《国际政治经济学》文献资料（Political Economy of Money and Finance：Monetary System and Exchange Rate）Democratic Institutions and Exchange Rate

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Democratic Institutions and Exchange-rate Commitments William Bernhard and David Leblang From the end of World War II until 1971,exchange-rate practices were governed by the Bretton Woods system (or the dollar standard)-an international regime of fixed exchange rates with the U.S.dollar serving as the anchor currency.The system oper- ated smoothly through the 1950s,but strains appeared in the 1960s,reflecting a combination of the gold overhang and lax U.S.macroeconomic policies.In 1971 the Nixon administration slammed the gold window shut,effectively ending the Bretton Woods system.Since the early 1970s,countries have been able to choose a variety of exchange-rate regimes ranging from a freely floating exchange rate to one that is rigidly fixed to that of another country.We examine the exchange-rate arrangements adopted by the industrial democracies since 1974.We focus on domestic political institutions to explain a government's choice among three main exchange-rate op- tions:a floating exchange rate,a unilateral peg,and a multilateral exchange-rate regime(specifically,the Snake and the European Monetary System). The choice of exchange-rate arrangement,although often shrouded in highly tech- nical language,has relatively predictable consequences for an economy.A fixed (pegged)exchange rate helps to stabilize the external trading environment by decreas- ing uncertainty surrounding the exchange rate and by reducing transaction costs across countries.Additionally,a fixed rate can provide a nominal anchor to macroeconomic policy.On the other hand,adherence to a fixed exchange rate implies a loss of domes- tic monetary policy autonomy.!Without the ability to use monetary policy to counter localized economic shocks,countries may suffer unnecessary welfare losses in out- put or employment. Commitment to a fixed exchange rate also has implications for domestic political competition.A fixed exchange rate might stabilize the environment for trade or help achieve certain macroeconomic policy goals,but it limits politicians'discretion over monetary policy.Under a fixed exchange rate,politicians in the governing parties lose the ability to manipulate monetary policy for electoral or partisan reasons.The 1.Mundell 1961 International Organization 53,1,Winter 1999,pp.71-97 1999 by The IO Foundation and the Massachusetts Institute of Technology

Democratic Institutions and Exchange-rate Commitments William Bernhard and David Leblang From the end of World War I1 until 1971, exchange-rate practices were governed by the Bretton Woods system (or the dollar standard)-an international regime of fixed exchange rates with the U.S. dollar serving as the anchor currency. The system operated smoothly through the 1950s, but strains appeared in the 1960s, reflecting a combination of the gold overhang and lax U.S. macroeconomic policies. In 1971 the Nixon administration slammed the gold window shut, effectively ending the Bretton Woods system. Since the early 1970s, countries have been able to choose a variety of exchange-rate regimes ranging from a freely floating exchange rate to one that is rigidly fixed to that of another country. We examine the exchange-rate arrangements adopted by the industrial democracies since 1974. We focus on domestic political institutions to explain a government's choice among three main exchange-rate options: a floating exchange rate, a unilateral peg, and a multilateral exchange-rate regime (specifically, the Snake and the European Monetary System). The choice of exchange-rate arrangement, although often shrouded in highly technical language, has relatively predictable consequences for an economy. A fixed (pegged) exchange rate helps to stabilize the external trading environment by decreasing uncertainty surrounding the exchange rate and by reducing transaction costs across countries. Additionally, a fixed rate can provide a nominal anchor to macroeconomic policy. On the other hand, adherence to a fixed exchange rate implies a loss of domestic monetary policy autonomy.' Without the ability to use monetary policy to counter localized economic shocks, countries may suffer unnecessary welfare losses in output or employment. Commitment to a fixed exchange rate also has implications for domestic political competition. A fixed exchange rate might stabilize the environment for trade or help achieve certain macroeconomic policy goals, but it limits politicians' discretion over monetary policy. Under a fixed exchange rate, politicians in the governing parties lose the ability to manipulate monetary policy for electoral or partisan reasons. The 1. Mundell 1961 International Organization 53, 1, Winter 1999, pp. 71-97 o 1999 by The I0 Foundation and the Massachusetts Institute of Technology

72 International Organization loss of policy discretion potentially harms their ability to maintain their position in office.A floating exchange rate,on the other hand,gives politicians the flexibility to use external adjustment not only to counter local shocks but also to employ macro- economic policy for electoral or partisan advantage.This political dilemma raises an interesting question:Under what conditions will politicians commit to a fixed exchange-rate regime? We argue that politicians'incentives over the exchange-rate regime reflect the configuration of domestic political institutions,particularly electoral and legislative institutions.In systems where the cost of electoral defeat is high and electoral timing is exogenous,politicians will be less willing to forgo their discretion over monetary policy with a fixed exchange rate.In systems where the costs of electoral defeat are low and electoral timing is endogenous,politicians are more likely to adopt a fixed exchange-rate regime.Consequently,differences in domestic political systems can help account for variations in the choice of exchange-rate arrangements. In the first section we review the conventional literature about exchange-rate ar- rangements.In the second section we develop our argument concerning the relation- ship between domestic political institutions and exchange-rate regime choice.In the third section we draw on the optimal exchange-rate and international political economy literatures to identify control variables,including systemic influences,domestic eco- nomic conditions,and other political factors.In the fourth section we evaluate the importance of domestic political institutions on a sample of twenty countries using a constrained multinomial logit model.We present our conclusions in the final section. Choosing an Exchange-rate Arrangement Two broad literatures address the choice of exchange-rate arrangement.First,the optimal exchange-rate literature considers the type of exchange-rate commitment that is "best"given the characteristics of a nation's economy.2 This literature focuses on country characteristics such as economic openness,country size,and labor mobil- ity.More recent contributions argue that the optimal exchange arrangement depends not only on the structure of the economy but also on the sensitivity of the economy to domestic and international macroeconomic shocks.3 One major problem with this literature is that it does not specify the origin of politicians'policy preferences.In fact the conclusions and policy prescriptions reached 2.For example,Bosco 1987:Dreyer 1978:Heller 1978:Holden.Holden,and Suss 1979;Savvides 1990;and Wickham 1985.A related literature concerns optimal currency areas.This literature considers whether regions should participate in a currency union based on factors such as common vulnerability to shocks.It is optimal for countries experiencing similar shocks to join a currency union,whereas the existence of dissimilar shocks makes a floating exchange arrangement the more prudent choice.The seminal contributions of Mundell and McKinnon focus,respectively,on the importance of external bal- ance and price stability.See Mundell 1961;and McKinnon 1963.More recent variants of this literature examine the source of the shocks (for example,Tavlas 1993;Frankel and Rose 1996;and Eichengreen 1992a)and the question of whether the EC constitutes an optimal currency area. 3.See Fischer 1977:and Savvides 1990

72 International Organization loss of policy discretion potentially harms their ability to maintain their position in office. A floating exchange rate, on the other hand, gives politicians the flexibility to use external adjustment not only to counter local shocks but also to employ macroeconomic policy for electoral or partisan advantage. This political dilemma raises an interesting question: Under what conditions will politicians commit to a fixed exchange-rate regime? We argue that politicians' incentives over the exchange-rate regime reflect the configuration of domestic political institutions, particularly electoral and legislative institutions. In systems where the cost of electoral defeat is high and electoral timing is exogenous, politicians will be less willing to forgo their discretion over monetary policy with a fixed exchange rate. In systems where the costs of electoral defeat are low and electoral timing is endogenous, politicians are more likely to adopt a fixed exchange-rate regime. Consequently, differences in domestic political systems can help account for variations in the choice of exchange-rate arrangements. In the first section we review the conventional literature about exchange-rate arrangements. In the second section we develop our argument concerning the relationship between domestic political institutions and exchange-rate regime choice. In the third section we draw on the optimal exchange-rate and international political economy literatures to identify control variables, including systemic influences, domestic economic conditions, and other political factors. In the fourth section we evaluate the importance of domestic political institutions on a sample of twenty countries using a constrained multinomial logit model. We present our conclusions in the final section. Choosing an Exchange-rate Arrangement Two broad literatures address the choice of exchange-rate arrangement. First, the optimal exchange-rate literature considers the type of exchange-rate commitment that is "best" given the characteristics of a nation's e~onomy.~ This literature focuses on country characteristics such as economic openness, country size, and labor mobility. More recent contributions argue that the optimal exchange arrangement depends not only on the structure of the economy but also on the sensitivity of the economy to domestic and international macroeconomic shock^.^ One major problem with this literature is that it does not specify the origin of politicians' policy preferences. In fact the conclusions and policy prescriptions reached 2. For example, Bosco 1987; Dreyer 1978; Heller 1978; Holden, Holden, and Suss 1979; Savvides 1990; and Wickham 1985. A related literature concerns optimal currency areas. This literature considers whether regions should participate in a currency union based on factors such as common vulnerability to shocks. It is optimal for countries experiencing similar shocks to join a currency union, whereas the existence of dissimilar shocks makes a floating exchange arrangement the more prudent choice. The seminal contributions of Mundell and McKinnon focus, respectively, on the importance of external balance and price stability. See Mundell 1961; and McKinnon 1963. More recent variants of this literature examine the source of the shocks (for example, Tavlas 1993; Frankel and Rose 1996; and Eichengreen 1992a) and the question of whether the EC constitutes an optimal currency area. 3. See Fischer 1977: and Savvides 1990

Democratic Institutions and Exchange Rates 73 in this literature vary according to initial assumptions regarding whether the policy- maker's objective function emphasizes price stability or aggregate output.4 We argue that the configuration of domestic political institutions will influence politicians' need to maintain policy flexibility,which,in turn,shapes their preferences over the exchange-rate arrangement. Second,the international political economy literature examines the question of exchange-rate regime choice.The literature has traditionally focused on the presence (or absence)of an international hegemon to explain developments in the interna- tional monetary system.According to this view,a major power is necessary to pro- vide credible backing to the world's currency and act as a lender of last resort.5 Subsequent work examines the classical gold standard,the interwar period,and the Bretton Woods regime.6 Since the breakup of Bretton Woods,however,states have been able to choose from a variety of exchange-rate arrangements.Under this permis- sive international monetary system,an emphasis on hegemonic power cannot ex- plain the specific variation of exchange-rate arrangements across states. More recent literature examines both systemic and domestic determinants of the international monetary behavior of a state.7 Substantively,much of this literature focuses on the development of alternative exchange-rate arrangements in Europe, including the Snake,the European Monetary System (EMS),and the planned transi- tion to a single currency.8 These accounts of European monetary cooperation empha- size the policy goals of insulating European economies from the fluctuations of the U.S.dollar,enhancing intra-EC trade,and controlling inflation by "importing"Ger- many's anti-inflation credibility. Political economists have also developed a variety of domestic-level explanations for macroeconomic policy and exchange-rate choice.One set of explanations fo- cuses on the demanders of exchange-rate policies,including economic sectors or specific interest groups.10 The policy demands of these actors are assumed to reflect their position in the global economy.11 These explanations,however,tend to under- play the role of politicians in the choice of exchange-rate arrangement.Although politicians are responsive to societal interests,they often have incentives and policy preferences independent of societal actors. Political economists have also investigated the relationship between domestic po- litical institutions and exchange-rate decisions.Three types of arguments-based on welfare gains,policymaking capabilities,and credible commitments-potentially link 4.See Aghevli,Khan,and Montiel 1991;and Melvin 1985. 5.Kindleberger 1973. 6.On the gold standard,see Eichengreen 1989;and Gallarotti 1993.On the interwar period,see Eichengreen 1992b;and Simmons 1994.On the Bretton Woods regime,see Eichengreen 1996;Gowa 1983;and Keohane 1984. 7.Cohen 1996. 8.For example,Eichengreen 1992a;Eichengreen and Frieden 1994;Loriaux 1991;Ludlow 1982; McNamara 1995;Oatley 1994;and Sandholtz 1993. 9.See Frieden 1991 and 1994;and Simmons 1994. 10.See Frieden 1991;and Gowa 1983. 11.See Frieden 1991;and Keohane and Milner 1996

Democratic Institutions and Exchange Rates 73 in this literature vary according to initial assumptions regarding whether the policymaker's objective function emphasizes price stability or aggregate o~tput.~ We argue that the configuration of domestic political institutions will influence politicians' need to maintain policy flexibility, which, in turn, shapes their preferences over the exchange-rate arrangement. Second, the international political economy literature examines the question of exchange-rate regime choice. The literature has traditionally focused on the presence (or absence) of an international hegemon to explain developments in the international monetary system. According to this view, a major power is necessary to provide credible backing to the world's currency and act as a lender of last re~ort.~ Subsequent work examines th,e classical gold standard, the interwar period, and the Bretton Woods regime.6 Since the breakup of Bretton Woods, however, states have been able to choose from a variety of exchange-rate arrangements. Under this permissive international monetary system, an emphasis on hegemonic power cannot explain the specific variation of exchange-rate arrangements across states. More recent literature examines both systemic and domestic determinants of the international monetary behavior of a state.' Substantively, much of this literature focuses on the development of alternative exchange-rate arrangements in Europe, including the Snake, the European Monetary System (EMS), and the planned transition to a single ~urrency.~ These accounts of European monetary cooperation emphasize the policy goals of insulating European economies from the fluctuations of the U.S. dollar, enhancing intra-EC trade, and controlling inflation by "importing" Germany's anti-inflation credibility. Political economists have also developed a variety of domestic-level explanations for macroeconomic policy and exchange-rate ch~ice.~ One set of explanations focuses on the demanders of exchange-rate policies, including economic sectors or specific interest groups.1° The policy demands of these actors are assumed to reflect their position in the global economy.ll These explanations, however, tend to underplay the role of politicians in the choice of exchange-rate arrangement. Although politicians are responsive to societal interests, they often have incentives and policy preferences independent of societal actors. Political economists have also investigated the relationship between domestic political institutions and exchange-rate decisions. Three types of arguments-based on welfare gains, policymaking capabilities, and credible commitments-potentially link 4. See Aghevli, Khan, and Montiel 1991; and Melvin 1985. 5. Kindleberger 1973. 6. On the gold standard, see Eichengreen 1989; and Gallarotti 1993. On the interwar period, see Eichengreen 1992b; and Simmons 1994. On the Bretton Woods regime, see Eichengreen 1996; Gowa 1983; and Keohane 1984. 7. Cohen 1996. 8. For example, Eichengreen 1992a; Eichengreen and Frieden 1994; Loriaux 1991; Ludlow 1982; McNamara 1995; Oatley 1994; and Sandholtz 1993. 9. See Frieden 1991 and 1994; and Simmons 1994. 10. See Frieden 1991; and Gowa 1983. 11. See Frieden 1991; and Keohane and Milner 1996

74 International Organization the electoral system to exchange-rate commitments.This link,however,is less clear, reflecting a lack of theoretical consensus among scholars First,recent literature argues that exchange-rate commitments can help stabilize the macroeconomy,providing an external source of policy discipline.12 A fixed ex- change rate,therefore,would provide greater social welfare gains where politicians are unable to pursue responsible monetary and fiscal policies.This argument implies that countries with weak and unstable governments will be more likely to adopt fixed exchange rates,since these governments are often unable to agree on stabilization programs.Given that proportional representation systems produce weaker,less du- rable governments more often than majoritarian systems,this argument suggests that countries with proportional representation electoral systems will be more likely to adopt fixed exchange rates than those with majoritarian systems. A second set of arguments focuses on the policymaking capabilities of the govern- ment to explain exchange-rate commitments.Weak or unstable governments lack the ability to implement the difficult domestic adjustments often necessary to sustain a fixed exchange rate.13 Strong,durable governments are able to pursue the policies required to maintain the fixed exchange rate.In contrast to the argument based on welfare gains,this argument implies that countries with majoritarian electoral sys- tems will be more likely to fix the exchange rate than countries with a proportional representation system.Majoritarian electoral systems usually produce single-party majority governments capable of decisive policy action.Proportional representation systems,on the other hand,typically produce coalition governments.These govern- ments may have difficulty shifting domestic policies to maintain the fixed exchange rate due to the bargaining and negotiation that must occur between the coalition parties.14 Consequently,they will be less able to sustain an exchange-rate commit- ment. Third,some political economists argue that exchange-rate commitments can serve to constrain the policy options of future governments.The "tying the hands"'argu- ment suggests that a government will fix the exchange rate if subsequent govern- ments 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.Sharp policy breaks between governments are more likely in majori- tarian systems than in proportional representation systems.15 Consequently,the "ty- ing the hands"argument implies that politicians in majoritarian systems will be more likely to fix the exchange rate than politicians in proportional representation systems. Given the variety of predictions,it is unsurprising that the empirical work on the relationship between electoral institutions and exchange-rate commitments has also been inconclusive.Eichengreen,for instance,examines the influence of electoral 12.See Flood and Isard 1989;Giavazzi and Pagano 1988;and Rogoff 1985. 13.See Eichengreen 1992b;and Simmons 1994. 14.Roubini and Sachs 1989. 15.Rogowski 1987

74 International Organization the electoral system to exchange-rate commitments. This link, however, is less clear, reflecting a lack of theoretical consensus among scholars. First, recent literature argues that exchange-rate commitments can help stabilize the macroeconomy, providing an external source of policy discipline.12 A fixed exchange rate, therefore, would provide greater social welfare gains where politicians are unable to pursue responsible monetary and fiscal policies. This argument implies that countries with weak and unstable governments will be more likely to adopt fixed exchange rates, since these governments are often unable to agree on stabilization programs. Given that proportional representation systems produce weaker, less durable governments more often than majoritarian systems, this argument suggests that countries with proportional representation electoral systems will be more likely to adopt fixed exchange rates than those with majoritarian systems. A second set of arguments focuses on the policymaking capabilities of the government to explain exchange-rate commitments. Weak or unstable governments lack the ability to implement the difficult domestic adjustments often necessary to sustain a fixed exchange rate.13 Strong, durable governments are able to pursue the policies required to maintain the fixed exchange rate. In contrast to the argument based on welfare gains, this argument implies that countries with majoritarian electoral systems will be more likely to fix the exchange rate than countries with a proportional representation system. Majoritarian electoral systems usually produce single-party majority governments capable of decisive policy action. Proportional representation systems, on the other hand, typically produce coalition governments. These governments may have difficulty shifting domestic policies to maintain the fixed exchange rate due to the bargaining and negotiation that must occur between the coalition parties.14 Consequently, they will be less able to sustain an exchange-rate commitment. Third, some political economists argue that exchange-rate commitments can serve to constrain the policy options of future governments. The "tying the hands" argument suggests that a government will fix the exchange rate 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. Shasp policy breaks between governments are more likely in majoritarian systems than in proportional representation systems.15 Consequently, the "tying the hands" argument implies that politicians in majoritarian systems will be more likely to fix the exchange rate than politicians in proportional representation systems. Given the variety of predictions, it is unsusprising that the empirical work on the relationship between electoral institutions and exchange-rate commitments has also been inconclusive. Eichengreen, for instance, examines the influence of electoral 12. See Flood and Isard 1989; Giavazzi and Pagano 1988; and Rogoff 1985 13. See Eichengreen 1992b; and Simmons 1994. 14. Roubini and Sachs 1989. 15. Rogowski 1987

Democratic Institutions and Exchange Rates 75 institutions on exchange-rate commitments during the interwar period.16 He finds no systematic relationship between proportional representational systems and exchange- rate regime choice.Instead,the severity of societal cleavages affected the ability of the state to maintain its commitment to the gold standard. One reason that the relationship between domestic political institutions and exchange-rate commitments is unclear stems from the fact that these arguments do not focus explicitly on politicians'incentives.Politicians and parties face political incentives-in particular,reelection-that condition their choice of exchange-rate arrangement.These political incentives,in turn,reflect the configuration of domestic political institutions.Domestic electoral and legislative institutions strongly influ- ence how politicians balance their own needs with the demands of economic and societal actors in the choice of exchange-rate regime.Consequently,we predict a relationship between the configuration of domestic political institutions and the choice of exchange-rate arrangement,even after controlling for international systemic and economic influences. Domestic Political Institutions and Exchange-rate Arrangements We argue that domestic political institutions influence politicians'incentives over the choice of an exchange-rate regime.We begin with the assumption that politicians in the governing party(ies)have an interest in maintaining their position in office.By serving in office,the governing party(ies)have the ability to control both public policy and particularistic policies,which,in turn,enhance their reelection fortunes. An exchange-rate commitment,although it may help stabilize the external trading environment or achieve certain macroeconomic policy goals,limits politicians'dis- cretion over monetary policy,especially in an era of capital mobility.The configura- tion of domestic political institutions affects the willingness of governing party(ies) to give up discretion over macroeconomic policy.In particular,we argue that the electoral system and legislative institutions condition the choice of exchange-rate regime. First,the decisiveness of the electoral system influences the need of the governing party(ies)to maintain discretion over macroeconomic policy.Majoritarian electoral systems tend to"manufacture"single-party majority governments.17 In these sys- tems changes in a relatively small number of votes can actually lead to large swings in the distribution of legislative seats and,potentially,a change in the governing party.Consequently,politicians in the governing party(ies)will wish to maintain full control over any policy instrument that may help to secure their electoral majority.In particular they want to retain the ability to manipulate monetary policy in the run-up to an election or to appeal to key swing constituents.Since an exchange-rate commit- 16.Eichengreen 1992b. 17.Lijphart 1984

Democratic Institutions and Exchange Rates 75 institutions on exchange-rate commitments during the interwar period.16 He finds no systematic relationship between proportional representational systems and exchangerate regime choice. Instead, the severity of societal cleavages affected the ability of the state to maintain its commitment to the gold standard. One reason that the relationship between domestic political institutions and exchange-rate commitments is unclear stems from the fact that these arguments do not focus explicitly on politicians' incentives. Politicians and parties face political incentives-in particular, reelection-that condition their choice of exchange-rate arrangement. These political incentives, in turn, reflect the configuration of domestic political institutions. Domestic electoral and legislative institutions strongly influence how politicians balance their own needs with the demands of economic and societal actors in the choice of exchange-rate regime. Consequently, we predict a relationship between the configuration of domestic political institutions and the choice of exchange-rate arrangement, even after controlling for international systemic and economic influences. Domestic Political Institutions and Exchange-rate Arrangements We argue that domestic political institutions influence politicians' incentives over the choice of an exchange-rate regime. We begin with the assumption that politicians in the governing party(ies) have an interest in maintaining their position in office. By serving in office, the governing party(ies) have the ability to control both public policy and particularistic policies, which, in turn, enhance their reelection fortunes. An exchange-rate commitment, although it may help stabilize the external trading environment or achieve certain macroeconomic policy goals, limits politicians' discretion over monetary policy, especially in an era of capital mobility. The configuration of domestic political institutions affects the willingness of governing party(ies) to give up discretion over macroeconomic policy. In particular, we argue that the electoral system and legislative institutions condition the choice of exchange-rate regime. First, the decisiveness of the electoral system influences the need of the governing party(ies) to maintain discretion over macroeconomic policy. Majoritarian electoral systems tend to "manufacture" single-party majority governments." In these systems changes in a relatively small number of votes can actually lead to large swings in the distribution of legislative seats and, potentially, a change in the governing party. Consequently, politicians in the governing party(ies) will wish to maintain full control over any policy instrument that may help to secure their electoral majority. In particular they want to retain the ability to manipulate monetary policy in the run-up to an election or to appeal to key swing constituents. Since an exchange-rate commit- 16. Eichengreen l992b. 17. Lijphart 1984

76 International Organization ment limits their policy discretion,potentially hurting their ability to retain office, politicians in a majoritarian system will prefer to let the currency float. In contrast,elections in proportional representation systems usually do not result in single-party majority governments.Instead,bargaining between parties deter- mines the composition of the government.Consequently,a party may lose a few votes in an election but retain the possibility of participating in the government. Since small vote swings do not necessarily have dramatic consequences for the com- position of the government,politicians in these systems may be less reticent to relin- quish discretionary control over monetary policy by fixing the exchange rate.More- over,a fixed exchange rate might actually help in coalition bargaining by providing a focal point for parties with diverse interests over monetary and economic policy.A pegged exchange rate 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.18 Parties in a coalition government might agree on a fixed exchange-rate focal point simply as a way to settle conflicts about policy. Additionally,a fixed exchange rate allows parties in the coalition government to monitor the policy activities of the party that holds the ministry of finance.19 In proportional representation systems where coalition or minority governments are common,therefore,politicians are more likely to fix their exchange rate. Second,the costs of serving in the opposition affect the incentives of the govern- ing party(ies)over the exchange-rate regime.In some systems opposition parties are excluded from the legislative policy process.Legislative committees may lack the resources to formulate policy or oversee the policy implementation.20 The governing party(ies)may also dominate committee membership or leadership positions,limit- ing the possibility of challenges to the government.21 Finally,the government may possess strict control over the legislative agenda,preventing committees from bring- ing issues to the legislative floor.In these systems,opposition legislators lack the ability to influence policy or to distribute particularistic policies to their constituents Politicians in the governing party(ies),therefore,have strong incentives not to risk their position in office.Consequently,they will not want to limit their policy discre- tion with a fixed exchange-rate arrangement. In other systems opposition parties play a larger role in the policy process.Legis- lative committee membership and leadership positions,rather than being dominated by the governing party(ies),are distributed across parties in proportion to their strength 18.See Aghevli,Khan,and Montiel 1991:and Bernhard 1997. 19.Parties in a coalition government bargain over both policy and the distribution of cabinet portfolios. See Laver and Schofield 1990;and Laver and Shepsle 1996.Although constrained by the coalition agree- ment,the party that controls the ministry of finance possesses institutional and informational advantages in the development and implementation of macroeconomic policy-advantages that the party could ex- ploit to enhance its own fortunes at the expense of its coalition partners.Bernhard 1998.A fixed exchange- rate commitment can help limit this potential for abuse by providing coalition partners with a clear stan- dard to monitor and evaluate the macroeconomic policy choices made by the party holding the finance portfolio. 20.See Krehbiel 1991;and Lupia and McCubbins 1994. 21.Strom 1990a

76 International Organization ment limits their policy discretion, potentially hurting their ability to retain office, politicians in a majoritarian system will prefer to let the currency float. In contrast, elections in proportional representation systems usually do not result in single-party majority governments. Instead, bargaining between parties determines the composition of the government. Consequently, a party may lose a few votes in an election but retain the possibility of participating in the government. Since small vote swings do not necessarily have dramatic consequences for the composition of the government, politicians in these systems may be less reticent to relinquish discretionary control over monetary policy by fixing the exchange rate. Moreover, a fixed exchange rate might actually help in coalition bargaining by providing a focal point for parties with diverse interests over monetary and economic policy. A pegged exchange rate 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.18 Parties in a coalition government might agree on a fixed exchange-rate focal point simply as a way to settle conflicts about policy. Additionally, a fixed exchange rate allows parties in the coalition government to monitor the policy activities of the party that holds the ministry of finance.19 In proportional representation systems where coalition or minority governments are common, therefore, politicians are more likely to fix their exchange rate. Second, the costs of serving in the opposition affect the incentives of the governing party(ies) over the exchange-rate regime. In some systems opposition parties are excluded from the legislative policy process. Legislative committees may lack the resources to formulate policy or oversee the policy implementati~n.~~ The governing party(ies) may also dominate committee membership or leadership positions, limiting the possibility of challenges to the go~ernment.~~ Finally, the government may possess strict control over the legislative agenda, preventing committees from bringing issues to the legislative floor. In these systems, opposition legislators lack the ability to influence policy or to distribute particularistic policies to their constituents. Politicians in the governing party(ies), therefore, have strong incentives not to risk their position in office. Consequently, they will not want to limit their policy discretion with a fixed exchange-rate arrangement. In other systems opposition parties play a larger role in the policy process. Legislative committee membership and leadership positions, rather than being dominated by the governing party(ies), are distributed across parties in proportion to their strength 18. See Aghevli, Khan, and Montiel 1991; and Bemhard 1997. 19. Parties in a coalition government bargain over both policy and the distribution of cabinet portfolios. See Laver and Schofield 1990; and Laver and Shepsle 1996. Although constrained by the coalition agreement, the party that controls the ministry of finance possesses institutional and informational advantages in the development and implementation of macroeconomic policy-advantages that the party could exploit to enhance its own fortunes at the expense of its coalition partners. Bemhard 1998. A fixed exchangerate commitment can help limit this potential for abuse by providing coalition partners with a clear standard to monitor and evaluate the macroeconomic policy choices made by the party holding the finance portfolio. 20. See Krehbiel 1991; and Lupia and McCubbins 1994. 21. Strom 1990a

Democratic Institutions and Exchange Rates 77 in the legislature.Committees have the resources,including research capabilities and access to the legislative agenda,to offer alternatives to the government's proposals and to monitor the government's policy choices.Since politicians can influence policy even while serving in opposition,politicians in the governing party(ies)will be less unwilling to lose some policy discretion with a fixed exchange rate. To test the role of electoral decisiveness and opposition influence over policy,we classify systems based on their electoral and committee systems.22 For the electoral system,we distinguish between majoritarian or proportional systems based on the work of Arend Lijphart.23 To examine opposition influence over policy,we classify systems according to the "strength"and "inclusiveness"of legislative committees, using a classification developed by G.Bingham Powell and Guy Whitten and Kaare Strom.24 The presence of a strong and inclusive committee system indicates that opposition parties have the ability to influence policy.Strong committee systems possess at least two of the three following characteristics:more than ten committees, specialization to match the government bureaucracy,and limitations in the number of committee memberships held by legislators.Inclusive committee systems require that committee chairmanships be distributed proportionally among all parties,regard- less of their participation in government. We combined these two measures to characterize different systems:majoritarian- low opposition influence,proportional-low opposition influence,and proportional- high opposition influence.25(There were no cases of majoritarian-high opposition influence.)26 We then included dummy variables for majoritarian-low opposition systems and proportional-low opposition systems in our analysis.We expect that the majoritarian-low opposition influence systems will be least likely to participate in a fixed exchange-rate regime,that proportional-low opposition influence systems will be somewhat more likely to fix the exchange rate,and that proportional-high opposi- tion influence systems will be most likely to participate in a fixed exchange-rate regime. We contend that another feature of electoral systems also affects the incentives of the governing party(ies)over the exchange-rate regime:the exogeneity of electoral timing.In most parliamentary systems the governing parties have the discretion to call for an election at any time,up to a specified maximum term.The government 22.See Powell 1989:and Strom 1990b. 23.Lijphart 1984. 24.See Powell and Whitten 1993:and Strom 1990a. 25.Majoritarian-low opposition influence systems include Australia,Canada,France,New Zealand, the United Kingdom,and the United States.Proportional-low opposition influence systems include Ire- land,Israel,Italy,Japan,and Spain.Proportional-high opposition influence systems include Austria,Bel- gium,Denmark.Finland,Germany.Netherlands,Norway.Sweden,and Switzerland. 26.It could be argued that the United States should be classified as a majoritarian-high opposition influence system.Congressional committees are relatively strong vis-a-vis the executive,but since the majority party dominates leadership posts,they fail to meet Powell and Whitten's inclusiveness criteria. The possibility of divided government,however,means that the party that controls the presidency (that is, the government)does not necessarily hold leadership positions in the committee system.As a check on the influence of the U.S.case,we reran our analysis without the United States in the majoritarian-low opposi- tion influence category.Dropping the U.S.case from this category did not substantially affect the results

Democratic Institutions and Exchange Rates 77 in the legislature. Committees have the resources, including research capabilities and access to the legislative agenda, to offer alternatives to the government's proposals and to monitor the government's policy choices. Since politicians can influence policy even while serving in opposition, politicians in the governing party(ies) will be less unwilling to lose some policy discretion with a fixed exchange rate. To test the role of electoral decisiveness and opposition influence over policy, we classify systems based on their electoral and committee systems.22 For the electoral system, we distinguish between majoritarian or proportional systems based on the work of Arend Lij~hart.~~ To examine opposition influence over policy, we classify systems according to the "strength" and "inclusiveness" of legislative committees, using a classification developed by G. Bingham Powell and Guy Whitten and Kaare Str~m.~~ The presence of a strong and inclusive committee system indicates that opposition parties have the ability to influence policy. Strong committee systems possess at least two of the three following characteristics: more than ten committees, specialization to match the government bureaucracy, and limitations in the number of committee memberships held by legislators. Inclusive committee systems require that committee chairmanships be distributed proportionally among all parties, regardless of their participation in government. We combined these two measures to characterize different systems: majoritarianlow opposition influence, proportional-low opposition influence, and proportionalhigh opposition influence.25 (There were no cases of majoritarian-high opposition infl~ence.)~~ We then included dummy variables for majoritarian-low opposition systems and proportional-low opposition systems in our analysis. We expect that the majoritarian-low opposition influence systems will be least likely to participate in a fixed exchange-rate regime, that proportional-low opposition influence systems will be somewhat more likely to fix the exchange rate, and that proportional-high opposition influence systems will be most likely to participate in a fixed exchange-rate regime. We contend that another feature of electoral systems also affects the incentives of the governing party(ies) over the exchange-rate regime: the exogeneity of electoral timing. In most parliamentary systems the governing parties have the discretion to call for an election at any time, up to a specified maximum term. The government 22. See Powell 1989; and Strom 1990b. 23. Lijphart 1984. 24. See Powell and Whitten 1993; and Strom 1990a. 25. Majoritarian-low opposition influence systems include Australia. Canada, France. New Zealand, the United Kingdom. and the United States. Proportional-low opposition influence systems include Ireland, Israel, Italy, Japan. and Spain. Proportional-high opposition influence systems include Austria, Belgium, Denmark. Finland. Germany, Netherlands. Norway. Sweden, and Switzerland. 26. It could be argued that the United States should be classified as a majoritarian-high opposition influence system. Congressional committees are relatively strong vis-a-vis the executive, but since the majority party dominates leadership posts, they fail to meet Powell and Whitten's inclusiveness criteria. The possibility of divided government, however, means that the party that controls the presidency (that is, the government) does not necessarily hold leadership positions in the committee system. As a check on the influence of the U.S. case, we reran our analysis without the United States in the majoritarian-low opposition influence category. Dropping the U.S. case from this category did not substantially affect the results

78 International Organization will often attempt to optimize the timing of the election based on its standing in the polls,economic conditions,and so on-that is,electoral timing is endogenous to the government's political calculations.In these systems politicians do not need to ma- nipulate monetary policy to insure an economic boom at a prespecified election time. Instead,politicians may manipulate the timing of the election to coincide with oppor- tune economic conditions.In these systems politicians in the governing parties will be less opposed to a fixed exchange rate. In other systems electoral timing is exogenous.Politicians stand for election at a predetermined time,regardless of political and economic conditions.In these sys- tems politicians in the governing parties have more incentive to manipulate policy to produce good economic conditions for the election period.A fixed exchange rate not only limits their discretion over policy but also makes domestic economic conditions (and their electoral consequences)vulnerable to external shocks.Consequently,poli- ticians in systems with exogenous timing will prefer a floating exchange. In our empirical analysis we include a dummy variable for countries with exog- enous electoral timing:Israel,Norway,Sweden,Switzerland,and the United States. We expect these countries to be more likely to adopt a floating exchange arrange- ment,even after other factors are taken into account. International and Domestic Influences on Exchange-rate Choice In addition to domestic political institutions,other factors have an important influ- ence on the choice of exchange-rate arrangement.This section identifies four sets of variables that affect this choice:international systemic factors,domestic macroeco- nomic conditions,domestic political factors,and policy inertia. International Systemic Variables According to the optimal exchange-rate literature,a country's structural position in the world economy strongly influences the decision to fix or float.The literature emphasizes three systemic factors:trade dependence,vulnerability to macroeco- nomic shocks,and capital mobility. Trade Dependence The literature on optimal currency areas argues that a country's dependence on exter- nal trade strongly affects the choice of exchange-rate arrangement.Countries that rely heavily on trade are more likely to fix the exchange rate.A fixed exchange rate decreases exchange-rate risk.With a predictable external environment,trading agents

78 International Organization will often attempt to optimize the timing of the election based on its standing in the polls, economic conditions, and so on-that is, electoral timing is endogenous to the government's political calculations. In these systems politicians do not need to manipulate monetary policy to insure an economic boom at a prespecified election time. Instead, politicians may manipulate the timing of the election to coincide with opportune economic conditions. In these systems politicians in the governing parties will be less opposed to a fixed exchange rate. In other systems electoral timing is exogenous. Politicians stand for election at a predetermined time, regardless of political and economic conditions. In these systems politicians in the governing parties have more incentive to manipulate policy to produce good economic conditions for the election period. A fixed exchange rate not only limits their discretion over policy but also makes domestic economic conditions (and their electoral consequences) vulnerable to external shocks. Consequently, politicians in systems with exogenous timing will prefer a floating exchange. In our empirical analysis we include a dummy variable for countries with exogenous electoral timing: Israel, Norway, Sweden, Switzerland, and the United States. We expect these countries to be more likely to adopt a floating exchange arrangement, even after other factors are taken into account. International and Domestic Influences on Exchange-rate Choice In addition to domestic political institutions, other factors have an important influence on the choice of exchange-rate arrangement. This section identifies four sets of variables that affect this choice: international systemic factors, domestic macroeconomic conditions, domestic political factors, and policy inertia. International Systemic Variables According to the optimal exchange-rate literature, a country's structural position in the world economy strongly influences the decision to fix or float. The literature emphasizes three systemic factors: trade dependence, vulnerability to macroeconomic shocks, and capital mobility. Trade Dependence The literature on optimal currency areas argues that a country's dependence on external trade strongly affects the choice of exchange-rate arrangement. Countries that rely heavily on trade are more likely to fix the exchange rate. A fixed exchange rate decreases exchange-rate risk. With a predictable external environment, trading agents

Democratic Institutions and Exchange Rates 79 will have more stable expectations,and,as a consequence,cross-border trade and investment will increase.27 Floating exchange rates,according to these arguments, lead to higher exchange-rate variability and,hence,to greater uncertainty and risk.In countries that are less dependent on trade,stabilizing the exchange rate will not be a priority.Instead,governments will want to use macroeconomic policy for domestic policy objectives. We measure a country's dependence on trade with an openness variable composed of imports plus exports as a percentage of GDP.Countries with higher levels of openness-that is,higher dependence on trade-will be more likely to fix their ex- change rates.In alternative specifications we disaggregated the openness variable into its component parts:imports as a percentage of gross domestic product(GDP), exports as a percentage of GDP,and the trade deficit as a percentage of GDP.The alternative measures did not substantially alter the results.28 Vulnerabiliry to Shocks Recent research in economics argues that a country's vulnerability to macroeco- nomic shocks conditions the optimal exchange-rate arrangement.The theoretical and empirical literatures conclude that a country faced with adverse shocks emanating from the real (that is,tradable)sector will be better able to insulate the domestic economy by adopting a floating exchange arrangement.29 A fixed exchange arrange- ment,on the other hand,is more desirable if the country experiences domestic(nomi- nal)disturbances. Following Michael Melvin and Andreas Savvides,we operationalize a country's vulnerability to shocks in several ways.30 The first variable,designed to capture do- mestic shocks,measures the variability in the growth rate of domestic credit over the course of a year,again based on quarterly data.Greater variability in the monetary sector makes a fixed exchange-rate arrangement more likely.To measure real shocks we include a measure of trade openness (discussed earlier)and a measure of the yearly rate of economic growth(discussed later).31 27.Frankel and Rose argue that,even where exchange-rate variability has been high.its effect on trade has been low.Frankel and Rose 1996.They suggest,however,that the exchange-rate variability argument "still carries some weight.It looms large in the minds of European policy-makers and business-people. Promoting trade and investment in Europe was certainly a prime motivation for the European Monetary System and for the planned E.M.U." 28.Including either exports or imports led to very similar empirical results-with the exception of the sign change.Including both indicators at the same time caused both variables to be statistically insignifi- cant because the correlation between imports and exports in our sample is 0.96. 29.For example,Fischer 1977;Melvin 1985:and Savvides 1990. 30.See Melvin 1985:and Savvides 1990. 31.In alterative specifications,we also included a measure of a country's economic size.based on its GDP in constant dollars,as a proxy of a country's vulnerability to shocks.Presumably,larger countries will be less vulnerable to exogenous shocks and,consequently,more likely to choose a floating exchange- rate arrangement.The economic size variable,however,was collinear with measures of openness and interational capital mobility

Democratic Institutions and Exchange Rates 79 will have more stable expectations, and, as a consequence, cross-border trade and investment will increase.27 Floating exchange rates, according to these arguments, lead to higher exchange-rate variability and, hence, to greater uncertainty and risk. In countries that are less dependent on trade, stabilizing the exchange rate will not be a priority. Instead, governments will want to use macroeconomic policy for domestic policy objectives. We measure a country's dependence on trade with an openness variable composed of imposts plus exposts as a percentage of GDP. Countries with higher levels of openness-that is, higher dependence on trade-will be more likely to fix their exchange rates. In alternative specifications we disaggregated the openness variable into its component parts: imposts as a percentage of gross domestic product (GDP), exports as a percentage of GDP, and the trade deficit as a percentage of GDP. The alternative measures did not substantially alter the results.28 Vulnerability to Shocks Recent research in economics argues that a country's vulnerability to macroeconomic shocks conditions the optimal exchange-rate arrangement. The theoretical and empirical literatures conclude that a country faced with adverse shocks emanating from the real (that is, tradable) sector will be better able to insulate the domestic economy by adopting a floating exchange a~angement.~~ A fixed exchange arrangement, on the other hand, is more desirable if the country experiences domestic (nominal) disturbances. Following Michael Melvin and Andreas Savvides, we operationalize a country's vulnerability to shocks in several ways.30 The first variable, designed to capture domestic shocks, measures the variability in the growth rate of domestic credit over the course of a year, again based on quarterly data. Greater variability in the monetary sector makes a fixed exchange-rate arrangement more likely. To measure real shocks we include a measure of trade openness (discussed earlier) and a measure of the yearly rate of economic growth (discussed late^).^' 27. Frankel and Rose argue that, even where exchange-rate variability has been high. its effect on trade has been low. Frankel and Rose 1996. They suggest, however. that the exchange-rate variability argument "still canies some weight. It looms large in the minds of European policy-makers and business-people. Promoting trade and investment in Europe was certainly a prime motivation for the European Monetary System and for the planned E.M.U." 28. Including either exports or imports led to very similar empirical results-with the exception of the sign change. Including both indicators at the same time caused both variables to be statistically insignificant because the correlation between imports and exports in our sample is 0.96. 29. For example. Fischer 1977; Melvin 1985: and Savvides 1990. 30. See Melvin 1985; and Savvides 1990. 31. In alternative specifications. we also included a measure of a country's economic size. based on its GDP in constant dollars, as a proxy of a country's vulnerability to shocks. Presumably, larger countries will be less vulnerable to exogenous shocks and, consequently, more likely to choose a floating exchangerate arrangement. The economic size variable. however. was collinear with measures of openness and international capital mobility

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