Do Monetary Handcuffs Restrain Leviathan? Fiscal Policy in Extreme Exchange Rate Regimes.(Statistical Data Included)

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Andrew K. Rose (*)

This paper studies fiscal policy in countries that have chosen an extreme monetary stance. We think of a country as having an extreme monetary policy if it is in either a currency board or a common currency area. In much of our analysis, we distinguish between multilateral currency unions (such as the East Caribbean Currency Area, or ECCA) and countries that have unilaterally adopted the currency of an anchor country (such as Panama).

It is possible to motivate our analysis in several ways. A number of countries are considering whether to abandon national monetary sovereignty and unilaterally adopt the money of another country, including Mexico and Argentina; Ecuador, Guatemala, and El Salvador are already proceeding with dollarization. In Europe, 12 countries have already abandoned national monetary discretion within the Economic and Monetary Union (EMU). More generally, there has been much discussion of the "disappearing center" of exchange rate regimes; countries are said to have a choice of either freely floating or going to an extreme monetary stance.

A tight monetary regime might be expected to be associated with a smaller fiscal presence because it reflects generally conservative economic policies. It also might induce conservative fiscal policy to harmonize policy, avoid fiscal externalities, and enhance the sustainability of the monetary regime, as is the (partial) intent of the "Growth and Stability Pact" (Eichengreen and Wyplosz, 1998). More generally, if one interprets an extreme monetary regime as a credible commitment device to improve credibility by limiting discretionary economic policy, then one might expect a smaller fiscal presence in extreme monetary regimes. On the other hand, a tight monetary regime makes fiscal policy a more potent tool of policy in a variety of models. For instance, the classic Mundell-Fleming logic dictates that fiscal policy grows in importance when monetary independence is abandoned. The role of fiscal policy might therefore be expected to be large in countries with extreme monetary regimes. The purpose of this paper is to explore if there is in fact any systematic difference between fiscal policy in extreme monetary regimes and fiscal policy in typical countries that retain monetary sovereignty.

In our analysis we consider the issue of endogeneity. Some countries have experienced episodes of hyperinflation associated with loose fiscal policy that have in turn led toward tighter monetary regimes. This is very relevant in practice for currency boards; one thinks of Argentina as the quintessential example. Hence, one might expect to see very loose fiscal policy preceding the adoption of a currency board and much tighter policy after the date of adoption. We argue below that this endogeneity problem is not nearly so relevant for currency unions. Currency unions have not been adopted as a result of episodes of macroeconomic instability, and indeed most of the currency unions in the data remain as such for the whole sample period. Still, our results are best viewed as correlations rather than causal statements, especially in the case of currency boards.

We find that currency boards and multilateral currency unions are characterized by conservative fiscal policies. Their governments are smaller, and on average they have kept a larger budget surplus when compared with either all the other countries in our sample or a restricted sample of countries with fixed exchange rates. Unilateral currency unions, on the other hand, are characterized by governments that spend more, as a percentage of GDP. This result supports the view that the implementation of fiscal policy in currency boards is dominated by the goal of adding credibility to the monetary regime. In multilateral currency unions, the restrictions on fiscal policy might originate in the possible externalities associated with loose national fiscal policies. This type of reasoning has recently led to explicit restrictions on budget deficits in both the EMU and the proposed West African Economic and Monetary Union (WAEMU).

The results of unilateral currency unions are in line with Rodrik (1998), who shows that countries exposed to larger external risk are associated with a larger safe government sector in order to stabilize economic fluctuations. Currency unions, where governments have already tied their hands by adopting the currency of some other country, use fiscal policy to ensure against the additional risk imposed by the extreme monetary regime. This logic also appears when we look at the composition of government spending and the type of taxes used by currency boards and multilateral currency unions. Even though they have smaller governments and larger surpluses, the composition of their budgets is biased toward direct taxes on the revenue side and social spending and transfers on the expenditure side. These components of fiscal policy are generally associated with the role of automatic stabilizers.

The paper is structured as follows. Section I provides a brief discussion of the theory of fiscal policy under different exchange rate regimes. Section II describes the econometric methodology, and Section III presents the data set used. The empirical analysis starts with some preliminary statistics in Section IV, the main results appear in Section V, and these are followed by some sensitivity analysis in Section VI. Sections VII and VIII extend the analysis to different measures of fiscal policy. Section IX discusses the findings. Section X concludes.

I. Theory

Although there is a large literature on the effects of the exchange rate regime on macroeconomic variables (volatility, trade), not much attention has been paid to the interaction between the exchange rate regime and the way fiscal policy should operate using modern techniques. This is even more true of the empirical relationship between the exchange rate regime and fiscal policy, about which little is known.

One way to rectify the empirical deficiencies in this literature would be to estimate the relationship between fiscal policy and the exchange rate regime for typical choices of the latter. Because most countries are in fixed, intermediate, or floating rate regimes, such an investigation would have to classify countries into exchange rate regimes and search for systematic differences in fiscal policy between, say, fixers and floaters. We choose to focus instead on the small number of countries that have chosen extreme monetary regimes. From a methodological perspective, we hope that these extreme regimes can shed light on the interaction that is blurred by other considerations when one compares fixers and floaters. Of course, there is no guarantee that looking at extreme data points will clarify the situation because outliers are fundamentally ... outliers.

Essentially there are three theoretical channels through which fiscal policy is related to the exchange rate regime: (1) fiscal policy as a credibility device, (2) fiscal policy as a stabilizing tool, and (3) the externalities associated with loose fiscal policies in multilateral currency unions.

A standard view of the connection between exchange rate regimes and fiscal policy is that fixed exchange rate regimes are associated with stricter fiscal policy because of the credibility role of economic policies. Because many exchange rate devaluations are associated with fiscal deficits and severe problems of credibility for governments and central banks, tighter fiscal policy becomes a required element in any exchange rate--based stabilization. Also, the external visibility and impact of devaluations in a fixed exchange rate regime raises the cost associated with irresponsible fiscal policy. Flexible exchange rates, on the contrary, not being subject to large realignments, do not provide the type of punishment that will discourage governments from running irresponsible fiscal policies.

This argument has recently been challenged by Tornell and Velasco (2000), who use the same credibility logic to argue that flexible exchange rates in fact provide more discipline. The reason is that movements in the currency reflect the excesses of fiscal policy faster and in a more transparent way. Under fixed exchange rates, the indicators of future crises, such as foreign reserves, are not transparent enough to reveal unsustainable paths of fiscal policy. In fact, one can think of the difference between flexible and fixed rates as being reflected in the intertemporal allocation of the inflation tax burden. Under flexible exchange rates, the excesses of fiscal policy are paid immediately. Thus, if the fiscal authority is impatient enough, there will be more adjustment under flexible than fixed exchange rates.

A second way of establishing a relationship between fiscal policy and exchange rate regimes is to think about fiscal policy as a stabilizing tool for business cycles. (1) Different exchange rate regimes are associated with different types of risks, and in an environment where economic policy is designed optimally, we should expect different exchange rate arrangements leading to different design of fiscal policies. When governments abandon monetary policy by fixing the exchange rate, they eliminate an important stabilization tool. The result is a greater need to make use of the other available tools, such as fiscal policy. Fiscal policy thus might be larger and be more responsive to business cycles under fixed exchange rates. (2) Along these lines, there is strong evidence (Rodrik, 1998) that openness and the additional risk that it imposes through terms of trade volatility are associated with larger governments (as a mechanism to stabilize fluctuations). (3)

The third connection between fiscal policy and extreme exchange rate regimes originates from the need to overcome the externality associated with the irresponsible fiscal policy of partners in multilateral currency unions. In the case of multilateral currency unions, countries might want to impose limits on fiscal policy because of the fear that partners in the currency union, having abandoned monetary policy, opt for fiscal policy that is too loose and imposes externalities on their neighbors. This is, for example, the principle behind the Growth and Stability Pact of the EMU and the fiscal restrictions set out by the proposed WAEMU. (4) The absence of such strictures clearly played an important role in the disintegration of the ruble zone in the former Soviet Union in the early 1990s.

In summary, the theoretical arguments are divided between those who put their emphasis on credibility and suggest that fixed exchange rates may be characterized by conservative fiscal policy and those who predict more active fiscal policy under fixed exchange rates, given that it is the only tool available to smooth out economic fluctuations. This theoretical ambiguity can only he resolved by an examination of the data. We next turn to that task.

II. Econometric Methodology

Our methodology consists of regressing different variables that characterize fiscal policy against dummy variables for the countries with extreme exchange rate regimes (currency unions or currency boards). We control for a set of variables …