Delaying the Inevitable? A Political Economy Model of Currency Defenses and Capitulation
It is puzzling from the standpoint of rational choice theory that policymakers often delay devaluations by spending billions of dollars in defense of a given exchange rate peg against speculative pressure, only to succumb to this pressure and to devalue their currency later on. Using a political economy approach we have argued that this can be explained by distributional considerations and institutions-related time asymmetry issues. These factors can keep governments from implementing the economically optimal policy response. We argue that distributional concerns often lead to a "bias" in favor of currency defense as long as market pressures are mild. Institutions such as elections can aggravate this distortion when they encourage policymakers to discount the future, but other institutions that promote a more long-term view (such as central bank independence) can mitigate the distributional bias. Once market pressure becomes strong, however, the politically salient alternative to not depreciating becomes raising interest rates rather than just running down reserves. This changes perceptions of underlying distributional considerations and hence the political trade-off between the costs and benefits of an exchange rate defense. As the coalition of devaluation-proponents grows, the likelihood of a devaluation increases. We illustrate our argument by discussing the salient distributional issues and their interaction with domestic institutions for a number of major recent currency crises. These cases show that some of the most spectacular currency crashes in the last decades exhibited a distributional and institutional setup that strongly encouraged a short-term pro-defense bias, which led to time-inconsistent behavior of the authorities and eventually resulted in a severe crisis.