Transcript ECONOMIC DEVELOPMENT & INTERNATIONAL POLITICS …

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
•
•
•
4.
Electoral models
Partisan models
Sectoral models
What to do?
•
•
Central bank independence
Other “commitment mechanisms”
•
•
5.
Domestic: veto players
International: FTAs (with investment chapters) & BITs (Bilateral
Investment Treaties)
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:
–
•
Interwar years:
–
–
•
Some XR flexibility (fixed-but-adjustable “snake”)
Capital controls
A stabilization fund (held on reserve at the IMF)
The International Monetary Fund – authority over XR changes + conditionality
attached to loans
Post Bretton Woods:
–
•
Mobile capital + fixed XR + democracy  collapse!
beggar-thy-neighbor policies (tariffs, competitive devaluations)
Bretton Woods (1944-1971/3):
1.
2.
3.
4.
•
Mobile capital, fixed XR, authoritarian governments
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
Inconsistent/Unholy
Trinity
Or
“Trilemma”:
a country can only have 2 out of
3 of these
Fixed Exchange Rate
Sovereign Monetary Policy
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://douglashibbs.com/Election2008/2008Elec
tion-MainPage.htm
65
Bread and Peace Voting in US Presidential Elections 1952-2008
60
1972
55
1956
1964
1984
1988
1996
50
2008
1992
1952
40
45
1976
1968
1980
2000
2004
1960
-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
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 COUNTERPBCs!
– 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
Dems
PUMA
Reps
민주당
한나라당
Employment
concerns
Inflation
concerns
Vote single-peaked preferences
In a 2-party system, where will the left & right parties locate?
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
Domestic
economic
autonomy
PUMA
XR stability
By the way, the median voter model does not have nice clean results
in multiple dimensions…   
Strong currency
Domestic
economic
autonomy
XR stability
Weak 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/fixed
Strong
currency
XR strength
preference
Weak
currency
Exporters colonial
in
Imperialist
???
other countries
–
powers?
Get them
keep
them out of
out
of our
our elections!
countries!
Export-oriented
low/float/ monetary
autonomy
Nontradable
Import-competing
Financial services
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 monetarypolicy 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 timeconsistency 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 timeinconsistent 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…
Education:
• 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).
• Hostages would like to commit to not pressing charges.
Time 1
H Promise K
(–,1)
Free
(–, 1)
Time 2
H Testify
(0,2)
(T,-10 years)
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).
Time 1
G Offer
F
(0,0)
(0,S)
Time 2
Invest
G Expropriate
(1,1)
Suppose that T>1>S>0
(T,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.)
• 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 comparing
2 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
AngloSaxo AngloSaxo
n
n
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
Political risk
• 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
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.
2.
3.
Preferences over inflation v. employment (monetary policy)
Fixed v. floating XR
Over-/under-valued XR
3.
Political business cycles appear to hurt in the long-run
4.
Insulate monetary policy from elections?
1.
2.
3.
5.
Central bank independence
International commitments
Domestic veto players
Democracies survive at high incomes
Thank you
WE ARE GLOBAL GEORGETOWN!