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).
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