0.49 (0.37, 0.64) 1994–1996 77.9 12.8 0.61 EMU Mix 0.37 (Ϫ0.87, 1.49) Ϫ0.12

*p Ͻ .05. 90% confidence intervals calculated using procedures developed by King, Tomz, and Wittenberg 2000. CBI: Ranking of CBI based on Cukierman, Webb, and Neyapti 1992. Exchange Rate Regime: Float ϭ Floating Exchange Rate; Fix ϭ Fixed Exchange Rate; EMU ϭ participation in the EMS after January 1993. For Austria, Finland, and Sweden, participation starts in January 1996. Italy rejoins in 1996. Cabinet Type: S ϭ single-party majority governments. M ϭ minimum-winning coalitions. C ϭ minority and oversize coalition governments. Mix ϭ sample based proportion of different government types. durability associated with actual institutional reforms to be statistically indis- tinguishable or higher than the expected cabinet durability associated with status quo institutions. To evaluate this argument, Table 4 compares expected cabinet durability in 1994–96 assuming the institutions of 1979–81 were in place with the expected cabinet durability in 1994–96 with the actual (reformed) institutions in place. (Recall that, in 1979–81, we coded participation in the EMS as equivalent to a floating exchange rate). Of the sixteen countries in the sample, Political Parties and Monetary Commitments 131 thirteen had reformed the exchange-rate commitment, the central bank, or the electoral system (that is, predominant government type).53 Of those thirteen countries, six had a statistically significant higher expected cabinet durability under the reformed institutions than they would have had with the 1979–81 institutions in place. Only one country, New Zealand, would have enjoyed significantly higher cabinet durability under the old set of institutions.54 A second way to evaluate the argument is to examine the impact of individual reforms. Of the thirty-eight individual reforms shown in Table 3, eleven had a statistically positive impact on cabinet durability—about a third of the reforms. In contrast, only three had a statistically significant negative effect on expected cabinet durability: Italy’s exit from the EMS in 1992, Norway’s abandonment of a fixed exchange rate in 1992, and Belgium’s decision to grant its central bank more independence in 1993. These incidents constitute about 8 percent of observed reforms. The other twenty-four reforms have had no statistically discernable effect on cabinet durability.

Exchange-Rate Commitments and Coalition Governments

The statistical results indicate that exchange-rate commitments provide higher levels of cabinet durability for minority and coalition governments, particularly in open economies. These results square with the empirical association between the adoption of exchange-rate commitments and small, open, proportional representation systems in western Europe.55 Austria, Sweden, Norway, and Finland pegged their exchange rates throughout much of the sample period. Each would have had significantly lower cabinet durability if it had moved to a floating exchange rate. Participation in the EMS after 1987 also significantly increased cabinet durability for Belgium, Ireland, and the Netherlands. In Belgium, for instance, expected cabinet durability increased by 0.30 or more than 430 days for a hypothetical government facing a four-year term. Of the other EMS members, all experienced an increase in expected cabinet durability, although none was statistically significant. Participation in the EMS after 1993 significantly increased expected cabinet durability for Denmark and the Netherlands—even beyond participation in the EMS. In the Netherlands, expected cabinet durability increased by 0.28 or slightly more than

53. Both Britain and Norway altered their exchange-rate institutions during the time period, but by the mid-1990s, each had returned to an exchange-rate arrangement similar to the one in place in 1979–81. 54. In 1979–81, New Zealand had a single-party majority government, a dependent central bank, and a fixed (but relatively soft) exchange-rate commitment. Between June 1979 and June 1982, New Zealand’s currency crawled with respect to a trade-weighted basket. However, the rate of crawl was not announced but was adjusted to inflation differentials. After mid-1982, New Zealand returned to a more fixed exchange-rate arrangement. In 1985, New Zealand dropped its fixed exchange rate, a move that had no statistically discernable effect on cabinet durability at that time. In 1989–90, New Zealand adopted an independent central bank and then, a few years later, a proportional representation system. The combination of those reforms produced an expected cabinet durability in 1994–96 that was equivalent to the expected cabinet durability of a single-party majority government, a dependent central bank, and a floating exchange rate (0.73 versus 0.71). 55. Bernhard and Leblang 1999. 132 International Organization

400 days for a four-tear term. For other member states within the EMS, the post-Maastricht period had a positive but insignificant effect on cabinet durability. Interestingly, prior to the 1990s, the post-Maastricht variable produces a statistically significant decline in expected cabinet durability for all but two member states. It is not until the completion of the internal market and the removal of all cross-border restrictions that such an extraordinary exchange-rate commitment enhances cabinet durability. A similar pattern emerges for countries seeking membership in the EU during the mid-1990s—Austria, Finland, Sweden, and Norway. Prior to the mid-1990s, joining the EU would have resulted in a significantly lower expected cabinet durability for each of these applicant countries. In the mid-1990s, however, participating in the post-Maastricht EMS did not hurt—and, in some cases, improved—expected cabinet durability. The results also indicate that the Maastricht Treaty requirement for each member state to grant its central bank independence as a precondition to participation in the final stage of EMU was relatively costless to implement in terms of cabinet durability. For the eight member states in the sample that participated in the EMS at some point during the 1990s and had relatively dependent central banks (that is, CBI Ͻ 0.52), the effect of granting the central bank more independence (that is, moving CBI to 0.52, about one standard deviation above the mean) had no statistically significant impact on cabinet durability. Only in Belgium did CBI have a negative and statistically significant effect on expected cabinet durability. The actual data on cabinet durability bear out these predictions. For the core EMS states in the sample (Belgium, Denmark, France, Germany, Ireland, and the Netherlands),56 actual cabinet durability improved significantly after 1993. Prior to 1993, the mean cabinet durability for these countries was 0.51. After 1993, mean cabinet durability increased to 0.77 (two-tailed t-test, p Ͻ .02). This increase is even more impressive in the face of a European-wide economic slump during the period, which might have been expected to shorten cabinet durability. Indeed, for sample countries outside the EMS, average cabinet durability declined after 1993 (0.67 prior to 1993; 0.58 after), although this decline was not statistically significant. The commitment to the post-Maastricht EMS appears to have helped those member-state governments weather the economic downturn in the 1990s. These results suggest a political rationale for EMU: helping member state governments cope with the political consequences of economic internationalization. A commitment to the single currency removes a potentially divisive policy issue from the domestic political agenda. Moreover, the Maastricht Treaty requirements helped politicians pursue fiscal retrenchment, providing both incentives for and justification of fiscal discipline.57 The single currency, therefore, can help parties avoid intra-party and intra-coalition conflicts over economic policy, preserving their positions in office and allowing them to rebuild their social coalitions around other issues areas.

56. Italy left the EMS in 1992 and rejoined in 1996. Even if Italy is included in this group, cabinet durability improved after 1993, although the difference is only marginally signiﬁcant (p Ͻ .07). 57. See Hallerberg 1999; Hallerberg and von Hagen 1999; and McNamara 2000. Political Parties and Monetary Commitments 133

Some Speculation: The Coincidence of Central Bank Reform and Electoral Reform

The results may also shed some light on the coincidence of monetary and electoral reform. While single-party majority governments tend to have the most stable cabinets, the statistical results indicate that monetary commitments may, under certain circumstances, extend the cabinet durability of minimum-winning coalition governments beyond that of a single-party majority cabinet. Assuming that a certain set of monetary institutions is in place, therefore, parties may be able to pursue electoral reform without the cost of increased cabinet instability. More specifically, if a country has an independent central bank, politicians may change from a majoritarian electoral system that produces single-party majority governments to an electoral system that produces minimum-winning coalitions (for example, dispro- portionate proportional representation) without sacrificing cabinet durability. The beneficial combination of an independent central bank and a minimum-winning coalition suggests that central bank reform and electoral reform may occur together.58 That is, parties might adopt an independent central bank to help preserve cabinet durability at the same time they are considering the adoption of an electoral system designed to produce minimum-winning coalitions. Consider, for instance, a major party in a majoritarian electoral system faced with the political consequences of increased economic openness: diversified constituent demands, decreased policy effectiveness, and increased intra-party conflict over policy. These intra-party conflicts may threaten to keep the party in opposition by making it increasingly difficult for the party to put forward a unified electoral appeal and, when in office, to maintain party discipline. Party leaders might decide that the party’s political fortunes would improve if they could focus on the party’s core supporters and allow dissatisfied constituents and legislators to form their own party. One way to encourage these dissatisfied actors to leave the major party—and still maintain the major party’s position in the party system—would be to adopt a more proportional (but not fully proportional) electoral system. One potential cost to a major political party of moving from a majoritarian electoral system to a proportional representation system is the prospect of decreased cabinet durability. If cabinets are likely to be unstable, the party might not have access to the policy and distributive benefits of office for as long a period.59 An independent central bank, however, can help the parties in a minimum-winning coalition overcome their potential differences on economic policy and, as a result, improve cabinet durability. At the same time, each party in the coalition can appeal

58. We are not arguing that central bank reform and electoral reform necessarily go together. Both events are far too contingent on a variety of factors for that to be the case. 59. Another cost is that the major party would no longer control all the cabinet portfolios. Laver and Shepsle 1996. But party leaders may judge that controlling most of the portfolios for a longer time is superior to controlling all of the portfolios for a shorter time (and, when in opposition, controlling none of the portfolios). 134 International Organization to the interests of its constituents. Parties, therefore, may use central bank reform as a way to shield themselves from some of the consequences of electoral reform. Interestingly, central bank reform and electoral reform have coincided in a number of industrial democracies. In New Zealand, the adoption of an independent central bank occurred just prior to major electoral reform. Before the 1990s, New Zealand had possessed a typical “Westminster” system, with two-party competition between the Labour party and the National party.60 In 1989–90, the Labour government reformed the central bank, uniquely linking the bank’s policy performance with the central bank governor’s tenure.61 When the National party won the 1990 election,62 it honored a pledge it had made in opposition to hold a referendum on the electoral system.63 In 1992, voters rejected the first-past-the-post electoral system, supporting a mixed majoritarian-proportional representation system. Since the implementation of that reform, several new parties have appeared, and New Zealand has experienced minimum winning coalitions rather than single-party majority governments. The expected cabinet durabilities based on the statistical results indicate that electoral reform without central bank reform would have resulted in a shorter cabinet durability (0.71 versus 0.59)—a difference of about 120 days for a hypothetical government beginning a three-year term. With central bank reform, however, the electoral reform did not have any meaningful effect on expected cabinet durability (0.73 versus 0.71). In Britain, the Labour government announced the 1997 reform of the Bank of England amid plans for other institutional changes, including regional devolution and the exploration of electoral reform. The Jenkins Committee proposed an alternative vote system combined with additional member constituencies, a compromise between the traditional first-past-the-post system and proportional representation that would likely produce minimum-winning coalitions. In the absence of central bank reform, the proposed electoral reform would shorten expected cabinet durability (0.66 versus 0.57) or about 240 days for a hypothetical government beginning a five-year term. With a more independent Bank of England, however, the electoral reform will have no effect on expected cabinet durability. In both Italy and Japan, central bank reform and electoral reform also occurred closely together. In Italy, just as the central bank received greater policy autonomy from the government in the early 1990s, the political system disintegrated under the weight of corruption scandals, increasing regional disparities, and voter dissatisfaction with Italy’s ruling parties, particularly the Christian Democrats. In a series of referenda, Italian voters approved an unusually complicated mixed majoritarian-proportional representation electoral system. Both reforms were designed, in part, to increase cabinet

60. Lijphart 1999. 61. See Walsh 1995b; and Dalzeil 1993. 62. The economic reforms instituted by the Labour government had exacerbated existing divisions within the National party. Consequently, the new National government had a “somewhat unwieldy caucus of backbenchers with widely differing views on the economy.” Keesing’s Archives 1991, 37(11): 38643. 63. The Economist, 26 September 1992. Political Parties and Monetary Commitments 135 stability. In Japan, central bank reform (1998) followed shortly after electoral reform in 1993. The electoral reforms have produced a series of coalition governments to replace the Liberal Democratic party’s dominance of the political system. The coincidence of central bank reform and electoral reform suggests a similar underlying cause: politicians are seeking to insulate themselves from the political consequences of economic internationalization. Established political parties are using institutional reforms to balance conﬂicting interests, rebuild social coalitions, and maintain electoral viability. An independent central bank can help protect cabinet durability even as politicians explore alternative electoral arrangements.

Conclusion

In one sense, the findings in this article are not particularly controversial. As with much of the recent literature in international political economy, we connect economic internationalization and monetary commitments. What is different, however, is the mechanism that links internationalization and those monetary commitments. Much of the literature contends that economic openness—particularly international capital mobility—presents an external constraint on policymakers, forcing them to choose certain types of policies and commitment technologies. Instead, we provide an explicitly political mechanism to link internationalization and monetary commitments: party leaders use monetary commitments to help manage the political consequences of economic internationalization. Increased openness alters the policy preferences of constituents in the electoral coalitions of the traditional governing parties, creating the potential for policy conflict among constituents and among party politicians. Internationalization also decreases the ability of the government to deliver macroeconomic outcomes. Both these developments are likely to hurt the ability of the traditional parties to maintain their position in office. Under certain circumstances, however, monetary commitments can help parties balance those diverse interests and increase their policy effectiveness. And where politicians benefit from those monetary commitments, they are likely to adopt them. Our focus on cabinet durability is simply one way to measure the political value of fixed exchange rates and CBI. The results indicate that both exchange rate commitments and CBI can improve cabinet durability, but their effects depend on the level of economic openness and the configuration of domestic political institutions. By placing the incentives and goals of political parties at the center of the analysis, however, we can begin to explain the choice of both exchange rate commitments and CBI.

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For more than thirty years, until the completion of Economic and Monetary Union (EMU), the member states of the European Union (EU) attempted to fix regional exchange rates. Naturally enough, most explanations of this process emphasize its monetary sources and effects. Some focus on how creating a multinational currency area might increase the efficacy of monetary policy. Others stress how fixing a national currency to a low-inflation monetary anchor, or adopting a single low- inflation currency, might enhance the anti-inflationary credibility of national monetary policies.1 In these views, European monetary integration was motivated by the belief that, by themselves, national monetary authorities would be unable or unwilling to pursue appropriate monetary policies. In this article, I focus, in contrast, on what might be called real as opposed to monetary sources and effects of European currency policies—that is, their expected impact on cross-border trade and investment. Exchange rates regulate the relationship between foreign and domestic prices, and thus the predictability and profit- ability of cross-border trade and investment. Rather than restrict my analysis to monetary reasons for exchange rate policies, I suggest examining motivations that come from the country’s trade, financial, and investment ties. In this view, policymakers weighed the costs and benefits of fixed exchange rates with regard to their impact on national trade and investment. The principal benefit of fixed rates and a single currency was to facilitate intra-European trade and investment; the principal

The author acknowledges the invaluable research assistance of Kathleen O’Neill and Mark Copelo- vitch. He also acknowledges the comments and suggestions of Alberto Alesina, S. Brock Blomberg, William Clark, Michele Fratianni, Geoffrey Garrett, Carsten Hefeker, David Leblang, Lisa Martin, Andrew Moravcsik, J. David Richardson, Andrew Rose, and of participants in seminars at Harvard University, Princeton University, Syracuse University, the University of California Los Angeles, and Washington University. 1. Another broader perspective looks at how EMU was linked to the general drive for European integration. Accurate as this may be—for an argument in its favor see Frieden 2001—it still relies on implicit assertions about the ultimate costs and beneﬁts of monetary integration. Most such assertions focus, as do the two mentioned here, on the monetary (anti-inﬂationary) aspects of the process.

International Organization 56, 4, Autumn 2002, pp. 831–860 © 2002 by The IO Foundation and the Massachusetts Institute of Technology 140 International Organization cost was losing the ability to manipulate currencies to change the relative prices of foreign and home products and thus the competitive position of national producers. The various weights that different economic interests gave to these costs and benefits help explain the political economy of European monetary integration. While this real interpretation of national currency policies might be consistent with explanations based on their monetary policy effects, it does lead to a very different emphasis, particularly with regard to the political supporters and opponents of monetary integration. Arguments based on anti-inflationary credibility and Optimal Currency Areas (OCAs) emphasize economic efficiency or very broad constituencies with different degrees of inflation aversion; the real argument here implicates much more specific distributional factors. In particular, it predicts support for monetary integration from cross-border investors and exporters of specialized manufactures who stand to lose from currency volatility. It anticipates opposition from those, especially import competers, who stand to lose from the inability of national governments to engage in depreciations to gain international competitiveness. The European experience provides a useful laboratory to investigate these claims. Over three decades, European currency relations experienced a great deal of variation. The snake and early European Monetary System (EMS) had only limited success, while the later EMS went through a cycle of optimism, crisis, and renewed optimism in the runup to EMU. While some countries were generally able to persist in pegging their exchange rates to the deutsche mark (DM), others were quite unsuccessful for long periods of time. This allows us to assess both why the fortunes of fixed rates varied over time and why their attainment varied so much among European countries. I suggest that the answers to these questions require prominent consideration of the sectoral implications of currency policy’s real impact, especially how fixing the exchange rate was expected to affect both those with strong interests in expanding inter-regional trade, finance, and investment and those with strong interests in limiting the impact on them of foreign competition. In this article, I look at the statistical record of exchange rate movements in Europe from 1973 until 1995. Although it is extremely difficult to find good proxies for interest-group pressures, especially in a cross-national context, I use two measures as indicators of private-sector concerns about the real effects of currency policy. The first is the level of manufactured exports to Germany, as a proxy for the interests of internationally engaged producers and investors who wanted to stabilize exchange rates. The second is changes in the trade balance (controlling for the state of the current account), which should reflect the level of concern about import and export competition. These measures have empirically important and statistically significant effects on both the rate of devaluation of national currencies against the DM and on their volatility (two closely related policy outcomes). Countries with more manufactured exports to Germany were more likely to sustain a currency fixed to the DM, consistent with the argument that exporters of complex manufactures were interested in currency stability. Periods of deterioration in the trade balance were associated with more subsequent floating and depreciation, consistent with the Sectoral Interests and European Monetary Integration 141 argument that difficulties in import and export markets led affected interests to support depreciation to improve their competitive position. Other factors also affected exchange rates. Positive macroeconomic trends— economic growth, a payments surplus, improvements in the terms of trade—reduced the propensity to devalue and currency volatility. There is little evidence for the explanatory importance of purely monetary considerations, such as the need for national anti-inflationary credibility—although admittedly the demand for credibility is extremely hard to measure. For example, countries with left-wing governments, presumably in greater need of anti-inflationary credibility, were not more likely to fix their currencies, and fixing the exchange rate was not more likely to be used when the country lacked an independent central bank. This is not to say that anti-inflationary credibility was never a reason why governments fixed their exchange rates, only that it is difficult to find evidence of its significance in the case of European monetary integration. Nor is much support found for OCA factors, specifically the similarity of industrial structure among countries and thus their propensity to face conditions that would call for similar monetary responses. These results indicate that European currency policies were strongly affected by their expected real effects, that is, their impact on trade and investment. The results do not support—but cannot conclusively reject—monetary interpretations of Euro- pean currency relations based on the anti-inflationary credibility-enhancing features of a fixed exchange rate or on OCA considerations. I begin with a summary of possible explanations of European monetary integration and how they relate to broader political economy arguments. I then argue for the role of real factors, and their distributional impact, in the evolution of European currency policies, and go on to present statistical evidence relating to the argument.

European Monetary Integration: Variation and Explanation

The ultimate success of European monetary integration has tended to obscure the variegated history of the region’s currency policies. In fact, exchange-rate arrangements in the EU have gone through many stages, and the policies of EU member governments have varied widely. The ﬁrst formal attempt to create a European zone of monetary stability came as the Bretton Woods system collapsed, with the 1973 formation of the “snake in the tunnel.”2 Within a few months, only Germany, the Netherlands, and Belgium/Luxembourg (which shared a currency) were full participants, with Denmark sometimes included; this remained the case until 1979. In that

2. Such expressions of intent predate the Treaty of Rome, although their relevance was limited before the Bretton Woods system began to collapse. In this article, I call the organization in question the EU, despite its several names in the period under review. For a less telegraphic survey of these developments, see Frieden 1997a. For a detailed analysis, which is roughly consistent with the argument here, see Moravcsik 1998, 238–313. 142 International Organization year, a new EMS and its exchange-rate mechanism (ERM) came into operation. The EMS appeared to have added little to the snake for its first five years: only Germany and the Benelux countries, and now more reliably Denmark, were able to keep their currencies more or less aligned. But between 1983 and 1985, France, Italy, and Ireland began to lock their currencies to the DM. From 1985 until 1992, the monetary unification process gained momentum, eventually attracting such improbable candidates as the United Kingdom (long unwilling) and Spain and Portugal (long unable). The Nordic countries and Austria, not EU members but considering joining, also tied their currencies to the EMS. In this setting, member states began to plan for a common European currency within a broader EMU. Progress toward this goal was interrupted in 1992–94, as tight German monetary policy in the aftermath of German unification drove many EMS members to let their exchange rates move—with at least a widening of the acceptable target zone and at most a substantial depreciation. Momentum for EMU was rebuilt after the currency crises faded. Eleven EU members started the final steps toward a single currency in 1999, Greece joined in 2000, and these twelve finalized full currency union in 2002. We can use these dimensions of variation to evaluate explanations of European monetary integration specifically and of currency policy more generally. Attempts to hold to fixed exchange rates3 were more successful at some times than at others in Europe. In addition, EU members had highly varied experiences within the snake and EMS. Therefore, meaningful variation occurs both over time and among countries.

The Dependent Variables The policy choice most in need of explanation can be expressed simply: the degree of fixity of the nominal exchange rate to the DM. This definition of the thing to be explained, which might be questionable in other historical and regional contexts, is justifiable in post-1973 Europe. First, exchange rate stability was a publicly stated goal of all EU members. Second, it was clear early on that such stability implied fixing against the DM. Third, the attention of all relevant actors—policymakers, observers, economic agents—was on nominal exchange rates.4 The statistical analyses use two simple measures of trends in national currency values against the DM. The first is the annual rate of nominal depreciation, which

3. For simplicity, I consider the target zones of the snake and ERM equivalent to a fixed-rate system. This raises two problems. First, target zones imply fixing within a much broader range than is usually associated with fixed rates. However, the general policy problem is similar, especially when—as has been the case—currencies have often reached the limits of their bands. Second, the acceptable bands were substantially widened in the aftermath of the 1992–94 crises, so this first point may be less valid recently. However, with the exception of the Irish pound, most currencies that stayed within the wider-band ERM kept roughly inside their previous narrow band, and the Irish pound appreciated (as sterling rose), which represents a less troubling policy problem than the more common pressure to depreciate. 4. I avoid the stronger claim that nominal and real exchange rates were tightly linked in the period, even though there is substantial evidence for this in almost all European countries. Sectoral Interests and European Monetary Integration 143 directly measures the general trend of the currency against the DM anchor. (All European currencies decline relative to the DM over the period, so there are no appreciating currencies.) The second measure is the annual coefficient of variation of monthly exchange rates. This gauges shorter-term volatility within each year rather than the trend of the currency’s value. Table 1 shows these two measures of the stability of European currencies against the DM. The table includes the thirteen pre-EMU EU currencies other than the DM (Luxembourg shared a currency with Belgium), plus that of Norway.5 The table is divided among four groups: hard-currency countries are those that were always members of both the snake and the ERM, soft-currency countries are those that were not reliable members of either, and intermediate countries are those that were members of the ERM but not the snake. The four countries that were not in the EU before 1995 (one of which, Norway, remains a nonmember) are shown separately. The simplest way to measure the relationship between exchange rates is the rate of change in their nominal values, in this case the average annual rate of depreciation against the DM, as presented in panel A of Table 1. This has the advantage of transparency of interpretation; however, it does not indicate potential currency volatility. For this purpose, the coefficient of variation of national currencies against the DM is presented in panel B of Table 1.6 The two measures produce very similar classifications of countries and country-years, and when used in statistical analysis, they give rise to virtually identical results. However, the differences are also interesting, as they pick up (inasmuch as they differ) differences between determinants of broad currency policy and of shorter-term policy toward volatility.

Explaining European Currency Policies

The varied progress and nature of European currency arrangements has attracted much analysis. Three common explanations of European monetary integration are relevant; they can be considered in the rough order in which they gained academic currency.7 The ﬁrst set of explanations emphasized criteria associated with OCA theory.8 OCA theory speciﬁes circumstances under which it is optimal for a nation

5. There might be an argument for including Iceland and Switzerland, except that neither has expressed real commitment to European currency stability. Iceland has had relatively high and variable inflation, and Switzerland’s international financial role makes purely European considerations somewhat less relevant. 6. The coefficient of variation is the standard deviation divided by the mean; in Table 1, currency values are taken at monthly intervals so that the volatility being measured is monthly over the periods in question, which are of five or six years. For the statistical analyses, the value is the volatility of monthly exchange rates over each country-year. This picks up both overall declines against the DM and general volatility, so that differences between the two dependent variables are presumably ascribable to different determinants of volatility itself (as opposed to depreciation). 7. The European literature discussed here parallels that described in Bernhard, Broz, and Clark 2002. 8. Mundell 1961; McKinnon 1963; and Kenen 1969 are early classics; Masson and Taylor 1993; and Tavlas 1994 are more recent surveys. 144 International Organization

TABLE 1. European currencies during the snake and the EMS

A. Average annual percentage depreciation of nominal exchange rates against the DM, select periods 1973–78 1979–83 1984–89 1990–94

Hard Currencies Netherlands 1.14 0.77 0.01 Ϫ0.13 Belgium 2.36 4.24 1.01 Ϫ0.48 Denmark 4.59 4.37 1.71 0.16 Intermediate Currencies France 6.53 5.02 2.31 0.01 Ireland 12.90 3.02 3.49 1.96 Soft Currencies United Kingdom 12.90 0.89 6.68 2.57 Italy 17.28 5.26 4.08 6.21 Spain 12.35 6.54 3.51 5.16 Greece 13.24 13.02 18.75 10.23 Portugal 20.83 14.16 10.64 2.88 Non–EU Members Austria 0.12 Ϫ0.71 Ϫ0.12 0.19 Norway 4.92 1.08 6.61 2.29 Finland 8.83 Ϫ0.32 3.06 6.83 Sweden 8.41 3.83 5.35 6.18 AVERAGE 9.03 4.37 4.79 3.15

B. Coefﬁcients of variation of nominal exchange rates against the DM 1973–78 1979–83 1984–89 1990–94

Hard Currencies Netherlands 2.15 1.18 0.31 0.43 Belgium 2.80 9.84 1.55 1.17 Denmark 7.20 7.99 2.85 1.57 Intermediate Currencies France 11.00 10.74 4.59 1.00 Ireland 20.47 6.75 7.02 4.83 Soft Currencies U.K. 20.47 7.43 10.91 8.11 Italy 24.02 10.64 6.63 12.56 Spain 23.14 16.31 7.38 11.65 Greece 18.43 18.98 26.54 14.66 Portugal 35.65 21.75 17.57 7.31 Non–EU Members Austria 1.63 1.48 0.23 0.23 Norway 8.28 4.89 11.40 5.00 Finland 14.24 5.63 6.06 16.08 Sweden 12.54 12.20 8.23 13.00 AVERAGE 14.43 9.70 7.95 6.97 Sectoral Interests and European Monetary Integration 145 to give up its exchange-rate autonomy.9 This is the case where exchange-rate policy would otherwise be superfluous, either because it would be ineffective or because it could better be carried out by a bloc of national monetary authorities rather than alone. High levels of factor mobility among countries make individual national currency policies ineffective, while production structures that imply correlated exogenous shocks make such policies unnecessary. The more mobile factors are across countries and the more similar their susceptibility to external shocks, the more desirable is a monetary union. Scholars quickly concluded that this was unlikely to explain very much of European currency policy. There was too little labor mobility among European countries, and too little correlation among exogenous shocks, to justify the level of interest in currency unification. Europe was not an OCA, and even the “hard core” of the EMS may not have been one at the time it was established.10 Of course, on both dimensions there is variation among EU member states, so that some might be more appropriate members of a currency union than others. OCA criteria may have had differential effects on different countries that are worth considering. To assess the degree to which OCA criteria affected currency policy, I examine the impact of the similarity of each nation’s industrial structure to that of Germany. (The appendix contains details on this and other measures used in this study.) This is the measure least likely to be endogenous to currency policy; such things as factor movements to and from Germany, another popular OCA proxy, are much more likely to be affected by real or anticipated currency policy than national industrial structure. A second set of arguments, motivated in part by the generally recognized failure of the OCA approach to explain European monetary integration, focused on the possibility that European countries pegged to the DM to “import” German anti-inflationary credibility.11 Various arguments have been proposed as to why a currency peg might itself be more credible than simply committing to lower inflation.12 Along these lines,

9. Although the theory is about currency unions, it applies—perhaps less stringently—to fixed-rate systems. Canzoneri and Rogers 1990 discuss optimal-taxation (seignorage)-based evaluations of currency union, but these seem unlikely to have been empirically particularly important. 10. Capital is more mobile than labor, but its relevance to adjustment is not so clear; capital controls were very common until the late 1980s. Two representative and influential studies are De Grauwe and Vanhaverbeke 1993 and Bayoumi and Eichengreen 1993. Frankel and Rose 1998 present the intriguing possibility that if “unsuitable “ countries form a currency union they might evolve to be more suited over time, as their factor markets become more integrated and their production structures more similar. 11. See Giavazzi and Pagano 1989; and Weber 1991. 12. Most plausible are that the exchange rate is much more visible to market operators than is monetary policy and that deviating from a peg imposes more costs on policymakers because of its impact on both inflation and cross-border relative prices. Broz 2002 presents one version of the argument and some evidence about its applicability. However, the logic of the argument is not fully worked out—it is hard to see why a stated commitment to a currency target is more credible than a stated commitment to a domestic monetary target. Indeed, Fratianni and von Hagen 1991 argue against any substantial independent effect, but the evidence is hard to evaluate. 146 International Organization it is commonly argued that European exchange-rate arrangements served as a nominal anchor for credibility-enhancing purposes.13 Certainly this could not explain German support for monetary integration, which is why some scholars focus on geopolitical rather than economic-policy grounds to explain German policy.14 It is also irrelevant to the important cases of Austria, Belgium/Luxembourg, Denmark, and the Netherlands, all of which were low- inflation countries that stood only to lose monetary credibility from linking their currencies to those of high-inflation countries. But there are undoubtedly European countries for which an attraction of the currency peg and single currency was the link to monetary-policy credibility. There are no good proxies for government desire for anti-inflationary credibility. Just about anything that might increase the demand for credibility will also increase the difficulty of attaining it. For example, the rate of inflation presumably raises both the value of a credibility-enhancing peg and the cost of implementing one—so its impact is likely to be indeterminate. However, the literature suggests that governments with independent central banks have less need for the potential credibility enhancements of a fixed exchange rate. And others have argued that left-wing governments, with a generally inflation-acceptant reputation, are particularly likely to need the credibility a peg can provide.15 I thus assess the credibility argument, quite imperfectly, by seeing whether fixed rates are associated with the absence of central bank independence, or with leftist governments. More recently, an alternative (or perhaps a supplement) to these monetary policy–based approaches has arisen, emphasizing the real effects of currency stability and currency union on cross-border trade and investment. Many scholars had been skeptical of such effects, as the prevailing wisdom held that deep forward and futures markets made currency volatility a trivial matter. But more recent research has found that reducing currency fluctuations, and especially sharing currencies, has a very substantial impact on cross-border trade. One controversial study found that currency unification tripled trade among union members.16 This has refocused attention on the ways in which currency policies can affect the environment for international trade and investment. By extension, it reinforces the plausi- bility of explanations of currency policy that focus on its impact on a country’s trade and financial ties. The argument made here builds on this third body of thought, emphasizing the real effects of currency policy and thus its impact on trade and investment. The effects of most importance to policy choice are of two sorts. First, just as currency

13. Milesi-Ferretti 1995, however, discusses how policymakers may have partisan electoral incentives not to tie their hands, inasmuch as precommitment strategies might reduce the electoral disadvantages of potential opponents. If, for example, Left parties have a bad inflationary reputation, anything that reduces a government’s ability to inflate reduces the electoral disadvantage of the Left. 14. Garrett 2001. 15. On central bank independence, Broz 2002 is a good example; on Left governments, see Simmons 1994. 16. Rose 2000. Sectoral Interests and European Monetary Integration 147 volatility increases the riskiness of cross-border transactions, exchange-rate stability reduces uncertainty about a price of great importance to those involved in cross- border economic activity. Second, currency movements affect the relative prices of home and foreign goods and services, and currency flexibility allows policymakers to vary the exchange rate, especially to devalue and make domestic products cheaper relative to foreign goods.17 Policymakers thus face a trade-off between exchange- rate flexibility and exchange rate stability, and political economy factors—especially the relative importance of groups in society who stand to gain from one or the other side of the trade-off—have a powerful impact on their ultimate choice.18 The trade-off between exchange-rate stability and the freedom to vary the currency’s value tends to pit two broad groups against one another, based on how highly they value the two conflicting goals. Both import-competing and exporting firms are helped by depreciation. For this reason, I expect opposition to fixing exchange rates to come especially from import-competing and exporting sectors. Conversely, the less threatening import- and export-market competition is to national producers, the less likely they are to oppose fixing the exchange rate. On the other hand, exchange-rate volatility principally affects those with substantial cross-border contractual interests. Foreign investors, lenders, and borrowers dislike the unpredictability associated with substantial fluctuations in currency values, which are often not amenable to hedging at longer time horizons. In addition, volatility typically harms exporters of goods with limited pass-through, that is, goods whose prices to consumers do not fully reflect exchange-rate movements, usually due to substantial product differentiation.19 I expect those with cross-border economic interests to have been more oriented toward fixing the value of the national currency.20

17. Although governments cannot affect the real (inflation-adjusted) exchange rate at will, available evidence is strong that policy can have a powerful impact over the medium run, usually estimated as four to seven years. For surveys, see Frankel and Rose 1995; and Rogoff 1996. 18. The argument here is closely related to that made in Frieden and Stein 2001 and tested in the Latin American context in Frieden, Ghezzi, and Stein 2001. It is consistent with the long-term neutrality of money and the efficiency of forward markets: short- and medium-term factors are politically relevant, and forward markets are limited in their ability to protect economic agents far into the future. 19. Pass-through refers to the extent to which movements in exchange rates are reflected in product prices. Some goods, especially highly standardized ones sold in highly competitive markets (for example, wheat, textiles), reflect exchange-rate changes immediately. Producers of other sorts of goods, especially more specialized and differentiated products in which quality, service, and customer loyalty—things related to market share—matter, are more reluctant to vary prices. This has been observed in such goods as transport equipment (think of the non-responsiveness of the prices of Japanese cars in the United States to the dollar-yen exchange rate), commercial aircraft, and machine tools. Goldberg and Knetter 1997 is an excellent survey. 20. I recognize that there are somewhat heroic assumptions underlying these assertions and do not defend them here. Certainly currency volatility is less costly when it is mean-reverting, and forward contracts are valuable; uncertainty is simply a part of doing business, some firms make money on currency fluctuations, and limited pass-through cuts both ways (to mention a few of the most common objections). However, relatively simple models with some price stickiness can easily provide the results I assert. In any case, whether these effects are present, and are politically relevant, is an empirical question—one that I attempt to assess here. 148 International Organization

There is one category of firms that can be divided in confusing ways by this trade-off: manufactured exporters. In general, exporters favor maintaining the exchange rate as an active policy instrument. The exporters and import competers most sensitive to nominal exchange rate levels are those whose product prices are more or less fully passed through, typically standardized products such as commod- ities, clothing, footwear, and steel. But the impact of the level of the exchange rate is mitigated in the case of industries with little pass-through; an appreciation does not cause an analogous rise in the (foreign-currency) price of exports, nor does a depreciation significantly increase (domestic-currency) export prices. In these instances, the exchange risk is carried by the export-producer, so that currency volatility can be quite costly. A common example is that of automobiles, which are priced to local market conditions. If the yen appreciates against the DM, studies find, Japanese car exporters hold their German prices steady, out of fear that price increases would lose them market share. For this reason, exporters of specialized, product-differentiated manufactured goods—typically the most important European exporters—are less likely to want a weak exchange rate and more likely to value currency stability. To summarize, I expect division between economic actors who support and oppose fixed rates for real rather than monetary reasons. Cross-border investors and financial actors, as well as export-competing producers of specialized manufactured goods, will be in favor of fixed rates. Producers of standardized import-competing and export goods—those in favor of maintaining the national ability to depreciate the currency—will be against fixed rates. This reflects the trade-off mentioned before, between stability and a predictable currency value, on the one hand, and the flexibility to alter currency values to facilitate competition with foreigners, on the other. Of course, much nuance and complexity is still masked. There are firms for which the trade-off between reduced currency volatility and the loss of exchange rate autonomy is not clear, either because both are important or because neither is important. I also have (mostly for brevity’s sake) ignored the interests of nontrad- able producers, such as public sector employees and small businesses, which typically favor maintaining monetary policy autonomy rather than sacrificing it to stabilize currency values that have little direct impact on them. The principal argument of this study, then, is that exchange-rate policy has enough prominent real economic and distributional effects to matter politically. Specifically, principal supporters of fixing European exchange rates were firms and industries with major cross-border investments, markets, or other business interests; principal opponents were producers of standardized import-competing and export products. In national political debates, this sometimes took the form of allegations that monetary integration was a tool of big business, or that opposition to monetary integration came from more backward and uncompetitive sectors. I expect the support of the former for fixing exchange rates to be relatively constant, while the opposition of the latter should increase at times of a real appreciation and associated Sectoral Interests and European Monetary Integration 149 competitive difficulties for national producers.21 This distributional aspect of Eu- ropean currency politics has been absent in most analyses of European monetary integration, and contrasts with the general focus on the anti-inflationary effects of the thirty-year process of currency unification.22 My focus on special-interest considerations is not meant to deny the potential importance of other factors, but rather to redress an imbalance in the literature. While special interests are a natural starting point for most economic policy analyses, this has not been the case for exchange-rate policy. In fact, many analysts are skeptical of the view that there are constituencies for and against currency policy. Prominent macroeconomists believe that the distributional effects of currency regimes are unclear, small, or both, while many political scientists believe that substantial collective action problems preclude serious politicking over currency values.23 Both positions are open to challenge. Economically, almost every attempt to fix exchange rates involves substantial real appreciations, with equally substantial distributional implications. Even in the steady state, it is not obvious that volatility is distributionally neutral, both in general and with regard to exchange rates; at the very least, clear evidence for this hypothesis is still lacking.24 Politically, the extraordinary political prominence of exchange rates in history and today seems to call the assertion into question. From the 1860s until the 1930s, the gold standard was a major, and mass, political issue in most countries; since 1980, exchange rates have been domestic “high politics” in many developed and developing countries as well.25

The Principal Explanatory Variables Attempts to evaluate arguments based on the distributional effects of exchange-rate policies are hampered by the general unobservability of special-interest politics. In this article, I use two variables that can be interpreted as affecting policy by way of

21. Again, all this leaves out much detail. One of the more interesting features of the runup to EMU was that import competers in the likely core increasingly came to insist on including the periphery— especially Italy and Spain—to eliminate the possibility of such “competitive depreciations” as those of 1992–4. Perhaps most striking in this regard is the position of import-competing French industries, which went from opponents of the EMS in the early 1980s to strong suppporters of a broad EMU by the mid 1990s. In the former period, EMS membership ruled out a French devaluation and led to a real appreciation; in the latter period, Italian and Spanish non-membership in EMU would have allowed them to depreciate against the franc, again causing a real appreciation of the French currency. The result was that potentially affected firms switched from opposition to French membership in the EMS to strong support for the inclusion of the entire EU in EMU. 22. For some exceptions, see the essays in Jones, Frieden, and Torres 1998; Pisani-Ferry, Hefeker, and Hallett 1997; and Hefeker 1997. 23. See Giovannini 1993 for an example of the former; and Gowa 1988 for a classic statement of the latter. 24. An interesting perspective on the potential costs—including distributional effects—of volatility is Inter-American Development Bank 1995. For arguments that currency volatility does matter, see Hefeker 1997; and Neumeyer 1998. 25. Frieden 1994 and 1997b discuss the issue in a historical and contemporary perspective. 150 International Organization their differentiated and distributionally relevant effects on particular groups. The first attempts to pick up the interests of manufacturers with significant intra- European export interests; the second tries to capture the interests of those facing significant import and export competition. Neither is unproblematic, but there are no readily available superior alternatives. The two variables are as follows. 1. Exports to the German currency bloc. As discussed above, I expect that producers of specialized manufactured products will seek to keep exchange rates stable. Of course, this is countered by concern for the level of the real exchange rate. Keeping this in mind, manufacturers where pricing to market is common tend to oppose currency volatility. This should be of special importance in European monetary politics to the extent that manufactured exports to Germany are significant. Here I use exports to the DM bloc, defined as Germany plus Benelux. The higher the share of manufactured exports to the DM zone as a share of gross domestic product (GDP), the more support I expect for stabilizing the currency with the DM. The use of the DM bloc as the relevant region is unimportant: overall manufactured exports to Germany alone, or to the broad EU, as a share of GDP are highly correlated with this, and their use yields nearly identical results. The variable name I use for this is MANUFACTURED EXPORTS TO DM ZONE AS PERCENT- AGE OF GDP, and I expect the sign to be negative. (A negative sign implies that a higher value of the variable is associated with less devaluation and less volatility. The appendix describes all variables in detail.) 2. Import competition. On the other hand, some of the most significant pressures to depreciate (or not to join the snake or ERM) came from producers that stood to lose from their government’s foregoing the ability to change the exchange rate to affect competitiveness. Although there is no ready way to measure concern about competitive pressures, one reasonable proxy is the rate of change in import and export competition. That is, where a country’s producers are experiencing a surge in imports or a drop in exports, they are more likely to be interested in a depreciation and less supportive of fixing the exchange rate. This implies that a deterioration in the trade balance should increase support for depreciation and reduce support for a fixed rate. This is analogous to the common observation that increased import competition tends to increase protectionist pressures from affected industries.26 In using this measure, I control for the state of the current account for important reasons. It would not be surprising if large current account defi-

26. It has analogous weaknesses. In fact, if producers can gain from a depreciation, or from trade protection, they should support these no matter how much import competition they face (even in the absence of import competition). Nonetheless, the virtually universal observation is that support for protection/depreciation is strongly affected by import competition. A variety of explanations for this have been proposed, but serious consideration of these is well beyond the scope of this article. Sectoral Interests and European Monetary Integration 151

cits were associated with depreciations, for they put direct currency-market pressure on the exchange rate. However, what I use here is the impact of changes in the trade balance controlling for the state of the current account. This measure can only plausibly be picking up particular sensitivity to trade relations, the state of imports and exports. This variable is not simply the economic impact of a trade deficit: a trade deficit that does not lead to a current account deficit does not put pressure on the currency in foreign exchange markets. It thus seems reasonable to regard it as an indicator of the position of national import-competers and export-competers.27 The greater the deterioration in the trade balance (again, controlling for the current account balance), the greater the pressures to depreciate. Here I use the change from the previous year in the trade balance as a share of GDP, so that a positive (negative) number is an improvement (deterioration). The variable name I use for this is CHANGE IN TRADE BALANCE AS PERCENT OF GDP, and I expect the sign to be negative.

The two proxies for private interests I use here are not as close as we might like to what we want to measure, the lobbying behavior of private interests. Nor do they cover all the private interests I argue should matter, especially those of cross-border investors. Better proxies, however, are difficult to identify, let alone obtain data on. The extent of intra-European trade is probably a reasonable approximation of the importance of stabilizing exchange rates for traders and export-oriented producers. But this ignores the interests of cross-border financial and investing interests—for the simple reason that data on them are essentially unavailable. One might imagine that foreign direct investment (FDI) among European countries would be easy to obtain. Unfortunately, this measure is only available for a few countries before the early 1980s, and even then with much error. When the statistical analysis is performed with FDI data, more than half of the observations have to be omitted, and the omitted countries are biased toward Southern Europe. It is thus not clear that these results (which are not reported here but which tend to be similar to those for manufactured exports) are valid. The FDI measures are in any case correlated (correlation coefficient of 0.54) with the manufactured export figures. It is, by the same token, extremely difficult to come up with reasonable proxies for private- sector concern about the ability to use the exchange rate to affect competitiveness. The strategy used here—to look at increased net imports as an indicator of how much competition producers face—has many flaws, but seems better than available alternatives. All in all, the two measures used are plausible, if imperfect, indicators

27. Of course, the trade balance also picks up exports, and this is also a measure of pressures from exporters for a “competitive depreciation.” In a sense, the inclusion of overall levels of exports in the previous measure and consideration of changes in net imports in this measure provide a contrast between a structural or secular trend in manufactured exports, on the one hand, and year-to-year surges in net imports on the other. It seems legitimate to presume, at least as a ﬁrst cut, that these are reasonable proxies for specialized exporting and import/export-competing interests, respectively. 152 International Organization of important private sector interests in currency policy. In the absence of other suitable indicators, they constitute a reasonable ﬁrst cut.

Alternative Explanatory Variables. As mentioned above, the principal alternative perspective emphasizes currency pegs as anti-inﬂationary commitment mechanisms; some attention is still paid to OCA theory. The variables I use to evaluate these arguments are as follows.

1. Credibility concerns. It is hard to imagine any clean measure of the demand for anti-inflationary credibility. Of course, high inflation implies a greater need for credibility, but it also implies a higher cost of achieving it. In addition, high inflation leads directly to currency depreciation when the authorities are not using the exchange rate as an anti-inflationary commitment device, which invalidates any simple expectation that high inflation should be generally associated with currency stability. Ideally, we would like a measure that reflects government need for, or use of, currency policy for credibility purposes; there is no simple way of assessing this. Here I use a series of measures all of which could plausibly be associated with government desires to enhance anti-inflationary credibility. None is a direct measure of the demand for credibility, but all are potentially related to it. A. Central bank independence. Inasmuch as the independence of the central bank is associated with lower inflation, this should reduce the government’s need for the anti-inflationary credibility that a currency peg is purported to provide, and thus reduce the likelihood of such a currency link. A more dependent central bank, on the other hand, should increase the demand for credibility and thus the likelihood of a currency peg. The measure used is the standard one created by a group of scholars in 28 an influential study. Variable name (expected sign): CENTRAL BANK IN- DEPENDENCE (ϩ). B. Partisan effects. To the extent that the Left is more inflation prone than the Right, we expect the Left to have a greater need for the sort of commitment technology that a currency link is expected to provide. So, the further Left a government, the more likely it is to choose the DM currency peg. The variable used here measures the partisan (Left-Right) nature of the cabinet in power; parties are coded on a widely accepted scale and weighted according to their importance in the cabinet. On this scale, lower numbers are more to the Left. (Alternate measures of the legislative center of gravity, or the government’s ideology, which use similar scales, yield nearly identical results.) Variable name (expected sign): CABINET CENTER OF GRAVITY (ϩ).

28. Cukierman, Webb, and Neyapti 1992. Sectoral Interests and European Monetary Integration 153

C. Government instability. It is a commonplace of macroeconomic political economy that less stable and/or more fragmented governments are particularly in need of monetary-policy credibility. So the more unstable and fragmented are governments, the more likely they should be to choose the DM link. I use two measures that are not closely related in institutional terms. The first is the share of all legislative seats held by the governing coalition, which indicates roughly the security of the government in office (a measure that uses share of all votes gives the same results). The bigger this seat share, the more stable the government, the less likely it is to need the currency as a commitment mechanism, and the less likely is a peg. The second measure is the number of parties in government, which gives a rough sense of the government’s stability; more parties in government should increase the need for credibility and thus the propensity to link to the DM.29 Variable names (expected signs): PERCENTAGE OF SEATS HELD BY GOVERNMENT PARTIES, NUMBER OF GOVERNMENT PARTIES (ϩ, Ϫ). None of these variables is, as noted, a direct measure of the demand for credibility. There is almost certainly no such direct measure, however, and all of the variables employed here have been used to evaluate credibility-based arguments in other studies. They are plausible proxies for a government’s desire to use exchange- rate policy for anti-inflationary credibility purposes. 2. Similarity of economic structure. In the OCA framework, the more similar national economies are, the less they need independent monetary policies. Here I use the correlation of a nation’s industrial structure with that of Ger- many, which should indicate how different the exogenous shocks affecting the two countries are likely to be. Other related measures might be used. The correlation of a nation’s trade structure with that of Germany has at- tractions (as it is more directly related to pressures on the exchange rate), but it risks endogeneity, as trade structure is much more likely to be affected by exchange-rate policy than overall industrial structure. In any case, the two measures are highly correlated and give nearly identical results. Other measures of OCA criteria tend to give rise to very similar categoriza- tions of countries.30 In the case of the measure of industrial structure, the greater the correlation with Germany, the more likely the country is, by OCA criteria, to maintain a fixed exchange rate with the DM. Variable name (expected sign): INDUSTRIAL CORRELATION WITH GERMANY (Ϫ).

29. As any political scientist knows, this last measure has major problems. The number of parties in government is the direct result of the electoral system and will generally increase with proportionality or district magnitude. Inasmuch as we know that small open economies are generally much more likely to have the “purest” proportional representation schemes, this measure may well be closely related to openness. In fact, the correlation between the number of parties in government and manufactured exports to the EU as a share of GDP is .18; the relationship is present but not particularly strong. 30. For example, Gros 1996. 154 International Organization

Control Variables. It is important to control for other factors that could be expected to affect exchange-rate movements. Macroeconomic conditions are foremost among these factors. I include these, and a couple of other common explanations of currency movements, as controls.

1. Macroeconomic conditions: Developments in national macroeconomic performance affect the propensity of a currency to depreciate. While the arguments for depreciation in each of these instances are problematic, generally speaking, particularly difficult years should be associated with a weaker currency. A. Growth rates. Recessions may increase the propensity of monetary authorities to use depreciation to stimulate the economy. This depends on the trade-off between the income and substitution effects of a depreciation, but the consensus is that depreciations can be stimulative in the short run. Variable name (expected sign): LAGGED GROWTH RATE OF GDP (Ϫ) (that is, the stronger GDP growth, the less depreciation). B. Unemployment. This can be expected to be significant for the same reason as the overall rate of economic growth. Variable name (expected sign): LAGGED UNEMPLOYMENT (ϩ). C. The current account. The weaker a country’s current account, the more downward pressure there will be on its currency and the likelier a depreciation. Note that this is the more or less purely economic effect mentioned above, for which I control to assess the independent impact of trends in imports and exports. Variable name (expected sign): LAGGED CURRENT ACCOUNT BALANCE AS PERCENTAGE OF GDP (Ϫ). D. The terms of trade. The difference between movements in the country’s terms of trade and those of Germany should affect the currency. The more the country’s terms of trade deteriorate relative to Germany, the harder it should be to sustain a fixed exchange rate. A positive number here means that the terms of trade improved in the year relative to Ger- many’s, while a negative number means they deteriorated. This implies that increases in the measure should make it easier to sustain the currency peg, and vice versa. Variable name (expected sign): DIFFERENCE IN TERMS OF TRADE RELATIVE TO GERMANY (Ϫ).

As can be seen from the variable names, all these are lagged one year except for the terms of trade figure. This is because policy can be expected to respond to such macroeconomic trends only with something of a delay, except for the terms of trade, which is a price-based measure and thus should have nearly immediate effect. In any case, using simultaneous (lagged, in the case of the terms of trade) data makes no difference to the results. The current account is expressed as a percentage of GDP, unemployment is a share of the labor force, GDP growth is a rate of (real) change, Sectoral Interests and European Monetary Integration 155 and the terms of trade are also a rate of change; all are expressed in percentage points. 2. Other controls: I include three other control variables, as they are commonly mentioned in the literature. A. Membership in the snake or EMS. Of course, this is endogenous, but many believe that the snake and EMS, as international (regional) institutions, may have had a substantial independent impact on government behavior. This is a dummy variable that takes the value 1 if the country was a member of one of the two exchange rate mechanisms and zero otherwise. Variable name (expected sign): MEMBER OF SNAKE OR ERM (Ϫ). B. Election timing. In the spirit of the political business cycle, governments may be expected to manipulate the currency in the runup to an election. What in fact they do depends on the relative desirability of the stimulative effect of depreciation and the income effect of an appreciation. However, the traditional view of inflation and depreciation as similar in source and effect would lead us to expect elections to be associated with depreciations. The measure here is simply whether an election occurred in the year in question; the measure has its problems but is adequate for present purposes. Variable name (expected sign): ELECTION (ϩ). C. Capital controls. Controls on capital movements should facilitate the maintenance of a fixed exchange rate. Of course, countries whose exchange rates face market skepticism for other reasons—such as macroeconomic fundamentals or political instability—are more likely to impose capital controls in the first place, so it may not be clear what to expect. However, in general it seems reasonable to expect countries with capital controls to be less likely to depreciate, all else being equal. The measure used is a composite created by Dennis Quinn and drawn from the International Monetary Fund’s categorization of restrictions on capital movements. Variable name (expected sign): CAPITAL CONTROLS (Ϫ).

Table 2 presents simple descriptive statistics, showing the evolution of the means of all dependent and explanatory variables over the course of the period, divided into four subperiods (snake, early EMS, late EMS, and EMU). Table 3 presents a correlation matrix, which demonstrates several key points. First, the two dependent variables are very closely related (0.82 correlation). Second, several alternate measures of similar factors are closely related—for example, exports to the DM zone are highly correlated (0.91) with exports to the EU more broadly. Third, where available, the correlation between FDI and exports among the same countries is relatively high (0.50 to 0.53). Fourth, there are very few correlations of note among explanatory variables—none above 0.5—and most substantially below that. This is of particular importance because it would be reasonable to worry about the 156 International Organization

TABLE 2. Averages of all variables for all countries across periods

1973–1978 1979–1983 1984–1989 1990–1994

AVERAGE DEPRECIATION VS. DM 9.034 4.963 4.227 3.147 COEFFICIENT OF VARIATION VS. DM .033 .027 .019 .019 INDUSTRIAL CORRELATION .723 .745 .750 .685 LAGGED GDP GROWTH 3.671 2.240 2.731 1.651 LAGGED UNEMPLOYMENT (AS % OF LABOR FORCE) 3.969 6.681 9.170 8.810 LAGGED CURRENT ACCOUNT AS A % OF GDP Ϫ1.917 Ϫ2.446 Ϫ.762 Ϫ.196 DIFFERENCE IN TERMS OF TRADE .198 1.833 Ϫ.820 .078 MEMBERSHIP OF SNAKE OR ERM .356 .420 .435 .536 CENTRAL BANK INDEPENDENCE .340 .344 .345 .345 (0–1, 1 MOST INDEPENDENT) CAPITAL CONTROLS 6.030 5.150 4.244 2.207 (0–15, 15 MOST CONTROLS) CABINET CENTER OF GRAVITY 2.788 2.934 3.017 2.873 (1–5, 5 MOST RIGHT WING) ELECTION .286 .357 .298 .271 NUMBER OF GOVERNMENT PARTIES 2.035 1.832 2.100 2.255 PERCENT OF SEATS HELD BY GOVERNMENT PARTIES 47.628 48.546 49.578 53.252 MANUFACTURING EXPORTS TO DM ZONE AS A % OF 3.479 3.801 4.504 5.063 GDP MANUFACTURING EXPORTS TO EC AS A % OF GDP 9.155 9.771 11.649 12.042 TRADE BALANCE CHANGE AS A SHARE OF GDP .039 .153 .142 .548 (LAGGED)

collinearity of many of the macroeconomic and monetary variables. It is reassuring to know that these problems are minimal.

Analyzing European Monetary Politics: A Statistical Assessment The following statistical analysis uses the two measures in Table 1 as dependent variables. The annual depreciation rate is a better indicator of broad trends of currency policy; the volatility measure picks up both overall depreciations and intra-year currency fluctuations. Although the two are strongly correlated and yield similar results, where results differ is interesting in itself, as I discuss in the following section. I look at all current EU members except Germany, the anchor country, and Luxembourg, which shared a currency with Belgium. I also include Norway, as it often attempted to stabilize its currency against the DM, and there would have been little ex ante justification for excluding it at the outset of the sample. The period runs from the beginning of 1973 to the end of 1994, with annual observations. I stop the analysis in 1995 because at that point the EU was clearly in the runup to EMU, whose dynamic was quite different from that of the attempts to fix exchange rates that had come before. The explanatory variables are as described previously and in more detail in the appendix. The regressions Sectoral Interests and European Monetary Integration 157 using these panel data are all corrected for serial autocorrelation and heteroskedasticity, and panel-corrected standard errors are presented.31 Tables 4 and 5 present the results. The first column of each table presents the full model including all the variables. The second model reanalyzes the data, dropping the explanatory variables that do not come close to statistical significance. In the third model, variables from the second model that now fail to reach statistical significance are dropped. The results are quite stable across specifications, as are the coefficients. Starting with Table 4, in which the left-hand-side variable is the annual depreciation rate, six explanatory variables are significant in all three models; only two other variables even come close to reaching significance in one or two specifications. The three principal macroeconomic control variables are clearly important. The state of the current account, GDP growth, and the terms of trade (relative to Germany’s) all have the expected signs and clearly had a powerful impact on exchange rates. The proxies for the importance of real—rather than monetary—factors and of private interests are statistically significant and in the expected direction. First, the larger the country’s manufactured exports to the DM zone as a share of GDP, the less likely it was to depreciate. Countries more commercially integrated with Germany were more likely to fix their currencies against that of Germany. This finding is consistent with the idea that export-oriented manufacturers, and multinational firms whose interests tend to track those of manufactured exporters, value currency stability. Second, deterioration in the trade balance (controlling for the current account balance), such as would be caused by an import surge, is strongly associated with depreciation. The more net import competition a country faced, the less likely the country was to fix its currency against the DM. This finding is consistent with the idea that the import- and export-competers faced with increased foreign competition pressed for a depreciation and, more generally, with the argument that currency policy was made with real considerations—its impact on trade and investment—strongly in mind. The proxies used here to attempt to capture anti-inflationary credibility or OCA motivations for currency pegs were not significant in any specification. None of the measures associated with credibility concerns had any impact on the propensity to hold to a currency peg: neither the partisan composition of government, the two measures of general government strength or stability (the government’s share of all seats and the number of parties in government), nor central bank independence had any impact. The correlation of national industrial structures with Germany’s, the proxy for OCA status, is not significant. The other factors considered yielded mixed results at best. Although there is some evidence that membership in the snake or ERM was associated with more stability

31. Data analysis was carried out on Stata 5.0 using the corrections for serial autocorrelation and panel heteroskedasticity (based on Beck and Katz) included in the Stata package. 158 International Organization

TABLE 3. Correlations among principal variables

SNAKE/ DEPRECIATE COV GDPGROWTH UNEMPLOY CURRACCT DIFFTOFT INDUSTCORR EMS CABINETCG

DEPRECIATE 1.00

COV 0.82 1.00

GDPGROWTH Ϫ0.19 Ϫ0.15 1.00

UNEMPLOY Ϫ0.08 Ϫ0.15 Ϫ0.02 1.00

CURRACCT Ϫ0.20 Ϫ0.21 0.11 Ϫ0.00 1.00

DIFFTOFT Ϫ0.37 Ϫ0.22 0.13 Ϫ0.04 Ϫ0.04 1.00

INDUSTCORR Ϫ0.20 Ϫ0.30 Ϫ0.00 0.43 0.16 Ϫ0.08 1.00

SNAKE/EMS Ϫ0.15 Ϫ0.40 Ϫ0.00 0.47 0.02 Ϫ0.04 0.47 1.00

CABINETCG 0.07 0.06 Ϫ0.07 0.38 Ϫ0.11 Ϫ0.08 0.14 0.21 1.00

ELECTION 0.06 0.03 Ϫ0.02 0.03 Ϫ0.03 0.01 0.02 0.04 0.04

GOVSEATS 0.03 Ϫ0.04 0.10 0.07 0.04 Ϫ0.06 0.02 Ϫ0.01 0.05

GOVPARTIES Ϫ0.09 Ϫ0.08 Ϫ0.01 Ϫ0.04 Ϫ0.04 Ϫ0.01 Ϫ0.01 0.16 Ϫ0.04

CBI 0.06 Ϫ0.12 Ϫ0.01 Ϫ0.11 Ϫ0.18 Ϫ0.09 Ϫ0.12 Ϫ0.05 0.07

CAPCTRLS 0.33 0.26 0.09 Ϫ0.17 Ϫ0.35 0.03 Ϫ0.37 Ϫ0.22 Ϫ0.11

MFGEXP-DM Ϫ0.21 Ϫ0.39 Ϫ0.04 0.09 0.21 Ϫ0.10 0.48 0.38 Ϫ0.03

MFGEXP-EC Ϫ0.20 Ϫ0.33 Ϫ0.01 0.17 0.05 Ϫ0.08 0.42 0.39 Ϫ0.00

FDI-DM Ϫ0.22 Ϫ0.32 0.03 0.08 0.40 Ϫ0.03 0.36 0.40 Ϫ0.02

FDI-EC Ϫ0.17 Ϫ0.26 0.06 0.21 0.30 Ϫ0.02 0.27 0.43 0.07

TRBALCHG Ϫ0.18 Ϫ0.22 Ϫ0.38 0.09 Ϫ0.41 0.17 Ϫ0.01 0.15 0.08

INFLATION 0.23 0.28 Ϫ0.14 0.08 Ϫ0.35 0.04 0.03 Ϫ0.05 0.08

against the DM, as expected, this variable does not reach statistical significance.32 There is little support for the notion that governments were more prone to depreciate in election years, as the results are not statistically significant. One variable is clearly significant but in the opposite direction to that usually expected. Capital controls, far from helping sustain the exchange rate against the DM, are associated with more depreciation. There is a clear problem of simultaneity here, though, as countries facing attacks on their currencies are more likely to impose capital controls.

32. However, the snake/ERM variable is mildly correlated (0.39) with manufactured exports so that there may be some collinearity problems. Sectoral Interests and European Monetary Integration 159

MFGEXP- MFGEXP- ELECTION GOVSEATS GOVPARTIES CBI CAPCTRLS DM EC FDI-DM FDI-EC TRBALCHG INFLATION

1.00

Ϫ0.07 1.00

0.02 0.28 1.00

0.04 Ϫ0.02 Ϫ0.11 1.00

Ϫ0.02 0.06 Ϫ0.16 0.04 1.00

0.04 0.23 0.05 0.03 Ϫ0.21 1.00

0.06 0.13 0.12 Ϫ0.08 Ϫ0.14 0.91 1.00

Ϫ0.03 0.24 Ϫ0.13 Ϫ0.11 Ϫ0.46 0.53 0.37 1.00

Ϫ0.00 0.28 0.02 Ϫ0.11 Ϫ0.45 0.56 0.50 0.83 1.00

0.01 Ϫ0.14 0.00 Ϫ0.00 0.01 0.10 0.22 Ϫ0.04 0.05 1.00

Ϫ0.04 Ϫ0.21 Ϫ0.12 Ϫ0.22 0.41 Ϫ0.40 Ϫ0.27 Ϫ0.51 Ϫ0.43 0.16 1.00

Table 5 presents results of the same sort of regression analysis, using the coefficient of variation of the nominal exchange rate as the dependent variable.33 Results for the private-interest variables and macroeconomic controls are essentially as before: more manufactured exports to the DM zone, improvements in the trade balance, faster GDP growth, and a stronger current account are all associated with reduced volatility. Evolution in the terms of trade is significant in only one specification. Most other variables are as before: elections and government strength and stability are insignificant, and capital controls is significant in a direction opposite to that expected. So far the results are essentially the same as in the previous specification.

33. In the regression, unlike in Table 1, the relevant period is a year; this is the standard deviation of a currency’s value (measured monthly) over its annual mean value. 160 International Organization

TABLE 4. Determinants of European depreciation rates. Dependent variable ϭ depreciation rate

(1) (2) (3)

Constant 3.660 3.305** 3.633** (3.703) (1.409) (1.372) LAGGED GROWTH RATE OF GDP Ϫ0.742** Ϫ0.647** Ϫ0.672** (0.208) (0.203) (0.203) LAGGED UNEMPLOYMENT 0.029 —— (0.111) LAGGED CURRENT ACCOUNT BALANCE Ϫ0.258 Ϫ0.393** Ϫ0.394** AS PERCENTAGE OF GDP (0.177) (0.180) (0.179) DIFFERENCE IN THE TERMS OF TRADE Ϫ0.424** Ϫ0.391** Ϫ0.378** RELATIVE TO GERMANY (0.092) (0.093) (0.093) INDUSTRIAL CORRELATION WITH Ϫ2.823 —— GERMANY (4.172) MEMBER OF SNAKE OR ERM Ϫ0.986 Ϫ1.549 Ϫ1.486 (1.115) (0.957) (0.950) CABINET CENTER OF GRAVITY 0.660 —— (0.675) ELECTION 1.258 1.233 — (0.897) (0.911) PERCENT OF SEATS HELD BY 0.042 —— GOVERNMENT PARTIES (0.040) NUMBER OF GOVERNMENT PARTIES Ϫ0.379 —— (0.374) CENTRAL BANK INDEPENDENCE Ϫ3.184 —— (2.602) CAPITAL CONTROLS 0.951** 1.066** 1.084** (0.260) (0.240) (0.239) MANUFACTURED EXPORTS TO THE DM Ϫ0.289** Ϫ0.257** Ϫ0.255** ZONE AS A PERCENTAGE OF GDP (0.147) (0.126) (0.125) CHANGE IN THE TRADE BALANCE AS A Ϫ0.740** Ϫ0.541** Ϫ0.547** PERCENTAGE OF GDP (0.248) (0.247) (0.247) N 278 313 313

Note: Standard errors appear in parentheses under the coefficients. *Draws attention to coefficients significant at or above the 10% level. **Draws attention to coefficients significant at or above the 5% level.

There are three differences between these results and those having to do with the depreciation rate; these differences have mixed implications for credibility-related perspectives. The partisan composition of government has an effect in the way generally anticipated by credibility-based arguments: the more left-wing the government, the less volatile the currency. But central bank independence does not: it is associated with less short-term volatility. In addition, snake/EMS membership is also associated with less volatility. The results imply therefore that these three factors are not strong enough to affect longer-term trends in currency values—the depreciation rate—but that they do reduce currency volatility. Left-wing govern- Sectoral Interests and European Monetary Integration 161

TABLE 5. Determinants of European currency variability. Dependent variable ϭ coefﬁcient of variation

(1) (2) (3)

Constant 2.628** 2.334** 2.304** (1.052) (0.755) (0.767) LAGGED GROWTH RATE OF GDP Ϫ0.121** Ϫ0.107** Ϫ0.112** (0.055) (0.054) (0.052) LAGGED UNEMPLOYMENT Ϫ0.011 —— (0.031) LAGGED CURRENT ACCOUNT AS A Ϫ0.077 Ϫ0.110** Ϫ0.118** PERCENTAGE OF GDP (0.052) (0.051) (0.051) DIFFERENCE IN THE TERMS OF TRADE Ϫ0.044* Ϫ0.027 — RELATIVE TO GERMANY (0.025) (0.025) INDUSTRIAL CORRELATION WITH GERMANY 0.278 —— (1.189) MEMBER OF SNAKE OR ERM Ϫ1.060** Ϫ1.103** Ϫ1.077** (0.306) (0.260) (0.266) CABINET CENTER OF GRAVITY 0.473** 0.498** 0.516** (0.186) (0.182) (0.183) ELECTION 0.269 —— (0.225) PERCENT OF SEATS HELD BY GOVERNMENT 0.002 —— PARTIES (0.012) NUMBER OF GOVERNMENT PARTIES Ϫ0.081 —— (0.102) CENTRAL BANK INDEPENDENCE Ϫ2.730** Ϫ2.427** Ϫ2.567** (0.765) (0.784) (0.777) CAPITAL CONTROLS 0.100 0.144** 0.139** (0.073) (0.068) (0.069) MANUFACTURING EXPORTS TO THE DM ZONE Ϫ0.145** Ϫ0.136** Ϫ0.130** AS A PERCENTAGE OF GDP (0.040) (0.032) (0.033) CHANGE IN THE TRADE BALANCE AS A Ϫ0.188** Ϫ0.144** Ϫ0.149** PERCENTAGE OF GDP (0.067) (0.065) (0.064) N 278 305 312

ments do use a currency peg more than right-wing governments for short-term purposes; an independent central bank can stabilize the exchange rate in the short run more effectively than a dependent one, and membership in the snake/EMS increased national ability to stabilize currencies. Again, note that these variables reduce short-term volatility but not the propensity to depreciate itself; they also do not unambiguously support OCA or credibility-based arguments. The substantive interpretation of most of the coefficients in the regressions is relatively straightforward. Those having to do with the average annual depreciation 162 International Organization rate are easier to interpret than the coefficient of variation. Looking at Table 4, column 3, the variables expressed as percentage points (of GDP or as rates of change) are easily understood. One percentage point improvements in the GDP growth rate, current account as a share of GDP, and terms of trade relative to Germany are associated with 0.672, 0.394, and 0.378 percentage point reductions, respectively, in the currency’s annual depreciation rate against the DM. Similarly, a one percentage point increase in manufactured exports to the DM zone as a share of GDP and a one percentage point improvement in the trade balance is associated with 0.255 and 0.547 percentage point reductions, respectively, in the rate of depreciation. These are all quite appreciable numbers. Increasing capital controls by one point on the fifteen-point scale leads to an increase in the depreciation rate of 1.084 percent. This means little in and of itself; one way of seeing it is that a three-point difference, roughly equivalent to that between Norway and Greece, increases the depreciation rate by 3.252 percent a year. The impact of explanatory variables on the coefficient of variation cannot be assessed so directly. A sense of their importance can be seen in the effect of a one standard deviation change in explanatory variables (holding all others at their means) on the volatility measure. By this measure, for example, a one standard deviation increase in the lagged GDP growth rate or the lagged current account is associated with a reduction in the coefficient of variation of 11.7 and 16.3 percent, respectively. An increase of one standard deviation in manufactured exports to the DM zone or the trade balance leads to 17.1 and 14.1 percent reductions in volatility, while such an increase in central bank independence is associated with a 15.1 percent decline in the coefficient of variation. On the other hand, one standard deviation’s move to the right of the cabinet center of gravity, or increase in capital controls, is associated with 13.6 and 14.8 percent increases, respectively, in volatility. These results are not generally supportive of credibility-oriented or OCA explanations of European currency policies. Only one significant result goes in the direction expected by an argument based on the credibility-enhancing effects of a fixed exchange rate: Left governments have less volatile exchange rates in the short run. But this applies only to month-to-month volatility, not to the overall longer- term stance of currency policy. It is extremely weak evidence, especially as the central bank independence variable is just as strongly significant, but in the opposite direction. To be sure, the difficulty of measuring the demand for anti-inflationary credibility implies that this evidence is not definitive. Nonetheless, while credibility motivations cannot be excluded, it is difficult to see any support for them in this analysis. Also, the data used here are not well suited to the assessment of the impact of elections on policy because each observation is a calendar year. Analyses of the data using a hazard model yield generally ambiguous results, although there is some mild evidence of an electoral exchange-rate cycle, in which politicians delay devaluations until after elections. This evidence is at best tentative, however. Sectoral Interests and European Monetary Integration 163

The principal results reported here are quite robust. Removing outliers—the Netherlands and Austria on one end, Greece and Portugal on the other—leaves the results essentially intact. This does reduce the significance of a few variables, which is not surprising, as it involves removing nearly one-third of all observations, but the major explanatory variables remain significant. When countries are omitted one by one, results are undisturbed. Adding year fixed effects only strengthens the results; adding country fixed effects has little impact, although (not surprisingly) it reduces the size of some coefficients. Many versions of the empirical models were assessed, with no impact on the principal results, those pertaining to the proxies for real sectoral considerations. Manufactured exports to the EU as a whole (not just to the DM bloc) gives essentially identical results. Inclusion of the fiscal deficit (lagged or simultaneous) serves to make most other variables more significant and their coefficients larger.34 The fiscal deficit is itself significant and associated with more depreciation. Some scholars suggest a relationship between union density and better macroeconomic outcomes.35 Data on union membership as share of the labor force, however, are unavailable for Ireland, Spain, and Portugal, and unavailable elsewhere after 1989 or 1990. In any event, when these data are included (with almost half the observations lost) the variable is not significant and does not change the other variables in appreciable ways. Alternative proxies for credibility factors are hard to identify. When past inflation is included—in the form of a three-year moving average of the Consumer Price Index, lagged one year—it is associated with depreciation and volatility, running directly against the expected credibility argument, although this result is not statistically significant (and does not affect the impact of the principal explanatory variables). Such a finding is not particularly surprising, as discussed previously: currencies from countries with high inflation typically depreciate against other currencies. In other words, the direct impact of high inflation on the exchange rate dominates whatever effect it might have on the demand for credibility. In any case, the principal results support a high degree of confidence—especially concerning the two proxies for private-sector interests and the macroeconomic controls. The results are summarized as follows:

1. Proxies for private-sector interests were significant and important. They were consistent with the argument that regionally oriented producers prefer a fixed currency, while import- and export-competers prefer flexibility. In other words, real factors were crucial. The more important manufactured exports to the DM zone (Germany and Benelux) were, the slower the depreciation rate and the less volatile the currency; an increase in net import

34. Not surprisingly, it does make the current account insignificant; it also makes central bank independence significant (but, again, not in the direction anticipated by credibility-based accounts). 35. Calmfors and Drifill 1988. 164 International Organization

competition, controlling for the current account, increased the depreciation rate and volatility significantly. 2. Macroeconomic control variables all had the expected effects. Such fundamentals as the current account balance, GDP growth, and the terms of trade relative to the anchor country all reduced the depreciation rate and currency volatility substantially. 3. Variables intended to capture inclinations to fix currencies to gain anti- inflationary credibility were almost never significant. The only exception was that left-wing parties were more likely to hold the currency stable in the short run; there was no partisan difference in depreciation rates. A measure of suitability for membership in an OCA was never significant.

The results are in line with my expectations about the role of private interests. The level of commercial integration with Germany led to a more ﬁxed exchange rate;increases in net import competition spurred depreciation. These two results provide a rough evaluation of the impact of private distributional interests—in the event of exporters of complex manufactures and of import-competers—on exchange-rate policy.

Conclusions

This study confirms the importance of real factors, and sectoral interests, in the development of European monetary integration. Higher levels of manufactured exports to Germany and Benelux and improvements in the trade balance are both associated with more fixed exchange rates against the DM. The empirical analysis also confirms the importance of macroeconomic conditions. I do not find appreciable support for arguments based on the alleged credibility-enhancing properties of currency pegs nor those based on OCA criteria. The results show that distributionally motivated private interests, driven by the real effects of currency policy on trade and investment, are relevant to the making of exchange-rate policy. Specifically, exporters of sophisticated manufactures and cross-border investors seem to support stable exchange rates, while import- and export-competers favor depreciation. There is little or no evidence of the use of the exchange rate as a commitment mechanism for governments without anti-inflationary credibility or of the relevance of OCA considerations to exchange-rate policy choice. Those attempting to explain currency arrangements in Europe and elsewhere—most notably dollarization in Latin America and Euroization in Central and Eastern Europe—would be wise to consider the potential importance of such distributional consderations for the future of national exchange-rate policies. Sectoral Interests and European Monetary Integration 165

Appendix

Deﬁnition and Sources of Explanatory Variables

LAGGED GROWTH RATE OF GDP. Growth rate of GDP, lagged one year. Data for 1971–79 from United Nations 1985; for 1980–93 from OECD 1994.

LAGGED UNEMPLOYMENT. Percentage of the labor force unemployed, lagged one year. Data from OECD 1993, 1995, 1980; and United Nations 1985.

LAGGED CURRENT ACCOUNT AS PERCENTAGE OF GDP. Current account balance as a percentage of GDP, lagged one year. Data from OECD various years (a).

DIFFERENCE IN TERMS OF TRADE RELATIVE TO GERMANY. Percentage point change in the terms of trade over the previous year, relative to Germany’s terms of trade. An increase in this ﬁgure signiﬁes a deterioration in Germany’s terms of trade relative to the country in question. Data from IMF 1996.

INDUSTRIAL CORRELATION WITH GERMANY. Correlation coefﬁcient comparing the percent contribution to GDP of each ISIC one-digit category and two-digit categories for manufacturing (ISIC code 3). Because industrial structure changes slowly, the correlation coefﬁcient is calculated for 1970, 1980, and 1990 only. Data from OECD various years (b). Where data were missing from the OECD statistics, data were taken from the United Nations various years (a).

MEMBER OF SNAKE OR ERM. Dichotomous variable ϭ 1 if country is a member of either snake or ERM, zero if not. Data obtained from BIS various years.

CABINET CENTER OF GRAVITY. Party composition of the cabinet, weighted by ideological scores using a scale constructed by Geoffrey Garrett. Data through 1991 provided by Geoffrey Garrett; updated using Mu¨ller 1994 and 1995; Sundberg 1993; and EJPR various years.

ELECTION. Number of elections per year (usually 1 or zero). Data obtained from Mackie and Rose 1991; Mu¨ller 1995 and 1994; Sundberg 1993; and EJPR various years.

PERCENTAGE OF SEATS HELD BY GOVERNMENT PARTIES. Percentage of legislative seats won by the government parties in the election at time t, where t denotes the current observation. Constructed in Powell and Whitten 1993; updated using EJPR various years.

NUMBER OF GOVERNMENT PARTIES. Number of parties in government. Constructed in Powell and Whitten 1993; updated using EJPR various years.

CENTRAL BANK INDEPENDENCE. An index of central bank independence, running from zero (least independent) to 1 (most independent). Data from Cukierman, Webb, and Neyapti 1992. 166 International Organization

CAPITAL CONTROLS. A measure of capital controls constructed by Dennis Quinn, described in Quinn 1997. His 15 point-scale measures “openness;” it is inverted here so that a higher number means more capital controls. Data obtained from the author.

MANUFACTURED EXPORTS TO DM ZONE AS PERCENTAGE OF GDP. Value of manufactured (SITC codes 6-8) exports to Germany, Belgium, Luxembourg, and the Netherlands as a percentage of GDP. Data from United Nations various years (b).

CHANGE IN TRADE BALANCE AS PERCENTAGE OF GDP. Change in the trade balance from the previous year, in percentage terms. Constructed from data for trade balance and GDP and IMF various years.

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Fratianni, Michele, and Ju¨rgen von Hagen. 1991. The European Monetary System and European Monetary Union. Boulder, Colo.: Westview Press. Frieden, Jeffry. 1994. Exchange Rate Politics: Contemporary Lessons from American History. Review of International Political Economy 1 (1):81–103. ———. 1997a. Economic liberalization and the politics of European monetary integration. In Liberal- ization and Foreign Policy, edited by Miles Kahler. New York: Columbia University Press. ——— 1997b. Monetary Populism in Nineteenth-Century America: An Open Economy Interpretation. Journal of Economic History 57(2):367–95. ——— 2001. Making Commitments: France and Italy in the European Monetary System, 1979-1985. In The Political Economy of European Monetary Uniﬁcation Second edition, edited by Barry Eichen- green and Jeffry Frieden, 23–47. Boulder, Colo.: Westview Press. Frieden, Jeffry, Piero Ghezzi, and Ernesto Stein. 2001. Politics and Exchange Rates: A Cross-Country Approach to Latin America. In The Currency Game: Exchange Rate Politics in Latin America, edited by Jeffry Frieden and Ernesto Stein. Baltimore, Md.: Johns Hopkins University Press. Frieden, Jeffry, and Ernesto Stein. 2001. The Political Economy of Exchange Rate Policy in Latin America: An Analytical Overview. In The Currency Game: Exchange Rate Politics in Latin America, edited by Jeffry Frieden and Ernesto Stein. Baltimore, Md.: Johns Hopkins University Press. Garrett, Geoffrey. 2001. The Politics of Maastricht. In The Political Economy of European Monetary Uniﬁcation Second edition, edited by Barry Eichengreen and Jeffry Frieden, 111–30. Boulder, Colo.: Westview Press. Giavazzi, Francesco and Marco Pagano. 1989. The Advantage of Tying One’s Hands: EMS Discipline and Central Bank Credibility. European Economic Review 32 (5):1055–75. Goldberg, Penelopi Koujianou, and Michael M. Knetter. 1997. Goods Prices and Exchange Rates: What Have We Learned? Journal of Economic Literature 35 (3):1243–72. Gowa, Joanne. 1988. Public Goods and Political Institutions: Trade and Monetary Policy Processes in the United States. International Organization 42 (1):15–32. Grilli, Vittorio, Donato Masciandaro, and Guido Tabellini. 1991. Political and Monetary Institutions and Public Policies in the Industrial Countries. Economic Policy 13 (October):341–92. Gros, Daniel. 1996. Towards Economic and Monetary Union: Problems and Prospects. Brussels: Centre for European Policy Studies. Gros, Daniel, and Niels Thygesen. 1992. European Monetary Integration. London: Longman. Hefeker, Carsten. 1997. Interest Groups and Monetary Integration: The Political Economy of Exchange Regime Choice. Boulder, Colo.: Westview Press. Inter-American Development Bank. 1995. Overcoming Volatility. Washington, D.C.: Inter-American Development Bank. International Monetary Fund (IMF). 1996. International Financial Statistics Yearbook. Washington, D.C.: IMF. International Monetary Fund (IMF). Various years. International Financial Statistics Yearbook. Wash- ington, D.C.: IMF. Jones, Erik, Jeffry Frieden, and Francisco Torres. 1998. EMU and the Smaller Countries: Joining Europe’s Monetary Club. New York: St. Martin’s Press. Mackie, Thomas T., and Richard Rose. 1991. International Almanac of Electoral History. Washington, D.C.: Congressional Quarterly. Masson, Paul, and Mark Taylor. 1993. Currency Unions: A Survey of the Issues. In Policy Issues in the Operation of Currency Areas, edited by Paul Masson and Mark Taylor. Cambridge: Cambridge University Press. McKinnon, Ronald. 1963. Optimum Currency Areas. American Economic Review 53 (4):717–25. Milesi-Ferretti, Gian Maria. 1995. The Disadvantage of Tying Their Hands: On the Political Economy of Policy Commitments. Economic Journal 105 (433):1381–402. Moravcsik, Andrew. 1998. The Choice for Europe. Ithaca, N.Y.: Cornell University Press. Mu¨ller, Wolfgang C. 1994. Austria. European Journal of Political Research 26 (3–4):241–46. Mu¨ller, Wolfgang C. 1995. Austria. European Journal of Political Research 28 (3–4):277–89. 168 International Organization

Mundell, Robert. 1961. A Theory of Optimum Currency Areas. American Economic Review 51 (4):657–65. Neumeyer, P. A. 1998. Currencies and the Allocation of Risk: The Welfare Effects of a Monetary Union. American Economic Review 88 (1):246–59. Organization for Economic Cooperation and Development (OECD). 1980. Main Economic Indicators, Historical Studies, 1960–1979. Paris: OECD. Organization for Economic Cooperation and Development (OECD). 1993. Main Economic Indicators, Historical Statistics, Prices, Labor and Wages, 1962–1991. Paris: OECD. Organization for Economic Cooperation and Development (OECD). 1994. Historical Statistics: 1960– 1993. Paris: OECD. Organization for Economic Cooperation and Development (OECD). 1995. Economic Outlook 58 (December). Paris: OECD. Organization for Economic Cooperation and Development (OECD). Various years (a). Economic Outlook. Paris: OECD. Organization for Economic Cooperation and Development (OECD). Various years (b). Industrial Structure Statistics. Paris: OECD. Pisani-Ferry, Jean, Carsten Hefeker, and Andrew Hughes Hallett. 1997. The Political Economy of EMU: France, Germany, and the UK. CEPS Paper Number 69. Brussels: Centre for European Policy Studies. Powell, G. Bingham, Jr., and Guy D. Whitten. 1993. A Cross-National Analysis of Economic Voting. American Journal of Political Science 37 (2):391–414. Price, Simon. 1997. Political Business Cycles and Macroeconomic Stability: A Survey. Public Choice 92 (3-4):407–427. Quinn, Dennis. 1997. The Correlates of Change in International Financial Regulation. American Political Science Review 91 (3):531–52. Rogoff, Kenneth. 1996. The Purchasing Power Parity Puzzle. Journal of Economic Literature 34 (2):647–88. Rose, Andrew. 2000. One Money, One Market: Estimating the Effect of Common Currencies on Trade. Economic Policy 15 (30):7–46. Simmons, Beth. 1994. Who Adjusts? Princeton: Princeton University Press. Sundberg, Jan. 1993. Finland. European Journal of Political Research 24 (4):419–23. Tavlas, George. 1994. The Theory of Monetary Integration. Open Economies Review 5 (2):211–30. United Nations. 1985. Economic Survey of Europe in 1984–85. Geneva: United Nations Research and Planning Division. United Nations. Various years (a). Industrial Statistics Yearbook. New York: United Nations Department of Economic and Social Affairs. United Nations. Various years (b). Yearbook of International Trade Statistics. New York: United Nations Department of Economic and Social Affairs. van der Ploeg, Frederick. 1989. The Political Economy of Overvaluation. Economic Journal 99 (397):850–55. Weber, Axel. 1991. Reputation and Credibility in the European Monetary System. Economic Policy 12:57–102. Political System Transparency and Monetary Commitment Regimes J. Lawrence Broz

Introduction

Central bank independence and fixed exchange rates are commitment mechanisms that can assist governments in maintaining credibility for low-inflation monetary policy objectives. In this article, I explore the political factors that shape the choice and effectiveness (in controlling inflation) of these alternatives. My argument is that the degree of transparency of the monetary commitment mechanism is inversely related to the degree of transparency in the political system. Transparency is the ease with which the public can monitor the government with respect to its commitments. Central bank independence (CBI) and fixed exchange rates (pegs) differ in terms of transparency. While legal CBI is an opaque commitment technology that is difficult to monitor, a commitment to an exchange-rate peg is more easily observed; in the extreme, either the peg is sustained or it collapses. In nations where public decision making is opaque and unconstrained (that is, in autocracies), governments must look to a commitment technology that is more transparent and constrained (that is, fixed exchange rates) than the government itself. The transparency of the peg substitutes for political system transparency to assist in engendering low inflation expectations. However, in nations where political decision making is transparent (that is, in democracies), legal CBI can help resolve the time-inconsistency problem and produce low inflation. The openness of the political system allows the attentive public or the political opposition to observe government pressures on the central bank, making it costly for the government to conceal or misrepresent its actions. Informal transgressions of CBI are likely to be

I thank Istvan Majoros, Kalina Manova, Sarah Matthews, and Stephanie Rickard for research assistance and William Bernhard, Marc Busch, William Roberts Clark, John Freeman, Jeffry Frieden, Joseph Gochal, David Lake, David Leblang, Lisa Martin, Kenneth Scheve, and Michael Tomz for valuable comments.

International Organization 56, 4, Autumn 2002, pp. 861–887 © 2002 by The IO Foundation and the Massachusetts Institute of Technology 170 International Organization detected by interested private agents and exploited by the political opposition when the political process is transparent. This analysis extends the logic of time-inconsistency to the problem of explaining the choice of monetary institutions. If governments sincerely seek to lower inflation by way of an institutional commitment, why do some adopt CBI while others commit to an exchange-rate peg for credibility purposes? My substitution hypothesis hinges on the disparate transparency characteristics of monetary commitments on the one hand and of political institutions on the other. A credible commitment to low inflation requires transparency to detect and punish government opportunism. Transparency, however, can be supplied directly, by way of transparent monetary institutions, or indirectly, via general political institutions. The former are obviously easier to change. I provide two tests of the argument that the transparency of the monetary commitment and the transparency of the political system are substitutes. First, I estimate the determinants of exchange-rate-regime choice for a panel of more than 100 countries during the period from 1973 to 1995. The expectation is that, all else equal, countries with opaque domestic political systems (autocracies) will have a higher probability of adopting pegged exchange rates than countries with transparent political systems (democracies). For autocracies, a formally independent central bank is not a credible commitment because the opacity of the political system makes it difficult to detect and punish governmental efforts to subvert the autonomy of the central bank. Opaque domestic political institutions should thus be positively associated with fixed exchange rates. The findings indicate that, controlling for other factors, opaque political systems are indeed significantly more likely to peg than transparent systems. Second, I estimate the institutional determinants of inflation in a cross-section of sixty-nine developed and developing countries. A testable implication of the substitution hypothesis is that a formally independent central bank will be effective in lowering inflation only when the political system is transparent. As proxies for the transparency of the political system, I use (1) an index of democracy and (2) an index of civil liberties. The test involves interacting formal/legal CBI with these measures of political system transparency. I find that the opaque commitment technology (CBI) is modestly effective in limiting inflation in countries with more- transparent political systems. Neither CBI nor political-system transparency is associated with lower inflation independently; a negative relationship between CBI and inflation is found only when political openness imparts the necessary transparency to this opaque monetary commitment. On the other hand, the transparent commitment technology (pegging) constrains inflation even in the absence of democratic institutions or extensive civil freedoms. The article is organized as follows. I first describe briefly the time-inconsistency problem in monetary policy and the transparency characteristics of alternative institutional solutions to it. I then examine the transparency aspects of political systems and develop the hypotheses regarding the substitution of commitment mechanism transparency for political system transparency. In the next section, I test Political Transparency and Monetary Regimes 171 the substitution hypothesis with respect to the choice of exchange-rate regimes. Finally, I test the implication that CBI lowers inflation in the context of transparent political systems. I conclude with a discussion of additional implications and future research.

Time-Inconsistency in Monetary Policy

There is broad consensus among economists that inflation is detrimental to growth and that successful monetary policy—that is, a policy that generates low inflation without incurring large output losses—requires “credibility.”1 The credibility problem relates to the fact that the money supply can be expanded to whatever level by fiat. As discussed in the Introduction to this volume,2 credibility involves persuad- ing private agents that the monetary policymaker will not exploit the flexibility inherent in a fiat standard to achieve short-run output gains. Although explicit political pressures are absent in the original models of time- inconsistency, the problem generalizes to the introduction of democratic political processes (elections) and rational political actors (politicians, parties, and interest groups). Indeed, William Clark, Robert Franzese, and William Bernhard and David Leblang build such political incentives directly into their explanations of monetary institutions.3 Yet it is important to note that the classic time-inconsistency problem is not exclusive to democracies. It befalls dictators (benevolent or otherwise) and elected politicians alike because ex post economic incentives are sufficient to generate counterproductive policies and inefficiently high inflation. I thus assume that countries with political systems of every stripe must find a resolution to the time-inconsistency problem. While the problem itself extends to all countries, a host of political and economic factors can affect the degree to which politicians behave inconsistently over time. For example, high levels of political instability may shorten the time horizon of leaders and thus weaken their ability to precommit. I control for such factors in the empirical analysis, as data permits. I also control for other considerations, such as the number of veto players4 and Optimal Currency Area (OCA) criteria.5

Transparency in Monetary Commitments

Several solutions have been suggested to enhance the credibility of the monetary policymaker.6 While these solutions take varied forms—CBI, exchange-rate pegs,

1. See Blackburn and Christensen 1989; and Fischer 1990. 2. Bernhard, Broz, and Clark 2002. 3. See Clark 2002; Franzese 1999; and Bernhard and Leblang 2002. 4. Keefer and Stasavage 2002. 5. Frieden 2002. 6. Mishkin 1999. 172 International Organization and other nominal anchors such as money growth rules or inflation targeting—they each involve changing the rules or institutional structure of policymaking to limit the scope for discretionary opportunism.7 Two of the most prominent forms of delegated decision making are CBI and fixed exchange-rate regimes. In theory, CBI and pegs can both have a positive influence on credibility and thereby on inflation performance.8 They are not, however, perfect substitutes. One difference involves the degree to which the institutions actually invoke a trade-off between credibility and flexibility. Another attribute on which they differ is transparency—the ease with which the public can monitor government behavior with respect to the commitment. Ideally, a monetary commitment should impose the constraint necessary to resolve the credibility problem but leave policymakers with enough flexibility to respond optimally to shocks. This is the classic case for discretion in the “rules versus discretion” debate.9 CBI has apparent welfare advantages over pegging on this account. Empirical evidence suggests that the low-inflation credibility generated by CBI does not come at the cost of higher output variability, that is, at the cost of forgone flexibility.10 In contrast, pegs leave little or no room for policy to perform a stabilizing role, which helps account for the finding that output is more variable in countries with fixed rates.11 As Maurice Obstfeld and Kenneth Rogoff put it, “the fundamental problem with a fixed exchange rate is that the government must be prepared to forgo completely the use of monetary policy for stabilization purposes.”12 But a peg may improve credibility precisely because it comes at the cost of flexibility. The knowledge that this costly trade-off exists lends credibility to the commitment since it will not be optimal to incur the cost except under the most unusual circumstances.13 In the spirit of signaling games, the greater the credibility problem, the more likely it is that a country will choose (costly) fixed exchange rates. While CBI would seem to have efficiency advantages over pegs in terms of the credibility-flexibility trade-off, the two institutions differ on another dimension— transparency. This difference is potentially important, because a commitment is only effective in producing desired goals insofar as it is verifiable.14 Transparency

7. Decentralized enforcement via reputation is theoretically possible but rare in practice, perhaps due to the costliness of the long transition during which a reputation for low inflation is established. 8. See Bernhard, Broz, and Clark 2002. 9. Fischer 1990. 10. See Debelle and Fischer 1994; and Alesina and Summers 1993. For surveys, see Eijffinger and de Haan 1996; and de Haan and Kooi 2000. For theoretical treatments addressing this paradox, see Lohmann 1992; and Walsh 1995. 11. Ghosh, Gulde, Ostry, and Wolf 1997. 12. Obstfeld and Rogoff 1995, 74. Obstfeld and Rogoff review other problems of using pegs to buy credibility for monetary policy, for example, the likelihood of costly speculative attacks, the transmission of shocks from the anchor country to the domestic economy, and conclude that reducing domestic inflation is better addressed through “the basic reform of domestic monetary policy institutions.” See also Mishkin 1999. 13. Flood and Isard 1989. 14. This point is addressed in an emerging literature on the verifiability of exchange-rate commitments. See Frankel, Schmukler, and Serven 2000. A simple peg to the dollar is easier to verify than an Political Transparency and Monetary Regimes 173 is the ease with which the public can verify and punish government misbehavior with respect to an institutional commitment. A peg has a clear advantage over CBI in this respect because an exchange-rate target is a simple and clear promise to which the government can be held accountable. When a government adopts policies that are inconsistent with maintaining an exchange-rate target, the eventual result is a currency collapse.15 If the government does not put its financial house in order, wage and price inflation will not be checked. The exchange rate will become steadily overvalued, and intervention in support of the currency will drain international reserves. Anticipating the exhaustion of the country’s reserves, speculators will run the central bank, thus forcing abandonment of the peg—a highly visible event. Doubts about the timing of a market attack on a currency are less important than the fact that it is bound to happen if a government’s policies are inconsistent with the peg.16 The simplicity and clarity of an exchange-rate target make it a transparent commitment because the interested public can directly monitor broken promises by the government.17 This transparency, in turn, enables the public to hold the government directly accountable if it abandons the peg. Indeed, Richard Cooper found that a devaluation roughly doubled the chance that a government would fall.18 In addition, finance ministers who presided over a devaluation were more than twice as likely as non-devaluing ministers to lose their jobs in the year following the devaluation. When governments shoulder direct responsibility for a transparent exchange-rate commitment, they pay political costs when the commitment is broken.19 CBI, by contrast, is an opaque commitment mechanism in the sense that it is quite difficult for the public to monitor what the government does in relation to a central bank.20 Even specialists find it tremendously hard to measure the actual autonomy of central banks, which is essential for credibility.21 Most specialists construct cross-sectional indices of formal/legal CBI from observable features of central bank laws: appointment procedures, dismissal and length-of-tenure rules, and the like. But a simple reading of central bank laws is a highly imperfect measure of CBI. The actual independence of the central bank is what enhances credibility, and laws alone

intermediate regime, such as a crawling peg to a basket of currencies. Here I draw the comparison between CBI and simple pegs. 15. Aghevli, Khan, and Montiel 1991. 16. For a critique of the “self-fulfilling” currency crises literature, see Bordo and Schwartz 1997. 17. See Bruno, di Tella, Dornbusch, and Fischer 1988; Giavazzi and Pagnano 1988; and Canavan and Tommasi 1997. 18. Cooper 1971. 19. See Bernhard 1998; Edwards 1996; and Collins 1996. 20. Monitoring CBI takes on various meanings in the literature. On the one hand, there is the statistical problem of finding meaningful measures of CBI. See Bernhard, Broz, and Clark 2002. On the other, there is the problem of monitoring the decision process of the central bank. Here, I am concerned with the ability of the public (wage and price setters) to monitor what the government does in relation to the central bank. 21. See Eijffinger and de Haan 1996, 22–28; and de Haan and Kooi 2000. 174 International Organization can hardly determine this.22 Governments can apply many forms of informal pressure on central banks short of changing the bank’s legal independence—the mere threat to revoke some or all of that independence can do the trick.23 Moreover, meddling governments can attribute any ex post change in central bank policy to an unanticipated monetary disturbance, and the public would be hard pressed to refute the claim. The public’s ability to distinguish the impact of instability in money demand (velocity shocks) from government interference is further complicated by the uncertain time lags with which changes in base money are transmitted to inflation.24 The opaque nature of the CBI commitment suggests that the credibility of CBI is not established by the ability of the public to directly observe broken promises, as with fixed exchange rates. Actual CBI depends on the government’s commitment to it: delegating monetary policy to an independent central bank does not solve the credibility problem, “it merely relocates” it to the government that makes the delegation decision.25 Something must make the government’s CBI commitment credible, and the transparency of the political system is a likely candidate.

Transparency in Political Systems

Governments create the institutions that constrain their own discretion. If there are no political costs to governments of revising or overturning the constraining institution, the commitment arrangement provides no credibility gains. When a government can renege without cost on a commitment arrangement, the arrangement will have no more effect on inflation expectations than when the government conducts monetary policy on its own.26 Before costs can be imposed, however, opportunism must be detected. If a government violates its promise and the public cannot detect the violation, or cannot distinguish meddling from an unanticipated disturbance, the government will bear few, if any, costs from acting opportunisti- cally. In the absence of transparency and costs, the commitment will not be credible. In the case of a peg, transparency and political costs are built into the commitment mechanism. By pegging, the government makes an easily verifiable commitment and bears political costs when it breaks that commitment. CBI, in contrast, is not directly observable and therefore cannot, on its own, generate the political costs required to adequately guarantee a commitment to low inflation. How then can it be made credible? I argue that transparency in political systems can provide the necessary monitoring and enforcement functions. Transparency in the political

22. Efforts to develop indicators of actual independence have been fraught with difficulties. See Bernhard, Broz, and Clark 2002. 23. See Havrilesky 1995; and Forder 1996. 24. Herrendorf 1999. 25. McCallum 1995, 210. 26. See Jensen 1997 for a formal treatment. Political Transparency and Monetary Regimes 175 system means that public decisions are made openly, in the context of competing interests and demands, political competition, and sources of independent information. Governments will have greater difficulty hiding their actions and avoiding the costs of opportunism when the political system is transparent. When government discretion is constrained by transparent political institutions, even an opaque monetary technology such as CBI may be credible. The argument borrows from James Fearon and Donald Wittman, who reason that institutions of political accountability—democratic institutions—facilitate information revelation and thereby improve a government’s ability to send credible signals.27 According to Fearon, governments incur “audience costs” if they make a threat or promise that they later fail to carry out. This suggests a role for political institutions, because the magnitude of these costs should depend on how easily domestic audiences can punish leaders. Fearon hypothesizes that democratic institutions generate higher audience costs, and hence democratic states can send more- credible signals of resolve. While the theory is developed in the context of signaling between nations during international disputes, it is more general and can be applied to the credibility of monetary commitment. Audience costs are the domestic political costs the government would bear if it failed to make good on a promise. In the case of a promise to respect the independence of the central bank, the attentive audiences include social actors with a stake in low inflation and the political opposition. Among the constellation of private interests that most strongly support CBI is the financial services sector.28 As creditors, banks are natural allies of the central bank and make up a powerful low-inflation constituency.29 In the United States, for example, the Federal Reserve relies on the support of the banking industry when its independence is threatened.30 Other allies of CBI include pensioners and institutional investors in fixed-rate corporate and government debt. These pro-CBI audiences, not individual voters, have special incentives to monitor government–central bank relations and report government misdeeds. Where political institutions allow for the expression and representation of societal preferences, pro-CBI audiences will find politicians willing to defend the central bank. With support from their inflation-averse principals, these politicians may gravitate toward legislative committees or cabinet ministries that control monetary legislation.31 When inflation-averse politicians sit on committees or ministries with agenda power and oversight responsibilities for monetary policy, informal pressures on the central bank are very likely to come to light. More generally, electoral competition provides opposition politicians with incentives to guard the central bank from government interference. The incentives to reveal information will be greater

27. See Fearon 1994; and Wittman 1989. 28. See Posen 1995; Havrilesky 1990; and Woolley 1984. 29. Faust 1996. 30. See Auerbach 1985; Woolley 1984; and Kettl 1986. 31. See Shepsle 1978 for a consistent theory of “self selection.” 176 International Organization when the low-inflation political party is in the minority or is a member of the governing coalition.32 When the opposition has a strong preference for low inflation, the government will tread on CBI only at its own peril. Civil liberties, particularly the freedom of expression, increase the transparency of the political process and make it easier for the public to obtain information on government reneging. Where media sources are independent of the government, the public can better monitor the government’s behavior with respect to the central bank, even to the point of differentiating monetary expansions due to political pressure from expansions that result from changes in velocity or other “uncontrol- lable” forces. In the United States and other open societies, the financial press closely monitors relations between the government and the central bank and provides analyses of policy changes. Back-channel political pressures on Federal Reserve officials are not secret for long, and media coverage has proven to be costly to the offending administrations.33 The monitoring role of interested domestic audiences and the magnitude of the costs these audiences can impose depend on the basic characteristics of the political system. In a transparent polity, civil liberties are afforded to a heterogeneous population, political parties compete openly for votes in regular and free elections, and the media is free to monitor the government. Political process transparency lowers the costs to the attentive public of detecting government manipulation of monetary policy and raises the costs to the government of interfering with the central bank. Inflation hawks in society and political challengers have interests in exposing violations of the CBI commitment; this puts constraints on the government’s ability to conceal or misrepresent its actions. Political competition ensures that opposition politicians and perhaps even the mass public will capitalize on the information and impose costs on the government. In opaque political systems, where there are severe restrictions on political expression, electoral and partisan competition, and the media, the audience costs of subverting CBI are low. Domestic anti-inflation groups and the political opposition cannot perform their monitoring and sanctioning roles. Without political transparency, an opaque monetary commitment like CBI is not likely to be credible. Autocrats may find that legal CBI is not effective in lowering inflation. Credibility- seeking autocratic governments must look to a more transparent monetary commitment, like pegging. In sum, a monetary commitment need not be directly transparent to impose costs on a government. CBI is not directly transparent. However, the costs needed to render an opaque commitment credible can be obtained indirectly by way of a political system that is itself highly transparent. In the following section, I lay out some testable implications.

32. Bernhard 1998a. 33. Kettl 1986, 130–31. Kettl documents how Nixon’s “dirty tricks” against Arthur Burns backﬁred and embarrassed the administration. Political Transparency and Monetary Regimes 177

FIGURE 1. Substitute sources of transparency

Political Institutions and Monetary Commitments as Substitutes

Transparency is a necessary characteristic of any credible government commitment. The public must be able to know when the government violates a commitment to impose audience costs. Transparency can be purchased by way of an easily observed commitment technology or generated indirectly via transparent political institutions. Commitment mechanisms and political institutions are substitute sources of transparency. Figure 1 depicts this negative relationship: the more transparent the political system, the less transparent the monetary commitment. CBI is the less transparent but more flexible commitment technology. It is associated with transparent political systems. A fixed exchange rate is the more transparent but less flexible technology. It is found more often in opaque political systems. When the political process is very open, CBI is rendered transparent indirectly through active monitoring by interested private and political agents. When political decision making is opaque, the government can import transparency by way of a peg—a commitment that is more transparent and constrained than the government. The transparency of the monetary commitment substitutes for the transparency of the political system to engender low inflation expectations. 178 International Organization

The foregoing analysis suggests the following hypotheses. (1) Countries with opaque political systems will have a higher probability of adopting a peg than countries with transparent political institutions. This tests the argument that the choice of exchange-rate regime is shaped by political system transparency. The propensity to choose a pegged regime should be negatively associated with the transparency of the political system. (2) Legal CBI has a negative effect on inflation in politically transparent nations. Since only legal CBI is directly observable, I test the implication that the effectiveness of statutory CBI in limiting inflation is conditional upon the transparency characteristics of the domestic political system. Note that this argument bears some similarity to Philip Keefer and David Stasavage’s point that a legally independent central bank reduces inflation when the political system has multiple veto gates.34 The arguments are not mutually exclusive: the number of veto players in a political system may have an effect on inflation performance independent of the degree of political transparency. I thus control for veto players in my analysis.

Evidence, Part I

The first test is to examine whether the transparency of the domestic political system affects the choice of exchange-rate regime. My substitution hypothesis predicts that countries with opaque domestic political institutions (autocracies) will have a higher probability of fixing the exchange rate than countries with transparent political institutions. CBI is not a credible option for autocracies because the closed nature of public decision making renders it difficult to detect and sanction governmental interference with the central bank. Sincere governments that want to establish low- inflation credentials must look to a commitment mechanism that is more transparent than the political system. The propensity to peg should thus be negatively associated with the transparency of domestic political institutions. I use cross-country, time-series data to test the prediction. The panel has yearly observations on as many as 152 countries during the 1973–95 period. Data availability constraints on some covariates reduce the sample size to around 2,300 observations (109 countries). The dependent variable is the exchange-rate regime, coded as an ordered categorical variable from data generously provided by Ilan Goldfajn and Rodrigo Valde´s.35 The original series has ten regime categories that I reduce to four, so as to collapse all currencies pegged to a single currency or basket of currencies into a single category. The highest value indicates a pegged regime, and lower values are progressively more flexible: 4 ϭ Fixed (pegged to the dollar,

34. Keefer and Stasavage 2002. 35. The series, developed for Goldfajn and Valde´s 1999, covers ninety-three countries. I filled in data on fifty-nine other countries from the original source, the International Monetary Fund’s (IMF’s) annual Exchange Arrangements and Exchange Restrictions, which provides a summary of each country’s officially reported exchange arrangement as of December of each year. Political Transparency and Monetary Regimes 179 some other currency, the SDR, or a basket of currencies); 3 ϭ Limited Flexibility (for cases such as the European Monetary System [EMS]); 2 ϭ Managed Floating; 36 and 1 ϭ Free Floating. The variable of interest is POLITY, an aggregate index of the “general openness of political institutions” from Polity III.37 It is constructed by subtracting the Polity III “Democracy” score from the “Autocracy” rating, according 38 to the emerging standard in the literature. POLITY ranges from Ϫ10 (most autocratic) to 10 (most democratic) and provides a fairly good stand-in for the openness of public decision-making. Table 1 contains summary statistics. In the initial specification, I control only for level of economic development, so as to isolate the effects of political institutions from the effects of development. The term for development is WEALTH (gross domestic product [GDP] per capita), which is included to control for potential differences between rich and poor countries in the propensity to peg; such differences might be correlated with the level of democracy (the sample correlation between polity and wealth is r ϭ 0.47.)39 More controls are added later to check robustness. All regressions include a lagged dependent variable. Given the ordered categorical nature of the dependent variable, I estimate the determinants of exchange-rate-regime choice using an ordered probit model with robust standard errors. Table 2 presents the results. The strongest and most consistent result is that exchange-rate regimes are slow to change: the lagged dependent variable is highly significant and has a large value. Although regime choice is path-dependent, it is influenced by other factors. Model 1 considers the relationship between political system characteristics and exchange- rate-regime choice, controlling for level of economic development. The estimated coefficient of POLITY, my proxy for political transparency, is negative and highly significant (z ϭϪ4.41), which suggests that the propensity to peg is inversely related to the level of political system transparency. It is also quantitatively large: when POLITY is set at its highest level (10) and all other variables are held at their means, the predicted probability of choosing a fixed exchange rate (Category 4) is 40 0.68, with a 5 percent margin of error. In contrast, when POLITY is set at its lowest level (Ϫ10), the predicted probability of pegging is 0.53. Being autocratic increases the probability of pegging by a statistically significant 15 percent. Of course, other factors influence the choice of exchange-rate system, and some may be correlated with political regime type. The OCA literature points to several considerations.41 Economic size, openness to trade, inflation performance relative to

36. I experimented with a dichotomous “Fixed-Flexible” dependent variable, and the results were substantively very similar. 37. Gurr, Jaggers, and Moore 1990. 38. Although the Democracy and Autocracy scores are highly correlated (r ϭϪ0.93), the categories and weights that make up the additive indices are somewhat different. The authors of the series note that the scales were not intended to be used separately. 39. GDP and population data are from World Bank 1997. 40. Predicted probabilities and conﬁdence intervals are estimated with the CLARIFY simulation software from Tomz, Wittenberg, and King 1998. See also King, Tomz, and Wittenberg 2000. 41. See Frieden 2002. 180 International Organization

TABLE 1. Summary statistics

Exchange-rate regressions Mean Std. dev Min Max

Lagged dependent variable 3.3136 1.0307 1 4 POLITY (Low ϭϪ10 to High ϭ 10) Ϫ.353 7.95 Ϫ10 10 WEALTH (Per capita GDP, $1,000s) 5.7637 6.7043 .1478 24.1361 SIZE (Log of GDP) 3.8544 1.0496 1.3887 6.7364 TRADE OPENNESS (X ϩ M/GDP) 74.2698 47.3279 3.7646 423.325 INFLATION DIFFERENTIAL (Country Ϫ World, log) .07486 .15661 Ϫ.2001 2.3778 FINANCIAL OPENNESS (Low ϭ 0 to High ϭ 14) 7.3435 2.4005 2.5 13.5 INT’L RESERVES (in months of imports) 3.2826 2.8713 Ϫ.09187 25.1768 FEASIBILITY (% of world on ﬁxed exchange rates) .6424 .1419 .3666 .8828 GOVERNMENT CRISES (Count) .1437 .4419 0 5

Inﬂation regressions All data in period averages (1973–89) Mean Std. dev Min Max

DV: LOG OF AVERAGE INFLATION 1.230 .541 .574 3.001 CBI .345 .119 .1 .69 POLITY 2.836 7.131 Ϫ910 CIVIL LIBERTIES 6.182 3.029 .312 10 POLITY ϫ CBI 1.149 2.723 Ϫ3.574 6.9 CIVIL LIBERTIES ϫ CBI 2.219 1.499 .056 6.156 WEALTH 5.763 6.704 .1478 24.136 PEG 2.944 .8652 1 4 FINANCIAL OPENNESS 7.565 2.497 3.235 12.794 GOVERNMENT CRISES .202 .252 0 1.235 FINANCIAL SECTOR SIZE .504 .366 .069 2.454 CHECKS1 .405 .0367 .329 .477

trading partners, and degree of financial openness are perhaps the most important considerations.42 The typical finding is that a peg (or a greater degree of fixity) is generally superior for small, open economies that have low inflation differentials with their trading partners and a lower degree of international financial integration. I include controls for these economic determinants in Model 2. Economic SIZE is measured as the log of GDP in constant U.S. dollars. TRADE OPENNESS is exports plus imports as a share of GDP. INFLATION DIFFERENTIAL is the absolute difference between the inflation rate of the country and the world inflation rate, logged. This term is lagged one period to avoid potential endogeneity problems. FINANCIAL OPENNESS is a

42. See Edison and Melvin 1990. Political Transparency and Monetary Regimes 181

TABLE 2. Political transparency and exchange-rate regime choice, 1973–95

Dependent variable: exchange-rate regime (2) Optimal currency (3) Other (Float ϭ 1 to Fixed ϭ 4) (1) Baseline area controls controls

Lagged dependent variable 1.36*** 1.29*** 1.24*** (.061) (.067) (.072) POLITY (from low ϭϪ10 to high ϭ 10) Ϫ.020*** Ϫ.015*** Ϫ.016*** (.005) (.005) (.005) WEALTH (per capita GDP) Ϫ.011** .023*** .024*** (.005) (.008) (.009) SIZE (Log of GDP) Ϫ.239*** Ϫ.257*** (.057) (.063) TRADE OPENNESS (X ϩ M/GDP) .169** .121 (.088) (.097) INFLATION DIFFERENTIAL (Country Ϫ World, Ϫ.306 Ϫ.212 logged and lagged) (.262) (.261) FINANCIAL OPENNESS (from low ϭ 0to Ϫ.068*** Ϫ.054** high ϭ 14) (.024) (.026) INT’L RESERVES (in months of imports) .041*** (.014) FEASIBILITY (% of sample pegging) 1.211*** (.427) GOVERNMENT CRISES (Count) .032 (.093) Pseudo R2 .48 .47 .47 Prob Ͼ chi2 0.00 0.00 0.00 Observations 2300 1983 1531

*p Ͻ .10, **p Ͻ .05, ***p Ͻ .01. Note: Ordered probit specification with robust (White’s heteroskedastic-consistent) standard errors in parentheses. fourteen-point scale derived from the IMF’s Exchange Arrangements and Exchange Restrictions, using the method developed by Dennis Quinn.43 The most important result in Model 2 is that the POLITY coefficient estimate remains significant and negative—the controls do not undermine this key finding. However, including SIZE does lead to a sign reversal in the WEALTH coefficient, the control for economic development. While collinearity between these terms is high (r ϭ 0.54), the results suggest that, controlling for size, richer countries tend to prefer more fixity in their exchange rates. One interpretation, often heard in the context of the EMS, is that wealthy countries desire stable exchange rates as a means of lowering the transaction costs of international trade and investment.44 Jeffry

43. Quinn 1997. I thank Istvan Majoros for extending Quinn’s series to developing countries. Data on economic size, trade, and country inﬂation rates are from World Bank 1997. World inﬂation rates used for the differential are from IMF 1998. 44. Frankel 1995. 182 International Organization

45 Frieden provides a more political interpretation. As for SIZE, the result confirms the implications of the OCA approach: the larger the economy, the stronger the case for flexible rates. The other controls have the expected signs. The negative sign on the inflation differential indicates that the more divergent a country’s inflation from the world rate, the greater the need for frequent exchange-rate changes. Divergent inflation rates make it difficult to sustain a fixed rate.46 A high degree of international financial integration also mitigates fixed exchange rates: FINANCIAL OPENNESS is negative and significantly related to pegging, presumably because a high degree of capital mobility makes it difficult to maintain a peg. Other influences are examined in Model 3. First, I include the size of a country’s foreign currency reserves, INT’L RESERVES, measured in months of imports. Larger reserves should make it easier to sustain a peg. The coefficient estimate is positive and significant—but very likely endogenous. Peggers would certainly try to maintain larger reserves than countries on more flexible regimes. More important as a control is the general “feasibility” of fixed exchange rates over time, given structural changes in the international environment, global shocks, and changes in expert opinion. There has been a steady decline in the number of pegging countries over time. In 1973, 87 percent of the world’s nations pegged; by 1995, the figure had dropped to 36 percent. The oil shocks of the 1970s, the debt crisis of the 1980s, large fluctuations in the value of the major currencies, increasing international capital mobility, and a number of dramatic speculative currency attacks surely influenced this shift away from currency pegs.47 Rather than include a time trend, I follow Frieden, Piero Ghezzi, and Ernesto Stein and use a variable— 48 FEASIBILITY—that measures the percentage of countries of the world with pegs. I expect the sign to be positive, as it is. The choice of a fixed exchange rate is positively and significantly related to the general climate of opinion regarding pegging. Note that, even though this is a large effect, the POLITY result hardly changes from the previous specification. Several studies on exchange-rate-regime determination include a term for political instability.49 The argument is that breaking from a promise to maintain a currency peg is a highly visible and politically costly occurrence, relative to gradual depreciation under a floating regime. Therefore, where political instability is high, governments with tenuous political support and short time horizons will be less likely to choose a fixed exchange-rate regime ex ante. I use GOVERNMENT CRISES to gauge the degree of political instability and expect the sign to be negative.50 The

45. Frieden 2002. 46. I also included a dummy variable for hyperinflation (Ͼ 200 percent inflation), on the idea that these countries may seek the discipline and credibility of a fixed rate. Though correctly signed, the term was not significant (z ϭ 0.56) 47. See Obstfeld and Rogoff 1995; Eichengreen 1994; and Edwards and Savastano 1999. 48. Frieden, Ghezzi, and Stein 2001. 49. See Edwards 1996; and Frieden, Ghezzi, and Stein 2001. 50. Banks 1994. Political Transparency and Monetary Regimes 183

FIGURE 2. Predicted probability of ﬁxing the exchange rate by POLITY score Note: Predicted probabilities are based on estimates from Table 1, Model 3. Vertical lines indicate 95 percent conﬁdence intervals. Simulations were performed with CLARIFY (Tomz et al. 1998).

variable is a count of “any rapidly developing situation that threatens to bring the downfall of the present regime.” The coefficient for GOVERNMENT CRISES is neither negative nor significant. I experimented with other indicators of political instability, such as the number of cabinet changes, riots, strikes, demonstrations, and revolutions.51 These results (not reported) were more consistent with the prevailing view in that the coefficients in every case were negative. None, however, was statistically significant. To examine the substantive effect of democracy on exchange-rate-regime choice, I conducted Monte Carlo simulations with estimates from the fullest specification (Model 3). Figure 2 demonstrates what happens to the predicted probability of adopting a fixed exchange rate as POLITY is allowed to vary over its entire observable range and all other covariates are held at their means. The figure shows that authoritarian polities are significantly more likely than democratic polities to adopt fixed exchange rates. The probability of adopting a peg is around 58 percent if a country is completely authoritarian and about 44 percent if it is fully democratic. While the prediction is relatively tight for democratic regimes, the confidence intervals widen once the Polity score falls below negative seven. In fact, the

51. Ibid. 184 International Organization probability of pegging for the most authoritarian polities varies by so much that, at the lower bound on the interval (0.51), it approaches, but does not overlap, the upper bound for fully democratic regimes (0.48). Although authoritarian countries can sporadically exhibit probabilities close to those of some weakly democratic nations, the probability of pegging remains significantly more likely for these nations. Overall, these findings indicate support for the transparency hypothesis. Auto- cratic systems lack the transparency to make an internal monetary commitment (for example, CBI) credible. Autocracies thus substitute the transparency of a visible commitment to a foreign currency peg for the transparency they lack internally. An alternative explanation based upon “Political Capacity” reasoning might be that autocrats peg because they are more insulated from domestic audiences and thus bear lower political costs if the peg collapses.52 That is, lower political costs ex post increase the likelihood that autocracies will choose a peg ex ante. I find this argument unconvincing. On the one hand, even autocratic governments must have societal support—if only from the military and the nationalist economic elite—to stay in power. Promising to maintain a peg, and then devaluing, is perhaps the surest way to undermine the support of these groups, since a strong and stable currency is a visible and powerful symbol of the national “honor” to the military and a source of cheap imported luxury goods to the elite. On the other hand, pegging is an inefficient means of generating credibility, given domestic alternatives that do not require as great a loss of policy flexibility. My point is that internal options are not available to autocracies due to the lack of political transparency. Pegging is, as Frederic Mishkin puts it, the “stabilization policy of last resort” for these countries.53

Evidence, Part II

In this section, I use cross-country data to test the implication that formal/legal CBI will have a negative impact on inﬂation only in countries with transparent political systems. A more direct test of the relationship between political transparency and CBI is not possible because the credibility of CBI, or actual CBI, is unobservable. However, since we can observe the kind of CBI obtained through legislation, it is possible to examine the implication that formal/legal CBI is rendered credible by an open political system. The sample consists of sixty-nine developed and developing countries during the 1973–89 period. Each observation pertains to a single country, with all values in period averages. The sample and averaging protocol is determined by data availability on CBI, which is from Alex Cukierman, Steven Webb, and Bilin Neyapti.54 This measure is an aggregate index of formal/legal CBI derived from

52. See Bernhard, Broz, and Clark 2002. 53. Mishkin 1999, 31. 54. Cukierman, Webb, and Neyapti 1992. Cukierman et al. have data on legal CBI for seventy-two countries for four periods (1950–59, 1960–71, 1972–79, and 1980–89), with each observation pertaining Political Transparency and Monetary Regimes 185 sixteen criteria found in central bank statutes. Legal CBI is an appropriate indicator because my argument predicts when formal/legal independence will have an impact on inflation performance. Specifically, I expect a high value of CBI to have a negative impact on inflation only when the domestic political system is transparent. By incorporating political system characteristics, I hope to improve upon existing studies that consistently fail to find support for the argument that CBI on its own lowers inflation in samples that include developing countries.55 The dependent variable is the inflation rate, measured as the log of the average annual change in the consumer price index.56 I use two alternative proxy indicators for the transparency of political systems: POLITY and CIVIL LIBERTIES. POLITY is from Polity III, as described previously.57 A high value corresponds to a political system in which leaders are freely chosen from among competing groups and individuals who were not designated by the government. This maps loosely to one conception of political transparency inasmuch as it captures the ability of the political opposition to openly scrutinize the government and compete freely in elections. CIVIL 58 LIBERTIES is an alternative indicator, from the Gastil/Freedom House series. Although there is extensive overlap in the two series (r ϭ 0.90), CIVIL LIBERTIES is explicitly designed to pick up the ability of private individuals and groups to monitor and criticize the government and to freely engage in social, political, and economic activity. Freedom of expression and the media weigh heavily in this index. Overall, the civil liberties index is slightly closer than polity to my conception of political transparency, in that it captures the ability of social actors to monitor government opportunism. To test my conditional argument, I multiply each proxy by CBI and expect the estimated coefficient of the interaction term to be negative. I use ordinary least squares (OLS) to estimate the effect of CBI, conditioned on the level of political transparency. Table 3 reports the results using the POLITY proxy. The baseline specification (Model 1) is a regression of the log of average inflation on CBI, POLITY, and WEALTH. WEALTH, measured as per capita GDP, is included to control for differences between rich and poor countries in the toleration for inflation;

to one decade in one country. I dropped Romania, Taiwan, and Yugoslavia due to missing data on regressors. I chose to restrict the analysis to a simple cross-section for two reasons. First, the post-1973 period provides a better (unbiased) sample for testing the political determinants of monetary credibility because the Bretton Woods fixed exchange-rate system operating before 1973 limited n Ϫ 1 nations’ (all but the United States) ability to pursue independent monetary policies. Second, central bank statutes vary very little over time relative to across countries; the country scores are in most cases identical across subperiods. 55. Cukierman, Webb, and Neyapti 1992 find that legal CBI is associated with lower inflation in twenty-one industrial countries but not in fifty-one developing nations. Other studies using legal indices fail to extend the findings to broader samples. See de Haan and Kooi 2000. 56. I take the log to reduce the importance of outlying observations, as in Romer 1993. Inflation data are from World Bank 1997. 57. I filled in missing data for three countries (Bahamas, Barbados, and Malta) with Gastil/Freedom House “Political Rights” scores, transformed to a twenty-point scale. 58. Freedom House 1999. 186 International Organization

TABLE 3. Democracy, central bank independence, and inﬂation

Dependent variable: log of average inﬂation, (2) CBI conditioned (3) Exchange rate 1973–90 (1) Baseline on polity commitment (4) Controls

Constant 1.254*** 1.064*** 1.456*** 2.818*** (.156) (.218) (.309) (.694) CBI (from low ϭ 0to .457 1.049 1.135* 1.292** high ϭ 1) (.437) (.673) (.662) (.606) POLITY (from low Ϫ.012 .034 .032 .029 ϭϪ10 to high ϭ 10) (.009) (.022) (.023) (.021) WEALTH (Per capita Ϫ.025*** Ϫ.023*** Ϫ.026*** Ϫ.004 GDP) (.009) (.009) (.009) (.012) POLITY ϫ CBI Ϫ.138** Ϫ.140** Ϫ.126* (.069) (.070) (.066) PEG (Floating ϭ 1to Ϫ.134** Ϫ.113* Fixed ϭ 4) (.060) (.068) CHECKS1 (logged count Ϫ2.695 of “veto players”) (1.678) FINANCIAL OPENNESS (low Ϫ.063** ϭ 0 to high ϭ 14) (.030) GOVERNMENT CRISES .730** (Count) (.302) FINANCIAL SECTOR SIZE Ϫ.360 (Liquid Liabilities/ (.256) GDP) R2 0.17 0.21 0.25 0.47 p-value for F 0.00 0.00 0.00 0.00 Observations 68 68 68 66

*p Ͻ .10, **p Ͻ .05, ***p Ͻ .01. Note: Ordinary least squares with White’s heteroskedastic-consistent standard errors in parentheses.

these differences could be correlated with democracy.59 The coefficient estimate of CBI has a positive effect on inflation, but the relationship is not significant. The positive sign suggests that countries with high average rates of inflation have central banks that are at least statutorily independent, contrary to the view that legal CBI 60 lowers inflation on its own. POLITY and WEALTH are negatively associated with inflation, but only the latter coefficient is statistically significant, and highly so. It is

59. GDP and population data are from World Bank 1997. 60. Cukierman, Webb, and Neyapti 1992 find that legal CBI is negatively but not significantly related to inflation in their seventy-two-country sample. My specification differs in the time period on which averages are taken (see above) and in the transformation of the dependent variable. To constrain inflation outliers, I use the log of inflation, while they use D ϭ ␲/(1 ϩ ␲), where ␲ is the inflation rate and D is the transformed inflation rate. I ran my model using their transformation, and the results (available on request) are not substantively different. In fact, my variables of interest increase in magnitude and significance. Political Transparency and Monetary Regimes 187 not surprising that richer countries have lower inflation rates, although the causal mechanism is not clear. Model 2 tests the argument that the effect of legal CBI is conditional on the level of political system transparency. The coefficient on the interaction term is negative and significant as expected, and the fit of the model improves slightly. CBI is associated with lower inflation when a nation’s political system is more democratic (more transparent). Some simple algebraic manipulation of the coefficients reveals that the conditional effect of CBI on inflation is negative for nations with polity scores above eight.61 Thus, CBI has a negative influence on inflation only in the most democratic states. The reason may be that it takes strongly democratic institutions to enable society’s inflation hawks to monitor the many ways that governments tamper with the policy independence of the central bank. Another part of my argument is that countries that peg will enjoy lower inflation irrespective of the transparency of their political systems. Pegging is a very transparent and therefore credible commitment in its own right. Model 3 includes an indicator of each country’s exchange-rate regime, PEG, coded as before on a four-point ordinal scale. As pegging puts tight constraints on monetary policy, I expect a negative association with inflation. The coefficient estimate for peg is correctly signed and significant. This suggests that a transparent commitment to a peg reduces inflation regardless of regime type. This specification also has slightly more explanatory power than the previous model, and the POLITY ϫ CBI interaction term is virtually unchanged. Model 4 includes other factors that might influence inflation and be related to my variables of interest. One variable in particular is crucial given its importance in another paper in this volume. Keefer and Stasavage argue that the effectiveness of legal CBI in limiting inflation increases with the number of veto players required to reverse a delegation of authority to the central bank.62 We therefore must determine whether political system transparency plays a role independent of the number of effective checks and balances in a political system. To control for the effect of multiple veto players, I use the log of CHECKS1 from the Database of Political 63 Institutions, as in Keefer and Stasavage. CHECKS1 counts the number of veto players in a political system, adjusting for whether these players are independent of each other, as determined by the level of electoral competitiveness in a system, their respective party affiliations, and electoral rules (open versus closed list). Other controls include the degree of political instability, the level of financial openness, and the size of the financial sector. Cukierman, Sebastian Edwards, and Guido Tabellini find that inflation is higher in countries that are less politically

61. To examine the impact of one term of an interaction variable on the dependent variable, take the partial derivative of the dependent variable with respect to the single term in question (Friedrich 1982). ? ϭ ? ϭϪ ␦ ␦ Since CBI 1.049 and Polity*CBI .138, Yinflation/ CBI is only negative when POLITY is more than eight. I thank Joseph Gochal for illustrating this procedure. 62. Keefer and Stasavage 2002. 63. Beck, Clarke, Groff, Keefer, and Walsh 2000. 188 International Organization stable because political instability reduces policymakers’ time horizons and ability 64 to precommit. My measure of political instability is GOVERNMENT CRISES, from Arthur Banks.65 A high level of financial openness (few barriers to limit the integration of national and international financial markets) imposes monetary policy discipline regardless of the degree of CBI because interest rates are constrained to world levels. FINANCIAL OPENNESS is from the IMF annual report Exchange Arrange- ments and Exchange Restrictions, coded as before on Quinn’s fourteen-point scale.66 Another potentially contaminating factor is the degree of financial sector opposition to inflation. Adam Posen argues that the level of financial sector opposition to inflation is the underlying cause of both inflation performance and 67 68 CBI. I use FINANCIAL SECTOR SIZE, as measured by liquid liabilities to GDP. The ratio of liquid liabilities to GDP is a general indicator of the size of financial intermediaries relative to the size of the economy. It is frequently used as an overall measure of financial sector development. I assume that a bigger financial sector means more financial opposition to inflation. These data are from another World Bank series.69 Model 4 results indicate that more veto players reduce inflation but the relationship is not quite significant at the 10 percent level. Financial openness and political instability are significantly related to inflation and in the expected directions. Financial openness, however, tends to be characteristic of rich countries. (The bivariate correlation between FINANCIAL OPENNESS and WEALTH is 0.72.) This collinearity leads to a sharp change in the wealth coefficient and suggests that we should not read too much into these estimates. The coefficient for GOVERNMENT CRISES, on the other hand, is meaningful. Inflation performance is influenced strongly by the underlying level of political instability.70 Finally, financial sector size relative to all economic activity has a negative but insignificant effect on inflation. The key point is that introducing these controls does not alter the basic story. The estimate for POLITY ϫ CBI remains at a similar magnitude and significance level, although peg falls slightly in significance. CBI remains associated with lower inflation in strongly democratic countries, and fixed exchange rates still improve inflation performance. The models in Table 4 replicate the analysis using CIVIL LIBERTIES as the proxy for political system transparency. Not surprisingly, the results are very similar. How- ever, the size and the significance level of the interaction variable of interest, CIVIL

64. Cukierman, Edwards, and Tabellini 1992. 65. Banks 1994. 66. Quinn 1997. 67. Posen 1995. 68. Liquid liabilities, also known as broad money or M3, are the sum of currency plus demand and interest-bearing liabilities of banks and other financial intermediaries. 69. Beck, Demirguä-Kunt, and Levine 1999. 70. I ran regressions with other measures of political instability (riots, strikes, demonstrations, and revolutions), and each was negatively associated with inflation, although only riots and demonstrations were significant. Political Transparency and Monetary Regimes 189

TABLE 4. Civil liberties, central bank independence, and inﬂation

Dependent variable: log of average inﬂation, (2) CBI conditioned (3) Exchange-rate 1973–90 (1) Baseline on civil liberties commitment (4) Controls

Constant 1.296*** .447 .849* 2.309*** (.151) (.379) (.463) (.695) CBI (from low ϭ 0to .432 3.115** 3.198** 3.139** high ϭ 1) (.438) 1.374) (1.371) (1.320) CIVIL LIBERTIES (from low Ϫ.004 .114*** .106** .101** ϭ 0 to high ϭ 10) (.022) (.040) (.042) (.043) WEALTH (per capita GDP) Ϫ.032*** Ϫ.027*** Ϫ.029*** Ϫ.008 (.009) (.009) (.009) (.013) CIVIL LIBERTIES ϫ CBI Ϫ.380*** Ϫ.382*** Ϫ.346** (.146) (.149) (.148) PEG (Floating ϭ 1to Ϫ.124** Ϫ.112* Fixed ϭ 4) (.062) (.068) CHECKS1 (count of “veto Ϫ2.657 players,” log) (1.662) FINANCIAL OPENNESS (low Ϫ.064** ϭ 0 to high ϭ 14) (.029) GOVERNMENT CRISES .665** (Count) (.302) FINANCIAL SECTOR SIZE Ϫ.407 (Liquid Liabilities/ (.255) GDP) R2 0.17 0.23 0.27 0.46 p-value for F 0.00 0.00 0.00 0.00 Observations 69 69 68 66

*p Ͻ .10, **p Ͻ .05, ***p Ͻ .01. Note: Ordinary least squares with White’s heteroskedastic-consistent standard errors in parentheses.

LIBERTIES ϫ CBI, improve over prior estimates using the polity measure. This may be due to the fact that civil freedoms are closer to my concept of political transparency than the democracy indicator. Freedom of expression, organization, and dissent is a precondition for effective monitoring of government commitments. The ability to openly denounce the government when it meddles in central bank affairs is a crucial ﬁrst step in applying audience costs. Once the transgression is exposed (by the media, for example), democratic institutions allow for sanctioning by way of electoral competition. To illustrate the substantive effect of CBI conditioned on the level of civil liberties, I estimated expected values of inﬂation from Model 2 by holding CIVIL LIBERTIES at a high level (75th percentile), setting WEALTH to its mean, and then increasing CBI incrementally from its lowest to its highest value. I generated 190 International Organization

FIGURE 3. Effect of CBI conditioned on CIVIL LIBERTIES: High CIVIL LIBERTIES (75th percentile)

expected values and 95 percent confidence intervals using Clarify.71 As part of the simulation, I exponentiated the expected values to yield more meaningful results— inflation rates rather than logged inflation. Figure 3 shows that there is a slightly negative relationship between CBI and inflation in democratic settings. These results provide modest support for the argument that CBI generates lower inflation in the context of transparent political institutions. In democracies, CBI constrains government opportunism and thus provides meaningful information about the commitment to low inflation. As for autocracies, the effect of CBI is very perverse. Figure 4 replicates the simulation but with CIVIL LIBERTIES set at a low level (25th percentile). There is a positive relationship between CBI and inflation in nondemocratic settings. Why a formally independent central bank might raise inflation in the absence of democracy or civil liberties is a legitimate puzzle. It could be that those states that are the least likely to be credible would go to great pains to profess the supposed independence of the central bank. Legal CBI might thus send a preserve signal to wage and price setters, creating an even greater time-inconsistency problem. Note also that the level of uncertainty surrounding these estimates increases dramatically as CBI increases. This suggests that, when the political system is not transparent, the effect on inflation of a statutorily independent central bank is highly

71. See Tomz, Wittenberg, and King 1998; and King, Tomz, and Wittenberg 2000. Political Transparency and Monetary Regimes 191

FIGURE 4. Effect of CBI conditioned on CIVIL LIBERTIES: Low CIVIL LIBERTIES (25th percentile)

varied. Overall, legal CBI signals little about the commitment to low inﬂation in autocratic settings.

Conclusion

The underlying presumption of this paper is that governments choose monetary institutions at least in part according to their usefulness in resolving the time- inconsistency problem. Credible monetary commitments must be transparent for governmental opportunism to be detected and punished. Transparency, however, need not be a characteristic of the commitment technology itself. In the case of CBI—an opaque technology—a transparent political system can be a workable substitute. When the political process is open, as in democracies, CBI is rendered transparent indirectly through active monitoring and sanctioning by interested private and political agents. When political decision making is not transparent, as in autocracies, the government can import transparency by way of a commitment technology that is more transparent than the political system. For autocratic governments, a highly transparent monetary commitment such as a peg can substitute for the transparency of the political system to engender low inﬂation expectations. 192 International Organization

Refinements of the argument are certainly possible. Future work can incorporate more fine-grained differences among democracies and autocracies as they relate to the transparency of political decision making. Among parliamentary systems, coalition governments should be more transparent than single-party governments, as coalition partners will have divergent preferences on monetary policy.72 Democra- cies with small electoral districts should be more transparent than those with large districts, since politicians will represent constituents with more heterogeneous monetary interests. The degree of political decentralization should also relate to transparency, with federal democracies more transparent than centralized systems due to the heterogeneity of regional preferences and their representation in strong bicameral institutions.73 While Mark Hallerberg analyzes the impact of federalism according to the logic of the veto gates model,74 my inclination is to treat federalism as an alternative source of transparency for government commitment, as Jon Faust does.75 Although there is less variation in transparency across autocracies, one possible avenue to explore is the transparency of the succession process. Mancur Olson argues that monarchies with clearly defined and stable succession procedures produce autocrats that take a long-term “encompassing” interest in the productivity of the economy.76 It follows that, when there is consensus about choosing the next ruler, political transparency and stability are likely to be higher than in systems plagued with succession crises. Nations (autocratic and democratic) also differ on the extent to which they are subject to outside monitoring, as by the IMF.77 External monitoring by the IMF might create the transparency necessary to make a monetary commitment credible. It might also be the case that foreign investors monitor government commitments and impose audience costs directly, by way of their investment and withdrawal decisions. However, domestic audiences are likely to have advantages over foreign ones in monitoring back-channel government behavior, given their greater familiarity with local political circumstances and dealings. Further research along these lines will help delineate the effects of political transparency on the choice and effectiveness of alternative monetary commitment mechanisms.

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Competing Commitments: Technocracy and Democracy in the Design of Monetary Institutions John R. Freeman

Some years ago, the noted economist Jan Tinbergen proposed a theory of the optimum regime.1 The optimum regime is a bundle of institutions designed to maximize social welfare. Politicians, according to Tinbergen, produce “doctrinal deviations” from this regime. Citizens therefore should defer to “economic think- ers,” social scientists who are “less emotional” and clearer headed than their elected ofﬁcials. While the struggle between economists and politicians might take some time to resolve and the actual makeup of the optimal institutions may vary slightly from country to country, Tinbergen was conﬁdent that eventually all countries would converge on this regime. In the minds of some observers, the recent reforms in central bank institutions and current trend towards the liberalization of national economies show that this convergence is occurring.2 This special issue of IO is, in a sense, an extension of this work, but an extension that treats politics much more seriously than Tinbergen. The contributors are expressly concerned with institutional design, especially the design of two monetary institutions: the degrees of central bank independence and exchange-rate commitment. Their analyses explicitly incorporate political variables. For them, the key to understanding the origins and consequences of today’s monetary institutions lies in the interplay of political and economic forces. Their investigations differ in the extent to which the welfare implications of institutional designs are implicit or explicit. Some authors emphasize more the motivations of politicians and less the macroeconomic consequences of their policies.3 Others focus on the impacts of

For useful comments and criticisms, I thank the former editors of IO, Peter Gourevitch and David Lake; the editors of this special issue, William Bernhard, Lawrence Broz, and William Clark; anonymous referees; and Kenneth Scheve, William Scheuerman, and David Stasavage. 1. Tinbergen 1959, 1963, and 1972. 2. For a presentation and critique of ideas of convergence in institutional choice, see such works as Ellman l980. 3. See Bernhard and Leblang 2002b; Clark 2002; and Hallerberg 2002.

International Organization 56, 4, Autumn 2002, pp. 889–910 © 2002 by The IO Foundation and the Massachusetts Institute of Technology 198 International Organization alternative institutional designs on inflation, growth, and competitiveness.4 To- gether, the articles show not only that political institutions must be incorporated in any monetary regime, but also that this choice is best made on the basis of a careful analysis of the motives and strategies of both politicians and economic agents. This special issue represents a significant advance over the more interpretive and heuristic studies of the 1970s and 1980s. Much deeper insights into the politics of institutional design are revealed within these contributions. The articles offer an explanation of why elites choose a combination of central bank independence and exchange-rate policy and why certain political institutions are chosen along with these combinations. In this sense, this special issue produces a much more complete and politically informed characterization of monetary regimes than Tinbergen and others could have imagined. The pieces by Lawrence Broz, Philip Keefer and David Stasavage, and Mark Hallerberg are noteworthy because they explain the rationale for and design of democratic institutions that must accompany monetary commitments. In addition, the articles explain some of the welfare consequences of regime choice, especially with respect to prices. The normative significance of this special issue lies in its results concerning the macroeconomic consequences of regime choice and in the larger implications of its results for democratic politics. The articles are valuable additions to the debate about the “room to maneuver” that remains for governments in advanced democracies— the degree to which officials in one country can choose a distinctive mix of welfare outcomes for their citizens.5 But the main purpose of this issue is to inform the choice of monetary institutions. In this respect, the articles’ significance lies in their support for monetary technocracy. The authors show how democracy can be designed to create and protect monetary authority, authority based on benign technical expertise rather than electoral manipulation. In this sense, the volume is a valuable extension of Tinbergen’s theory.6 In this article, I refine and expand the agenda for this project. First, I evaluate the analyses and research designs in the other articles. Out of this evaluation, I identify ideas about how to produce a “third generation” of research on this topic. Specif- ically, I consider how to broaden the welfare criteria on which institutional choices are made, deepen the political analyses on which the choice of institutions are based, and strengthen the tests that are offered in support of these choices. I explore the questions of how and whether popular sovereignty over economic policy and institutional choice is achieved in the second part of the article. This part shows that the regimes proposed in the special issue are, in a sense, democratic as long as the public’s “perceived consensus” about economic policies and macroeconomic out-

4. See Broz 2002; Frieden 2002; and Keefer and Stasavage 2002. 5. For example, see Garrett 1998; and Rodrik 1997 and 2000. 6. For a deﬁnition of technocracy as a distinct subgroup of bureaucracy that enjoys autonomy and operates with a policy paradigm based on instrumental rationality, see Centeno 1993. While the contributors to this special issue do not advocate a single, optimum regime, most are supportive of democratically supervised, “independent” central banks. Technocracy and Democracy in Monetary Institutions 199 comes is real. However, if, as new work suggests, there is genuine dissensus about policy and macroeconomic objectives, it is no longer clear that the regimes are democratic. This leads, in my conclusion, to a brief discussion of the possibility of a crisis of imagination in institutional design.

Advancing the Research Program

Important facts and questions motivate this special issue. Foremost among the facts are recent episodes of central bank reform in such countries as the United Kingdom, New Zealand, and Italy. Less emphasized is the fact that there have been few reversals in central bank independence. In fact, the contributors do not discuss any episodes in which authorities have reneged on their decisions to make central banks more independent. This suggests that the arrangements these authors describe are designed to prevent reversals. To the believers in an optimum regime, this is evidence of enlightened convergence on central bank independence.7 But the questions that motivate the volume are more complex. The authors seek to understand why central bank independence is chosen in combination with (1) a particular kind of exchange rate commitment and (2) a set of expressly political institutions—institutions that help enforce the choice of monetary commitment technologies.8 The implication is that the political institutions are essential parts of the bundle of institutions that make up the most preferred regime. Put another way, in any optimum regime, nondemocratic institutions such as central banks must be combined with democratic institutions such as legislatures and elections. The articles are based on common understandings about the workings of the economy and polity.9 The former includes what in economics is called the neoclas- sical model of inﬂation and the time inconsistency of optimal plans. These essentially are the bases for seeking monetary commitment technologies.10 The Mundell-Fleming conditions for open economies are also important. The presump-

7. One explanation for the absence of reversals in central bank independence is that monetary authorities make necessary policy changes whenever the threat of such reversals arise (Stasavage, personal communication). But it is surprising that such changes are always adequate to head off reversals. 8. Especially Broz 2002; Hallerberg 2002; and Keefer and Stasavage 2002. 9. The investigations are clearly rooted in what political scientists might call a neoliberal perspective. The need for government intervention in markets and the existence of genuine (intragenerational) distributional conflicts are taken as a given. Politics is equated with struggles over the intragenerational distribution of wealth—struggles among groups not classes. See Bernhard, Broz, and Clark 2002; Frieden 2002; and Hallerberg 2002. Politicians are motivated by the desire to remain in office and, in one case at least, enhance the growth rate of real income rather than (un)consciously serve any class interests. Bernhard and Leblang 2002. The optimum regime is discovered by elites apparently through some dialogue with these self-interested politicians. An example of the tendency to equate politics with distributional struggles is Hallerberg’s argument that “an independent central bank is a device to assure that explicit political manipulation of the money supply does not occur.” Hallerberg 2002, 775. My conception of liberal (classical and neoliberal) approaches as distinct from so-called radical approaches to political economy can be found in Freeman 1989a, chap. 2. See also fn. 35. 10. Bernhard, Broz, and Clark 2002. 200 International Organization tion is that capital mobility now is a given, so there are really only two choices available to countries: monetary autonomy or fixed exchange rates.11 Again, the question is which of these two alternatives is preferable and which political institutions best support this choice. As for democracy, the papers are rooted in conventional understandings about the workings of the respective institutions. The contributors share common understandings of the workings of majoritarian versus consensual government, federalism, interest group politics, the separation of powers, and other political institutions. For example, Hallerberg and Keefer and Stasavage invoke familiar unidimensional spatial reasoning to explain the power that veto players exert.12 “Transparency” is among the ideas that bind the articles together in this regard. This is the notion that democratic politics is an inherently effective means of revealing information, especially about rent-seeking. Democracy’s virtue lies mainly in its ability to reveal elected officials’ attempts to tamper with the authority of what are benign monetary authorities.13 The challenge is to design democracy so that transparency is enhanced and, at the same time, the defenders of central bank independence and of the chosen exchange-rate policy have effective veto power over any attempts to renege on monetary commitments. How can this research be advanced still further? On what questions and issues should the “third generation” of studies focus? In the following section, I consider these questions.

Toward a Better Interdisciplinary Synthesis

Work in this genre would benefit from incorporating additional ideas from economics. For example, studies of exchange-rate politics should employ more explicitly what we know about the way exchange rates adjust to policy changes, for example, the so-called J-curve. Politicians can exploit delays in adjustment to produce cycles of overvaluation.14 Also, we know that the effects of fiscal policy are diminished in open versus closed economies. This is because some increases in spending eventually “leak out” of the economy in the form of imports. Whereas, in some respects, fiscal policy may be a more effective electoral tool than monetary policy,15 its effectiveness in this regard may diminish as countries’ economies become more and

11. Clark 2002; see also Rodrik 2000. The omission of capital controls is one reason the volume emphasizes choices for developed rather than emerging democracies. 12. See Hallerberg 2002; and Keefer and Stasavage 2002. This is the now-standard “setter model” developed by Weingast and Moran 1983 and elaborated on by Ferejohn and Shipan 1989 and 1990, among others. 13. See Broz 2002; and Keefer and Stasavage 2002. 14. van der Ploeg l989. 15. Clark 2002. Technocracy and Democracy in Monetary Institutions 201 more open to international trade and financial flows. Such features of open economies should be incorporated in future analyses of institutional design.16 Economic research on expectational mechanisms and information processing is equally important. This special issue draws from the research on central bank behavior in only the most general sense. Few authors take up the challenge of analyzing the “expectational mechanisms”17 that govern the relations among economic agents, political agents, and monetary policymakers. In fact, some, like William Clark, treat expectations as “exogenous.”18 Yet it is these mechanisms that lie at the heart of the causal relationships that determine the behavioral and welfare implications of regime choice. This includes the effectiveness of central bank reforms vis-a`-vis inflationary outcomes. We must learn more about how politics is related to these expectational mechanisms and about the associated reputational equilibria. For instance, Robert Barro and David Gordon show that the discount rate of the monetary authority is a key parameter in its decision rule and hence in determining the type of equilibrium that is established between the monetary authority and private agents. Future research should be devoted to analyzing how this discount rate depends on the workings of democratic institutions.19 New work in information economics potentially is quite important for the study of monetary institutions. This research addresses the question of whether it is socially beneficial to have public institutions such as central banks publish the results of their analyses (forecasts); if private agents have more precise information of the same kind, dissemination of public information, under some conditions, can be socially harmful.20 But, in a recent study, Stasavage argues that, in fact, “central bank transparency”—the practice of central banks publishing their forecasts of money demand—reduces the costs of disinflation, especially if governments are Left or Center in their partisanship.21 This practice helps private agents learn the disposition of central banks (as well as of what presumably are less inflation-averse politicians). In turn, it is easier for these agents to make quicker and less costly adjustments to disinflationary policies. Smaller output and job losses therefore are observed. In this way, central bank transparency can be a beneficial complement to political transparency.

16. Frieden 2002 alludes to the J-curve and to van der Ploeg’s 1989 research. But Frieden’s model is so aggregated, cross-sectionally and temporally, that he is unable to offer many insights into the respective political-economic processes. 17. Barro and Gordon l983a and 1983b. 18. Clark 2002. 19. Barro and Gordon’s work, 1983a and 1983b, is most inﬂuential in this special issue as well as in parallel works such as Iverson 1998 and 1999. Barro and Gordon offer rich models of the processes whereby expectations are formed by private agents about monetary policy, policymakers choose decision rules, and reputational equilibria of various kinds emerge. On the importance of the discount rates of central banks and political actors in determining certain kinds of (reputational) equilibria, see the companion piece by Keefer and Stasavage 2000, especially page 2 and fn. 8. 20. Morris and Shin 2001. 21. Stasavage 2001. 202 International Organization

This line of research also raises some interesting questions about political transparency, however. Specifically, do the results from information economics extend to political information? For example, is it beneficial for governments and (or) private firms to publish poll results in the runups to elections? Interestingly, because of its presumed impact on financial markets, the Taiwanese government recently placed restrictions on just this kind of public information.22 This suggests that, in some circumstances, this aspect of political transparency might not be desirable. Simply put, the welfare consequences of the dissemination of political information—especially information about the electoral prospects of parties—must be addressed.23 Finally, economists have devoted much time and energy to studying the properties of financial time-series such as exchange rates. They have found, among other things, that these series exhibit nonstationary (non-constant means), episodes of volatility that tend to cluster together and extreme events that occur much more often than one would expect if the series were normally distributed.24 They also have found that these series display “break points”; the properties of exchange-rate and other series vary across in different eras.25 These essentially experimental results are the basis for the efficient market hypothesis (EMH) and other important economic ideas. Empirical work on the politics of monetary institutions and on international political economy in general must be better informed by this branch of economics. So that we can use standard statistical distribution in our hypothesis tests, we must check our political and economic series to determine if they are stationary. If our series contain unit roots, standard statistical tests may be inappropriate. Also, indications of nonstationarity may mean that the political and economic processes we are studying share “common trends.” The simple functional forms we use in our regression models may be inaccurate; more complex functional forms called “error correction models” may be required to capture the relationships between political and economic series. Tests for kurtosis (non-normality of residuals) often are used to determine if there are multiple, political-economic equilibria or, literally, if more than one model is needed to explain the series. Empirical economics suggests that

22. Lin and Roberts 2001. 23. Morris and Shin 2001 argue that when they have better information than private agents, the dissemination of information by public institutions like central banks can be welfare-enhancing. Unfortunately, they make no distinction between economic and political information. In relation to the arguments advanced by Morris and Shin 2001, Stasavage (personal communication) contends that private agents do not have good information about future money demand; the U.S. Federal Reserve and other central banks produce better forecasts of future money demand than private forecasters. Therefore, Morris and Shin’s results about the beneﬁcial effects of public dissemination of information apply. The questions are: is the political information in electoral polls and public opinion surveys inherently more imprecise than information about such things as money demand? And, either way, is there reason to believe that private pollsters have better information about future electoral outcomes than public sources of the same information? 24. deVries l992. 25. See Corporale and Grier 2000; and Garcia and Perron 1996. Technocracy and Democracy in Monetary Institutions 203 political-economic processes “switch” continuously between the two (or more) models. Ignoring high levels of kurtosis (levels greater than three) might lead us to employ a single model when a switching setup with two or models would be appropriate. The result, again, would be mistaken causal inferences. Checking for serial correlation and heteroskedasticity or outliers is commendable.26 But empirical economics shows that, for exchange rates and other series we often study, disturbance variance is itself time-dependent; these economic series display so-called autoregressive conditional heteroskedasticity (ARCH). Once more, failure to account for ARCH can create inefﬁciency and mistaken inference in hypothesis tests. Finally, our interpretations of results should acknowledge the EMH as it relates to the processing not just of economic information but also of political information.27

Analytics The political analyses in this special issue should be strengthened in several ways. First, multiparty systems loom large in the investigations of several authors. In fact, one of the main lessons of this volume is that multiparty systems produce veto players and government coalition partners that guard the independence of central banks.28 The analyses of the workings and stability of multiparty systems is somewhat underdeveloped analytically, however. For example, the authors restrict their investigations to a single policy dimension. As Michael Laver and Kenneth Shepsle have shown, multiparty governments are better conceived in terms of multidimensional policy spaces.29 Strategy and cabinet stability depend on a complex combination of four factors: the spatial location of parties’ preferences, policy salience weights, seat distributions, and legislative decision rules. For instance, sometimes parties, by virtue of occupying dimension-by-dimension policy medians, can ensure themselves of membership in a wide range of, if not all feasible, governments. In such circumstances, it is not clear that such parties necessarily prefer to increase their vote share (popularity). Similarly, small parties may be more likely to become members of ruling coalitions if they modify their policy positions slightly or even lose seats. These features of coalition government must be incorporated more fully in the study of veto players and other features of monetary institutions.30

26. Frieden 2002, for example. 27. Examples of works that are informed by veins of experimental economics include Bernhard and Leblang 2002a; Freeman, Hays, and Stix 2001; Hays, Freeman, and Nesseth 2001; and Hays, Stix, and Freeman 2001. Bernhard and Leblang 2002a grapple with the way politics and political information affects conditional variance in exchange rates. The Freeman, Hays, Stix, and Nesseth studies analyze the effects of political information on the probability of regime switching in currency and bond markets. 28. See Keefer and Stasavage 2002; Hallerberg 2002; and Bernhard and Leblang 2002b; see also Lohmann 1998a and 1998b. 29. Laver and Shepsle 1996 and 1998. 30. Government durability may be a function of the four factors Laver and Shepsle 1996 and 1998 analyze rather than of regime choice. Or regime choice may be a cause and a consequence of these same factors. Keefer and Stasavage 2002 emphasize the impact the number of veto players has on the tendency 204 International Organization

Second, international politics should be incorporated more fully into the analyses. To their credit, a number of contributors acknowledge the role that international political factors play in regime choice.31 They suggest the decision to peg one’s currency to that of another country involves explicit consideration of that other country’s bundle of institutions. Of course, this idea is related to the earlier point: the “strength” of inflation-averse parties in the country to which one pegs is a key element of the decision to fix one’s own exchange rate. Illustrative is the power that the Christian Democratic Union-Christian Social Union (CDU-CSU) enjoyed in Germany—a country to whose currency several European countries pegged—by virtue of its location at the dimension-by-dimension median of the respective policy space.32 There also is the matter of central bank cooperation and coordination.33 The choice of monetary regime surely is both a cause and a consequence of the activities of the epistemic community among central bankers. We must learn more about the understandings and political behavior of this community insofar as regime choice is concerned. Finally, there is the question of regime choice for regional and international institutions. Hallerberg’s results help us understand certain institutional features of the European Union (EU).34 However, none of the contributors teaches us much about how the existence of a regional political regime like that embodied in the EU changes the calculus of the elites who design the regime of a single country. Presumably the knowledge that political integration is under way and that alternative regional regimes are being negotiated between a country and its neigh- bors changes the expected costs and benefits of monetary commitment technologies.35 Third, a more complete set of welfare criteria should be employed in evaluating monetary institutions. This special issue emphasizes the effects of regime choice on inflation; it bases the case for central bank independence and exchange-rate commitment primarily on this desideratum. But citizens also care about other macroeconomic objectives like employment. And, as Bernhard, Broz, and Clark note, the choice of monetary institutions limits governments’ abilities to stabilize output and create jobs.36 Moreover, there is much evidence that, in these respects,

to reverse monetary commitments. They seem sensitive to the kinds of factors that Laver and Shepsle analyze. But they do not provide any demonstration in the present article that the raw number of veto players necessarily captures the existence of very strong parties and other features of stable cabinets. Cf. Laver and Shepsle 1996, chap. 5. Although they cite Laver and Shepsle’s work, Bernhard and Leblang 2002b supply no such microfoundations for their analysis of cabinet durability. 31. See Bernhard, Broz, and Clark 2002; Hallerberg 2002; and Bernhard and Leblang 2002b. 32. Laver and Shepsle 1996, chap. 10. 33. Kapstein 1992 and 1989. 34. Hallerberg 2002. 35. On the institutional design of the EU in relation to that of national regimes, see works such as Iversen 1998; Soskice and Iversen 1998; and Winckler et al. 2000. The radical perspective takes a much different view of why central banks, particularly the U.S. Federal Reserve Bank, are insulated from electoral forces and of the constellation of interests that central banks serve. See, for example, Wade and Veneroso 1998; and Hoogvelt 1997, chap. 7. 36. Bernhard, Broz, and Clark 2002. Technocracy and Democracy in Monetary Institutions 205 the choice of monetary institutions has different welfare consequences across sectors of the economy. Because of such things as varying ability to “pass through” price changes caused by currency movements, different industries suffer to differing degrees as a result of exchange-rate policies.37 The study of regime choice must be based on broader (welfare) considerations of these kinds. This amendation will lead to evaluations of a larger set of institutional arrangements. For example, there is a well-developed argument that job performance hinges on the design of wage-bargaining arrangements. There also is evidence that the abilities of countries to “tie their hands” with exchange-rate pegs38 depend on the existence of certain kinds of wage bargaining.39 For these reasons, wage-bargaining institutions must be included in the optimum regime. Ostensibly this means there are three40 or even six 41 additional options for countries. In all there are conceivably (3 ϫ 4 ϭ)12 or (6 ϫ 4 ϭ)24 different regimes from which to choose. Unfortunately, because it focuses essentially on only two of these choices, the contributors in this special issue cannot yet teach us which is the most preferred of these regimes.42 Interestingly, one current theory argues that the optimum regime is clear. Torben Iversen contends that the choice of wage-bargaining institutions is inexorably tied to the choice of monetary institutions, and that, in effect, the choice of the exchange rate institution is linked to wage-bargaining arrangements.43 The most preferred regime is “decentralized monetarism,” which provides for a hard currency policy, non-accommodating monetary authority—namely, a high degree of central bank independence and monetary conservatism—and intermediate wage bargaining. According to Iversen, decentralized monetarism produces the best performance in terms of inﬂation and unemployment (Table 1). The challenge is to show how the results of the present articles are (in)consistent with those of Iversen and, as explained below, how this special issue’s results about the design of democratic institutions complement decentralized monetarism.44

37. Frieden 2002. 38. Clark 2002. 39. Hochreiter and Winckler 1995. 40. Iversen 1998 and 1999. 41. See Traxler and Kittel 2000; and Traxler, Blaschke, and Kittel 2001. 42. In a new paper on central bank transparency, Stasavage 2001 analyzes the “sacrifice ratio.” This is the number of percentage points of output (employment) lost per policy-induced one-point reduction in inflation. Again, he finds that this kind of transparency reduces the ratio, especially for Left and Center governments. Stasavage finds that wage-bargaining institutions have no impact on this ratio. However, he is quick to point out that the expectations of the respective literature with respect to the costs of disinflation are somewhat ambiguous. Stasavage 2001, 12, 18–19. 43. Iversen 1998 and 1999. 44. Iversen equates wage-bargaining institutions with currency policies, maintaining that the two are highly correlated. Iversen 1999, 10–12, 168. He stresses convergence on one regime in particular, namely, that which provides for a nonaccomodating monetary commitment and intermediate wage bargaining. Using a somewhat different research design than Iversen—for example, different measures for monetary policy and for temporal units—Traxler, Blaschke, and Kittel 2001, 259–74, find support for Iversen’s thesis but only for the growth in unit labor costs, not for employment or changes in employment. They find that there is some interactive effects of some of their six bargaining modes with monetary policy on these and other measures of economic performance. 206 International Organization

TABLE 1. Expanded institutional choices associated with optimum regime based on Iversen’s studies (1998, 1999) of wage-bargaining systems

Central bank dependence Central bank independence

Wage-bargaining Hard currency Soft currency Hard currency Soft currency system policy policy policy policy

Decentralized

Intermediate Iversen’s Optimum Regime Centralized

Note: Traxler, Baschke, and Kittel 2001 suggest that there are actually six different wage-bargaining systems that should be considered; hence there are at least twenty-four possible regimes.

Research Design The contributors to this issue employ both mathematical and statistical approaches to institutional design. The former are noteworthy for the multiple equilibria they illuminate. These demonstrations help explain the variety of regimes we observe today. As suggested previously, the mathematical analyses should be extended in certain ways. Learning—Bayesian sequential updating—must be more fully incorporated in the setups. For example, the analyses could be enriched to allow citizens (voters) to learn over time about their parties’ commitments to certain regimes. Conceivably, such an extension could provide insights into why certain “inﬂationary biases” in money growth45 persist longer in some countries than in others (for example, because of differences in the learning capabilities of the respective mass publics). Such learning also could be a source of multiple, reputational equilibria. Barro and Gordon allude to the possibility that over time private agents learn about the preferences of policymakers.46 They also note that the length of time over which private agents punish policymakers for cheating may be longer than one period or that such punishment might be meted out only “occasionally.” These two possibil- ities may be related: learning about the preferences of monetary authorities and political parties produces extended or sporadic punishment that, in turn, produces multiple, reputational equilibria.47

45. Goodhart 2001. 46. Barro and Gordon 1983a and 1983b. 47. Morris and Shin 2001 study binary action coordination games. The importance of multiple equilibria is stressed by Stasavage 2001, 7. Technocracy and Democracy in Monetary Institutions 207

In many respects the statistical analyses in this volume are sound. For example, the authors are careful to analyze the impact of country outliers in particular and of heteroskedasticity in general on their estimates. But, as noted in my call for a better synthesis with economics, the empirical work on the political economy of monetary institutions can be improved. In addition to incorporating economists’ results about the time-series properties of relevant variables, more attention should be paid to measurement issues. For instance, Joseph Gochal recently has shown that, because of Berkson measurement error, the impact of central bank independence on inﬂation is weaker than previously thought.48 The use of trends or natural rates is a second important measurement issue. Striving for deeper interdisciplinary syntheses will illuminate the need for temporal decomposition and the measurement of variables relative to natural rates of growth and employment. Most authors in this volume do not build such a conceptual bridge to economics in their measures.49 The decisions to use annual or even multiyear averages of variables and to pool country data are understandable.50 Many authors focus on long-term, macro relationships. However, these decisions have costs. The associated (reduced form) statistical models provide insights only into the average effects of institutions among a given sample of countries.51 The use of highly temporally economic and political time series destroys information and masks break points; this can lead to mistaken causal inferences.52 This is especially true where we analyze intermediate variables like exchange rates and money supplies or welfare outcomes like prices. Just as there is value in comparative, historical case studies of central bank creation and reform,53 there is value in comparative empirical analyses of individual countries at lower levels of temporal aggregation. Carefully designed comparisons of political- economic processes in particular countries can provide quasi-experimental insights into institutional design. When conducted at lower levels of temporal aggregation, we gain better insights into the way expectational mechanisms and reputational equilibria operate as well as into the short- and medium-term consequences of regime choice.54 The (reduced form) models in this special issue force economic and political structures of countries into a single, one-way causal functional form. For instance,

48. Gochal 2001. 49. See, however, Stasavage 2001; and Suzuki and Chappell 1995. Also some of the seemingly contradictory evidence about the performance of decentralized monetarist systems may be due to the use of different measures of central bank authority. Cf. Traxler, Baschke, and Kittel 2001, 259ff. 50. Frieden 2002, for example. 51. Meier and Gill 2000. 52. Freeman l989b. 53. Goodman l992; and Bernhard 2002. 54. I am much less sanguine than Traxler, Baschke, and Kittel 2001 about the use of multiperiod averages of variables. Ibid., 25. My reading of the time-series literature is that such practices mask causal relationships. Freeman 1989b. Gochal 2001 makes similar arguments about the pitfalls of pooling. He advocates the use of reduced form hierarchical models and a Bayesian Monte Carlo Markov chain approach to gauging (sampling) the coefficients in the respective equations; such a setup is essentially the same as a complex random coefficients model. 208 International Organization none of the authors allows for causal relationships between variables within countries. Several use measures for the average value of variables among a set of countries as a shorthand for relationships between variables across national polities and economies. The first practice is indicative of the fact that none of the authors employs even a small-scale simultaneous equation model of the political economy. The second practice might be adequate for smaller countries, but it is likely to introduce biases of various kinds for larger countries like the United States and Germany.55 In the “third generation” of work on this topic, we must build and analyze more temporally disaggregated, multiequation, reduced-form models for individual countries and (or) for the interconnections between countries’ politics and economics. Such models will allow for a richer and more meaningful analysis of the origins and impacts of regime choice.56 It also is important to establish the analytical connections between the mathematical and statistical setups in the articles. Stochastic elements must be introduced in the mathematical analyses of commitment technologies, and “microfoundations” must be supplied for the reduced-form models used to study this subject. Such amendations have the potential of yielding fresh insights into the nature and existence of game theoretic equilibria between central bankers and elected officials on the one hand, and of avoiding serious misspecification problems on the other. Thus, for example, in a related paper, Keefer and Stasavage suggest how Robert Franzese’s idea of “multiple hands on the wheel” translates, in the context of a separation of powers, into a testable equilibrium inflation pattern on which central bankers, the executive, and the legislature agree.57 Extending the mathematical and statistical analyses of monetary institutions in the ways I have indicated will pose challenges. One of these is tractability. Complex, multiequation models can be estimated with maximum likelihood and other familiar methods. However, as the scale of the model increases, the results often become less and less interpretable. Bayesian multivariate time-series approaches therefore may be required.58 The paucity of cases does make it difficult to study individual

55. The political and economic processes of large countries might be exogenous to those of small countries, but processes of small countries clearly are not exogenous to those of large countries. The second practice therefore probably creates simultaneity biases in the estimates of the respective models. 56. For instance, Frieden 2002 emphasizes the importance of factor mobility and the impact of exchange-rate changes on relative prices across countries. But then, like other contributors, he relies on a pooled, one-way causal statistical setup that treats countries’ political economics as independent of one another. Keefer and Stasavage 2002 do address the simultaneity issue. However, it is not clear that their use of the Hausman test is adequate. For examples of the kinds of models I am referring to, see Freeman, Williams, and Lin 1989; Ang and Bakaert 1998; and Sims and Zha 2002. 57. See Keefer and Stasavage 2000; and Franzese 2002. The former study negotiations between central banks, the executive, and the legislator. They show how inflation results from certain equilibria decisions among these three agents in a stylized version of consensual democracy. In this way, they provide some microfoundations for Franzese’s work as well as for Broz’s 2002 argument about political transparency. The more general importance of joining formal, mathematical, and statistical political science is the goal of the so-called Empirical Implications of Theoretical Models project of the National Science Foundation. Political Science Program 2002. 58. Brandt and Freeman 2002. Technocracy and Democracy in Monetary Institutions 209 regimes. It is true that, as the number of cells in Table 1 grows, we have fewer and fewer countries we can study to gain insights into the relative virtues of different institutional designs. Computational analyses of artificial political economies are one way to address this problem. This approach has proven useful in economics in such areas as real-business-cycle theory. Recently, examples of similar investigations have appeared in the field of political economy.59 Less familiar approaches of this kind must be explored to make progress toward sorting out the complex array of institutional choices.60

Monetary Technocracy and Democracy

This special issue informs the debates about globalization. It helps us gauge the extent to which alternative institutional arrangements give governments more or less capacity to shape macroeconomic outcomes. In this sense, the articles help charac- terize one leg of the so-called “political trilemma.”61 But, is this capacity consistent with popular preferences? The fact that certain regimes afford authorities more “room to maneuver” does not mean that society’s most preferred blend of welfare— intragenerational and intergenerational—necessarily has been achieved, let alone that it has been achieved in a way that preserves democratic processes and values.62 The contributors to this special issue suggest explicitly or implicitly that this capacity is best achieved through monetary technocracy. The articles take as a given the conventional wisdom that democracy is ill suited to the making of monetary policy. The motivations of elected officials are such that they consistently “distort” what would otherwise be “optimal monetary policy” thereby creating unnecessary, harmful levels of inflation, reduced output, etc. For example, elected officials create unnatural macroeconomic fluctuations (cycles) that are socially harmful.63 As

59. See Freeman and Houser 1998; and Houser and Freeman 2001. 60. For more temporally disaggregated experimental studies of relevant political economic processes, see Bernhard and Leblang 2002a; Freeman, Hays, and Stix 2001; Hays, Freeman, and Nesseth 2001; and Hays, Stix, and Freeman 2001. I am advocating the study of small-scale structural models with rational agents and stochastic elements; calibration and simulation are the main methods used in such an approach. See Freeman and Houser 1998; and Houser and Freeman 2001. This is not the same case study approach discussed by Gochal 2001, 9. 61. Rodrik 2000 proposes a political trilemma akin to the Mundell-Flemming conditions. Rodrik argues that two of the following are possible: the nation-state, internationally integrated national economies, and mass politics (democracy). Since, like the authors in this special issue, Rodrik considers the second condition a given, the choice is between preserving the nation-state and having limited “room to maneuver” and creating world federalism that, with one political jurisdiction, would allow mass politics to have greater impact on the making of economic policy and macroeconomic outcomes. Cf. fn. 87. 62. Intragenerational welfare has to do with the (distribution of) well-being of (within) major age cohorts and, sometimes, all living citizens. The relative well-being of the same cohorts as well as of living and unborn citizens is indicative of intergenerational justice. Gini indices and other income distribution statistics are used to gauge the former, whereas child allowances, social insurance coverage, and long-term growth rates are often used to measure the latter. See Freeman 1989a, especially chap. 6. 63. See Bernhard, Broz, and Clark 2002; and Franzese 2002. 210 International Organization channels for the expression of popular sovereignty over monetary policy, then, legislatures and other representative institutions are of limited value; at best these institutions provide a means by which the defenders of technocracy—or small groups (veto players) who understand the virtues of technocracy—defend the independence of monetary authorities.64 How might this stand be reconciled with a commitment to democratic values and popular sovereignty?65 One answer is through the idea of “expert democracy.” Essentially, this holds that citizens are unable or unwilling to make judgments about complex matters like central bank independence and exchange-rate policy. Citizens willingly defer to benign technocrats to make these decisions. The identities of these technocrats is less important than their scientific training and presumed commitment to the public interest, including the pursuit of the interest of unborn citizens (intergenerational equity). If necessary, oversight is exercised by a small, highly informed segment of the citizenry together with a select group of legislators who periodically appoint and interact with monetary officials.66 Unfortunately, as a case for expert democracy, this special issue is underdeveloped. To begin with, the values and understandings of monetary authorities are taken as a given. For some time, political scientists have studied the attitudes and dispositions of bureaucrats.67 Now it is time to do the same with central bankers. We must know more about how monetary authorities understand the expectational mechanisms and other key features of the political economy, how they conceive of social welfare both in an intragenerational and intergenerational sense, and whether and how they see themselves as trustees or guardians. Most important, we must better understand how central bankers conceive of their role in a democracy; for example, to whom and how do they believe they are accountable politically? We must know more about the rationale for and uses of the polls that central banks like the Bank of England conduct.68 We also must address the debate about “representative bureaucracy”: by virtue of their scientific training and professionalism, are the identities of central bankers of little importance vis-a`-vis issues of race, gender, and ethnicity? Research may show that central bankers are not as benign as the contributors assume and that the absence of certain ethnic, racial, and gender

64. Broz 2002. 65. Popular sovereignty can be defined as citizens having the “undisputed right to determine the framework of rules, regulations, and policies within a given territory and to govern accordingly.” Held l991a, 150. Note that Held points out there are restrictions on popular sovereignty in all democracies, including checks and balances and guaranteed rights. Note also that his definition emphasizes the “input” dimension of democratic legitimacy; cf. Schimmelfennig l996. 66. On the concept of expert democracy, see such works as Hanson l989, especially 81–2. 67. Aberbach, Putnam, and Rockman l981. 68. The Bank of England Inflation Attitudes Survey (www.bankofEngland.co.uk) asks citizens about their inflation preferences, basic knowledge of monetary policy (making), and the evaluation of the Bank’s performance. Interestingly, in a classic essay on public administration, Woodrow Wilson argued that civil servants should be “intimately connected with popular thought by means of elections and constant public counsel.” Wilson 1887. He believed this would prevent “arbitrariness or class spirit” on the part of public administration. Not surprisingly, Wilson did not anticipate the development of opinion polling. Technocracy and Democracy in Monetary Institutions 211 identities within their ranks results in policies that produce distributional injustices of various kinds within and between generations.69 This special issue offers limited insights into citizens’ dispositions toward monetary institutions, let alone toward the idea of technocracy. For instance, Broz argues that there is an “audience” monitoring regime choice. And Hallerberg emphasizes the importance of citizens being able to “identify” those responsible for making certain policy decisions. But neither author provides survey data about how citizens—or any highly informed and efficacious segment of the citizenry— comprehend and evaluate monetary institutions (or such things as the way international markets constrain those institutions). Nor, surprisingly, do the contributors provide any evidence that citizens understand and support the central bank reforms that connote convergence to preferred regimes.70 In fact, new studies suggest that, in some respects, a case for expert democracy might be sustainable. In a forthcoming book entitled Stealth Democracy, John Hibbing and Elizabeth Theiss-Morse find that “perceived consensus” best charac- terizes Americans’ views of many issues. That is, U.S. citizens believe that, with regards to inflation and other matters, they and their counterparts agree about what is desirable. Moreover, citizens are willing to defer to experts, because, in contrast to elected officials who emphasize what are perceived to be false (minor) differences in preferences, these experts are willing and able to choose the best means to achieve what are perceived to be mutually preferred ends. “The apparent desire to empower people often cohabits with the desire to empower entities virtually unconnected to the people.”71 We need additional survey research of this kind, research that establishes more deeply and clearly the existence of such consensus and deference cross-nationally. Such evidence may move us closer to placing monetary technocracy on the footings of expert democracy.72

69. The idea of representative bureaucracy is explored and evaluated in works like Krislov and Rosenbloom l981. To my knowledge, no one has produced a thorough demographic profile of central bankers in relation to the ethnic, racial, gender, and other makeup of their respective societies or, for Europe, for the European Community. Representative bureaucracy presumably would yield more just distributions of such things as male and female unemployment (that is, the distribution of the costs of disinflation). This point is explained further in the following text. 70. One interesting idea is to probe citizens’ understanding of the nature of and potential impact of central bank reform. Bernhard 2002, chap. 7 alludes to the need for this kind of research but, unfortunately, does not present any relevant survey data. 71. Hibbing and Theiss-Morse forthcoming, chap. 6, 12. 72. James Monroe puts forth an interesting, related argument. Monroe argues that, for Americans, “direct democracy with scientific administration is a contradiction only when observed from liberal ground. If, instead of clashing interests, the people really did share an underlying communal goal, then both methodologies serve the same end.” Hibbing and Theiss-Morse forthcoming, chap. 6, 12. Hibbing and Theiss-Morse also point out that, when at the Federal Reserve, Alan Blinder made a similar argument about the legitimacy of the U.S. monetary authority. Ibid., 13. In this sense, the Federal Reserve may have a “political constituency”; cf. Bernhard 2002, 201, fn. 5. Also germane here are Delli Carpini and Keeter’s 1996, 70–1 finding that only eighteen percent of Americans comprehend the nature of monetary policy, and Hibbing and Theiss-Morse’s findings supporting the view that citizens lack meaningful policy preferences. Ibid., forthcoming, chap. 6, 21ff. 212 International Organization

TABLE 2. Public attitudes toward less democratic arrangements in the United States

Leave decisions to successful Leave decisions to Run government like business people nonelected experts a business

Strongly Agree 4% 3% 10% Agree 28 28 50 Disagree 59 60 37 Strongly Disagree 10 9 3

Source. Hibbing and Theiss-Morse forthcoming, Table 6.2. The original source is the Democratic Processes Survey, Gallup Organization 1998.

This project also must address evidence that challenges the idea of expert democracy. For example, in a sophisticated study of the inflationary preferences of mass publics in Organization for Economic Cooperation and Development countries, Kenneth Scheve recently found, contrary to the American public’s perceptions, within and across countries there are significant differences in the importance citizens attach to inflation relative to other outcomes like employment.73 Moreover, the public’s macroeconomic preferences vary over time depending on the context (for example, phase of the business cycle). In addition, Hibbing and Theiss-Morse present data that show more than two-thirds of the American electorate are uncomfortable with deference to non-elected experts (Table 2).74 Their data also provide little popular support for the idea of public-spirited veto players who guard the independence of central banks. Finally, Timothy Hellwig reports that openness of the economy tends to diminish citizens’ abilities and willingness to hold government responsible for economic outcomes. This is particularly true of more highly-educated citizens and those who are employed in tertiary, private sector jobs.75 Together these findings suggest that elected officials have not so much delegated monetary policy to technocrats as they have abdicated their responsibility to their constituents.76 In addition, the reduced amplitude in political business cycles that presumably results from the convergence on central bank independence represents a diminution of popular sovereignty. Consensus with respect to the goals of monetary institutions is a false perception. Citizens may have genuinely different interests with respect to inflation and other macroeconomic outcomes. Elected officials ought to promote and protect these interests, and these interests ought to be

73. Scheve 2002. 74. Hibbing and Theiss-Morse forthcoming. 75. Hellwig 2001. 76. Bernhard 2002. Technocracy and Democracy in Monetary Institutions 213 reflected in electoral outcomes. Citizens may not understand the role of veto players in expert democracy and (or) how regime choice provides governments with the capacity to choose different mixes of inflation and unemployment. A segment of the citizenry conceivably comprehends how and why monetary authority has been delegated to technocrats and therefore does not hold its elected representative accountable for the respective policies. But further research about this segment may show that the respective citizens simply lack efficacy or are misinformed. Then we have the irony that, despite decades of public education and the rise of the mass media, today’s citizens are less able to participate in the making of economic policy than their nineteenth century predecessors.77 The challenges to the idea of expert democracy do not end here. As noted previously, in addition to their impact on different sectors of the economy, monetary institutions may have lasting gender, ethnic, and racial consequences.78 If these consequences are shown to be inconsistent with the preferences of the respective groups of citizens, the identities of central bankers become an issue. Evidence that central banks are “unrepresentative bureaucracies” coupled with the increased propensity to delegate to and insulate these institutions seriously undermines any case for expert democracy. There also are questions about the meaningfulness and nature of legislative oversight of central banks. As we have seen, such oversight may not be understood or supported by citizens. Worse, such oversight may be a process by which certain interest groups ally with the technocrats to produce arbitrary (but real) redistribu- tions of wealth. For example, it could be that constellations of interest groups— particularly groups representing different sectors of the economy—strategically lobby the legislative and/or executive branches of government to exploit those branches’ veto powers. The link between “polarization” of the preferences of the legislative and executive branches and expected inflation actually reveals a distributional struggle between different coalitions of industries, each with different “pass through” capabilities and preferences regarding exchange-rate volatility.79 In this

77. Frieden 1994. Scheve 2002 finds that the distributional consequences of inflation and employment are key determinants of how individuals value these macroeconomic outcomes and also that inflation aversion depends on country-level factors that bear on the expected costs of inflation and unemployment. The editors of this special issue stress that monetary commitments “limit opportunistic business cycles.” Bernhard, Broz, and Clark 2002, 16; see also Franzese 2002. And there is much evidence—Freeman and Houser 1998, 651; and Houser and Freeman 2001—that suggests the workings of democratic polities now have only marginal impacts on jobs, output, and other important variables. These findings need to be reexamined to determine whether they represent a decline in popular sovereignty over the economy. Unfortunately, Hellwig’s data (personal communication) do not allow him to determine if the tendency to hold elected officials less accountable for the economy is due to the realization that the respective decisions are now made by independent monetary authorities. 78. Frieden 1991 and 2002. See also Scheve and Slaughter 2001. 79. Keefer and Stasavage 2000 overlook the possible link between their work and Frieden 2002, focusing instead on ethnic diversity. Bernhard 2002, chap. 4, fails to discover any link between the presence and size of the financial industry and central bank independence. But he does not explore the possibility that it is through an alliance with certain industries that financial interests influence regime choice. 214 International Organization sense, legislative and executive influence over central banks is more a matter of “capture” and coalitional politics than the (transparent) protection of any public interest.80 In sum, much work remains to be done before we can decide if the optimal regimes sketched in this special issue are democratic. Making the case for monetary technocracy and extending it to the EU and other supranational institutions requires a third generation of multifaceted research. This may be the most important challenge we face in institutional design.81

A Crisis of Imagination?

Just as Tinbergen argued several decades ago, the articles in this volume suggest that countries will settle on a particular set of regimes. Convergence will produce the best possible inflation rates and perhaps the most desirable responses to shocks in national output. These regimes will be democratic to some degree, either because democracy is a better means of protecting and preserving monetary technocracy than authoritarianism82 or because politicians in democracies are able to devise ways to influence monetary policy or use fiscal policy to pursue their more selfish interests.83 Wage bargaining institutions may be part of the most preferred regimes. In fact, Iversen predicts convergence on a similar set of institutions, although he too is unclear about whether or how these institutions preserve democratic norms and values. Iversen suggests that supranational regimes eventually will embody the same choice of institutions.84

80. In fact, the classics on congressional inﬂuence over bureaucracy are quite ambiguous about the arrangements by which central banks are monitored by subcommittees. For instance, Ferejohn and Shipan 1990, 9 write, “...itispossible that in some cases, Congress wishes to enact a policy that would not get majority support. The classic example is this: Congress wishes to implement a low-inﬂation monetary policy, knowing that it will have an incentive to renege. Faced with this dilemma, Congress delegates authority over monetary policy to a conservative agency, and delegates monitoring authority to a conservative committee that provides political shelter for the agency’s decisions.” They offer no explanation of who or what “Congress” represented (in terms of interest groups or party factions) in this case. The implication seems to be that, as regards monetary policy, the motivation was the protection of minority rather than collective interest. 81. This special issue does not go into much detail about how the democratic features of EU institutions are related to those of the new European central bank. Needless to say, many of the points made in this section apply in this setting as well. For example, Frieden 1991 and 2002 suggests that sectoral consequences of the creation and management of the euro are present but transnational in nature. Hence one might conjecture that transnational coalitions of industries behave strategically toward the representative institutions that negotiate with the European monetary authority in the same way that their counterparts do in countries like the United States. 82. See Broz 2002; Hallerberg 2002; and Keefer and Stasavage 2002. 83. See Bernhard and Leblang 2002a; and Clark 2002. 84. Iversen 1999, chap. 6; and Iversen 1998, 498. While some students of wage bargaining allude to electoral politics within labor organizations—for example, Hall and Franzese 1998, 513—for the most part, the respective studies also fail to explain (whether) the regimes they analyze preserve popular sovereignty over economic policy. Technocracy and Democracy in Monetary Institutions 215

Only time will tell if these predictions are accurate or simply indicative of a crisis of imagination. There are serious questions about the capability of today’s citizens—even in the most advanced democracies—to comprehend and engage in monetary and other kinds of economic policymaking. And, despite the information revolution, as yet, there have been few technological innovations in democracy— innovations that would enhance the capabilities of citizens.85 Finally, the visions of global governance associated with the other feasible leg of the “political trilemma”—world federalism86—appear to be little more than old wine in new bottles. But it could be that in some respects the predictions of convergence are more a description and rationalization of what we are observing today than a refutation of some possible worlds. My hope is that these possible worlds include a regime in which there is markedly more popular sovereignty over the making and implementation of economic policy.87

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