Do exchange rate regimes affect the conditions under which developed country governments borrow?
In this paper, we argue that they do, but their impact on bond yields depends on the prevailing macroeconomic context. When financial markets regard inflation as the most relevant risk to investment in a country’s debt, fixed-peg arrangements and monetary union have distinct advantage over floating exchange rates, because of their in-built mechanisms to control inflation. However, once default becomes the most relevant risk to bond holdings – like in the deflationary context prevalent in OECD-countries since the late-2000s – exchange rate rigidity turns into a liability due to its constraining effect on governments’ ability to stimulate growth. We test our argument with a moving-window panel-analysis for 23 OECD countries from 1980 to 2017. We find that from the 1980s to the 2000s, inflation was penalized in countries with floating and (to a lesser extent) fixed exchange rate regimes, but not in countries in monetary union. Since the 2010s, inflation carries no penalty under any exchange rate regime. Variables linked to default risk – public debt and entitlement spending – did not affect bond yields under any exchange rate arrangements before the mid-2000s. Since the mid-2000s, countries in monetary union are significantly penalized for public debt and entitlement spending, whereas other exchange rate arrangements are comparatively exempt from such penalties.
Alison Johnston is an Associate Professor and the U.G. Dubach Chair in political science at Oregon State University. She completed her PhD at the European Institute at the London School of Economics in 2011. Her research interests lie at the intersection of comparative and international political economy. She has published on the political economy of comparative capitalism and European integration, housing markets, sovereign credit ratings, and general strikes in Comparative Political Studies, Comparative Politics, Politics & Society, the Journal of Common Market Studies, and West European Politics, among other outlets. Her book, published by Cornell University Press, examined the labour market origins of the European sovereign debt crisis. She is also a co-editor for the Review of International Political Economy.
Paul De Grauwe is John Paulson Chair in European Political Economy at the LSE European Institute.