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Jonas Teusch
1 November 2010
About size and proximity
Bernard and Leblang argue that domestic political institutions help explain a governments choice
among three main exchange-rate options: a floating exchange rate, a unilateral peg, and a multilateral
exchange-rate regime (BL 1999: 71). In other words, they expect politicians in proportional-high
opposition influence systems to be most likely to participate in a fixed exchange-rate regime [i.e.
either independent peg or participation in a multilateral currency agreement (MCA)] (ibid: 77). By
contrast, politicians in proportional low-opposition influence and majoritarian systems are
hypothesized to be less likely to opt for such a regime. BLs analysis of a sample of 20 industrial
countries from 1974 to 1995 strongly supports their hypotheses (ibid: table 3 and 4). However, I
show that BL fail to adequately control for a plausible alternative explanation. More precisely, I
hypothesize that small countries should have an interest in joining a fixed exchange-rate regime with
a geographically close major economic power.

The fact that half of the samples ten proportional-high opposition influence systems
participated in a fixed exchange-rate regime during the entire period under study ostensibly supports
BLs argument (ibid: 85). However, a quick look at these countries reveals another notable feature.
Austria, Belgium, Denmark, Germany, and the Netherlands do not only have a similar political
system, they also share a border with Germany. As the gravity model of trade shows, geographic
proximity can be expected to have a positive impact on trade, meaning that these countries are
potentially important trading partners. Notably, one of the main benefits of fixed rate regimes is that
they promote trade and investment by reducing exchange rate risk (Broz and Frieden 2006: 591).
This effect should be greatest if the major trading partners are part of the very same fixed exchange-

By country size, I mean the economic size of a country, usually measured as GDP.

rate regime. Therefore, I would expect neighboring countries to have an increased interest in
participating in a fixed-exchange rate regime.
In addition, all proportional-high opposition influence countries but Germany are relatively
small economies (Denmark, Finland, Norway, Sweden, Switzerland, and the ones already
. As Obstfeld and Rogoff point out, literally only a handful of countries in the world
today have continuously maintained tightly fixed exchange rates [;] all of these countries are
relatively small (1995: 87). Accordingly, Broz and Frieden state that smaller countries have tended
to fix their currencies against one of the major currencies or to allow their currencies to float with
varying degrees of government management (2006: 588). Again, the gravity model helps understand
why. Small countries can be expected to trade mainly with geographically close countries, whereas
the trade flows of large economies are less dependent on proximity. In other words, while small
countries are fairly dependent on a large neighboring country, the latters trading patterns are usually
geographically more diversified. In order to decrease the uncertainty that arises from floating
exchange rates, small countries, then, have an incentive to fix their currency to a geographically close
major economic power. A countrys economic size should therefore be negatively correlated with
the choice for a fixed exchange-rate regime.

Taking both country size and geographic proximity into account, my alternative explanation
can explain why Canada did not fix its currency to the US dollar, whereas Belgium decided to join an
MCA with Germany. But why did Germany, an economically large country, choose to participate in
the EMS? Applied to our case, the Mundell Fleming conditions predict that by joining the EMS,
Germany lost control over its monetary policy - as Germany could not implement capital controls

Note also that these other proportional-high opposition influence countries are geographically remarkably close to
Germany as well.
In table 1 BL predict the very same effect for economic size (1999: 84). However, they do not include GDP in their
regressions because the economic size variable [] was collinear with measures of openness and international capital
mobility (ibid: 79).

due to the free movement of capital rule of the EC. Why was Germany willing to bear these costs?
The answer is simple, it didnt have to. Since the single largest component of the ecu was the
deutschmark [] the EMS was little more than a deutschmark-zone (Brawley 2005: 384; see also
Broz and Frieden 2006: 589). More precisely, Germanys central bank, the Bundesbank, was free to
set an independent policy, while the central banks of the other EMS members could not (Brawley
2005: 384) The EMS was therefore less multilateral than BL seem to assume (1999: 87 f.). Germany
did not really fix its currency to the other EMS members; rather the other EMS members fixed their
currencies to the deutschmark.
Admittedly, BL do partly control for both country size and proximity. Indeed, their measure
of trade openness captures two aspects of my argument. First, it measures the relative trade
dependence of a country. Yet, it does not measure to what extent this trade takes place among
geographically close countries. Since I expect the fixing effect to be greatest for neighbors of a
large economic power, trade openness cannot be considered a sufficiently valid control. BL include
two more controls for a countrys vulnerability to shocks: domestic credit shock and economic
growth rates. Yet, again, these variables do not measure if countries are geographically close to a
leading economy to which they would want to peg their currency. The fact that BL include two
variables measuring proximity, namely Europe and EC, does not help to address my validity
concerns either, as these variables are not interacted with measures of country size.
To conclude, BL do not adequately control for a possible interaction effect of geographic
proximity and country size. With reference to the gravity model of trade, I have argued that small
countries should be particularly interested in pegging their currencies to a geographically close large
economy. In BLs sample, Germany is the only major economic power surrounded mainly by small
countries. Consequently, it is the only geographic area for which I could observe this effect. To test

to what extent my hypothesis travels across countries and continents, the sample would need to be
increased considerably.

Bernhard, William and David Leblang. 1999. Democratic Institutions and Exchange-Rate
Commitments, International Organization 53 (1): 71-97.
Brawley, Mark R. (2005): Power, Money, & Trade, Peterborough (Ontario): Broadview Press.
Broz, J. Lawrence, and Jeffry A. Frieden (2006): The Political Economy of Exchange Rates, in:
Oxford Handbook of Political Economy, ed. Barry Weingast and Donald Wittman, New York:
Oxford University Press.
Obstfeld, Maurice and Kenneth Rogoff (1995): The Mirage of Fixed Exchange Rates Journal of
Economic Perspectives, 9(4): 73-96.