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Institutional Constraints, Mercantilism or Free Riding? The Political Economy of Changes in Global Dollar Holdings, 2000-2005
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Farmers versus Financiers: Logrolling and the Political Economy
of Exchange Rate Overvaluation in Developing Countries
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David A. Steinberg
Department of Political Science
Northwestern University
## email not listed ##
Abstract: Scholars have paid limited attention to the political causes of exchange rate valuation. Existing theories do not adequately explain why overvalued currencies have been so common in developing countries. Overvaluation is a puzzling outcome: it contradicts the common assumption that states want to maximize net exports; and it has harmful economic effects, such as low growth and financial crises. I argue that previous theories under-predict the prevalence of overvaluation because they have overlooked one important motive for this policy—logrolling. Fixed exchange rates and high government spending typically coincide with overvaluation, and some tradable producers benefit more from these policies than they lose from overvaluation. Thus, they have an incentive to logroll and strategically support overvaluation. The likelihood of logrolling, and thus overvaluation, depends on whether policy promises are credible or not. Logrolling is subject to credibility problems, which are easier to solve when there are multiple veto points in the political system. I predict that the interaction between veto points and sector size best explains patterns of currency valuation in the developing world. Previous analysts have used the exchange rate regime as a proxy for currency valuation, but I use the black market exchange rate premium and the Dollar index, which are more valid measures of currency valuation. Statistical tests, based on a large sample of developing countries from 1974-1995, reveal that the financial sector is associated with overvaluation in cases where there are multiple veto points, and the agricultural industry reduces overvaluation only when there are few veto points.The majority of developing states have used their policy instruments to keep their real
exchange rates above market value. Deliberate attempts to maintain overvalued
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Prepared for presentation at the 48
th
Annual ISA convention, Chicago, IL, Feb. 28-Mar. 3, 2007. Previous
versions were presented at the 2006 MPSA and 2006 APSA conferences. This research was supported by a doctoral fellowship from the Social Sciences and Humanities Research Council of Canada. I am indebted to those who supplied me with their datasets. For helpful comments, I thank Mark Brawley, Sean Gailmard, Sebastian Karcher, James Mahoney, Quan Li, Angela O’Mahony, Louis Pauly, Michael Pisa, Reuel Rogers, Ben Ross Schneider, Victor Shih, Hendrik Spruyt, and Stefanie Walter.
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| | Authors: Shih, Victor. and Steinberg, David. |
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Farmers versus Financiers: Logrolling and the Political Economy
of Exchange Rate Overvaluation in Developing Countries
David A. Steinberg
Department of Political Science
Northwestern University
Abstract: Scholars have paid limited attention to the political causes of exchange rate
valuation. Existing theories do not adequately explain why overvalued currencies have
been so common in developing countries. Overvaluation is a puzzling outcome: it
contradicts the common assumption that states want to maximize net exports; and it has
harmful economic effects, such as low growth and financial crises. I argue that previous
theories under-predict the prevalence of overvaluation because they have overlooked one
important motive for this policy—logrolling. Fixed exchange rates and high government
spending typically coincide with overvaluation, and some tradable producers benefit
more from these policies than they lose from overvaluation. Thus, they have an incentive
to logroll and strategically support overvaluation. The likelihood of logrolling, and thus
overvaluation, depends on whether policy promises are credible or not. Logrolling is
subject to credibility problems, which are easier to solve when there are multiple veto
points in the political system. I predict that the interaction between veto points and sector
size best explains patterns of currency valuation in the developing world. Previous
analysts have used the exchange rate regime as a proxy for currency valuation, but I use
the black market exchange rate premium and the Dollar index, which are more valid
measures of currency valuation. Statistical tests, based on a large sample of developing
countries from 1974-1995, reveal that the financial sector is associated with
overvaluation in cases where there are multiple veto points, and the agricultural industry
reduces overvaluation only when there are few veto points.
The majority of developing states have used their policy instruments to keep their real
exchange rates above market value. Deliberate attempts to maintain overvalued
*
Prepared for presentation at the 48
th
Annual ISA convention, Chicago, IL, Feb. 28-Mar. 3, 2007. Previous
versions were presented at the 2006 MPSA and 2006 APSA conferences. This research was supported by a
doctoral fellowship from the Social Sciences and Humanities Research Council of Canada. I am indebted
to those who supplied me with their datasets. For helpful comments, I thank Mark Brawley, Sean
Gailmard, Sebastian Karcher, James Mahoney, Quan Li, Angela O’Mahony, Louis Pauly, Michael Pisa,
Reuel Rogers, Ben Ross Schneider, Victor Shih, Hendrik Spruyt, and Stefanie Walter.
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