The Most Important Price

Jeffry A. Frieden’s Currency Politics: The Political Economy of Exchange Rate Policy, as the subtitle of the book indicates, is not concerned with the economics of the market’s determination of the exchange rate. Neither does it deal with the efficiency of this market in setting the rates, how effective government manipulations of the exchange rate are, or what the rate does under different exchange rate regimes. It does not provide any normative statements about what the desirable regimes would be for particular countries.

Rather, Currency Politics seeks to explain the interplay of interest groups in the political arena to influence legislatures to pass bills that would benefit them. The emphasis is on the distributional effects of alternative currency choices.

Conflicting interests are at the core of the political process of choosing a particular exchange-rate regime and the level of the exchange rate. There is a long tradition in economics that departs from that assumption. From Adam Smith’s “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our meal,” to modern public choice theory, the use of economic apparatus to deal with traditional problems of political science is well established.

The book applies the analysis of collective decisionmaking and rent-seeking to describe and test a simple proposition: private interest groups battle to achieve currency policies that better suit their private interests. These interests are varied, depending on the nature of the groups involved: Some fear the consequences of hard competition in the domestic market and abroad, and prefer a currency system that protects their competitiveness through a floating exchange rate system. Others, especially producers of high-grade manufactured goods, feel safe enough from competition due to the specific nature of their products, but consider exchange-rate volatility a major threat to their activities. For the latter, a fixed exchange rate is preferable to the vagaries of a freely floating rate.

The general idea is that economic actors try to influence governmental authorities to promote their interests by defining both the exchange regime—fixed or floating rates—and the level of the exchange rate, under a given regime (depreciated or appreciated rates). Let me now summarize Frieden’s econometric testing of this hypothesis.

Concerning the choice of regime, the assumption to be tested is that actors who rely heavily on international trade, investment, or international financial ties will, all else being equal, prefer a stable exchange rate—the gold standard regime, and the similar regimes of fixed rates, dollarization, and euroization. With regard to the latter, the basic assumption is that producers of tradables will, all else being equal, prefer a depreciated exchange rate.

There was enough U.S. data for econometric analysis comparing the 1862 to 1879 period—the greenback-to-gold years—and the period between 1880 and 1896, which was the era of controversy between a gold standard and a silver standard. Of special interest to political scientists and economists alike is the book’s vivid and encompassing analysis of the actual events and how they affected the debates and congressional voting of alternative foreign exchange policies. The results of the econometric analysis did not refute the main hypothesis tested.

The same detailed analysis and econometric testing, however, in the case of the European Union and Latin American foreign exchange policies were not rich as in the case of the United States. Concerning the members of the European Union, the overall objective of most proposals for a European exchange-rate system have focused on to what extent any given system might accelerate European integration.

The assumptions to be tested in the case of the EU countries were: exposure to foreign exchange volatility; the effects of the share of tradables in the composition of GDP; and the pass-through of exchange rate changes to domestic prices affecting industrial manufacturers. Those sectors fearing volatility—especially the financial sector and exporters of specialized manufactures—would, ceteris paribus, prefer a fixed-rate regime. The opposite would hold for producers of tradables subjected to substantial price competition. The evidence reported in the book is consistent with the argument that producers more exposed to currency risk prefer a fixed currency, while tradables producers concerned with price competitiveness prefer flexibility.

A similar analysis was performed with respect to the Latin American currency policy. In general, one would expect that countries that were more open to international trade and foreign direct investment would be more likely to prefer fixed exchange rates, given the risks associated with exchange-rate volatility. In contrast, governments and economies experiencing very high and unstable inflation, in some cases bordering to hyperinflation, would be more likely to have flexible exchange rate regimes.

The analysis of the Latin American experience introduced a variable not present in the investigation of the previous American and European foreign exchange policies: the exchange-rate-based electoral cycles. The evidence shows clearly that governments allow the currency to appreciate in the run-up to an election, and also delay going off a currency peg during the period prior to a general election—as the Mexican crisis of 1994-1995 dramatically illustrates.

It goes without saying that analyzing currency regimes and the level of exchange rates in Latin America is inseparable from studying the region’s recurrent foreign exchange crises. One common Latin American experience with exchange rate regimes is the high inflation rates plaguing most nations in the region. In some cases, the chronic pressures from a government’s public sector deficit pushed economies to overheating to near hyperinflation levels. Hyperinflation is defined as inflation rates that reach or exceed 50 percent or more per month. In general, the analysis of the Latin American exchange-rate policy is very accurate, in spite of the inherent difficulties in understanding the formulation of policy in the region and the unavailability of reliable data for some of the countries involved.

Frieden’s analysis and conclusions are sound, on the whole. But a few additional points may merit attention. The first is minor and has to do with what seems to be an undue generalization. Discussing the economics and politics of monetary policy in closed economies, the author states “monetary policy in a closed economy operates by way of interest rates, which in turn affect real variables . . . a monetary expansion increases real cash balances and lowers interest rates.” This would be the case only if the agents had not anticipated the monetary expansion; otherwise, the effect on interest rates would be transitory.

Second, it might be interesting to have had the political economy analysis of the crawling peg exchange-rate regimes introduced and followed by some Latin American countries in the 1970s. Those regimes intended to keep a fixed real exchange rate vis-à-vis the U.S. dollar, thus safeguarding the interests of exporters and of those pursuing import-substitution activities in the face of high and volatile inflation rates and competition from abroad in the domestic market.

Finally, the treatment of China’s exchange rate policy is too short, compared with the European and Latin American cases. China is the world’s largest exporter and is a relevant actor in world trade and investment. Chinese foreign exchange policy is critical for Chinese export, import, and investment activities.

In the section entitled “The China Syndrome,” the author declares that “there is little question that the Chinese government has purposely kept the renminbi artificially weak at least since the early 1990s, and that this has played a major role in stimulating China’s manufactured exports to the rest of the world.” Irrespective of having a depreciated currency in the past, the People’s Bank of China—the Chinese central bank—has kept the renminbi pegged to the U.S. dollar at a rate of RMB 8 from the early to mid-1990s to mid-2000s.

In the aftermath of the financial crisis of late 2007 to 2009, the Federal Reserve flooded the market with liquidity, soon followed by the European Central Bank, the Bank of England, and the Bank of Japan. To preclude the inflationary effects of such a huge monetary expansion, the Fed introduced Quantitative Easing and lowered the domestic interest rates to near zero, causing a significant devaluation of the U.S. dollar.

Due to these policy measures, the Chinese renminbi appreciated by more than 25 percent. Since a depreciation of the renminbi was mentioned in the context of its use as an incentive to Chinese exports, it would be fair to consider not only positive but negative effects—specifically, the negative consequences of a depreciation of the Chinese currency for Chinese exports and world trade.

Besides, a thorough examination of the causes and consequences of the 1.9 percent devaluation of the renminbi that occurred in August of last year might help us understand how expectations were formed in the foreign exchange markets and the functioning of the world exchange-rate system.

Currency Politics is a fine book, worth reading by political scientists, economists, or indeed anyone interested in the history of currency politics. Frieden’s contention that the exchange rate is the most important price in any economy, since it affects all other prices, is correct. Even slight changes in exchange-rate policy in a major economy can rattle rates throughout the world—as in that minuscule 1.9 percent devaluation of the renminbi last year, which action by Beijing sent shock waves that affected the real side of many economies, large and small. This kind of comprehensive study of the political economy of exchange-rate policies is a must for those who would understanding the globalized world economy, so prone to real and currency shocks.