Weingast B.R., Wittman D. The Oxford Handbook of Political Economy
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582 voting and the macroeconomy
The domestic political-institutional variables featured in the research of Powell
and Whitten (1993) and others, along with structural economic variables such as
trade openness, domestic product concentration, and terms of trade risk featured
in Rodrik’s (1998) analysis of international variation in the size of government,
appear to make excellent instruments for identifying the impact of politically relevant
macroeconomic performance on voting outcomes when only gross performance is
observed, which is of course always the case in national accounts data. It could be
more illuminating, however, to entertain explicit latent structure models of the form
X = X
g
+ e = Zγ
1
+
(
Z · X
−Ù
)
γ
2
+ e (31)
V = · + X
g
β + u (32)
V = · + X
g
β +
(
X − X
g
)
θ + u (33)
where Z represents a matrix of predetermined institutional and structural economic
variables of the sort discussed above that are believed to affect political relevance.
Equations (31)and(32)or(31)and(33) could be estimated either jointly by a full-
information maximum-likelihood procedure, or in two-step fashion yielding reduced
form voting equations such as
38
V = · +
ˆ
X
g
β +(X −
ˆ
X
g
)θ +
˜
u (34)
where
ˆ
X
g
= Z
ˆ
γ
1
+
(
Z · X
−Ù
)
ˆ
γ
2
. Notice that models in the form of (33)and(34)permit
direct tests of whether “politically relevant” variation in macroeconomic conditions
dominate voting outcomes in the presence of “politically irrelevant” residuals. By
comparison to current practice in the “clarity of responsibility” trade, empirical
experiments based on test equations such as (31)–(34) hold excellent prospects of
enhancing understanding of stability of macroeconomic voting over time and space.
6 Concluding Remarks
.............................................................................
Research on voting and the macroeconomy emerged around three generations ago.
However, all the way up until the end of the 1960s studies of macroeconomic voting
were for the most part a-theoretical, and relied upon rudimentary graphical, tabular,
and correlational analyses to investigate empirical regularities. The gradual integra-
tion of the General Linear Model—the statistical workhorse of social science—into
graduate training programs beginning in the late 1950s, along with the appearance of
Downs’s monumental work in 1957, laid the foundations for econometrically sophis-
ticated, theoretically grounded research. Yet for a decade or more following Kramer’s
³⁸ It is not appropriate for me to get into identification and efficient estimation issues here. Pagan
1984 supplies an excellent analysis of various specific set-ups, including models like (31)–(34). The
references cited earlier in this chapter to the econometric work in the 1970s on unobserved variables are
also centrally relevant.
douglas a. hibbs, jr. 583
landmark 1971 paper, the lion’s share of empirical studies were based mainly on free-
form regressions only tenuously connected to a theory of electoral choice.
During the past dozen years theory, method, and knowledge have advanced sig-
nificantly.Theliveliestdebateshavecenteredonwhethertheelectorate’svaluation
horizons are retrospective or prospective, and on the degree to which voters inter-
nalize domestic institutional arrangements and international economic forces that
constrain the capacity of elected authorities to manage national economies. Research
on institutional determinants of clarity of responsibility has exploded over the past
decade, but testing formats are commonly ad hoc regressions populated by various
interaction and conditioning variables that are not well motivated by either sub-
stantive or econometric theory. The potential leverage offered by unobserved, latent
variable models, which were fully developed by the mid-1970s, remains unexploited.
Some guidance, or at least commiseration, might be also be found in the analogous
efforts to bring institutional factors to bear on measurement of “potential incomes”
in neoclassical models of economic growth.
39
Nonetheless, the incorporation of insti-
tutional and international constraints to models of economic voting is an important
development that is likely to progress steadily and productively.
Rational retrospective voting theory has appealing theoretical coherence, but it has
not yet delivered any empirical value added. As matters stand, it gives every sign of
going the way of the “surprise” macroeconomics paradigm generally—theoretical el-
egance devoid of empirical relevance, leading inevitably to abandonment. There is no
reason in principle why voters might not apply mixed prospective and retrospective
standards of political valuation and electoral choice, but no one has figured out how
to implement the combination empirically, aside from studies based on perceptions
about future outcomes obtained from opinion surveys.
40
But such survey data suffer
³⁹ Ireviewarangeofsuchefforts in Hibbs 2001.
⁴⁰ One can find regressions in the literature that allegedly test forward voting by using actual future
outcomes as regressors. Such “perfect foresight” models have no logical foundation, because no one is
endowed with perfect foresight; at best voters have rational expectations about the future. Considered at
any election period t, rationality of expectations means that regressor(s) X satisfy
X
t+T
= E
t
(
X
t+T
)
+ e
t+T
, e
t+T
∼ white-noise, E
[
E
t
(
X
t+T
)
, e
t+T
]
= 0 (35)
and that defensible voting models should be of the form:
V
t
= ‚E
t
(
X
t+T
)
+ u
t
.
“Perfect foresight” models like
V
t
= ‚
(
X
t+T
)
+ u
∗
t
are mis-specified because a logically admissible model, written in terms of actual future outcomes,
implicitly would be
V
t
= ‚
[
X
t+T
−e
t+T
]
+ u
t
,
that is, u
∗
t
= u
t
−‚e
t+T
.Clearlyu
∗
t
is negatively correlated with regressors X
t+T
. Consequently, perfect
foresight models deliver estimates of ‚ that are biased toward zero, and that could even have the wrong
sign in more elaborate, mixed retrospective–prospective set-ups.
584 voting and the macroeconomy
from severe problems of projection and rationalization, and for those reasons are
viewed by many with profound skepticism. Devising models that bring forward-
looking, competency models to macroeconomic data with statistical power poses one
of the greatest challenges to future research.
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chapter 32
..............................................................
THE POLITICAL
ECONOMY OF
EXCHANGE RATES
..............................................................
j. lawrence broz
jeffry a. frieden
The exchange rate is the most important price in any economy, for it affects all other
prices. In most countries, policy toward the national currency is prominent and
controversial. Economic epochs are often characterized by the prevailing exchange
rate system—the Gold Standard Era, the Bretton Woods Era. Contemporary develop-
ments, from the creation of an Economic and Monetary Union in Europe to succes-
sive waves of currency crises, reinforce the centrality of exchange rates to economic
trends.
The analysis of the political economy of currency policy has focused on two sets of
questions. The first is global, and has to do with the character of the international
monetary system. The second is national, and has to do with the policy of particular
governments towards their exchange rates. These two interact. National policies,
especially of large countries, have an impact on the international monetary system.
By the same token, the global monetary regime influences national policy choice.
At the frontiers of research, political economists are grappling with the complexi-
ties of this interaction, analyzing the linkages between the international and domestic
aspects of exchange rate policy-making. In this chapter, we start by separating the
analysis of the international monetary system from the analysis of the policy choices
of national governments. This allows us to simplify the issues in each area and present
them in generic political economy terms. We then discuss how the issues might be
analyzed jointly, across the domains, in the next phase of research.
588 the politics of exchange rates
1 The International Political Economy
of Exchange Rate Policy
.............................................................................
International monetary regimes tend toward one of two ideal types. The first is a
fixed rate system, in which currencies are tied to each other at publicly announced
rates. Some fixed rate systems involve a common link to a commodity such as gold
or silver; others peg to a national currency such as the US dollar. The second ideal-
typical monetary regime is free floating, in which national currency values vary with
market conditions and national macroeconomic policies. There are many potential
gradations between these extremes.
In the past 150 years, the world has experienced three broad international monetary
orders. For about fifty years before the First World War, and again in modified form in
the 1920s, most of the world was on the classical gold standard, a quintessential fixed
rate system. Under the gold standard, governments committed to exchange gold for
currency at an announced rate. From the late 1940s until the early 1970s, the capitalist
world was organized into the Bretton Woods monetary order, a modified fixed rate
system. Under Bretton Woods, currencies were fixed or “pegged” to the US dollar and
the US dollar was fixed to gold. However, national governments could change their
exchange rates when they deemed it necessary. Under this “adjustable peg” system,
currencies were not as firmly fixed as under the classical gold standard. Since 1973 the
reigning order has been one in which the largest countries have had floating national
currencies, while smaller countries have tended either to fix their currencies against
one of the major currencies or to allow their currencies to float with varying degrees
of government management.
Monetary regimes can be regional as well as global. Within the international
monetary free-for-all that has prevailed since 1973, a number of regional fixed rate
systems have emerged. Some countries have fixed their currency to that of a larger
nation: the franc zone of the African Financial Community, or “CFA franc zone,” ties
the currencies of fourteen African countries to each other and to the French franc
(now to the euro). Several countries in Latin America and the Caribbean have pegged
their exchange rates to the US dollar. European monetary integration began with a
limited regional agreement, evolved into a Deutschmark link, and eventually became
a monetary union with a single currency and a common central bank. Countries in
the eastern Caribbean and southern Africa have also developed monetary unions.
Analyses of international monetary regimes treat nation states as decision-making
units (like “firms” in microeconomics) and consider how these units deal with stan-
dard coordination and cooperation problems. Coordination entails interaction among
governments to converge on a focal point—for example, linking national currencies
to gold or to the dollar. This implies the existence of a Pareto improving equilibrium
(often more than one), such as is the case in an assurance game, in which each actor
wants to choose the same strategy as other actors. In this case, each country wants
to choose the same currency regime as other countries—nobody wants to be the
j. lawrence broz & jeffry a. frieden 589
only country on gold, or the only country to float—but may disagree over which
one to choose. Cooperation among nation states involves the adjustment of national
policies to support the regime—such as joint intervention in currency markets. This
implies the existence of a Pareto inferior Nash equilibrium, which can be improved
upon (i.e. to a Nash bargaining solution), such as is the case in a prisoner’s dilemma
game: countries can work together to improve their collective and individual welfare.
The two problems are not mutually exclusive; indeed, the resolution of one usually
presupposes the resolution of the other. But for purposes of analysis it is helpful to
separate the idea of a fixed rate system as a focal point, for example, from the idea
that its sustainability requires deliberately cooperative policies.
Coordination in international monetary relations. An international or regional fixed
rate regime, such as the gold standard or the European Monetary System, has impor-
tant characteristics of a focal point around which national choices can be coordinated
(Meissner 2005;Frieden1993). Such a fixed rate system can be self-reinforcing: the
more countries that were on gold, or pegged to the Deutschmark, the greater the
benefits to other countries of also choosing to go along. This can be true even if
the motivations of countries differ: one might particularly appreciate the mone-
tary stability of a fixed rate, the other the reduction in currency volatility. It does
not matter, so long as the attractions of the regime increase with its membership
(Broz 1997).
Most fixed rate regimes appear to grow in this way, as additional membership
attracts ever more members. This was the case of the pre-1914 gold standard, which
owed its start to gold-standard Britain’s centrality to the nineteenth-century interna-
tional economy, and its eventual global reach to the accession of other nations to the
British-led system. European monetary integration also progressed in this manner,
as the Deutschmark zone of Germany, Benelux, and Austria gradually attracted more
European members. The focal nature of a fixed rate system can lead to a “virtuous
circle” as more and more countries sign on, but the unraveling of the regime can lead
to a “vicious circle.” The departure of important countries from the system can reduce
its centripetal pull, as with the collapse of the gold standard in the 1930s: British exit
began a stampede which led virtually the rest of the world off gold within a couple
of years.
We have illustrated coordination problems by reference to fixed rate regimes,
but similar problems arise in floating rate regimes. Members of a floating regime
can benefit—individually and jointly—by committing to a common standard on
payments and exchange restrictions (Simmons 2000).Afocalpointinthisrespect
is the voluntary standard on payments restrictions embodied in the International
Monetary Fund’s Articles of Agreement. The IMF standard proscribes governments
from rationing or limiting access to foreign exchange when citizens request it to
pay for imports or service a foreign debt. This promotes international trade, which
benefits all members. Simmons (2000) finds strong evidence of regional diffusion
effects, suggesting that the gains of adopting the standard increase with the number
of nations in a region that do so.
590 the politics of exchange rates
Cooperation in international monetary relations. International monetary relations may
require the resolution of problems of cooperation. A fixed rate system may give
governments incentives to “cheat,” such as to devalue for competitive purposes while
taking advantage of other countries’ commitment to currency stability. Even a system
as simple as the gold standard sometimes relied on agreements among countries to
support each others’ monetary authorities in times of difficulty. An enduring mone-
tary system, in this view, requires explicit cooperation among its principal members.
The welfare gains associated with interstate collaboration in the international mon-
etary realm are several. First, reduced currency volatility almost certainly increases
international trade and investment. Second, fixed rates tend to stabilize domestic
monetary conditions, so that international monetary stability reinforces domestic
monetary stability. Third, predictable currency values can reduce trade conflicts: a
rapid change in currency values often leads to an import surge, protectionist pres-
sures, and commercial antagonism.
These joint gains may be difficult to realize because they can require national
sacrifices. Supporting the fixed rate system may require painful adjustment policies
to sustain a country’s commitment to its exchange rate. Governments may be forced
to raise interest rates to high levels in order to defend an overvalued currency, and
the domestic economic and political consequences can lead to conflict over the
international distribution of adjustment costs. For example, under Bretton Woods
and the European Monetary System, one country’s currency served as the system’s
anchor. This forced other countries to adapt their monetary policies to the anchor
country, and led to pressures on the key-currency government to bring its policy more
in line with conditions elsewhere. Under Bretton Woods, from the late 1960s until
the system collapsed, European governments wanted the United States to implement
more restrictive policies to bring down American inflation, while the US government
refused. In the EMS in the early 1990s, governments in the rest of the European
Union wanted Germany to implement less restrictive policies to combat the European
recession, while the German central bank refused. Generally speaking, the better able
countries are to agree about the distribution of the costs of adjustment, the more
likely they are to be able to create and sustain a common fixed rate regime.
Historically, intergovernmental cooperation has been crucial to the durability of
fixed rate monetary systems. Barry Eichengreen (1992) argues that credible cooper-
ation among the major powers before 1914 was the cornerstone of the classical gold
standard, while its absence explains the interwar failure to revive the regime. Many
regional monetary unions, too, seem to obey this logic: where political and other fac-
tors have encouraged cooperative behavior to safeguard the common commitment to
fixed exchange rates, the systems have endured, but in the absence of these cooperative
motives, they have decayed (Cohen 2001).
Two recent regional ventures, Economic and Monetary Union in Europe (EMU)
and dollarization in Latin America, illustrate these international factors. Dollariza-
tion appears largely to raise coordination issues, as national governments consider
independent choices to adopt the US dollar. The principal attraction for dollarizers is
association with dollar-based capital and goods markets; the more countries dollarize,
j. lawrence broz & jeffry a. frieden 591
the greater this attraction will be. The course of EMU from 1973 to completion did
have features of a focal point, especially in the operation of the European Monetary
System as a Deutschmark bloc, but the transition to EMU went far beyond this.
Participants bargained over the structure of the new European Central Bank, the
national macroeconomic policies necessary for membership in the monetary union,
and a host of other issues. These difficult bargains were unquestionably made much
easier by the small number of central players, the institutionalized EU environment,
and the network of policy linkages between EMU and other European initiatives.
Despite the importance of international factors, international monetary coopera-
tion and coordination rest on the foundation of national currency policies, which are
subject to an array of political economy pressures.
2 The Domestic Political Economy
of Exchange Rate Policy
.............................................................................
Political factors within nations give rise to two basic types of pressures for—or
against—coordination and cooperation in the international arena. On the one hand,
exchange rate policies involve trade-offs with domestic distributional implications.
International coordination or cooperation may not find sufficient support within
a nation, if the losers are sufficiently powerful. On the other hand, exchange rate
policies have electoral implications. The exchange rate is such an important price that
politicians may wish to manipulate it for the purpose of winning elections, rather
than stabilizing an international regime. We suggest ways in which distributional
politics and electoral politics might interact with external monetary conditions to
shape exchange rate outcomes.
Two fundamental currency decisions confront policy-makers, and each has dis-
tributional consequences. First, policy-makers must decide whether to heed external
signals and join the dominant international or regional regime. This regime decision
involves choosing whether to allow the currency to float freely, to be fixed against
some other currency, or to adopt a system in between a hard fix and a pure float.
Second, for all but irrevocably fixed rate regimes, policy-makers also confront choices
involving the level of the exchange rate, the price at which the national currency
trades in foreign exchange markets. Level decisions fall along a second continuum that
runs from a more depreciated to a more appreciated currency. Although regime and
level decisions are interconnected, we treat them separately to illustrate their distinct
political economy implications.
Choice of exchange rate regime. Regime decisions involve trade-offs among desired
national goals, whose benefits and costs fall unevenly on actors within countries.
Fixed rate regimes have two main national benefits. First, they promote trade and
investment by reducing exchange rate risk. Countries that share a common currency