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The FX Impact of Differences Between Democracies

Monetary policy alone cannot account for the national differences in price levels that currency prices ultimately track. Recall that what induces central banks to turn up the printing press is pressure from politicians to monetize large deficits and debt.[1] My contention in this book that democratic forms of government are constitutionally disposed to spend more than they garner in revenue will be of limited avail in dealing with the present-day FX market. After all, a currency’s value is always relative to that of another, and the major currencies are all associated with democracies. Rather than speaking of democracy in general, i will have to explore whether there is something to the variations that regime can assume. Might these variations explain why one country’s paper is either less or more abundantly supplied than that of another? An obvious possibility is the degree of insulation from the political process that is afforded the central bank. The scholarly literature leans toward the view that greater central bank independence correlates with lower levels of inflation.[2]

Applying PPP to this finding, it follows that central bank independence must vary directly with the currency price. If we consider nations with the most actively traded exchange rates and utilize the US dollar as the basis of comparison, the German and Swiss units should have performed well on the FX markets. This expectation is confirmed from 1971 to 1998, when the Swiss franc was the strongest currency of the non-US big five, appreciating by 184 % versus the greenback.[3] The German deutschemark, which doubled in value over the same period against the US dollar, was only surpassed by the Japanese yen, though the latter’s performance was helped by strong exports. Meanwhile in France and Italy, where more pliant central banks ran their respective currencies, the French franc declined 6 % against the US dollar, while the Italian lira depreciated by 31 %.

As for the euro, we do well to remember that the ECB was modeled on the Bundesbank. As such, the ECB was handed a mandate to concentrate on price stability above all else. So it makes sense that, for most of its lifetime, the euro has traded at a higher level versus the US dollar than where it opened in 1999. But Mario Draghi’s adoption of QE starting in December 2011, more aggressively following up on similar actions taken in the late days of the Jean-Claude Trichet regime, reveals that the ECB has also succumbed to political pressure. Much of this pressure has obviously come from the Eurozone sovereign debt crisis. But no small amount of pressure has come too from the unwillingness of Europe’s political elites to undertake structural reforms of their economies along free market lines. Here again, democracy is at the core of the dilemma. Structural reforms aimed at liberalizing the economy generate short-term economic dislocations, besides hurting those benefitting from the status quo. To the government in power, that consequence represents votes which are likely to be lost come the next election. Witness what happened in Greece. No doubt, the Greek government did less than they ought to have by way of economic reform upon receiving its first bailout in 2010. Yet even the limited efforts made were met with the voters’ rejection of the two dominant parties, the Socialists and New Democracy, that had been running the country. It was the public’s enmity against austerity which created the opportunity for the Syriza party to be elected. Likewise, in Portugal, where a right-of-center coalition, made up of the Social Democrats and Christian Democrats, had implemented various reforms, while successfully taking the country out of a bailout program it was forced to accept in 2011. As thanks for this, in the 2015 elections, the incumbent coalition lost their majority in Portugal’s legislature, which emboldened a group of left-wing parties to come together and form a new government. With cautionary examples like these, it is not something to be wondered at that

Table 7.3 US dollar and presidential elections, 1976-2012

Election year

Year over year % change on election day


















+7.9 %


+2.6 %

Source: St. Louis Fed; calculations based on Fed Trade Weighted US dollar index—Major Currencies

Europe’s politicians have pushed the responsibility of reviving Europe’s economy onto the ECB. Accordingly, the euro has moved lower versus the US dollar. By 2015, it was well-ensconced under the $1.19 per euro threshold, where the continental currency inaugurated in 1999.

Other political determinants impinging on the supply of currency are harder to pin down. The scholarly literature on the political economy of fiscal policy originates with the political business cycle thesis. According to that thesis, incumbent governments attempt to gain re-election by running deficits to pump up the economy.[4] To affect the currency market more directly, the central bank would have to accommodate this fiscal stimulus with an easier monetary policy. There is some, though admittedly not overwhelming, evidence that money supply goes up in a statistically significant rate prior to elections.[5] Everything else remaining equal, then, elections must, as a matter of logic, be something of a depressant on the currency. As not everything else remains equal in reality, however, this relationship does not readily show up in the historical data. Taking the US as an example, ten presidential elections took place between 1976 and 2015 ever since currencies have been fully allowed to float. In seven of these instances, the Fed’s trade weighted US dollar index (major currencies) rose in the 12-month period leading up to the election (Table 7.3).

While these upward moves went in the opposite direction than would have been expected, seven out of ten is not statistically telling. That said, a possible explanation for this is that central banks, in an attempt to preserve their reputations, are driven to hide their pursuit of a loose money policy. By selling a portion of their FX reserves heading into an election, the central bank can avoid showing their hand in the FX market by keeping the currency from falling. Illustrating this is the experience in Latin America, where devaluations have often been delayed until after the elec- tion.[6] Based on an analysis of 149 countries from 1975 to 2001, another study verified this hypothesis, though attempts to prop up the currency were stronger among democracies in the developing world than those in developed nations.[7] Perhaps, as the authors of this study conjecture, the public in the democracies of the latter group is more sophisticated and better educated, and therefore not so easily fooled.

The political economy of fiscal policy literature offers three additional explanations of deficits and debt that impinge upon the FX market.[8] One of them refers to political instability, understood as the proclivity for changes in government. The greater this proclivity, the more likely are incumbents to engage in deficit spending and consequent debt accumulation in order to remain in power. Facing more uncertainty about their careers, such incumbents are more disposed to undertake strong measures. They also face a greater likelihood of passing on any fiscal mess to their political opponents created by their attempts to retain power. A second hypothesis holds that ruling coalitions within parliamentary systems are more apt to run up state expenditures than majority ruled administrations. The reasoning here is that minority parties and interest groups hold greater leverage in the budget bargaining process. These factions, then, must be granted additional monies to prevent a collapse of the government. That the reigning political ideology matters is the substance of the third explanation. This explanation argues that left-wing governments, being more concerned about employment than inflation, are more liable to run deficits and accumulate debt than right-wing parties. If these three theories are valid, then political instability, coalition governments, and leftist regimes put downward pressure on the currency. By contrast, political stability, majority governments, and rightist regimes will tend to put upward pressure on the currency.

Going through each of these possibilities, the least persuasive is that concerning the impact of coalition as opposed to majority governments. No logical reason exists why the presence of coalition rule alone must lead to excess government expenditures. The idea that it should relies on the assumption that the chief end of all political parties is to maximize the wealth of their supporters. Only on this basis can one argue that parties who hold out in negotiations must be bought off with an allocation of public funds. Yet not all parties are motivated by the economic demands of its followers. Some are driven by ideologies that have little or no bearing on fiscal policy. These can only be assuaged with the promise of offices and policies to advance their world-view rather than pecuniary considerations. Even when parties have economic demands to make, their leverage will vary over time with the voter’s willingness to hold another election and hold intransigent politicians to account. Moreover, it is not as if majority governments are necessarily more fiscally responsible. A party intent on rewarding its backers has greater freedom to do so holding a majority in the legislature than within a coalition government.

Mirroring all this theoretical ambiguity, econometric analyses have arrived at conflicting conclusions about the effect of coalition governments on the size of deficits and debt. Germany, Switzerland, and the


Netherlands have a long history of coalition governments without any notably adverse impact on their currencies since the move to floating rates in the early 1970s. Nonetheless, the prospect of a coalition government does involve uncertainty as to who will compose it as well as which sort of policies are going to be implemented as a result. It does turn out that this augments the volatility of FX prices. 3 0 Coalition governments, too, come to sight as more likely to reject fixed rate regimes in favor of letting the currency float.[9] [10] This is because coalitions lack the political strength to enforce the austerity and wage deflation measures that might occasionally be necessary in lieu of a depreciation. Coalition governments would rather let the currency fall to restore the country’s export competitiveness. They prefer to have the economic stimulus promised by greater exports serve as a reassurance to the financial markets that the fiscal situation will be less of a temptation to monetize the public debt. Now one might try to extrapolate this conclusion to a floating-rate environment. One might infer, in other words, that coalition governments will, under floating rates, lean toward allowing the currency to fall rather than tackle structural problems. One must be wary of doing so, however. Floating rates present a slighter test of a coalition’s political will than does the preservation of a fixed level whose misalignment with the economic fundamentals grows by the day.

More compelling is the logic behind the claim that political instability buffets the currency. Repeated changes in government reinforce the shortcoming of democracy that officeholders, being temporary stewards of the public realm instead of holders of a more enduring stake, will be inclined to heavily discount the future costs of immediately beneficial projects. A case in point is Italy, a country notorious for its instability, having witnessed more than 60 different governments since World War II. Prior to the euro, the Italian lira suffered a 64 % decline from 1950 to1998. This was among the worst performances of the dozen currencies that originally gave way in establishing the continental unit. Portugal’s escudo was the worst performer, dropping an eye-popping 84 % over the same time frame. Much of that depreciation, though, occurred between 1976 and 1986 when the Iberian nation went through nine governments.

Portuguese politics then had a definite left-wing tilt. So its experience lends credence to the thesis that governments animated by such ideological leanings are associated with currency weakness. Committed to a more expansive state, requiring larger revenues to fund, left-wing parties face the greater prospect of tax resistance. They might well be enticed to avoid this by encouraging the central bank to print money instead. Yet it is difficult to find empirical corroboration of this in econometric studies. Neither does any consistent finding come to view when we turn to specific historical cases. It was, after all, Greece’s fiscal predicament that initially sparked the euro crisis. Yet that country’s public finances imploded under the rule of the New Democracy party, ideologically located on the right side of the Greek political spectrum. When the euro’s travails subsequently deepened with Portugal’s request for a bailout in 2011, the country had been led by the Socialist party on the left for 14 out of the previous 16 years. In Britain, amid the two consecutive Labor governments of 1974-1979, the British pound sagged against its European benchmark, the German deutschemark. It then rallied strongly in the first two years of Margaret Thatcher’s administration, thus comporting with theoretical expectations. Afterwards, though, the British pound resumed its downward trend against the German benchmark. Not until the first several years of Tony Blair’s tenure as the Prime Minister in the late 1990s was this reversed. Of course, Tony Blair was the head of the Labor Party, not the Conservatives.

A similar defiance of expectations implied by party ideology is present in the American experience. The Fed’s trade weighted US dollar index (major currencies) fell 10 % when the Democrats held the Presidency with Jimmy Carter from 1977 to 1981. Later, however, the greenback saw its best post-Bretton Woods performance under one of America’s two major parties, ascending 14 % during Bill Clinton’s Democratic administration from 1993 to 2001. With just over a year left in the Obama administration,

Table 7.4 US Dollar performance by presidential administration and party, 1977-2015

Presidency (Dates)


% Change in USD during tenure

% Change in USD per annum

Jimmy Carter




-2.7 %

Ronald Reagan




-0.5 %

George H. Bush




+0.1 %

Bill Clinton



+ 14.1

+1.7 %

George W. Bush (2001-2009)



-1.5 %

Barack Obama




+1.8 %

Total 1977-2015


-0.3 %

Total Democratic


+0.8 %

Total Republican


-1.4 %

Source: St. Louis Fed; calculations based on Fed trade weighted US dollar index—Major Currencies *Obama administration evaluated as of November 20, 2015; Total Democratic and Republican percentages do not add up to the Total figure from 1977 to 2015 because those percentages are calculated from different bases

the US dollar’s performance was veering close to Clinton’s post-Bretton Woods record. Near the end of 2015, the US dollar was up 13.1 % during Obama’s Democratic term of office. By contrast, under each of the full Republican administrations since the move to a system of floating rates— Ronald Reagan, George H.W. Bush, and George W. Bush—the American greenback either declined or was little changed (Table 7.4).

Thus I arrive at the same conclusion that I did in my examination of the relationship between party ideology and the stock market: it is complicated. Tying currency price movements to the political philosophies of those in power is complicated by the fact that not every left- or right-wing party ends up acting in line with their professed views. This could be because these views are followed with varying levels of doctrinal purity or because political circumstances demand a pragmatic compromise. Hence, investors endeavoring to make decisions based on partisan variables cannot rely on statistically attested empirical regularities. They must apply their prudential understanding to the peculiarities of the situation at hand.

  • [1] Peter Bernholz, Monetary Regimes and Inflation (Cheltenham, UK: Edward Elgar, 2003).
  • [2] Helge Berger, Jakob De Haan, and Sylvester CW Eijffinger. “Central bank independence:an update of theory and evidence”. Journal of Economic Surveys 15, no. 1 (2002): 3-40.
  • [3] All currency price movements noted here were obtained from Werner Antweiler, “PacificExchange Rate Service”,
  • [4] William Nordhaus, “The Political Business Cycle”, Review of Economic Studies 87, no. 2(1975): 169-190.
  • [5] Alberto Alesina, Gerald D. Cohen, and Nouriel Roubini. “Macroeconomic policy andelections in OECD democracies”, National Bureau of Economic Research Working Paper, no.w3830 (1991).
  • [6] Jeffrey Frieden and Ernesto Stein, “The Political Economy of Exchange Rate Policy inLatin America: An Analytical Overview” in The Currency Game: Exchange Rate Politics inLatin America, eds. Jeffrey Frieden and Ernesto Stein (Washington, D.C. Inter-AmericanDevelopment Bank, 2001), 15.
  • [7] Axel Dreher and Roland Vaubel. “Foreign exchange intervention and the political businesscycle: A panel data analysis”. Journal of International Money and Finance 28, no. 5 (2009):755-775.
  • [8] For an overview of this literature, see Alberto Alesina and Roberto Perotti. “The PoliticalEconomy of Budget Deficits”. IMF Staff Papers42, no. 1 (1995): 1-31.
  • [9] John R. Freeman, Jude C. Hays, and Helmut Stix. “Democracy and markets: The case ofexchange rates”. American Journal of Political Science (2000): 449-468; William Bernhardand David Leblang, Democratic Processes and Financial Markets, 37-39.
  • [10] David A. Leblang, “Domestic political institutions and exchange rate commitments in thedeveloping world”. International Studies Quarterly 43, no. 4 (2002): 599-620; JeffreyFrieden, Pierro Ghezzi, and Ernesto Stein, “Politics and Exchange Rates: A Cross-CountryApproach” in The Currency Game. Exchange Rate Politics in Latin America., eds. JeffreyFrieden and Ernesto Stein (Washington D.C. Inter-American Development Bank, 2001),35^32.
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