Citizen Preferences over monetary & exchange rate policies & what

governments might do about them

INTERNATIONAL BUSINESS ENVIRONMENT Course numbers STRT 571-44 & -45, Spring 2010, Mod 4

James Raymond Vreeland, School of Foreign Service

Week 6 (Wednesday, 21 April; Monday, 26 April)

Plan for tonight:1. Quick review

2. Discuss projects

3. Citizen preferences over monetary & XR politics• Electoral models• Partisan models• Sectoral models

4. What to do?• Central bank independence• Other “commitment mechanisms”

• Domestic: veto players• International: FTAs (with investment chapters) & BITs (Bilateral

Investment Treaties)

5. The stability of democracy

Review/summary slides

Factors, Sectors, & Institutions• Trade is “efficient”

• But there are winners & losers– Globalization winners – factor model: Abundant factor– Globalization losers – factor model: Scarce factor

– Globalization winners – sector model: Export-oriented sector– Globalization losers – sector model: Import-competing sector

• Political institutions may influence how we deal with losers

– E.g., Domestic political institutions like democracy v. dictatorship

• Import-Substitution Industrialization

• Export-oriented industrialization

• International Institution – the IMF – can help break gridlock

The Trilemma:Why would you want…

• Free Capital Flow?– Draw on the savings of the rest of the world– Investment opportunities abroad

• Fixed Exchange Rate?– Reduce uncertainty in trade

• Sovereign Monetary Policy?– Address inflation/unemployment

Stylized history of the international monetary system

• Late 19th century: – Mobile capital, fixed XR, authoritarian governments

• Interwar years:– Mobile capital + fixed XR + democracy collapse!– beggar-thy-neighbor policies (tariffs, competitive devaluations)

• Bretton Woods (1944-1971/3):1. Some XR flexibility (fixed-but-adjustable “snake”)2. Capital controls3. A stabilization fund (held on reserve at the IMF)4. The International Monetary Fund – authority over XR changes + conditionality

attached to loans

• Post Bretton Woods:– The major economies: Democracy + Floating exchange rates

• Current system contradiction:– The 2 major economies (the US, a debtor & China, a creditor) have incongruent

solutions to the “trilemma”:• Floating XR + open capital flows + independent* monetary policy• Fixed XR + capital controls + independent* monetary policy

– If the US solution to current account deficits is a floating XR, & China fixes to the dollar, there’s no way out, and the system is long-run unsustainable

End of review/summary slides

Society-based models of monetary & XR politics

1. Electoral models

2. Partisan models

3. Sectoral models

Free Capital Flow

Fixed Exchange Rate Sovereign Monetary Policy

Inconsistent/UnholyTrinity

Or“Trilemma”:

a country can only have 2 out of 3 of these

Assuming free capital flows…

• Governments must choose between

– monetary policy autonomy

– XR stability

1. Electoral models

• Predict floating XR monetary autonomy used to manipulate political-business cycles

• If there is a fixed XR commitment may not be credible before elections (elections like the Sirens!)

• Pocketbook voter model – people vote according to changes in their income

– http://www.youtube.com/watch?v=loBe0WXtts8

• Sociotropic model – voters consider macro performance (economic growth, unemployment, inflation)

Of course, for the US don’t forget the electoral college institution!

The update…check it out:

http://douglas-hibbs.com/Election2008/2008Election-

MainPage.htm

1956

1960

19641972

1976

1980

1984

1988

1992

1996

20002004

1952

1968

2008

4045

5055

6065

Incu

mb

en

t sh

are

of t

wo

-pa

rty

vote

(%

)

-2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Real income growth and military fatalities combined

Combination of real growth and fatalities weights each variable by its estimated coefficient.Estimated fatalities effects: -0.7% 2008, -7.6% 1968, -9.9% 1952; negligible in 1964, 1976, 2004.Source: www.douglas-hibbs.com

Bread and Peace Voting in US Presidential Elections 1952-2008

Political-business cycles (PBC)?

• Governments may be less willing to accept monetary policy constraints before an election

• Problem 1: empirical – debate over whether we really observe PBCs

• Problem 2: theoretical – if voters are rational, they shouldn’t be fooled by a PBC (short-run employment eaten up by eventual inflation)

• Kaplan: Lately in Latin America, we see COUNTER-PBCs!– International explanation: lack of international finance since Latin

American Debt Crisis

– Domestic explanation: Hyper-inflation history makes voters “inflation-averse”

2. Partisan models

• Left-wing parties are “pro-employment”– Tied to organized labor

• Right-wing parties are “anti-inflation”– Tied to business interests

• Prediction:– Right-wing governments more likely than left-wing governments

to establish & maintain a fixed XR

• It is possible to connect this to the electoral model:– Voters choose left-wing parties during recessions & right-wing

parties under inflation

Downs offers a “spatial” model of party competition.

• Based on Hotelling’s (1929) model– Where should PUMA locate if people shop at stores closest to their house?

NIKE PUMA

Employment concerns

Inflation concerns

Vote single-peaked preferences

In a 2-party system, where will the left & right parties locate?

Dems

민주당

Reps

한나라당

What happens when somebody decides not to vote?

Median preference shifts away from the absent voter

Final thought on “partisan” models

• As we move into “sectoral models,”

• Consider that in the “partisan” model, we have – Left – labor-oriented – parties – VS– Right – business oriented – parties

• In the trade models, what does a model based on labor & owners of capital recall?

• FACTOR MODEL

• So, you can think of the partisan models as analogous to factor models

3. Sectoral models

• Interest groups have different preferences on the trade-off between domestic– economic autonomy & XR stability

• Some groups prefer XR stability• Others domestic economic autonomy

• In this model, the interest groups are sector-based

NIKE PUMA

Domestic economic autonomy

XR stability

By the way, the median voter model does not have nice clean results in multiple dimensions…

Domestic economic autonomy

XR stability

Weak currency

Strong currency

Four domestic interest groups

1. Export-oriented producers

2. Import-competing producers

3. Nontraded-goods producers

4. Financial services industry

Fixed or Float / Strong or Weak?

• Export-oriented producers prefer…– Fixed XR: stability for their international transactions– Weak XR: keeps the price of their products world

markets low (keeps demand high)

• Import-competing producers prefer…– Floating XR: prefers monetary policy to address

recessions/inflation– Weak XR: keeps the price of imports high! This spurs

domestic demand

• Nontraded-goods producers prefer…– Floating XR: prefers monetary policy to address

recessions/inflation– Strong XR: consume more traded goods, travel

more, pay for tuition

Fixed or Float / Strong or Weak?

• Financial services industry prefer…– XR stability leads to more international transactions…– But XR volatility leads to XR-risk business…– And monetary autonomy helps maintain a stable

domestic banking system, low inflation, and more stable interest rates

– So: A weak preference for Floating XR

– As for currency strength: buy foreign assets when XR is strong, repatriate returns when the XR is weak

– So: No preference on XR strength

Sectoral XR preferences summary

XR stability preference

High/fixedlow/float/ monetary

autonomy

XR strength preference

Strong currency

  Nontradable

Weak currency

Export-oriented Import-competing

Financial services

???Exporters in other countries – keep them out of our elections!

Imperialist colonial powers? Get them out of our countries!

BREAK

돈 주지 마 !

• It’s all about commitment

• Insulate policy-makers from short-term political pressures

• Time 1: beginning of your term in office

• Time 2: right before elections

• Option A: sound monetary policy

• Option B: drop interest rates

• Time 1: U(A2)>U(B2)

• Time 2: U(A2)<U(B2)

• The “sirens”: electoral pressures

• The commitment: Independent central banks ( 돈 주지 마 )

First – the “sirens” policy mechanism:Monetary & Unemployment

• Assume a “natural rate of unemployment”– New entrants, labor unions, minimum wages, hiring & firing

practices, unemployment compensation… (raise the wage, lower the demand for labor)

• Workers care about their REAL wage (purchasing power), but paid a NOMINAL wage

• An unanticipated reduction of the interest rate unexpected increase in inflation lower REAL wage reduce unemployment

• An unanticipated increase of the interest rate unexpected decrease in inflation increase REAL wage increase unemployment

• In the long-run, labor market adjusts and changes are reversed return to the “natural rate of unemployment”

But is there a cost???...

• If a government continually uses monetary policy to keep unemployment below the natural rate, it must continually increase the rate of inflation (accelerationist principle)

What is the real cost?

• Inflation raises uncertainty among firms & unions

• This uncertainty can *reduce* investment & *economic growth*

• This, in turn, raises the natural rate of unemployment

• So, we “commit” to low inflation with independent central banks

Commitment mechanisms• Central bank independence measured:

1. CB’s freedom to decide economic objectives– Inflation v. unemployment

2. CB’s freedom to decide how to set monetary policy

3. Whether CB decisions can be reversed by other branches of the government

• Examples:– Swiss National Bank – highly independent

• No provision whatsoever for the government to influence monetary policy

– Reserve Bank of Australia – highly subordinate• Secretary of the Treasure has final authority over monetary-

policy decisions & must approve any interest-rate changes proposed by the Reserve Bank

Time-inconsistent preference problem• Exams force students to study – solves their time-consistent

preference problem• But the prof has a time-consistency problem too!• The day of the exam, my optimal strategy is to cancel the exam

– I can use my time for other things– Students are also better off – they did their studying, but are

spared the exam-anxiety• But if I cancelled all my exams, my reputation would suffer• Imagine you had heard that I often cancel my mid-term, would you

have studied?• Then the exam would not have worked to solve your time-

consistency problem• So my campus reputation encourages me to be credible• Adjunct problem? A one-shot game! Forget grades!• Institutions to force me to give you a final exam?

– Past summer: KU wouldn’t pay me!– My commitment is credible after all… so keep studying

The generic problem of time-inconsistent preferences:

Individual’s preferences over time:

• Time 1: U(A)>U(B)

• Time 2: U(B)>U(A)

• Anticipating the change in preferences, can the individual commit @ Time 1 to choosing State A @ Time 2?

Examples:

• Classic: Ulysses & the Sirens

• Time 1=Before listening to the Sirens.

• Time 2=While listening to the Sirens.

• State A=Sailing home…

• State B=Belly of the beast…

• Principal=student.

• Delegates to agent=professor.

• Time 1: Beginning of the semester.

• Time 2: Any Thursday night.

• State A: State of knowledge.

• State B: State of… (Toads).

Education:

• Hostages would like to commit to not pressing charges.

H Promise

Not

K Free

Kill

H Testify

Not

(–,1) (–, 1) (0,2)

(T,-10 years)

Time 1 Time 2

Under democracy:

• Time 1: Voter elects a government that offers incentives to firms to invest.

• Time 2: Voter elects a government to tax the firm (expropriate the benefits from investment).

G Offer

Not

F Invest

Not

G Expropriate

Not

(0,0) (0,S) (1,1)

(T,0)

Time 1 Time 2

Suppose that T>1>S>0

Note that this can happen under dictatorship too.

• A new dictatorship can come to power

• E.g., a market-friendly dictatorship can be replaced by a socialist dictatorship

• Or the old dictatorship can simply change its mind!

• But if the dictatorship can guarantee that he will be around a long time,

• His long-run interest REPUTATION may help solve the time-inconsistent preference problem!

• Is dictatorship more or less fickle than democracy?

• Why would we think a dictator will be around a long time?

More examples for

Time-inconsistent preference problem…

Another government example:

• Principal: Government.

• Agent: Central bank.

• If the central bank is not independent of the government, it may be subject to pressures to lower interest rates before elections…leading to inflation and long-run economic problems.

• Is this is a particular problem in the run up to contested elections?

• The problem of time-inconsistent preferences pervades many political, economic, and other relationships.

• This is an analytical tool that can be applied well outside of the study of political science.

Marriage:• Not needed if there is “true love” or “happily ever after.”

• Needed because we anticipate the possibility of “Time 2.”

• Time 2: U(B)>U(A)

• State A=Together

• State B=Sirens, Toads, etc…

• “Richer,” “health,” & “better” added for symmetry.

• “Poorer,” “sicker,” “worse” are the kickers.

Suggested readings

• Elster, Jon. 1990. Ulysses and the Sirens: Studies in Rationality and Irrationality. New York: Cambridge University Press.

• Elster, Jon. 2000. Ulysses Unbound. New York: Cambridge University Press.

Other commitment mechanisms?

International commitment mechanisms?

International commitment mechanisms?

• We find a very weak relationship between BITs and FDI. Further, we find that rather than encouraging greater FDI in riskier environments, BITs only have a positive effect on FDI flows in countries with an already stable business environment. Overall, BITs seem to have little positive effect either on foreign investment or on outside investors' perception of the investment environment in low- and middle-income countries.

What role do DOMESTIC institutions play?

Tsebelis, George. 1995. “Decision Making in Political Systems.” British Journal of

Political

Science 25: 289-326.

10-29-01

• The median voter may prefer a high degree of redistribution.

• If so, “the rich” may actually be willing to risk the struggle for dictatorship than to comply with the results of democratic elections.

• Subvert democracy? (E.g. Aristide in Haiti overthrown by Cedras.)

Recall Madison’s Dilemma.• If you allow groups to organize polarizing factions.

This can potentially rip society apart.

• But if you outlaw factions restrict liberty. This solution is worse than the disease.

• Solution: Set up institutions (Federalism) that allow for –and even encourage – factions to compete.

• With many factions/interest groups competing, no single faction can come to dominate.

• Conservative outcomes: stability/status quo. (Important!)

• What kinds of democratic institutions promote policy stability?

• What institutions promote policy change?

• (Agnostic on normative issues.)

Tsebelis points out that debates about the effects of institutions are usually conducted in pairs:

• Federalist versus Centralized

• Parliamentary versus Presidential

• 2 party versus Multi party

• Bicameral legislature versus Unicameral

Consider the usefulness when comparing2 political systems:

• Unicameral, presidential, 3 party with coalition government.

• Bicameral, parliamentary, 2 party system.

The cause of differences between these 2 systems (growth, policy change, inequality) is not “identified.”

Is it due to legislative structure, regime, or party structure?

We can conceive of these differences as differences along a single dimension:

The number of “veto players.”

What is a “veto player”?

• Individual or collective actors whose agreement (by majority rule for collective actors) is required for a change of the status quo.

• It may be misleading to examine institutional features in isolation.

• Tsebelis offers a consistent framework for comparing across regimes, legislature types, and party systems.

Consider US, UK, & Italy.

• Culturalists group US & UK together as different from Italy (Anglo Saxon v. Latin).

• Party theorists also group US & UK together (2 party v. multiparty).

• But parliamentary theorists group UK & Italy as different from the US.

• Who would group US and Italy together?

Italy UK US

# parties Multi 2 party 2 party

Regime Parl Parl Pres

Culture Latin AngloSaxon

AngloSaxon

But on the veto player dimension:

• UK: Almost always 1.

• US: Up to 3.

• Italy: Usually about 4.

• US and Italy are predicted to be more similar with respect to policy stability than UK.

How does the # of veto players affect policy stability?

By definition of “veto player,” unanimity between such players is

required for policy change.

Straightforward predictions:

• Increasing veto players increases policy stability.

The connection between income & democracy

• One of the strongest correlates of democracy:– PER CAPITA INCOME (economic development)…

• Why?– Democracy causes development?

• Mixed evidence (seems to change every decade)

– Spurious?• Maybe… yet there does seem to be a causal connection

– Development causes democracy to EMERGE?• Evidence is weak

– Development causes democracy to SURVIVE!• One of the strongest findings in comparative politics

Political risk

Think DYNAMICALLY

• Don’t just look at correlations

• Consider – Onset– Continuation

• In this article we consider onset/emergence– In other work, Pevehouse addresses continuation/survival

Take-homes

1. Economic performance survival in office!

2. Still there are cleavages in society:1. Preferences over inflation v. employment (monetary policy)2. Fixed v. floating XR3. Over-/under-valued XR

3. Political business cycles appear to hurt in the long-run

4. Insulate monetary policy from elections?1. Central bank independence2. International commitments3. Domestic veto players

5. Democracies survive at high incomes

Thank youWE ARE GLOBAL GEORGETOWN!