The Impact of Fixed Exchange Rates on Fiscal Discipline
| Date | 01 November 2011 |
| Published date | 01 November 2011 |
| Author | Makram El‐Shagi |
| DOI | http://doi.org/10.1111/j.1467-9485.2011.00564.x |
THE IMPACT OF FIXED EXCHANGE
RATES ON FISCAL DISCIPLINE
Makram El-Shagi*
ABSTRACT
In this paper, it is shown that contrary to standard arguments, fiscal discipline is
not substantially enhanced by a fixed exchange rate regime. This study is based
on data from 116 countries collected from 1975 to 2004, and uses various esti-
mation techniques for dynamic panel data, in particular a generalized method of
moments estimation in the tradition of Arellano and Bover [Journal of Econo-
metrics (1995), 68, 29] and Blundell and Bond [Journal of Econometrics
(1998), 87, 115]. Contrary to previous papers on this topic, the present paper
takes into account that the consequences of a new exchange rate regime do not
necessarily fully manifest immediately.
II
NTRODUCTION
One of the essential arguments in support of fixed exchange rate regimes,
especially in developing and emerging economies, is that fixed exchange rates
allegedly enhance discipline in fiscal and monetary policies. Partially, this aug-
mentation of political discipline is considered the original goal of fixed
exchange rate policies. However, recommendations to peg the exchange rate
for other reasons –for example, stabilization of the terms of trade or capital
flows –mostly rely on the assumption that pegs enforce sound monetary and
fiscal policies that are consistent with maintaining the peg as well. As expan-
sionary monetary policy in developing countries is often employed to ease or
to finance government spending, in the present paper we focus on fiscal disci-
pline that can be considered the original problem.
Based on data from 116 countries from 1975 to 2004, and using various
estimation techniques for dynamic panel data, particularly a generalized
method of moments (GMM) estimation in the tradition of Arellano and
Bover (1995) and Blundell and Bond (1998), the present paper shows that fis-
cal discipline is at least not substantially enhanced by a fixed exchange rate
regime. Contrary to older studies on this topic, the present paper takes into
account that the consequences of a new exchange rate regime do not necessar-
ily fully manifest immediately. The paper is structured as follows: Section II
*Halle Institute of Economic Research and University of Mannheim
Scottish Journal of Political Economy, Vol. 58,No. 5, November 2011
©2011 The Author. Scottish Journal of Political Economy ©2011Scottish Economic Society. Publishedby Blackwell
Publishing Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148,U SA
685
reviews the current state of the discussion in the literature. Section III intro-
duces the data used for estimation, focusing on the measurement of exchange
rate regimes, which is based on the index developed by Reinhart and Rogoff
(2004). Section IV presents the methods employed and the basic econometric
model that is tested in the present paper. The results and their interpretation
are presented in Section V. Section VI includes some extensions: a fixed-effects
vector decomposition (FEVD), which allows for the analysis of the long-run
effects, and an approach that tests for asymmetries between the regime
switches from fixed to flexible and vice versa.
II LITERATURE REVIEW
The argument that political discipline is allegedly induced by fixed exchange
rates has been discussed for several decades, and has been already thoroughly
addressed by Johnson (1969). The hope for enhanced discipline under a fixed
exchange rate regime is founded on the idea that fixed exchange rates and
excessive government spending are incompatible without resorting to unfavor-
able monetary policy. To avoid being punished for the collapse of the fixed
exchange rate regime, politicians are expected to enact a policy that is com-
patible with the fixed exchange rate, i.e., to limit the budget deficit. This argu-
ment is most often applied to developing countries that lack other efficient
political control mechanisms (Aghevli et al., 1991); however, it is sometimes
applied to industrialized nations as well, e.g., the member countries of the
European Union in the EMS (Giavazzi and Pagano, 1988). The majority of
relevant literature has focused on individual aspects of this argument. Cooper
(1971), Edwards and Santaella (1993), and Frankel (2005) analyzed the politi-
cal consequences of collapsing exchange rate regimes. Each found evidence
for substantial political costs, ranging from the loss of political responsibility
(Cooper, 1971; Frankel, 2005) to full-fledged political riots (Edwards and San-
taella, 1993). The latter is especially interesting, as developing countries, which
are much more likely to resort to fixed exchange rates to improve fiscal disci-
pline than industrialized countries, often do not possess strong democratic
institutions. Thus, for the potential disciplining effect in autocratic regimes, it
is important to know that there exist relevant political costs other than being
voted out of office. Another strand of the literature deals with the incompati-
bility of fixed exchange rates and lax fiscal policy, and with the effects of fiscal
policy on exchange rate movements. Especially noteworthy are the seminal
papers of Krugman (1979) and Flood and Garber (1984) that formed the first
generation of crisis models. Daniel (2000) showed that an increasing budget
deficit causes the almost immediate collapse of a fixed exchange rate regime
within the general equilibrium framework; however, this extreme result is
barely supported by empirical evidence. Another analysis of the interaction of
exchange rates and fiscal policy in the modern general equilibrium models is
found in Annicchiarico (2002). The most important argument against a posi-
tive impact of a fixed exchange rates on fiscal discipline was proposed by
Johnson (1969), who stated that although a fixed exchange rate regime with
686 MAKRAM EL-SHAGI
Scottish Journal of Political Economy
©2011 The Author. Scottish Journal of Political Economy ©2011 Scottish Economic Society
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