Realigning interests crisis and credibility in european monetary integration (europe in transition the NYU european studies series)

AN National Alliance Italy CERES Centre d’études de recherches et d’éducation socialistes France DC Christian Democratic Party Italy DM Deutsche mark EMS European Monetary System EMU Eu

Realigning Interests

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Realigning Interests: Crisis and Credibility in European Monetary Integration

By Michele Chang

Crisis and Credibility in

European Monetary Integration

Michele Chang

REALIGNING INTERESTS

© Michele Chang, 2004 All rights reserved No part of this book may be used or reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles or reviews.

First published 2004 by PALGRAVE MACMILLAN TM

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ISBN 1–4039–6438–6 hardback Library of Congress Cataloging-in-Publication Data Chang, Michele.

Realigning interests : crisis and credibility in European monetary integration / by Michele Chang.

p cm.—(Europe in transition) Includes bibliographical references and index.

ISBN 1–4039–6438–6

1 Currency crises—European Union countries 2 Monetary policy— European Union countries 3 European Union countries—Economic integration I Title II Europe in transition (New York, N.Y.) HG3942.C47 2004

To my family: Wayne, Adoracion, William, and Robert

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4.1 Ifop-RTL-Le Point poll on intentions to vote for the PS 854.2 Summary table of arguments on emergence of currency

4.3 Summary table of arguments on devaluation in France,

5.5 Poll: “Do you hope that in the next legislative

elections voters will manifest their support for Mitterrand and the current government or that the voters will use this occasion to manifest their discontent?” 1075.6 Summary table of French economic indicators,

5.7 Progress toward fulfilling Maastricht criteria: deficits and

5.8 Poll: Do you think the following personalities would

5.9 Intentions to vote in second round: Le Nouvel

5.10 Intentions to vote in the second round:

5.11 First-round results of the presidential election 1185.12 Second-round results of the presidential election 1185.13 Summary table of arguments on the emergence of currency

List of Figures

4.2 Quarterly current account balance, 1981 electoral period 64

4.4 One-month Eurofranc interest rates, 1981 electoral period 66

4.6 Quarterly current account balance, 1983 electoral period 73

4.8 One-month Eurofranc interest rates, 1983 electoral period 74

4.10 Quarterly current account balance, 1986 electoral period 82

4.12 One-month Eurofranc interest rates, 1986 electoral period 844.13 Ifop-RTL-Le Point poll: Do you have a good opinion or

4.14 Poll: Do you have a good opinion or bad opinion of

5.2 Quarterly current account balance, 1988 electoral period 92

5.4 One-month Eurofranc interest rates, 1988 electoral period 935.5 Le Nouvel Observateur polls: intentions to vote in the

5.6 Intention to vote in the second round,

5.7 Intention to vote in the second round,

5.8 Poll: Which of the following would make a good president

5.9 Monthly inflation rates, 1993 electoral period 1045.10 Quarterly current account balance, 1993 electoral period 1055.11 Monthly reserves during 1993 electoral period 1055.12 Eurofranc interest rates, 1993 electoral period 105

5.13 Summary of polls on intentions to vote (%)

5.14 Gallup-L’Express poll on approval of the prime minister 113

5.17 Monthly inflation, 1995 electoral period 1195.18 Quarterly current account balance, 1995 electoral period 1195.19 France monthly reserves, 1995 electoral period 1205.20 One-month Eurofranc interest rates, 1995 electoral period 1206.1 Italian elections and devaluations, 1979–1995 1266.2 French elections and devaluations, 1979–1995 1266.3 Current account balance and elections, 1979–1995 129

6.6 Real exchange rates and elections, 1979–1995 1327.1 Irish elections and devaluations, 1979–1996 1417.2 Annual current account balance as percentage of GDP,

7.3 Exchange rates and elections in Ireland, 1979–1983 1487.4 Quarterly current account balance, 1987 electoral period 1527.5 Quarterly current account balance, 1989 electoral period 152

xii ● List of Figures

AN National Alliance (Italy)

CERES Centre d’études de recherches et d’éducation

socialistes (France)

DC Christian Democratic Party (Italy)

DM Deutsche mark

EMS European Monetary System

EMU European Monetary Union

ERM Exchange Rate Mechanism

GDP Gross Domestic Product

MSI Italian Social Movement

OECD Organization of Economic Cooperation and

DevelopmentPCI Italian Communist Party

PD Progressive Democrat (Ireland)

PDS Democratic Party of the Left (Italy)

PRI Italian Republican Party

PPI Italian People’s Party

PS Socialist Party (France)

PSI Italian Socialist Party

PSDI Italian Social Democratic Party

RPR Rassemblement pour la Republique (France)

STF Short-Term Facility

TD Member of Parliament (Ireland)

UDF Union pour la Démocratie Française (France)

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My greatest debt is to my adviser, Stephan Haggard His guidance,

criticism, and encouragement made possible both my tation and the successful completion of this book I also offer

disser-my thanks and gratitude to the other members of disser-my dissertationcommittee: Neal Beck, Graham Elliott, Miles Kahler, Ross Starr, andKaare Strom

Others who have assisted me in various ways by reading drafts, ing me in the research process, or talking through some of the ideas with

help-me include: David Andrews, Bill Bernhard, the Bundesbank PressOffice, Benjamin Cohen, Harold Colson, Russell Dalton, PaulDeGrauwe, Jeff Frieden, John Freeman, Peter Gourevitch, Daniel Gros,Peter Hall, Mark Harmon, Erik Jones, Peter Katzenstein, Peter Kenen,David Lake, David Leblang, Arendt Lijphart, Ivo Maes, MatMcCubbins, Kate McNamara, Jacques Mélitz, Michael Moran, AndrewMoravscik, Thomas Oatley, Paul Papayoanou, Dennis Quinn, KevinRask, Larry Ryan, Jerry Sheridan, Pierre Siklos, Chris Way, and partici-pants of the 1995 Harvard Graduate Student Workshop, the 1995 APSAmeeting, the 1996 Conference of Europeanists, and the 1996 Institute

on Western Europe Graduate Student Conference I also thank all thosewho graciously allowed themselves to be interviewed for this book

I would like to thank the following organizations for providing mewith funding: the Ford Foundation, the Institute on Global Conflictand Cooperation, the Deutscher Akademischer Austausch Dienst, andColgate University’s Faculty Development Council The University ofCalifornia, San Diego and Colgate University provided the institutionalsupport necessary to complete this book I also thank my editors atPalgrave, Anthony Wahl and Heather Van Dusen, for their role in bring-ing this book to completion Venn Saltirov and Maura McClellandprovided excellent research assistance

The following individuals offered much needed and much ated support during the writing of this book: Stephen Applebaum, Alex Bergmann, Bob Bowman, Marci Bowman, Maureen Feeley, Bill

appreci-Griswold, Kathleen Hancock, Lisa Hilbink, Jamie Gerber, ChrisHarrison, Carolyn Hsu, Karen Leahy, Jennifer Smith, Cami Townsend,and Ali Yegulalp I would also like to thank the friends I made

in Europe, especially the Rothenburg Posse and my Dresden buddies,for renewing my interest in Europe and giving me reasons to keep going back

Finally, I dedicate this book to my family: Wayne and AdoracionChang, my parents, and my brothers William and Robert Through theyears, your belief in the importance of my education and your unwaver-ing support allowed me to pursue my interests, and I thank you for allthat you have done

CHAPTER 1

Introduction

Why do crises occur within fixed exchange rate systems? How

do governments react to currency pressure? With majorcurrency crises affecting both developed and developingcountries in the 1990s, identifying the variables that lead to currencycrises has become a major concern of both economists and politicalscientists While economic fundamentals play a large role in thesematters, an accepted model of currency crises has not yet been devel-oped because such conditions do not necessarily predict the timing, size,

or duration of currency crises

The onset of currency crises preoccupies analysts, but the resolution ofthese crises also illustrates important political and economic dynamics.Currency crises are not synonymous with devaluation; either can occur inthe absence of the other What determines when and if a government willdevalue?

Elections and political instability can provide at least a partial answer

to both of these questions First, we need to understand what factorscontribute to market valuations and make a currency vulnerable.Second, we must determine how and why a government responds tomarket attacks through either the defense of the currency, its devalua-tion, or both Currency crises expose critical political interests and haveboth international and national repercussions Thus it should not besurprising that many currency crises and devaluations occur during elec-toral periods, as government changes have serious consequences for thecountry’s policy direction and therefore future economic conditions.Monetary policy and other economic policies have the possibility ofchanging in ways that would alter future economic conditions andtherefore the sustainability of the exchange rate Factions within politi-cal parties jockey for dominance while competing parties and coalitions

do the same thing Differences between the relevant political actors areemphasized in order to distinguish policy objectives and to make a casefor why one party/faction should be the preferred choice of voters Thisendemic conflict in the political system during an election makes thecurrency vulnerable to market speculation due to the uncertainty itengenders about future policies and economic conditions.

Of course, neither currency crises nor devaluations occur in an national political vacuum Maintaining a fixed exchange rate within aregime such as the European Monetary System (EMS) (now EuropeanMonetary Union (EMU)) involves sharing credibility and resources.Participating countries draw on the resources and reputations of othermembers in order to buttress their own currencies Moreover, memberstates decide on exchange rate realignments collectively Therefore, theshared nature of crisis management and resolution make an understand-ing of the dynamics between the countries as important as those occur-ring within the state that precipitated the crisis Monetary cooperationhas always been connected with European cooperation in general, andthus has important repercussions for foreign policy

inter-This book argues that electoral instability generates market tion regarding the intentions of the future government A close election(or the lack of a dominant preference for a party/coalition) destabilizesmarket expectations and provokes currency speculation Despite suchmarket pressures, the incumbent government strives for continuity anddefends the currency until the election passes Devaluation becomesmore feasible politically after an election has passed, and the govern-ment is more likely to favor devaluation at this time, if at all Moreover,the government may be able to enlist the assistance of its allies in hold-ing off a currency crisis and in externalizing the adjustment costs Thishas important implications for theories of the international politicaleconomy as well as international cooperation in general

specula-The Economics and Politics of Exchange Rates

Explaining Currency Crises

The central premise of this book is that explanations of exchange rateinstability must incorporate political analyses that can explain the timingand severity of an exchange rate crisis Economists have conducted thebulk of the work on exchange rate crises, and the same economic factors

do not necessarily play the same role in each crisis Current theoriesalso lack a sense of when a currency crosses a critical threshold that

determines that economic conditions no longer support a givenexchange rate.

The first-generation work has focused on economic fundamentals asthe main cause of currency instability As the government’s policiesbecome inconsistent with the maintenance of a given exchange ratelevel, the defense of the currency depletes reserves until devaluationbecomes necessary (Krugman 1979) Though some argue that economicfundamentals continue to drive exchange rate crises (Bordo andSchwartz 1996; Goldstein et al 2000), others counter that a singleexchange rate equilibrium does not exist Therefore, economic funda-mentals can support a range of different exchange rate values, providedthat markets expect the government to support those rates; governmentsstill retain considerable autonomy when making policy, despite risingcapital mobility (Lukauskas and Minushkin 2000; Mosley 2000) But ifthe exchange rate is attacked, it may not be sustainable, even in theabsence of appreciable differences in economic fundamentals (Obstfeld

1986, 1996) This idea of a self-fulfilling speculative attack implies thatmarket expectations may be at least as important in explaining currency

crises as economic fundamentals Government credibility becomes

criti-cal, and this necessarily hinges on politics Market expectations of policychange can have a similar effect to an actual policy change as marketsattempt to ascertain future economic conditions based on these expec-tations If the market expects inflation to continue in a high-inflationenvironment, these expectations lead to the selling of and depreciation

of the currency, which in turn exacerbate inflation If markets believe agovernment will act a certain way in the future, investors will try to actfirst so as not to be caught by surprise

Can governments control or at least influence these expectations?Economists and political scientists have constructed a myriad of explana-tions regarding what makes an exchange rate credible One of the primarytheories is that institutions, specifically and independent central bank,contribute to government credibility by removing incentives to generatesurprise inflation or to manipulate the economy for political motivations

By removing monetary policymaking from the hands of politicians,governments delegate authority to a body with preferences geared towardprice stability rather than short-term political gains (Cukierman 1992).Though institutional attributes like central bank independence mayaffect the general trajectory of the exchange rate (with higher degrees ofcentral bank independence associated with lower inflation and astronger currency), such structural characteristics explain neither theonset of a currency crisis nor its resolution For example, countries like

France and Britain had politically weak central banks during the 1980s;they also were prone to a greater number of currency crises and hadweaker currencies than countries with stronger central banks such asGermany France and Britain were not, however, in a perpetual state ofcrisis Though economic fundamentals may have been weak (high infla-tion posed a particularly vexing problem), pressure to devalue generallycame suddenly, as demonstrated by rapid flight of capital in the wake ofSocialist François Mitterrand’s 1981 electoral victory The institution(a weak central bank) remained constant, but the currency and threat ofcrisis did not: what happened?

An alternative explanation of currency credibility rests on partisaninterpretations of policy formation (Leblang and Bernhard 2000).Empirical analysis shows that macroeconomic outcomes have class-related distributional effects in Britain, which have consequences for thesupport of political parties (Hibbs 1982) Left governments preferhigher growth while conservative governments favor price stability; leftgovernments may therefore be prone to implementing policies thatwould reduce price stability In the aforementioned example, the transi-tion in France from a conservative president to a Socialist presidentoccurred concurrently with exchange rate pressure

Another societal explanation emphasizes sectoral interests that maydefy traditional partisan interpretations of policy, as exchange rate levelsand volatility have differential effects on various economic sectors(Frieden 1991) Actors extensively involved in international trade, forexample, would prefer exchange rate stability despite the loss of mone-tary sovereignty Domestically oriented sectors, on the other hand,would rather the government not fix the exchange rate and thus retainthe ability to form an independent monetary policy Moreover, addi-tional conflict may arise due to divergent interests on the level ofexchange rates

Partisanship and explanations based on the preferences of variouseconomic sectors, however, also fail to explain the timing of currencycrises Like institutional measures of government credibility, societalaccounts of exchange rate determination do not consider the rapiditywith which markets overturn previously accepted exchange rates Whydid the Mitterrand election provoke capital flight in advance of theformation of any policies or abrupt changes in economic conditions?Understanding exchange rates requires an explanation not only of long-run determinants of currency valuation but how and why markets asso-ciate political change with economic change

Elections and changes in government can cause markets to shiftexpectations regarding future policy Elections also affect exchange ratesbecause they alter the current government’s willingness and ability tomaintain the exchange rate (Bernhard and Leblang 1999, 2002; Leblangand Bernhard 2000) In Latin America, for example, the probability of alarge depreciation during normal times is only 3.84 percent This figurefalls almost 40 percent immediately prior to elections to 2.66 percent,indicating that incumbent governments prefer not to devalue before anelection, but the probability then jumps to almost 10 percent followingthe inauguration of a new government, which may have different prior-ities and constituents (Frieden and Stein 2001: 15–16) Such behaviorcan also be seen in European countries for similar reasons.

When a change in government is at hand, market expectations ofthe incoming government’s preferences regarding the exchange rate can

be divided into three probabilities: (1) government preferences will beunchanged, (2) government preferences will change, or (3) governmentpreferences are unknown

In the first case, there is no reason to expect a correlation betweencurrency crises and political instability caused by the election or change

in government; any crises that occur in this instance would be attributed

to other factors The second and third instances, however, presentmarkets with a challenge as to how to protect investments and circum-vent any losses that could be generated by potential policy changes

If markets expect the new government to have different preferencesthan the most recent government, this provides forward-lookingmarkets with the incentive to act on this information in advance of theactual change in government The incoming government may represent

a different constituency than its predecessor, which could alter the level

of the exchange rate or even lead to the abandonment of a fixedexchange rate system altogether, depending on how the existing systemaffects the interests of the politically favored sectors The aforemen-tioned Frieden argument considers the different effects that fixed versusflexible exchange rates have on various economic sectors in detail(Frieden 1991, 1994) The effect of these expectations can be eitherpositive or negative in terms of the strength of the exchange rate Theexpectation of a government committed to price stability and a strongcurrency, for example, could bolster the exchange rate as easily as theopposite expectations could lead to capital flight Thus the direction ofthe exchange rate can vary depending on the interests of the futuregovernment

As noted earlier, this process need not be limited to elections but mayalso apply to changes in government (Bernhard and Leblang 2002;Leblang and Bernhard 2000) A factional change in either the rulingcoalition or ruling party could result in exchange rate instability Within

a coalition government, the parties in the coalition could change or therelative strength of the parties could shift in a way that favors differenteconomic policies Even within a government composed of similarparties in terms of left–right differences, substantial conflict can emergeover policy as elections and government changes can consolidate power

in favor of one faction or another

The government’s strength and coherence indicate its ability not only

to cope with a crisis swiftly and resolutely, but also its capacity to ate policy adjustment If the crisis erupts after a period of deterioratingeconomic fundamentals, the government may be reluctant to stabilizethe economy because of the distributional consequences (Alesina andDrazen 1991) Also, this may make it difficult for a party to claim creditfor formulating popular economic policies and implement tough choicesprior to an election (Frieden 1997) Thus stabilization would be delayeduntil one side emerges as politically dominant and therefore may imposethe costs on the other side

initi-In addition to these problems, markets must also contend with thepossibility of not knowing the incoming government’s preferences Thismight stem from uncertainty regarding the outcome of the electionand/or the composition of a coalition government This political insta-bility creates a bias in forward exchange rates that indicates the shift inmarket expectations as market actors try to make adjustments in antici-pation of government changes (Bernhard and Leblang 2002)

Thus expectations of changing government preferences or tainty surrounding government preferences could cause changes withregard to exchange rates that are less related to economic conditions thanearly economic analyses have indicated Even with the absence of chang-ing economic conditions or official policy changes, forward-lookingmarkets can drive currency fluctuations during politically uncertaintimes Variables relating to electoral instability reduce the government’scredibility and influence market expectations A country undergoing anelection with either an uncertain outcome or an outcome expected tochange the direction of monetary and economic policy will be vulnera-ble to currency speculation

uncer-The aforementioned arguments assume that markets look forward asthey act on their expectations of future economic conditions.Presumably voters and other relevant actors could also see through any

attempts at preelectoral manipulation of the economy and negate itseffects This contrasts with the pre-rational expectations revolutiontheorists (Nordhaus 1975) who argued for myopic voters who regardedthe government’s past record (rather than expectations of future deeds)

as the basis for evaluation The possibility of contrariety between pastperformance and future expectations presents an interesting conundrumfor analysts: if an economy weakens relatively gradually and a currencycrisis occurs during a period of government transition, to what extentcan the crisis be attributed to economic fundamentals as opposed to thechanging political conditions? For those who advocate an explanationbased on economic fundamentals, the question becomes one of timing.Did the conditions reach that unknown threshold that made a currencyunsupportable at its current rate, or did a crisis occur in reaction topolitical instability? Did political factors act as catalysts that precipitated

an economic crisis? Or alternatively, can political factors calm tially volatile market forces? The “correct” policy and institutional mixcould prevent elections from triggering market jitters Domestic as well

poten-as international political factors can affect market speculation bothpositively and negatively

The prospect of international cooperation in managing exchange ratelevels can impact the onset and duration of a crisis Participation in aninternational regime like the EMS can stave off speculative attacks byboosting the credibility of the currency peg First, joining a multilateralorganization sends markets a signal of what type the government is.Governments publicly proclaim their commitment to exchange ratestability (and whatever other goals are involved in membership), and thepublic nature of joining an exchange rate regime enhances the credibil-ity of the pronouncement by raising the cost of defection Membershipremoves the ambiguity surrounding government goals and providesgovernments with a clear blueprint for action International obligationsconstrain national policymakers’ ability to implement partisan policiesthat could result in an electoral cycle (Lohmann 1993)

Second, exchange rate fluctuations are extremely easy to monitor anddeviations are very easy to spot Deviation in the case of an exchangerate commitment is particularly costly because devaluation decisions aremade jointly The government and central bank have partially delegatedtheir authority to the international institution, making markets morelikely to believe in the government’s policy Realignment negotiationscan become heated and it is within a government’s rights to requestanother government to make costly concessions in exchange for realign-ment A government may agree to cut public spending, for example, in

order to secure a realignment agreement from its partners Cheating isdifficult when one is dealing with the exchange rate, and retribution ispossible for other countries if a partner slacks with regard to its commit-ment The government can lose influence within the international orga-nization and possibly risk exclusion It can also lose any side-paymentsthat the government enjoyed while being a member of the system.Third, audience costs raise the stakes for governments consideringbreaking an international obligation (Fearon 1994; Martin 1993) arehigher The international audience is larger and failure is highly visible.Exchange rate fluctuations demand attention in a way that they did notwhen the rates were floating Frequent realignments signal the weakness

of a government and its inability to maintain its commitment Althoughrealignments are technically permitted, if it happens too frequently itgoes against the spirit and purpose of the agreement, which is to create

a zone of monetary stability and to encourage the convergence of tary policy A fixed exchange rate system would become worthless ifcurrencies were realigned too readily because it would neither strengthen

mone-a government’s credibility with mmone-arkets, nor would it promote economiccoordination among participants

Furthermore, membership in a regime can also benefit a countrysuffering from a currency crisis If a country has access to additionalfunds via international arrangements, which countries participating inthe EMS did, this augments their power and increases the ability todefend against speculative attacks by increasing available reserves

Explaining Devaluation

While market expectations (based either on current conditions or tations of future ones) affect the timing of currency crises, do they alsodrive devaluation? According to rational expectations theory, marketsshould be able to anticipate any opportunistic behavior on the part ofgovernments and to neutralize their effect For example, in the politicalbusiness cycle literature, rational expectations prevent governmentsfrom successfully generating economic cycles to create a preelectionboom because markets and the public would be able to anticipateopportunistic behavior given past behavior (Cukierman and Meltzer1986) If this were the case, one should not expect governments toengage in opportunistic behavior regarding the timing of the devaluationeither If markets and the public could predict that a government woulddevalue after an election, the government would not be able to fool themotherwise Henceforth, the government would not have the discretion topush the devaluation to a more politically palatable time period

However, the electoral process adds a considerable amount of noise tothe development of rational expectations when the preferences of theincoming government are uncertain due to a close election or uncer-tainty about the composition of the constituents A government maytherefore have some leeway with regard to the timing of the devaluation;after all, an election may cause devaluation to be more likely, but it doesnot make it a certainty Governments may also be able to engage in someopportunism when it comes to devaluation They can retain an infor-mation advantage that allows them to engage in cyclical behavior based

on elections (Rogoff 1990; Rogoff and Sibert 1988a,b) or partisanship(Alesina and Roubini 1990; Alesina et al 1997)

Whether or not a government will do this depends on the audiencethat a government targets On the one hand, defending the exchangerate could involve rising interest rates and slower economic growth,neither of which would be popular before an election On the otherhand, changing a major policy like the exchange rate parity shortlybefore an election could send negative signals regarding the govern-ment’s competence in managing the economy After all, why would acurrency be under attack if the government were able to make theeconomic fundamentals support the exchange rate?

This indicates that there are three possible audiences for governmentactions during periods of election and government change: markets,primary constituents, and voters Whichever audience the governmentdecides to target could yield different policy outcomes at different times.The question becomes: Why does a government devalue or not devalue,and under what circumstances?

In the first instance, the government could respond to exchange ratepressure as a challenge to currency markets By defending the exchangerate vigorously, the government could try to signal that market estima-tions regarding either the government’s unwillingness or its inability todefend the exchange rate were mistaken, and that the government isindeed committed to seeing the continuation of current exchangerate policy Much has been made of the power of global capital to influ-ence policy and to create incentives for governments to implementsimilar policies so as to attract or at least not drive off international capi-tal (Goodman and Pauly 1993) If the government does not manipulatepolicy for electoral advantage, there should be no reason why devalua-tion should occur at election time more than at any other time.Next, there is the issue of coalition costs Exporters, particularly largebusinesses, have traditionally supported governments of the right whilethe more domestically oriented groups such as labor generally vote forthe left Business interests prefer low inflation, and exchange rate pegs

are one way of achieving this Thus, if the primary constituents were themain targets of government response, one would expect governments ofthe right to be less likely to devalue because this would disrupt exchangerate stability and alienate one of its core constituencies On the otherhand, left-wing parties may be more amenable to breaking an exchangerate peg because it does not benefit from fixed exchange rates and in factlabor suffers from the economic adjustment needed to maintain it(Leblang and Bernhard 2000; Simmons 1994) Partisan effects can bemuted, however, by institutional mechanisms such as an independentcentral bank or exchange rate commitments (Clark et al 1998).Finally, governments could target voters when responding toexchange rate crises Devaluation so soon before an election could indi-cate to the electorate that the exchange rate policy was a mistake, or thatthe government was incapable of carrying it through A governmentwould be particularly vulnerable to such charges if the economy reallywas in a weak state and/or the reelection of the incumbent governmentwas in jeopardy, for devaluation would confirm economic mismanage-ment Market intervention can have a paradoxical effect an electorate’sperceptions of government competence For example, intervention mayremind voters of negative economic conditions (Alt 1988: 243): in order

to intervene in the economy so that it will be better later, the ment must first call attention to the fact that there is a problem Thevery act of intervention indicates that something is wrong with theeconomy

govern-When a government makes a bid for reelection, it is apt to engage incredit-claiming and position-taking to enhance its prospect (Mayhew1974) In credit-claiming, a government tries to assert its responsibilityfor causing a desired outcome—such as economic growth—in order toboost support for its reelection bid When a government engages inposition-taking, it asserts its stance on politically relevant issues, like anannouncement that it will defend the exchange rate or pursue pricestability Both credit-claiming and position-taking become nearlyimpossible during market speculation The unstable markets send asignal that there is a problem with the economy, justified or not Thegovernment wants to celebrate its track record and its accomplishmentsbefore an election, not begin new policies that will confuse voters andmarkets Governments use exchange rate pegs because they are moretransparent than other mechanisms like central bank independence(Broz and Frieden 2001: 13; Broz 2002); as a result, “politically, theword ‘devaluation still carries a notion of defeat’ ” (Ungerer 1997: 175),making “devaluations cost votes” (Mélitz 1988: 58) Moreover, the

government would likely not benefit from any positive effects of uation until after the election The fall in exports and outputs due to thestronger currency (also known as the J-curve effect) would not happenfor months.

deval-Governments therefore have stronger incentives to postpone ation until after election (Frieden 2001; Klein and Marion 1997; vander Ploeg 1989) This allows governments to defer difficult questions ofadjustment (Alesina and Drazen 1991) and to defend its economicrecord and the exchange rate After the election has passed, however, theincoming government could try to shift blame for the devaluation onthe previous administration

devalu-The Outline of the Book

Chapter 2 summarizes the operations and the development of the EMS,and it places monetary cooperation in the context of European integra-tion The European playing field is not level, and some economies aremore vulnerable than others due to different economic and politicalstrengths Economic power obviously confers advantages on a country;greater resources make the currency less susceptible to an attack in thefirst place and improve its chances of surviving the crisis Political powerrefers to the influence a country has in the EMS and its ability to exter-nalize the costs of adjustment The bilateral parity grid of the EMS indi-cates that a currency crisis affects both a strong currency (such asGermany’s DM) and a weak currency, driving their currencies in oppo-site directions The onus of adjustment falls more on the country withthe weaker currency because it depletes its reserves that would be needed

to prop up the currency Once the crisis reaches a point where tion is preferable to defense, then all of the EMS countries negotiate theterms During this process, currencies not involved in the original crisiscan become part of a collective adjustment A country with a weakercurrency like France can externalize some of the costs of the devaluation,not just onto Germany but onto other countries as well Its ability to do

devalua-so is a function of its power and influence within the EMS and theEuropean Community (EC)

Chapter 3 is a quantitative study of currency crises and devaluation

An economic model developed to explain currency instability inexchange rate “target zones” like the EMS discerns the relative impor-tance of economic and political variables in the onset and resolution ofcurrency crises First, a pooled time-series analysis of currency crisesfrom 1979 to 1993 (the period known as the ERM I) establishes that

currency crises coincide with electoral periods Time series regressionsfor each country supplement this section, allowing one not only to drawinferences from a large number of cases but also to situate each countryand currency crisis within a specific political environment After explor-ing the economic and political causes of currency crises, another regres-sion uses the same variables to determine the sources of exchange ratedevaluation This target zone model adds political variables to test howpolitical variables like electoral cycles and government coherence affectthe timing of devaluations.

Chapters 4 and 5 consider the electoral impact of the French ment, not only on the franc but also on the other EMS currencies Thefluctuations of the franc–DM exchange rate drive the EMS becauseFrench participation distinguishes it from being a strictly mark zone (asthe snake eventually became) and makes the EMS a possible platform forfurther cooperation and integration Without France the Germans wouldnot have proceeded with monetary integration and would have been lesswilling to adjust its own policies to suit the needs of the EMS Frenchpower and influence in the EC also manifested itself in France’s uniqueability to externalize its exchange rate adjustment French currency crisesnot only correlate with French elections but also with the general realign-ments of the EMS These general realignments were enacted to placateFrance and to ease the stigma associated with devaluation by making it aEuropean problem rather than a strictly French problem

govern-Chapter 6 considers the politics of another major player in theEuropean Union (EU)—Italy—in determining the timing of a currencycrisis The connection between political instability and currency insta-bility will be examined and contrasted with the French experience.Though the Italian economy is not substantially smaller than the Frencheconomy, the Italians have wielded considerably less influence inEuropean integration (and monetary cooperation) Italy, therefore, hasfound itself more often on the receiving end of currency contagion andrequests for devaluation Currency crises based on changing domesticpolitical expectations were unlikely because the same parties dominatedItalian politics for most of the postwar period The changing nature ofthe party system in the mid-1990s and the effort to make the first round

of monetary union made politics a relevant factor by 1994 Thus theItalian system began to exhibit similar political imperatives to theFrench system with regard to competition for policy credibility andperceived economic competence

Chapter 7 evaluates the experience of a smaller country, Ireland.Like Italy, its party system did not have the clearly defined partisan

competition found in France for the last two decades Currency crisesbased on changing political expectations were also be muted by the size

of the Irish economy and its vulnerability to outside shocks Despitethese constraints, the Irish government not only found itself on thereceiving end of devaluation requests from other Member States, but in

1992 it also found itself in the position of fending off a speculative attack

on its currency shortly before an election Political developments—both external and internal—had the power to drive currency marketdecisions and government responses in states of varying size, power, andopenness

Chapter 7 considers the implications of these currency crises forEurope under monetary union as well as for non-European states Theexpansion of Europe and eventually EMU eastward makes such crises acontinued issue of concern, as they will be vulnerable to similar marketpressures prior to EMU membership

Summary of Findings

This study traces the evolution of the EMS and how domestic and national political concerns increasingly dominated the occurrence andresolution of currency crises Countries facing uncertain electoral results

inter-or elections that could change the course of policy will find their cies vulnerable to speculation, whereas countries with predictableoutcomes or outcomes that would not change major policies will not besubject to such currency instability The timing of devaluation coincideswith the consolidation of political power after an election becauseelections frequently incur other policies of adjustment (see table 1.1 and 1.2)

curren-Why should the origins of European exchange rate crises concern us

in the wake of Economic and Monetary Union? The eastward expansion

of the EU and the choice of several governments not to participate inmonetary union make the question of currency crises of current rele-vance Understanding the domestic and European origins of currencycrises will provide analysts with a guide to what the new EU membersmay encounter as they struggle to bring their economies up to par prior

to EMU membership

Currency crises are not unique to Europe, and despite substantialdifferences in financial infrastructure and economic development, manycurrency crises may also be explained by government instability Theinability to predict the onset, length, and severity of crises on economic

fundamentals alone indicate the government’s willingness and ability tohandle a crisis could be a determining factor explaining such crises.Finally, this question of currency instability involves a larger issue ofmonetary cooperation and cooperation in general When a government

Table 1.2 Summary of arguments to be tested: theories of devaluation

Reasons for devaluation Indicators Timing of devaluation

(if any)

Governments target markets Defense of currency by None

incumbents and new governments Governments target primary Partisanship Defense of currency by

incumbent or new; devaluation by left, incumbent or new Governments target voters Defense by all incumbents After election; when no

election looms Systemic pressure General or shared realignments According to the

realignment needs of the strong states in the EMS

Table 1.1 Summary of arguments to be tested: theories of currency crises

Theories of currency crises Independent variables Implications for the

exchange rate

Economic conditions Indeterminate combination of Weaker economic (backward-looking) economic variables conditions lead to a

weaker currency Partisanship Left governments likely to prefer Current right government (backward-looking) policies with inflationary has a stronger exchange

government Expectation of policy Expected new government, new Expected right

change (forward-looking) party/partisanship government leads to a

Changing coalition stronger currency Policy uncertainty Uncertain polling results Currency volatility; (forward-looking) Coalition governments tendency to err on selling

currency rather than holding

devalues its currency in the context of an international arrangement likethe EMS, this decision affects other members and must be resolvedjointly The factors that alter a country’s ability to uphold one policy(like a fixed exchange rate) may similarly affect its ability to maintainother international commitments Moreover, the joint nature of credi-bility and the ability of countries to externalize adjustment costs across

an international organization like the EU can be applied to a variety ofregimes As we shall see, power, issue-linkage, ideas, and the institution-alization of interests all play a role in European monetary cooperation

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CHAPTER 2

Rules and Norms of European Monetary Cooperation

Explaining European Monetary Cooperation

What drives monetary integration? Countries can participate

in a variety of systems, ranging from general statements ofsupport for economic cooperation and policy coordination,

to the extreme case of monetary union A fixed-but-adjustable exchangerate peg like the EMS fell in between these two poles by offering partic-ipants some flexibility In the EMS, countries were able to periodicallyrealign the exchange rate to adapt to changes in the monetary environ-ment Under the best of circumstances, this would mean that partici-pants would enjoy the benefits of exchange rate stability such asenhanced trade and investment flows due to the removal of exchangerate uncertainty, without entirely sacrificing the exchange rate as anadjustment tool The delegation of monetary policy to a more credibleinstitution than a national finance ministry or a national central bank(such as the central bank of another country within the exchange rateagreement) also could make monetary policy announcements morecredible, thus allowing lower interest-rate premiums and making iteasier to achieve price stability

Monetary union both offers more rewards and poses more risks forcountries On the one hand, monetary union eliminates the risk ofexchange rate pegs becoming less credible against one another andgenerating speculative attacks against their respective currencies (as theyshare a single currency) When an arrangement demands financialsupport from participating governments (as the EMS did), marketspeculation can be quite costly for both the country with the weak

currency and the country with the strong currency A single currencyalso offers the region greater autonomy in the international monetaryrealm and makes it less prone to fluctuations from other currencies Thispromotes trade within the region, further strengthening the ties betweenthe countries and potentially leading to the synchronization of partici-pating economies and their business cycles (Frankel and Rose 1998).These positive effects of monetary integration contribute to furtherregional cooperation and lead to even more intra-regional trade andinvestment.

On the other hand, monetary union removes the exchange rate as atool of adjustment because it demands a single monetary policy If thecomposite regions are not sufficiently integrated, economic shocks thataffect the region asymmetrically cannot be offset with exchange ratechanges Economic theory therefore points to the importance of statesthat share a currency to form an optimum currency area (Mundell 1961)

If a region forms such an area, this indicates that a single monetarypolicy could be used in the adjustment process for an economic shockthat affects the region similarly; or, in the case of an asymmetric shock,that adjustment could be facilitated via labor mobility or with the use offiscal transfers High labor mobility and the ability to make fiscal trans-fers are thus two potential indicators of an optimum currency area,along with the trade patterns of the constituent components of the areaand the level of synchronization of business cycles Though economistshave argued that the existing members of EMU did not form such anoptimum currency area (Eichengreen 1992a), the intensified tradepatterns and expected higher correlation of business cycles in a post-EMU environment could rectify this situation in the future (Frankeland Rose 1998)

However, though monetary integration can offer these benefits thatultimately lead to greater trade and investment and therefore betterlong-term growth prospects, in the short to medium term there will beactors whose interests may be harmed by such exchange rate commit-ments and will try to impede its progression At the international level,some states will benefit more than others because they will pay fewercosts while enjoying the benefits Fixed exchange rate systems have lead-ers (also known as the anchor) and followers The anchor currencycan make monetary policy without regard to the monetary policy of thefollowers (known as the “n minus one problem” in the economicsliterature) Costs to the anchor currency vary according to the type

of commitment it has made to other countries in the exchange rateagreement In the case where a country unilaterally pegs its currency to

another (which some countries in Latin America have done to the U.S.dollar), the anchor currency pays no costs But if the government of theanchor currency agrees to support other currencies and adjust its policiesfor the sake of an exchange rate agreement, this can entail substantialcosts The country could suffer from a loss of currency reserves used tobuy and sell currencies in order to keep them within the exchange rateagreement It may also suffer from the implementation of an inappro-priate monetary policy (normally in the form of interest rate changes)for that country’s particular economic circumstances.

The follower countries must adjust their monetary policy in order tosupport the exchange rate, a situation referred to as the “unholy trinity”

in which countries may choose only two out of the following three:monetary sovereignty, capital mobility, or fixed exchange rates (Cohen

1993, 1996) The extent to which a follower country will be willing to

do so depends in part on the degree of openness of the economy, withmore open economies suffering more from exchange rate turbulence andenjoying little monetary independence anyway

While these structural factors indicate when monetary cooperationwill become more or less likely, political factors often determine thetiming and the terms of the cooperative arrangement Changing exter-nal circumstances can affect domestic calculations and make monetarycooperation more desirable Alternatively, changing internal circum-stances also can drive countries toward more cooperation as changinggovernment coalitions pursue different policies than their predecessors.Likewise, changing internal events can tip the balance of power towardpolitical actors that favor a fixed exchange rate and its benefits (such astrade effects and price stability) over monetary autonomy The incorpo-ration of monetary integration within the framework of European inte-gration provided additional incentives that favored participation, andthese incentives increased over time with rising capital mobility and thedynamics of the creation of the internal market, as well as the politicalexigencies caused by the end of the Cold War

In the case of European monetary integration, we see changing externalcircumstances, namely the instability of the U.S dollar in the 1960s,driving the participants of the EC into monetary cooperation in anarrangement known as the Snake This fixed exchange rate system envi-sioned the economies coming together in a monetary union by 1980,although this did not come to pass Countries dropped in and out of theexchange rate arrangement when the adjustment burden became costly,thus opting for monetary sovereignty over the fixed exchange rate Theexceptions were the German mark and a small group of countries that

depended on the German economy for much of their trade, a group thatbasically turned the Snake into a mark zone in which participantsfollowed the movements of the DM (Gros and Thygesen 1998: 16–19;Tsoukalis 1977: 181) Generally speaking, however, the pegs were there-fore not credible and did not serve as a basis for trade and investment, orfor further European cooperation By the early 1970s the EC fell into astate known as “Eurosclerosis” during which cooperation stagnated.External events continued to drive monetary integration later thatdecade, as the dollar’s continued volatility and the desire to jump startEuropean cooperation led to the creation of the EMS in March 1979.This came about through the work of German Chancellor HelmutSchmidt, French President Valéry Giscard d’Estaing, and EuropeanCommission President Roy Jenkins Jenkins proposed the idea of renew-ing monetary cooperation in the hopes of reawakening Europeanintegration (Giscard d’Estaing 1988; Jenkins 1989; Ludlow 1982;Schmidt 1990) The purpose of the EMS was to create a “zone of mone-tary stability” in the wake of the large exchange rate fluctuations thatfollowed the end of the Bretton Woods regime and the first oil crisis.These fluctuations exposed Germany to currency instability and theprospect of imported inflation This instability also wreaked havoc withthe Common Agricultural Policy, a treasured benefit of EC membershipfor the French (Giavazzi and Giovanninni 1989: 11–19).

The EMS offered France and Germany political and economicopportunities that they could not achieve on their own Monetary coop-eration offered France the chance to offset what it viewed as an irre-sponsible American monetary policy An exchange rate arrangementembedded within European integration also provided the Conservativegovernment, led by Prime Minister Raymond Barre, with a scapegoat forits austerity policies Monetary cooperation gave Germany the chance tostabilize its exchange rate with some of its major trading partners and topromote its interest in European cooperation But relevant actors withinGermany gave a mixed reaction to the prospect of European monetarycooperation Schmidt argued that the EMS could prevent the excessivedepreciation of the French franc and the Italian lira (De Cecco 1989:89), which would hurt the competitiveness of German firms The chem-ical and steel industries, for example, had been losing market shares

to competitors because of the strong mark; these industries reacted tively to the prospect of exchange rate stabilization (De Cecco 1989:89) The banking community, however, expressed divided opinions onthe subject, and, “although privately hostile, in public, the Bundesbankdid not reject the system outright” (Henning 1994: 187)

Schmidt reportedly threatened to revoke the Bundesbank’s dence if it did not agree, claiming that the EMS was a matter of highpolitics The EMS and monetary integration were essential aspects offoreign policy, and Schmidt made its political significance clear fromthe beginning He even attended a meeting of the Bundesbank CentralCouncil in Frankfurt to plead his case, an unprecedented act thatindicated that the political stakes were very high (Henning 1994: 188).The Bundesbank and the government formed a truce in the informalagreement known as the “Emminger Letter”: in exchange for not inter-fering with the establishment of the EMS, the Bundesbank retained theright to discontinue intervention if it threatened the German moneysupply (Heisenberg 1998: 63–5; Henning 1994: 188–9) ChancellorSchmidt essentially agreed not to compromise the Bundesbank’sindependence for the sake of European integration.

indepen-This act set the tone for the rest of development of the EMS, asindependence from political interference in the setting of monetarypolicy was seen as the key to credibility If monetary policy could cred-ibly be de-coupled from political considerations, such as with thedelegation of policy to an independent central bank, governmentswould supposedly enjoy greater price stability and exchange rate stabil-ity without painful costs like high interest rates Decision-making would

be delegated to the German Bundesbank, and later plans would be madefor a European-wide version of the Bundesbank The development ofthis norm will be discussed in greater detail later in this chapter.However, these norms did not evolve until several years after theinception of the EMS The EMS was clearly a political project, initiated

by politicians at the highest levels in a setting that deliberately excludedcentral bankers until relatively late in the process The political nature

of the EMS and its relationship to the EC was exemplified by itsmembership: all members of the EC were automatically officialmembers of the EMS and participated in the European Currency Unit(ECU), a basket of currencies Members were not obliged to participate

in the fixed exchange rate commitment of the EMS, known asthe Exchange Rate Mechanism (ERM) Thus Britain had been anofficial member of the EMS since it began in 1979, but it became amember of the ERM in 1990 when it committed the pound to a fixedexchange rate.1

The early period of the EMS was marked by frequent realignments,and for the most part they involved just Germany and one other coun-try European governments did not make a concerted effort to coordi-nate policy, and there was no overt linkage between EMS membership

and other aspects of EC membership Domestic issues still dictatedgovernment decisions; Belgium, Denmark, and France all devaluedwithin months of their respective legislative elections The underlyingcause was the eroding competitiveness of their economies, but theimmediate cause could be linked to their changing political landscapes.While the Belgians dealt with rising government subsidies, the Danishand French governments had to contend with the influence of unionsover the government and Socialist parties that advocated monetary andfiscal laxity.

The EMS was originally designed to make the burden of adjustmentmore equitable between the weak currency country and the strongcurrency country, but these institutional innovations fell into disuse,and by 1983 Germany had assumed a de facto leadership position in theEMS The 1981 and 1982 devaluations of the French franc began asbilateral negotiations between the French and German delegations, withFrance turning to Germany for devaluation before asking the MonetaryCommittee Chancellor Schmidt agreed to revalue the mark in exchangefor some promises of policy change by the French government, which

began the U-turn of the French Socialist government’s l’autre politique.

This policy program had attempted to buck the European and Americantrend of monetarism in favor of Keynesian policies

Internal factors (primarily the weakening of the Communist Party inthe French government) strengthened the faction in the French govern-ment that supported exchange rate stability within Europe and allowedmonetary cooperation to intensify By 1983 the Socialist U-turn wascomplete, and the French government had done a 180-degree turn awayfrom its original 1981 policy objectives German emulation was seen asthe key to stability and prosperity (McNamara 1998, 1999) The DM’sfluctuations had normally been relatively small, and the Bundesbankguarded against the erosion of its competitiveness The size of theGerman economy also made it a natural reference point for othercurrencies, and its strength served as proof that German economicpolicy was superior

After the 1983 realignment, the EMS went into a new phase ofdevelopment that was characterized by fewer realignments and greaterconsultation between governments on realignment decisions January

1987 marked the last EMS realignment for over five years, not ing the devaluation of the Italian lira in January 1990, which was done

includ-in conjunction with the currency’s move includ-into the narrow bands Durinclud-ingthis period the bands “hardened”; no realignments occurred, andthe currencies began being treated as if the exchange rate pegs were

permanent (Frankel and Phillips 1992) A growing sense of “Europhoria”was heightened by the burgeoning plans for the single market By the late1980s, enthusiasm for a truly free trade union had spread to createrenewed interest in monetary union.

In 1989 the Delors Report was published, outlining a plan foreconomic union Though this report was not the first such plan drafted

by the EC, the events of 1989 gave the plan a sense of urgency lackingfrom previous initiatives The prospect of German unification and theend of the Cold War made it necessary to reexamine the direction andpace of European integration to ensure that the EC survived thesetumultuous events (Sandholtz 1993) At the end of 1991 the heads ofstate and government of EC members met in Maastricht, and the result

of their dialogue was the Treaty on European Union (also known asthe Maastricht Treaty) The centerpiece of this treaty was the plan formonetary union

The political roots of the Maastricht Treaty rested in Germany’s desirefor unification, France’s desire to harness Germany’s power, and thedesire of all EU nations to finally enjoy monetary credibility, lower inter-est rates, and greater stability (Dyson and Featherstone 1999) Whilecountries participating in the EMS enjoyed more exchange rate stabilityand took advantage of rising trade opportunities with one another,monetary union offered additional advantages Transaction costs would

be even lower under a single currency than under a fixed exchange ratesystem that still required hedging With the Single Market due forcompletion in 1992, a single currency seemed to be a natural step inconsolidating its benefits (Emerson et al 1992) The interest rates andinflation rates of EMS countries also had converged substantially,indicating a possible endogeneity of the creation of an optimum currencyarea: greater trade and monetary cooperation made the economies moresimilar to one another, thus reducing the costs of giving up nationalcurrencies There also would be greater transparency in prices, whichwould make firms more competitive both with one another and outsidethe region Politically, monetary union provided a potent symbol ofEuropean cooperation and unity in the aftermath of the end of the ColdWar and gave the EC direction during a politically charged time (Baun1995–1996, 1996) In addition, rising capital mobility during the 1980shad further eroded governments’ ability to pursue independent monetarypolicy and made currencies more vulnerable to speculation, as the EUdiscovered in 1992 Monetary union would thus alleviate such concerns.For the follower countries, under EMU monetary policy would allowall participating countries the opportunity to formulate policy for