Fiscal discipline and exchange rates: Does politics matter?
| Published date | 01 May 2021 |
| Author | Joao Tovar Jalles,Carlos Mulas‐Granados,José Tavares |
| Date | 01 May 2021 |
| DOI | http://doi.org/10.1111/sjpe.12262 |
Scott J Polit Econ . 2021;68:155–178. wileyonlinelibrary.com/journal/sjpe
|
155
© 2020 Scottis h Economic Societ y
Accepted: 9 July 2 020
DOI: 10 .1111/sjpe.1 2262
ORIGINAL ARTICLE
Fiscal discipline and exchange rates: Does politics
matter?
Joao Tovar Jalles1,2,3,4 | Carlos Mulas-Granados5| José Tavares6
We thank two ano nymous refere es for useful com ments and sugg estions on an ea rlier version . We are grateful to Vi tor Gaspar, Sanje ev Gupta and
Ben Clement s for useful com ments and sugg estions. Par ticipants of t he IMF’s FAD Semina r Series also con tributed with v aluable discu ssions. We
also thank Jai me Marques Per eira, Michela S chena and Car olina Correa C aro for excellent r esearch assis tance. The opi nions express ed herein are
those of the au thors and do not n ecessarily re flect those of t he authors’ em ployers.
1Instituto Su perior de Economia e G estão
(ISEG), Universidade de Lisboa, Lisboa,
Portugal
2Research in Economics and Mathematics
(REM) and Resea rch Unit on Complexi ty and
Economics (UECE), ISEG, Universidade de
Lisboa, Lisbon, Portugal
3Economics for P olicy and Centre fo r
Globalization and Governance, Nova School
of Business and Economics, Universidade
Nova de Lisboa, Carcavelos, Portugal
4IPAG Business School, Paris, France
5International Monetary Fund, European
Departm ent, Washington, D C, USA
6Nova School of B usiness and Economi cs,
Universidade Nova de Lisboa, Carcavelos,
Portugal
Correspondence
Joao Tovar Jalles, I nstituto Superi or de
Economia e Ges tão (ISEG), Universi dade de
Lisboa, Rua do Q uelhas 6, 1200 -781 Lisboa,
Portugal.
Email: joaojalles@gmail.com
Funding information
Fundação par a a Ciência e a Tecnologia
Abstract
We look at the effect of exchange rate regimes on fiscal
discipline, taking into account the effect of underlying po-
litical conditions . We present a m odel where strong politics
(defined as policymakers facing longer political horizon and
higher cohesion) are associated with better fiscal perfor-
mance, but fixed exchange rates may revert this result and
lead to less fiscal discipline. We confirm these hypotheses
through regression analysis performed on a panel sample
covering 79 countries from 1975 to 2012. Our empir ical re-
sults also show that t he positive effect of strong politic s on
fiscal discipline is not enough to counter the negative im-
pact of being at/moving to fi xed exchange rates. Our results
are robust to a number of sensitivity checks, including the
use of different est imators, alternative proxies for fis cal dis-
cipline and sub-sample analysis.
KEYWORDS
deficit, excha nge rates, political eco nomy, fiscal discipline
JEL CLASSIFICATION
H11; H62; H63
1 |IN T R O D U C T I O N
The issue of what t ype of exchange rate regime is be tter for fiscal discip line has a long traditio n in macroeconom-
ics. Traditionall y, the view that fixed exchange r ate regimes could be as sociated with increa sed fiscal discipl ine was
widely accepted . However, more recent theoretica l models, together with mixed e mpirical evidence, have paved
156
|
JALLES EtAL.
the way to an alterna tive policy view according to wh ich flexible exchange rate reg imes are also compatible wit h
healthy public finances.1 In parallel, we have witnessed many countries moving from fixed to flexible exchange
rates in the last t wo decades.2 On t he economic front, two o pposing views are at stake: t he first considers a f ixed
peg as a provider of credible discipline and associates fixed exchange rates with enhanced fiscal restraint; the
second defends t hat flexible rates induce b etter fiscal perfor mance instead because th ey expose the costly eco-
nomic conseque nces of fiscal profliga cy and do not allow polic ymakers to hide the deter ioration of fiscal bal ances
behind a loss of dom estic reserves.
The empirical evidence that examines the relationship between fiscal discipline and exchange rate regimes is
mixed. Gavin and Pe rotti (1997) uncover an associat ion between fixed- exchange rate regimes a nd public deficit s in
Latin Ameri can economies, but they d o not find similar evidence fo r advanced economies. Fatá s and Rose (2001)
find that, whi le adherence to a common curre ncy area is not associated with i ncreased fiscal discip line, adoption
of a currency bo ard is. Tornell and Velasco (1995, 1998) and Sun (2003) present e vidence of the effects of f ixed
exchange rate regim es on fiscal disciplin e. Their evidence is limite d to a specific set of countri es—notably the CFA
zone in Africa an d the pegged currency u nion in the Caribbean . In sum, there are divergent e mpirical results as to
the relationship between exchange rate regimes and fiscal discipline.
In our view, these mixe d findings stem fro m the fact that the lit erature has mostly n eglected the impor tance of
the politica l context in which fisc al policy decision s are made. On the polit ical front, we prop ose that there are two
dimensions aff ecting fiscal po licy decisions that mu st be taken into account . First, the elec toral calendar, which i n-
volves a clear timi ng dimension which dire ctly impacts th e policymaker’s hori zon; and second, the degr ee of cohe-
sion or politic al fragmentation th at policymakers enjoy—o r not—within the government coalit ion structures or t he
legislature. In ot her words, considering the un derlying political condi tions—both in terms of electora l timing and
political coh esion—under which fiscal pol icy choices are made is crucial to p roperly understand how al ternative
exchange rate regim es interact with f iscal outcomes. In t his paper, we examine the que stion of how politic s affects
the interaction between currency regime and fiscal discipline using the broadest possible sample yet available.
Determining wh ether fixed or flexibl e exchange rates are better f or enhanced fiscal disc ipline in the presence
of different po litical conditions, is impor tant for several reasons. Fi rst, the exchange rate regime m ay affect the
incentives to use deficits with electoral motives (Tanzi & Schuknecht, 1997), or limit the sustainability of fiscal
adjustment s (Lambertini & Tavares, 20 05; Lane & Perotti, 20 03). Second, if flexib le exchange rates are assoc iated
with closer pub lic scrutiny of policy makers and this in turn e ncourages fisca l discipline, shift ing to a flexible regime
may be a “low cost” in stitutional fix to a recu rrent issue. This is part icularly importan t in countries where credib le
economic and political institutions do not exist or are incapable of monitoring fiscal authorities. A flexible ex-
change rate regime can in these cases be seen as a substitute, albeit imperfect, for the harder task of building
better insti tutions. Third, as the exper ience of the Eurozone during the soverei gn debt crises testifies, har d and
credible pegs , even in advanced economies, a re not necessarily associate d with fiscal restraint . Here too, one of
the determina nts of the fiscal stance may b e the quality of institut ions ensuring accountabil ity and transparency
at the national level. Finally, many of the developing countries adopting fixed pegs are small open economies,
vulnerable to considerable exogenous shocks, so that determining how internal politics affects the relationship
between fix ing the exchange rate and fis cal performance bec omes a key issue.3
1For instanc e, the 1990s witne ssed a series of cr ises in emergi ng market econom ies, as well as Euro pean countrie s under the Exch ange Rate
Mechanism (E RM), that sugges ted financia l openness, mo netary inde pendence and p egs were incomp atible. In the c ase of emerging e conomies, the
experienc e suggested th e only options wer e either stron g currency peg s or floating exc hange rate regim es.
2As reviewed in B ordo (2003), e xchange rate reg ime choice evolve d considerabl y over the last cent ury. In the earl y 20th centur y adopting the go ld
standard—a nd, thus, a hard p eg, seemed th e obvious polic y choice, follow ed by most advanc ed economies . Today the policy cho ice became the
opposite, al though equal ly “obvious.” All dev eloped econom ies, with the ex ception of Eurozon e countries amo ng themselves , have adopted fl exible
exchange rate s. Developing c ountries, wit h some exceptio ns, seem more or l ess constrain ed to follow the pr evailing polic y view, and mimic—if n ot
follow, developed countries actions.
3Duttagu pta and Tolosa (20 06) explore the s ample of small eco nomies in the C aribbean, wh ile Tornell and Velas co (1995) present evide nce for the
CFA Franc commun ity in Africa .
Get this document and AI-powered insights with a free trial of vLex and Vincent AI
Get Started for FreeStart Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting