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

m PROJECT MUSE' Political Cycles and Exchange-Rate-Based Stabilization Hector E.Schamis Christopher Way WORLD World Politics,Volume 56,Number 1,October 2003,pp.43-78(Article) POLITICS Published by Cambridge University Press D0l:10.1353/wp.2004.0007 hm6Nmn】l31 For additional information about this article http://muse.jhu.edu/journals/wp/summary/v056/56.1schamis.html Access provided by Shanghai Jiao Tong University(24 Jun 2013 04:28 GMT)

Political Cycles and Exchange-Rate-Based Stabilization Hector E. Schamis Christopher Way World Politics, Volume 56, Number 1, October 2003, pp. 43-78 (Article) Published by Cambridge University Press DOI: 10.1353/wp.2004.0007 For additional information about this article Access provided by Shanghai Jiao Tong University (24 Jun 2013 04:28 GMT) http://muse.jhu.edu/journals/wp/summary/v056/56.1schamis.html

POLITICAL CYCLES AND EXCHANGE RATE-BASED STABILIZATION By HECTOR E.SCHAMIS and CHRISTOPHER R.WAY I.INTRODUCTION INCE the 1980s,but especially in the 1990s,the spread of currency and financial crises has been singled out as the most important source of instability across emerging markets.It has been widely recog- nized that the adoption of fixed exchange rate regimes is at the root of many of those crises.Whether to increase credibility and attract foreign investment or as an alternative approach to stabilization policy in high- inflation economies,fixing the exchange rate,it has been shown,can lead to undesirable outcomes in the medium to long term,even as it can be successful in expanding economic activity and correcting infla- tion in the short term.Especially in the developing world,though not only there,this currency arrangement tends to produce boom/bust cy- cles.1 This appears to be the record of several exchange rate-based stabi- lization experiments.In describing the life cycle of the boom/bust process that often follows the adoption of a nominal anchor,2 a wealth of literature has documented the dangers of attempts to fix the currency 'We thank Robert J.Franzese,John Freeman,Jeffry Frieden,Kurt Taylor Gaubatz,Hyeok Kwon, Susan Pratt,Andres Velasco,participants in seminars at Cornell,Northwestern,and Yale Universities, and three anonymous reviewers from World Politics for helpful comments and suggestions.Marci Brooks,Ana Frischtak,and Sharon Sprayregen provided valuable research assistance. This happened in the OECD countries,for example,during the ERM crisis of September 1992.See Willem Buiter,Giancarlo Corsetti,and Nouriel Roubini,"Excessive Deficits:Sense and Nonsense in the Treaty of Maastricht,"Economic Policy 16(April 1993);and Barry Eichengreen and Charles Wyplosz,"The Unstable EMS,"Brookings Papers on Economic Activity 1(1993). 2For example,Guillermo Calvo,"Temporary Stabilization:Predetermined Exchange Rates,"ou nal of Political Economy 94 (December 1986);Guillermo Calvo and Carlos Vegh,"Exchange-Rate- Based Stabilization under Imperfect Credibility,"International Monetary Fund Working Papers 91/77 (1991);Miguel Kiguel and Nissan Liviatan,"The Business Cycle Associated with Exchange Rate- Based Stabilizations,"World Bank Economic Review 6(May 1992);Alexander Hoffmaister and Carlos Vegh,"Disinflation and the Recession-Now-Versus-Recession-Later Hypothesis:Evidence from Uruguay,"International Monetary Fund Working Papers 95/99(1995);Aaron Tornell and Andres Ve- lasco,"Fixed versus Flexible Exchange Rates:Which Provides More Fiscal Discipline?Journal of Monetary Economics 45 (April 2000). World Politics 56(October 2003),43-78

World Politics 56 (October 2003), 43–78 POLITICAL CYCLES AND EXCHANGE RATE–BASED STABILIZATION By HECTOR E. SCHAMIS and CHRISTOPHER R. WAY* I. INTRODUCTION SINCE the 1980s, but especially in the 1990s, the spread of currency and financial crises has been singled out as the most important source of instability across emerging markets. It has been widely recog￾nized that the adoption of fixed exchange rate regimes is at the root of many of those crises. Whether to increase credibility and attract foreign investment or as an alternative approach to stabilization policy in high￾inflation economies, fixing the exchange rate, it has been shown, can lead to undesirable outcomes in the medium to long term, even as it can be successful in expanding economic activity and correcting infla￾tion in the short term. Especially in the developing world, though not only there, this currency arrangement tends to produce boom/bust cy￾cles.1 This appears to be the record of several exchange rate–based stabi￾lization experiments. In describing the life cycle of the boom/bust process that often follows the adoption of a nominal anchor,2 a wealth of literature has documented the dangers of attempts to fix the currency * We thank Robert J. Franzese, John Freeman, Jeffry Frieden, Kurt Taylor Gaubatz, Hyeok Kwon, Susan Pratt, Andrés Velasco, participants in seminars at Cornell, Northwestern, and Yale Universities, and three anonymous reviewers from World Politics for helpful comments and suggestions. Marci Brooks, Ana Frischtak, and Sharon Sprayregen provided valuable research assistance. 1This happened in the OECD countries, for example, during the ERM crisis of September 1992. See Willem Buiter, Giancarlo Corsetti, and Nouriel Roubini, “Excessive Deficits: Sense and Nonsense in the Treaty of Maastricht,” Economic Policy 16 (April 1993); and Barry Eichengreen and Charles Wyplosz, “The Unstable EMS,” Brookings Papers on Economic Activity 1 (1993). 2For example, Guillermo Calvo, “Temporary Stabilization: Predetermined Exchange Rates,” Jour￾nal of Political Economy 94 (December 1986); Guillermo Calvo and Carlos Végh, “Exchange-Rate￾Based Stabilization under Imperfect Credibility,” International Monetary Fund Working Papers 91/77 (1991); Miguel Kiguel and Nissan Liviatan, “The Business Cycle Associated with Exchange Rate￾Based Stabilizations,” World Bank Economic Review 6 (May 1992); Alexander Hoffmaister and Carlos Végh, “Disinflation and the Recession-Now-Versus-Recession-Later Hypothesis: Evidence from Uruguay,” International Monetary Fund Working Papers 95/99 (1995); Aaron Tornell and Andrés Ve￾lasco, “Fixed versus Flexible Exchange Rates: Which Provides More Fiscal Discipline?” Journal of Monetary Economics 45 (April 2000). v56.1.043.schamis 3/2/04 4:29 PM Page 43

44 WORLD POLITICS as part of a stabilization strategy.Adopting a nominal anchor as part of a stabilization effort generally leads to an appreciation of the real ex- change rate and a falling real interest rate,thus feeding a consumption boom of imports,a burst of investment,and a gradual deterioration of the current account.Under an open capital account,inflows of capital can finance the trade deficit in the short term.However,because the burgeoning current account deficit is unsustainable in the medium term,it often induces inconsistent fiscal policies,which in turn affect the credibility of the peg.At this point the sustainability of the regime itself comes into question:runs on the currency become widespread, usually with important losses in foreign-exchange reserves(as the gov- ernment tries to defend the parity)and,inevitably,a departure from the fixed exchange rate arrangement with a subsequent devaluation. This rendition conforms to the stylized facts of a balance-of-payment crisis as outlined in Krugman's seminal article.3 Moreover,it is also con- sistent with the main attributes of many exchange-rate and financial crises seen in much of the developing world:the Southern Cone of Latin America in the 1980s,Mexico,Asia,Russia,and Brazil in the 1990s,Turkey in 2001,and Argentina's explosive termination of the currency board in 2002(accompanied by the default on its external debt),to name a few prominent examples.If these boom/bust cycles appear with some frequency as a result of exchange rate-based stabi- lizations,the appeal of such programs-and,more generally,the nom- inal anchor approach to the exchange rate-appears puzzling.Why do governments implement policies that generate a short-term boom but are prone to collapse later in a sequence of devaluation and inflation that results in a severe balance-of-payment crisis and potentially poor economic performance? The literature on the political economy of exchange rates has left this question unanswered.The various contributions,including Krugman's, have showed how exchange rate crises unfold but not why govern- ments repeatedly choose those policies,exposing themselves to known risks.We embark on this discussion with a political economy explana- tion based on the notion of a self-interested government for which short-term stabilization is attractive in the face of incentives posed by the electoral cycle.If the election coincides with the boom phase, incumbent governments increase their likelihood of winning re- election-as the bust phase will develop,if at all,only after the contest. 3Paul Krugman,"A Model of Balance-of-Payments Crises,"Journal of Money,Credit,and Banking 11(August1979)

as part of a stabilization strategy. Adopting a nominal anchor as part of a stabilization effort generally leads to an appreciation of the real ex￾change rate and a falling real interest rate, thus feeding a consumption boom of imports, a burst of investment, and a gradual deterioration of the current account. Under an open capital account, inflows of capital can finance the trade deficit in the short term. However, because the burgeoning current account deficit is unsustainable in the medium term, it often induces inconsistent fiscal policies, which in turn affect the credibility of the peg. At this point the sustainability of the regime itself comes into question: runs on the currency become widespread, usually with important losses in foreign-exchange reserves (as the gov￾ernment tries to defend the parity) and, inevitably, a departure from the fixed exchange rate arrangement with a subsequent devaluation. This rendition conforms to the stylized facts of a balance-of-payment crisis as outlined in Krugman’s seminal article.3 Moreover, it is also con￾sistent with the main attributes of many exchange-rate and financial crises seen in much of the developing world: the Southern Cone of Latin America in the 1980s, Mexico, Asia, Russia, and Brazil in the 1990s, Turkey in 2001, and Argentina’s explosive termination of the currency board in 2002 (accompanied by the default on its external debt), to name a few prominent examples. If these boom/bust cycles appear with some frequency as a result of exchange rate–based stabi￾lizations, the appeal of such programs—and, more generally, the nom￾inal anchor approach to the exchange rate—appears puzzling. Why do governments implement policies that generate a short-term boom but are prone to collapse later in a sequence of devaluation and inflation that results in a severe balance-of-payment crisis and potentially poor economic performance? The literature on the political economy of exchange rates has left this question unanswered. The various contributions, including Krugman’s, have showed how exchange rate crises unfold but not why govern￾ments repeatedly choose those policies, exposing themselves to known risks. We embark on this discussion with a political economy explana￾tion based on the notion of a self-interested government for which short-term stabilization is attractive in the face of incentives posed by the electoral cycle. If the election coincides with the boom phase, incumbent governments increase their likelihood of winning re￾election—as the bust phase will develop, if at all, only after the contest. 44 WORLD POLITICS 3Paul Krugman, “A Model of Balance-of-Payments Crises,” Journal of Money, Credit, and Banking 11 (August 1979). v56.1.043.schamis 3/2/04 4:29 PM Page 44

POLITICAL CYCLES/STABILIZATION 45 We thus suggest a modified version of the traditional political business cycle.In the original formulation,a government facing reelection re- duces unemployment via expansionary monetary or fiscal policy prior to the election,although at the cost of increasing inflation after the election.+Corrective contractionary measures will then be introduced once the election has taken place,resulting in recession.In the cycle as- sociated with fixed exchange rates(with or without stabilization goals), a government facing reelection times the introduction of a nominal an- chor carefully-hoping for the boom to kick in before the election and for the election to occur before the potential difficulties associated with financing the current account deficit point to the possibility of a deval- uation.Viewed from the standpoint of opportunistic office-seeking governments,the political rationality of exchange rate-based stabiliza- tion explains its attractiveness despite its questionable appeal as an eco- nomic policy. The rest of the article proceeds as follows.In Section II we review the political economy literature on choice of exchange-rate arrange- ment.Taking the variant of this literature emphasizing domestic polit- ical incentives as our point of departure,we argue in Section III that the peculiar macroeconomic dynamics of exchange rate-based stabi- lizations provide democratic governments with powerful incentives to adopt such policies precisely when their time horizons are shortest: prior to elections.Section IV marshals data on decisions to fix the ex- change rate and on election timing in eighteen Latin American coun- tries from 1970 to 1999 and presents preliminary plausibility probes of our argument,whereas Section V analyzes these cycles with time- series/cross-sectional logistic regression models and describes several robustness tests.By way of conclusion,the final section discusses the implications of our findings for the broader literature on stabilization and electoral cycles. II.EXCHANGE RATE CHOICE:THE DEBATE The growing interest in recent exchange rate policies can hardly be ex- aggerated.A vast literature on the subject has addressed different +As espoused by William Nordhaus,"The Political Business Cycle,"Review ofEconomic Studies 42 (April 1975);and Edward Tufte,Political Control of the Economy (Princeton:Princeton University Press,1978).Later contributions along these lines have substituted fully rational voters for the myopic electorate of the original versions,relying instead on voters'imperfect information about government competence to drive the models.See,for example,Alex Cukierman and Alan Meltzer,A Positive Theory of Discretionary Policy,the Cost of Democratic Government,and the Benefits of a Constitu- tion,"Economic Inguiry 24(July 1986);and Kenneth Rogoff and Anne Sibert,"Elections and Macro- economic Policy Cycles,"Review ofEconomic Studies 55 (January 1988)

We thus suggest a modified version of the traditional political business cycle. In the original formulation, a government facing reelection re￾duces unemployment via expansionary monetary or fiscal policy prior to the election, although at the cost of increasing inflation after the election.4 Corrective contractionary measures will then be introduced once the election has taken place, resulting in recession. In the cycle as￾sociated with fixed exchange rates (with or without stabilization goals), a government facing reelection times the introduction of a nominal an￾chor carefully—hoping for the boom to kick in before the election and for the election to occur before the potential difficulties associated with financing the current account deficit point to the possibility of a deval￾uation. Viewed from the standpoint of opportunistic office-seeking governments, the political rationality of exchange rate–based stabiliza￾tion explains its attractiveness despite its questionable appeal as an eco￾nomic policy. The rest of the article proceeds as follows. In Section II we review the political economy literature on choice of exchange-rate arrange￾ment. Taking the variant of this literature emphasizing domestic polit￾ical incentives as our point of departure, we argue in Section III that the peculiar macroeconomic dynamics of exchange rate–based stabi￾lizations provide democratic governments with powerful incentives to adopt such policies precisely when their time horizons are shortest: prior to elections. Section IV marshals data on decisions to fix the ex￾change rate and on election timing in eighteen Latin American coun￾tries from 1970 to 1999 and presents preliminary plausibility probes of our argument, whereas Section V analyzes these cycles with time￾series/cross-sectional logistic regression models and describes several robustness tests. By way of conclusion, the final section discusses the implications of our findings for the broader literature on stabilization and electoral cycles. II. EXCHANGE RATE CHOICE: THE DEBATE The growing interest in recent exchange rate policies can hardly be ex￾aggerated. A vast literature on the subject has addressed different POLITICAL CYCLES/STABILIZATION 45 4As espoused by William Nordhaus, “The Political Business Cycle,” Review of Economic Studies 42 (April 1975); and Edward Tufte, Political Control of the Economy (Princeton: Princeton University Press, 1978). Later contributions along these lines have substituted fully rational voters for the myopic electorate of the original versions, relying instead on voters’ imperfect information about government competence to drive the models. See, for example, Alex Cukierman and Alan Meltzer, “A Positive Theory of Discretionary Policy, the Cost of Democratic Government, and the Benefits of a Constitu￾tion,” Economic Inquiry 24 ( July 1986); and Kenneth Rogoff and Anne Sibert, “Elections and Macro￾economic Policy Cycles,” Review of Economic Studies 55 ( January 1988). v56.1.043.schamis 3/2/04 4:29 PM Page 45

46 WORLD POLITICS aspects involved in the choice of one type of exchange rate arrangement over another.Early literature in economics built on the optimal cur- rency area literature,emphasizing that different exchange rate regimes might be appropriate for countries with different economic characteris- tics.Recent approaches have shifted the focus to credibility arguments, suggesting that governments can gain anti-inflationary credibility by fixing to a nominal anchor currency of a low-inflation country.5 For the most part,however,the economics literature does not problematize the preferences of policymakers and generally treats them as fixed and ex- ogenous,tending to assume a government that is a benevolent social welfare maximizer.As we highlight above,however,to the extent that a nominal anchor to the exchange rate is prone to boom-bust cycles,its adoption cannot be explained solely on the basis of considerations of efficiency. Recent research on globalization,by contrast,has emphasized the role of the integration of transnational economic actors and the pene- tration of market forces into the national space in diminishing the au- tonomy of national states.Arguably,nowhere is this trend more visible than in the area of monetary and exchange rate policy.Confronted with fully mobile financial capital and rapid technological change,the argu- ment goes,states find it increasingly difficult to implement domestic policy that deviates from the externally induced norm.As a result and regardless of domestic conditions,the adoption of rules and institu- tional configurations aimed at signaling to foreign investors the au- thorities'commitment to exchange rate and price stability emerges as a logical response.? For all its merits,much of the literature on globalization reduces government to a passive actor merely reactive to international condi- tions.Because of this,a domestic reading of the process leading to the adoption of exchange rate policy is more in tune with our take on the subject.Demand-side approaches have,in turn,viewed the adoption of exchange rate policies in terms of the response of governments to in- s See Robert Mundell,"A Theory of Optimal Currency Areas,"American Economic Review 51(Sep- tember 1961);Ronald McKinnon,"Optimum Currency Areas,"American Economic Review 53(Sep- tember 1963);George S.Tavlas,"The Theory of Monetary Integration,"Open Economies Review 5 (April 1994). Francesco Giavazzi and Marco Pagano,"The Advantage of Tying One's Hands:EMS Discipline and Central Bank Credibility,"European Economic Review 32 (June 1988). Benjamin J.Cohen,"Phoenix Risen:The Resurrection of Global Finance,"World Politics 48 (Jan- uary 1996);Jeffry Frieden and Ronald Rogowski,"The Impact of the International Economy on Na- tional Policies:An Analytical Overview,"and Stephan Haggard and Sylvia Maxfield,"The Political Economy of Financial Liberalization in the Developing World,"both in Robert Keohane and Helen Milner,eds.,Internationalization and Domestic Politics(Cambridge:Cambridge University Press, 1996);and Susan Strange,Mad Money (Ann Arbor:University of Michigan Press,1998)

aspects involved in the choice of one type of exchange rate arrangement over another. Early literature in economics built on the optimal cur￾rency area literature, emphasizing that different exchange rate regimes might be appropriate for countries with different economic characteris￾tics.5 Recent approaches have shifted the focus to credibility arguments, suggesting that governments can gain anti-inflationary credibility by fixing to a nominal anchor currency of a low-inflation country.6 For the most part, however, the economics literature does not problematize the preferences of policymakers and generally treats them as fixed and ex￾ogenous, tending to assume a government that is a benevolent social welfare maximizer. As we highlight above, however, to the extent that a nominal anchor to the exchange rate is prone to boom-bust cycles, its adoption cannot be explained solely on the basis of considerations of efficiency. Recent research on globalization, by contrast, has emphasized the role of the integration of transnational economic actors and the pene￾tration of market forces into the national space in diminishing the au￾tonomy of national states. Arguably, nowhere is this trend more visible than in the area of monetary and exchange rate policy. Confronted with fully mobile financial capital and rapid technological change, the argu￾ment goes, states find it increasingly difficult to implement domestic policy that deviates from the externally induced norm. As a result and regardless of domestic conditions, the adoption of rules and institu￾tional configurations aimed at signaling to foreign investors the au￾thorities’ commitment to exchange rate and price stability emerges as a logical response.7 For all its merits, much of the literature on globalization reduces government to a passive actor merely reactive to international condi￾tions. Because of this, a domestic reading of the process leading to the adoption of exchange rate policy is more in tune with our take on the subject. Demand-side approaches have, in turn, viewed the adoption of exchange rate policies in terms of the response of governments to in- 46 WORLD POLITICS 5See Robert Mundell, “A Theory of Optimal Currency Areas,” American Economic Review 51 (Sep￾tember 1961); Ronald McKinnon, “Optimum Currency Areas,” American Economic Review 53 (Sep￾tember 1963); George S. Tavlas, “The Theory of Monetary Integration,” Open Economies Review 5 (April 1994). 6 Francesco Giavazzi and Marco Pagano, “The Advantage of Tying One’s Hands: EMS Discipline and Central Bank Credibility,” European Economic Review 32 ( June 1988). 7Benjamin J. Cohen, “Phoenix Risen: The Resurrection of Global Finance,” World Politics 48 ( Jan￾uary 1996); Jeffry Frieden and Ronald Rogowski, “The Impact of the International Economy on Na￾tional Policies: An Analytical Overview,” and Stephan Haggard and Sylvia Maxfield, “The Political Economy of Financial Liberalization in the Developing World,” both in Robert Keohane and Helen Milner, eds., Internationalization and Domestic Politics (Cambridge: Cambridge University Press, 1996); and Susan Strange, Mad Money (Ann Arbor: University of Michigan Press, 1998). v56.1.043.schamis 3/2/04 4:29 PM Page 46

POLITICAL CYCLES/STABILIZATION 47 terest groups and coalitions in both advanced industrial and developing economies.8 Similarly,another line of research has also emphasized domestic conditions,although stressing the way politicians respond to the insti- tutional configuration of the polity rather than to interest-group poli- tics.Accordingly,Simmons argues that weak or unstable governments will be unable to implement the domestic adjustments needed to sus- tain a fixed exchange-rate regime.This line of argument was more re- cently picked up and extended by Bernhard and Leblang.They see weakness as very much a function of electoral rules and legislative insti- tutions.In systems where the cost of electoral defeat is high(majority rule)and the electoral calendar is exogenous(usually presidentialism), they argue that politicians will prefer a flexible exchange rate arrange- ment,desiring to retain the ability to manipulate monetary policy in- struments for political gain.Moreover,in extending the argument to developing countries,Leblang argues that,largely for these reasons, floating exchange rate regimes are more likely to occur in democratic than in nondemocratic polities.1 In addition to the desire to retain control of monetary policy for political business-cycle purposes, Leblang argues that increased pressure for distributive and expansion- ary policy accompanies democracy,providing policymakers with an- other motive to prefer foating to fixed exchange rates. Even though we agree with the primacy attributed to the politician's choice in this recent literature,the reasoning is at odds with our argu- ment.First,it rules out the possibility that the adoption of a fixed exchange rate becomes itself a source of strength for an unstable gov- ernment,helping it build political capital during the boom phase.In the case of exchange rate-based stabilizations,adoption of a nominal anchor itself is a policy tool for engineering an upswing in the business sFor the former,see Jeffry Frieden,"Exchange Rate Politics:Contemporary Lessons from Ameri- can History,"Review of International Political Economy 1(Spring 1994);Geoffrey Garrett and Peter Lange,"Internationalization,Institutions,and Political Change,"in Keohane and Milner(fn.7).For the latter,see Jeffry Frieden,"The Politics of Exchange Rates,"in Sebastian Edwards and Moises Naim,eds.,Mexico 1994:Anatomy of an Emerging Market Crash (Washington,D.C.:Carnegie En- dowment for International Peace,1997);Eugenio Diaz-Bonilla and Hector E.Schamis,"From Re- distribution to Stability:The Evolution of Exchange Rate Policies in Argentina,1950-98,"in Jeffry Frieden and Emesto Stein,eds.,The Currency Game:Excbange Rate Politics in Latin America(Balti- more:Johns Hopkins University Press,2001). Beth Simmons,Who Adjusts?Domestic Sources of Foreign Economic Policy during the Interwar Years (Princeton:Princeton University Press,1994). 10William Bernhard and David Leblang,"Democratic Institutions and Exchange Rate Commit- ments,"International Organization 53 (Winter 1999). David Leblang,"Domestic Political Institutions and Exchange Rate Commitments in the Devel- oping World,"International Studies Quarterly 43(December 1999)

terest groups and coalitions in both advanced industrial and developing economies.8 Similarly, another line of research has also emphasized domestic conditions, although stressing the way politicians respond to the insti￾tutional configuration of the polity rather than to interest-group poli￾tics. Accordingly, Simmons argues that weak or unstable governments will be unable to implement the domestic adjustments needed to sus￾tain a fixed exchange-rate regime.9 This line of argument was more re￾cently picked up and extended by Bernhard and Leblang.10 They see weakness as very much a function of electoral rules and legislative insti￾tutions. In systems where the cost of electoral defeat is high (majority rule) and the electoral calendar is exogenous (usually presidentialism), they argue that politicians will prefer a flexible exchange rate arrange￾ment, desiring to retain the ability to manipulate monetary policy in￾struments for political gain. Moreover, in extending the argument to developing countries, Leblang argues that, largely for these reasons, floating exchange rate regimes are more likely to occur in democratic than in nondemocratic polities.11 In addition to the desire to retain control of monetary policy for political business-cycle purposes, Leblang argues that increased pressure for distributive and expansion￾ary policy accompanies democracy, providing policymakers with an￾other motive to prefer floating to fixed exchange rates. Even though we agree with the primacy attributed to the politician’s choice in this recent literature, the reasoning is at odds with our argu￾ment. First, it rules out the possibility that the adoption of a fixed exchange rate becomes itself a source of strength for an unstable gov￾ernment, helping it build political capital during the boom phase. In the case of exchange rate–based stabilizations, adoption of a nominal anchor itself is a policy tool for engineering an upswing in the business POLITICAL CYCLES/STABILIZATION 47 8For the former, see Jeffry Frieden, “Exchange Rate Politics: Contemporary Lessons from Ameri￾can History,” Review of International Political Economy 1 (Spring 1994); Geoffrey Garrett and Peter Lange, “Internationalization, Institutions, and Political Change,” in Keohane and Milner (fn. 7). For the latter, see Jeffry Frieden, “The Politics of Exchange Rates,” in Sebastian Edwards and Moises Naim, eds., Mexico 1994: Anatomy of an Emerging Market Crash (Washington, D.C.: Carnegie En￾dowment for International Peace, 1997); Eugenio Diaz-Bonilla and Hector E. Schamis, “From Re￾distribution to Stability: The Evolution of Exchange Rate Policies in Argentina, 1950–98,” in Jeffry Frieden and Ernesto Stein, eds., The Currency Game: Exchange Rate Politics in Latin America (Balti￾more: Johns Hopkins University Press, 2001). 9Beth Simmons, Who Adjusts? Domestic Sources of Foreign Economic Policy during the Interwar Years (Princeton: Princeton University Press, 1994). 10William Bernhard and David Leblang, “Democratic Institutions and Exchange Rate Commit￾ments,” International Organization 53 (Winter 1999). 11David Leblang, “Domestic Political Institutions and Exchange Rate Commitments in the Devel￾oping World,” International Studies Quarterly 43 (December 1999). v56.1.043.schamis 3/2/04 4:29 PM Page 47

48 WORLD POLITICS cycle.Second,that reasoning is at odds with the fact that the adoption of nominal anchors in much of the developing world over the past two decades took place under democratic conditions.Third,the numerous fixed exchange-rate regimes adopted in the Latin American presiden- tial systems during the 1980s and 1990s cast serious doubts on the alleged association between fixed electoral calendars/majoritarian political institutions and a preference for flexibility in exchange-rate policy.On the contrary,we argue,it is precisely the high cost of elec- toral defeat and the exogenous nature of the electoral calendar that ex- plain the appeal of exchange rate-based stabilizations in these countries.To address this puzzle we adopt a decidedly supply-side ap- proach to the politics of exchange rates. III.EXPLAINING THE ADOPTION OF A FIXED EXCHANGE RATE REGIME A wealth of literature in economics has presented compelling evidence on the limitations and risks of a nominal anchor approach to the ex- change rate,particularly,though by no means only,when used as a sta- bilization strategy.Drawing inspiration from several episodes of chronic inflation in Latin America,empirical work in economics has produced a stylized picture of the distinctive macroeconomic dynamics associated with exchange rate-based stabilizations(ERBS).12 Typically, fixing the exchange rate leads to a relatively rapid increase in domestic absorption,the progressive decline in inflation,and the appreciation of the real exchange rate (due to price stickiness).This leads to a con- sumption-and investment-driven upturn in output,often lasting sev- eral years.13 However,on this account,a trade deficit may follow,the The rendition of the dynamics of a typical exchange-rate-based stabilization is based on Kiguel and Liviatan (fn.2);Guillermo Calvo and Carlos Vegh,"Inflation Stabilization and Nominal An- chors,"Contemporary Economic Policy 12 (April 1994);and idem,"Inflation Stabilization and Bop Crises in Developing Countries,"in John B.Tavlor and Michael Woodford,eds..Handbook of Macro- economics (New York:Elsevier,1999).Stanley Fisher advances macroeconomic models to document the strikingly different trajectories of exchange rate-based versus money-based stabilizations;Fisher, "Exchange Rate versus Money Targets in Disinflation,"in Fisher,ed.,Indexing,Inflation,and Economic Policy(Cambridge:MIT Press,1986).Calvo and Vegh and Fisher,Ratra,and Vegh survey the various theoretical models that have been put forth to account for the empirical regularities of ERBS;Calvo and Vegh,"Inflation Stabilization and BOP Crises in Developing Countries,"and Stanley Fisher,Shay Ratra,and Carlos Vegh,"Modern Hyper-and High Inflations,"both in Journal ofEconomic Literature 40(September 2002). A variety of macroeconomic models have been proposed to account for the real effects of ERBS.A partial list includes Calvo and Vegh(fn.2);Jose De Gregorio,Pablo Guidotti,and Carlos Vegh,"In- fation Stabilization and Consumption of Durable Goods,"Economic fourna/108(January 1998); Fisher(fn.12);Amartya Lahiri,"Disinflation Programs under Policy Uncertainty,"Journal ofInterna- tional Economics 50 (April 2000);Sergio Rebelo and Carlos Vegh,"Real Effects of Exchange Rate- Based Stabilizations:An Analysis of Competing Theories,"NBER Macroeconomics Anmual(1995)

cycle. Second, that reasoning is at odds with the fact that the adoption of nominal anchors in much of the developing world over the past two decades took place under democratic conditions. Third, the numerous fixed exchange-rate regimes adopted in the Latin American presiden￾tial systems during the 1980s and 1990s cast serious doubts on the alleged association between fixed electoral calendars/majoritarian political institutions and a preference for flexibility in exchange-rate policy. On the contrary, we argue, it is precisely the high cost of elec￾toral defeat and the exogenous nature of the electoral calendar that ex￾plain the appeal of exchange rate–based stabilizations in these countries. To address this puzzle we adopt a decidedly supply-side ap￾proach to the politics of exchange rates. III. EXPLAINING THE ADOPTION OF A FIXED EXCHANGE RATE REGIME A wealth of literature in economics has presented compelling evidence on the limitations and risks of a nominal anchor approach to the ex￾change rate, particularly, though by no means only, when used as a sta￾bilization strategy. Drawing inspiration from several episodes of chronic inflation in Latin America, empirical work in economics has produced a stylized picture of the distinctive macroeconomic dynamics associated with exchange rate–based stabilizations (ERBS).12 Typically, fixing the exchange rate leads to a relatively rapid increase in domestic absorption, the progressive decline in inflation, and the appreciation of the real exchange rate (due to price stickiness). This leads to a con￾sumption- and investment-driven upturn in output, often lasting sev￾eral years.13 However, on this account, a trade deficit may follow, the 48 WORLD POLITICS 12 The rendition of the dynamics of a typical exchange-rate-based stabilization is based on Kiguel and Liviatan (fn. 2); Guillermo Calvo and Carlos Végh, “Inflation Stabilization and Nominal An￾chors,” Contemporary Economic Policy 12 (April 1994); and idem, “Inflation Stabilization and  Crises in Developing Countries,” in John B. Taylor and Michael Woodford, eds., Handbook of Macro￾economics (New York: Elsevier, 1999). Stanley Fisher advances macroeconomic models to document the strikingly different trajectories of exchange rate-based versus money-based stabilizations; Fisher, “Exchange Rate versus Money Targets in Disinflation,” in Fisher, ed., Indexing, Inflation, and Economic Policy (Cambridge: MIT Press, 1986). Calvo and Végh and Fisher, Ratra, and Végh survey the various theoretical models that have been put forth to account for the empirical regularities of ERBS; Calvo and Végh, “Inflation Stabilization and BOP Crises in Developing Countries,” and Stanley Fisher, Shay Ratra, and Carlos Végh, “Modern Hyper- and High Inflations,” both in Journal of Economic Literature 40 (September 2002). 13A variety of macroeconomic models have been proposed to account for the real effects of ERBS. A partial list includes Calvo and Végh (fn. 2); José De Gregorio, Pablo Guidotti, and Carlos Végh, “In- flation Stabilization and Consumption of Durable Goods,” Economic Journal 108 ( January 1998); Fisher (fn. 12); Amartya Lahiri, “Disinflation Programs under Policy Uncertainty,” Journal of Interna￾tional Economics 50 (April 2000); Sergio Rebelo and Carlos Végh, “Real Effects of Exchange Rate￾Based Stabilizations: An Analysis of Competing Theories,” NBER Macroeconomics Annual (1995). v56.1.043.schamis 3/2/04 4:29 PM Page 48

POLITICAL CYCLES/STABILIZATION result of appreciation bolstered by the oversupply of credit and the re- duction of the real interest rate.The difficulties in financing growing current account imbalances induce governments to adopt fiscal and monetary policies that are inconsistent with the exchange rate regime.14 If this happens,the sustainability of the peg comes into question,either because perceptions of the indefensibility of the arrangement become widespread or because foreign-exchange reserves are insufficient to sus- tain the deficit.Either way,attacks on the currency bring down the par- ity,whether on the basis of self-fulfilling prophecies or of objective conditions.At this point,a balance-of-payments crisis occurs and the boom turns into bust. The dynamics of money-based stabilization(MBS),which uses a sharp contraction of the money supply as the primary policy tool in an orthodox program,differs in striking fashion.15 In this case,tightening of monetary policy leads to increased real interest rates,reduced do- mestic absorption,and an improved trade balance.Although inflation often falls,this takes time and is accompanied by severe recessionary ef- fects on output and employment.The money-based stabilization pro- gram in Spain from 1977 to 1980,for example,led to a sharp drop in GDP growth,falling inflation,and rising unemployment,over a cycle that lasted two years.Chile and Argentina in the mid-1970s are promi- nent examples of money-based stabilizations in Latin America with clear recessionary consequences. These stylized facts were initially intended to describe experiences in a handful of Latin American countries,and recent research has ques- tioned the tendency to generalize them into an "ERBS syndrome,"con- testing the alleged empirical regularities associated with the two stabilization strategies.6 Even so,a recent critical study along these lines does concede the existence of"a distinctive consumption boom during ERBS's,"confirming a pattern of real exchange rate appreciation Though conducive to inconsistent fiscal policies,not all exchange rate-based stabilizations are necessarily accompanied by such policies,and thus not all end with a bust in the medium run.For ex- ample,Mexico's Pacto of 1987,initiated nine months before the presidential election,was accompa- nied by fiscal adjustment.The downward inflation trend continued after the election,and the regime endured for several years.Similarly,Argentina's currency board arrangement appeared for quite a while to provide enduring stability,but its collapse in 2002-as well as the Mexican Tequila crisis of 1994-95-cast doubt even on these"success"stories.As Michael Klein and Nancy Marion observe, while there is large variability in the duration of pegs resulting from stabilizations,few escape an even- tual dramatic collapse;Klein and Marion,"Explaining the Duration of Exchange Rate Pegs,"NBER Working Papers 4651 (1994). is Kiguel and Liviatan (fn.2);Calvo and Vegh (fn.12). For example,William Easterly,"When Is Stabilization Expansionary?Evidence from High In- flation,"Economic Policy 22(April 1996);and A.Javier Hamman,"Exchange-Rate-Based Stabiliza- tion:A Critical Look at the Stylized Facts,"IMF Staf Papers 48 (December 2001)

result of appreciation bolstered by the oversupply of credit and the re￾duction of the real interest rate. The difficulties in financing growing current account imbalances induce governments to adopt fiscal and monetary policies that are inconsistent with the exchange rate regime.14 If this happens, the sustainability of the peg comes into question, either because perceptions of the indefensibility of the arrangement become widespread or because foreign-exchange reserves are insufficient to sus￾tain the deficit. Either way, attacks on the currency bring down the par￾ity, whether on the basis of self-fulfilling prophecies or of objective conditions. At this point, a balance-of-payments crisis occurs and the boom turns into bust. The dynamics of money-based stabilization (MBS), which uses a sharp contraction of the money supply as the primary policy tool in an orthodox program, differs in striking fashion.15 In this case, tightening of monetary policy leads to increased real interest rates, reduced do￾mestic absorption, and an improved trade balance. Although inflation often falls, this takes time and is accompanied by severe recessionary ef￾fects on output and employment. The money-based stabilization pro￾gram in Spain from 1977 to 1980, for example, led to a sharp drop in GDP growth, falling inflation, and rising unemployment, over a cycle that lasted two years. Chile and Argentina in the mid-1970s are promi￾nent examples of money-based stabilizations in Latin America with clear recessionary consequences. These stylized facts were initially intended to describe experiences in a handful of Latin American countries, and recent research has ques￾tioned the tendency to generalize them into an “ERBS syndrome,” con￾testing the alleged empirical regularities associated with the two stabilization strategies.16 Even so, a recent critical study along these lines does concede the existence of “a distinctive consumption boom during ERBS’s,” confirming a pattern of real exchange rate appreciation POLITICAL CYCLES/STABILIZATION 49 14 Though conducive to inconsistent fiscal policies, not all exchange rate–based stabilizations are necessarily accompanied by such policies, and thus not all end with a bust in the medium run. For ex￾ample, Mexico’s Pacto of 1987, initiated nine months before the presidential election, was accompa￾nied by fiscal adjustment. The downward inflation trend continued after the election, and the regime endured for several years. Similarly, Argentina’s currency board arrangement appeared for quite a while to provide enduring stability, but its collapse in 2002—as well as the Mexican Tequila crisis of 1994–95—cast doubt even on these “success” stories. As Michael Klein and Nancy Marion observe, while there is large variability in the duration of pegs resulting from stabilizations, few escape an even￾tual dramatic collapse; Klein and Marion, “Explaining the Duration of Exchange Rate Pegs,” NBER Working Papers 4651 (1994). 15Kiguel and Liviatan (fn. 2); Calvo and Végh (fn. 12). 16For example, William Easterly, “When Is Stabilization Expansionary? Evidence from High In- flation,” Economic Policy 22 (April 1996); and A. Javier Hamman, “Exchange-Rate-Based Stabiliza￾tion: A Critical Look at the Stylized Facts,” IMF Staff Papers 48 (December 2001). v56.1.043.schamis 3/2/04 4:29 PM Page 49

50 WORLD POLITICS that is unique to stabilizations using the exchange rate as an anchor.17 Of course,our argument does not require a completely uniform and au- tomatic cycle but only a pattern suggesting the possibility that ERBS will provide a quick fix for governments facing elections.Yet even if all the other stylized facts were shown to be wrong,18 the existence of a"dis- tinctive consumption boom"is sufficient to underpin the political logic of our argument.Nonetheless,it is worth emphasizing that evidence suggests that the regularity appears more pronounced in Latin America than in other regions and that the recent studies question the general- izability of the phenomena more than its aptness for the Latin Ameri- can countries from which the stylized facts were initially derived and which are the focus of our study.19 To explain the enduring nature of exchange rate-based stabilizations despite their rather risky long-term prospects,we emphasize the polit- ical attractiveness of the arrangement for governments.Here we under- line the distinctive macroeconomic dynamics of exchange rate-based stabilizations versus those of money-based stabilizations.We argue that the adoption of nominal anchors and exchange rate-based stabilization policies are particularly attractive to governments with short time hori- zons.This is especially so for governments approaching elections in presidential systems where the electoral calendar is fixed.Correctly timed,the introduction of an ERBS program will produce a decline in inflation,a consumption boom,robust output growth,and a decline in unemployment.Sometimes in high-inflation economies,in Latin America and elsewhere,the critical economic issue before elections is inflation.Governments could try to combat inflation with a money- based stabilization,but that would entail a willingness to endure falling output and rising unemployment during the run-up to an election. With an exchange rate-based stabilization,by contrast,governments do not have to sacrifice output,consumption,and employment to bring down inflation-at least not in the short to medium term:"all good things go together"for at least a while.The strong economic perfor- mance and falling inflation help the incumbent government seeking re- 17Hamman (fn.16),134.Similarly,Easterly (fn.16)finds that '"consumption growth booms a bit more than output growth in the early years of stabilization"(p.84). is And they are probably not wrong,as Fisher,Ratra,and Vegh(fn.12)show:"For ERBS,GDP growth rises very sharply upon stabilization and then stays high until T+2 only to fall sharply in T+3," in"sharp contrast to non-ERBS stabilizations"(p.868).They also reaffirm the distinctive consumption boom pattern characteristic of ERBS. The evidence presented in Hamman(fn.16),for example,suggests that the ERBS syndrome is most pronounced in Latin America,and Easterly (fn.16)does not take issue with the stylized facts for Latin America itself,aiming only"to examine whether such stylized facts underlie the patterns de- tected here in a broader sample of inflation stabilizations"(p.89)

that is unique to stabilizations using the exchange rate as an anchor.17 Of course, our argument does not require a completely uniform and au￾tomatic cycle but only a pattern suggesting the possibility that ERBS will provide a quick fix for governments facing elections. Yet even if all the other stylized facts were shown to be wrong,18 the existence of a “dis￾tinctive consumption boom” is sufficient to underpin the political logic of our argument. Nonetheless, it is worth emphasizing that evidence suggests that the regularity appears more pronounced in Latin America than in other regions and that the recent studies question the general￾izability of the phenomena more than its aptness for the Latin Ameri￾can countries from which the stylized facts were initially derived and which are the focus of our study.19 To explain the enduring nature of exchange rate–based stabilizations despite their rather risky long-term prospects, we emphasize the polit￾ical attractiveness of the arrangement for governments. Here we under￾line the distinctive macroeconomic dynamics of exchange rate–based stabilizations versus those of money-based stabilizations. We argue that the adoption of nominal anchors and exchange rate–based stabilization policies are particularly attractive to governments with short time hori￾zons. This is especially so for governments approaching elections in presidential systems where the electoral calendar is fixed. Correctly timed, the introduction of an ERBS program will produce a decline in inflation, a consumption boom, robust output growth, and a decline in unemployment. Sometimes in high-inflation economies, in Latin America and elsewhere, the critical economic issue before elections is inflation. Governments could try to combat inflation with a money￾based stabilization, but that would entail a willingness to endure falling output and rising unemployment during the run-up to an election. With an exchange rate–based stabilization, by contrast, governments do not have to sacrifice output, consumption, and employment to bring down inflation—at least not in the short to medium term: “all good things go together” for at least a while. The strong economic perfor￾mance and falling inflation help the incumbent government seeking re- 50 WORLD POLITICS 17 Hamman (fn. 16), 134. Similarly, Easterly (fn. 16) finds that “consumption growth booms a bit more than output growth in the early years of stabilization” (p. 84). 18 And they are probably not wrong, as Fisher, Ratra, and Végh (fn. 12) show: “For ERBS, GDP growth rises very sharply upon stabilization and then stays high until T+2 only to fall sharply in T+3,” in “sharp contrast to non-ERBS stabilizations” (p. 868). They also reaffirm the distinctive consumption boom pattern characteristic of ERBS. 19 The evidence presented in Hamman (fn. 16), for example, suggests that the ERBS syndrome is most pronounced in Latin America, and Easterly (fn. 16) does not take issue with the stylized facts for Latin America itself, aiming only “to examine whether such stylized facts underlie the patterns de￾tected here in a broader sample of inflation stabilizations” (p. 89). v56.1.043.schamis 3/2/04 4:29 PM Page 50

POLITICAL CYCLES/STABILIZATION 51 election,as long as the potential bust phase does not materialize before the contest. Anecdotal evidence from Latin America suggests the plausibility of the argument.For example,participants in the policy-making process report that the Real Plan,launched in Brazil in 1994,was specifically timed to help the ruling party's candidate for president,Fernando Hen- rique Cardoso,who had been trailing in the polls at the time.20 Riding the tide of falling inflation and improving economic conditions result- ing from the ERBS,Cardoso won a dramatic and convincing come- from-behind victory.Similarly,the Primavera Plan of 1988 in Argentina was widely recognized as a final attempt to control inflation before the upcoming presidential election of 1989.21 Whereas the Pri- mavera Plan,launched nine months before elections,was a gamble that did not pay off because it collapsed prior to the poll,Argentina's Con- vertibility Plan of 1991,launched seven months prior to crucial con- gressional elections,did pay off,both yielding electoral benefits for the incumbent party and,accompanied by fiscal restraint,maintaining low inflation even after the election. While our characterization of the political business cycle of stabiliza- tion may seem to rest on assumptions of adaptive expectations on behalf of voters,we believe the general story is consistent both with traditional models of the political business cycle,2 which assume adaptive expecta- tions on behalf of voters,and with newer"competence"models,23 which assume rational expectations.The implications of assuming backward- looking adaptive expectations are straightforward:voters base evaluations on the recent past and thus reward governments for the falling inflation and booming economy resulting from an exchange rate-based stabiliza- tion.Indeed,some evidence suggests that adaptive expectations models outperform rational expectations models of political business cycles in Latin America,lending plausibility to this interpretation for our pur- poses.24 However,a similar cycle can result from competence models of the political business cycle that are grounded in rational expectations.In Ernesto Stein and Jorge Streb,"Political Stabilization Cycles in High-Inflation Economies,o nal of Development Economics 56 (June 1998). 2Daniel Heymann,"From Sharp Disinflation to Hyperinflation,Twice:The Argentine Experi- ence,"in Michael Bruno,ed.,Lessons of Economic Stabilization and Its Aftermath(Cambridge:MIT Press,1991). 2Nordhaus (fn.4);and Tufte (fn.4). 2 Cukierman and Melzer(fn.4);Rogoff and Sibert(fn.4);and Torsten Persson and Guido Tabellini,Macroeconomic Policy,Credibility,and Politics(New York:Harwood Academic Publishers, 1990). Sebastian Edwards,"The Political Economy of Inflation and Stabilization in Developing Coun- ties,"Economic Development and Cultural Change 42(January 1994)

election, as long as the potential bust phase does not materialize before the contest. Anecdotal evidence from Latin America suggests the plausibility of the argument. For example, participants in the policy-making process report that the Real Plan, launched in Brazil in 1994, was specifically timed to help the ruling party’s candidate for president, Fernando Hen￾rique Cardoso, who had been trailing in the polls at the time.20 Riding the tide of falling inflation and improving economic conditions result￾ing from the ERBS, Cardoso won a dramatic and convincing come￾from-behind victory. Similarly, the Primavera Plan of 1988 in Argentina was widely recognized as a final attempt to control inflation before the upcoming presidential election of 1989.21 Whereas the Pri￾mavera Plan, launched nine months before elections, was a gamble that did not pay off because it collapsed prior to the poll, Argentina’s Con￾vertibility Plan of 1991, launched seven months prior to crucial con￾gressional elections, did pay off, both yielding electoral benefits for the incumbent party and, accompanied by fiscal restraint, maintaining low inflation even after the election. While our characterization of the political business cycle of stabiliza￾tion may seem to rest on assumptions of adaptive expectations on behalf of voters, we believe the general story is consistent both with traditional models of the political business cycle,22 which assume adaptive expecta￾tions on behalf of voters, and with newer “competence” models,23 which assume rational expectations. The implications of assuming backward￾looking adaptive expectations are straightforward: voters base evaluations on the recent past and thus reward governments for the falling inflation and booming economy resulting from an exchange rate–based stabiliza￾tion. Indeed, some evidence suggests that adaptive expectations models outperform rational expectations models of political business cycles in Latin America, lending plausibility to this interpretation for our pur￾poses.24 However, a similar cycle can result from competence models of the political business cycle that are grounded in rational expectations. In POLITICAL CYCLES/STABILIZATION 51 20Ernesto Stein and Jorge Streb, “Political Stabilization Cycles in High-Inflation Economies,” Jour￾nal of Development Economics 56 ( June 1998). 21 Daniel Heymann, “From Sharp Disinflation to Hyperinflation, Twice: The Argentine Experi￾ence,” in Michael Bruno, ed., Lessons of Economic Stabilization and Its Aftermath (Cambridge: MIT Press, 1991). 22Nordhaus (fn. 4); and Tufte (fn. 4). 23 Cukierman and Melzer (fn. 4); Rogoff and Sibert (fn. 4); and Torsten Persson and Guido Tabellini, Macroeconomic Policy, Credibility, and Politics (New York: Harwood Academic Publishers, 1990). 24Sebastian Edwards, “The Political Economy of Inflation and Stabilization in Developing Coun￾tries,” Economic Development and Cultural Change 42 ( January 1994). v56.1.043.schamis 3/2/04 4:29 PM Page 51