When are Monetary Commitments Credible? Parallel Agreements and the Sustainability of Currency Unions

Abstract

This article investigates the conditions which make it costly for governments to renege on institutional commitments governing monetary policy. Focusing on one such type of commitment – monetary integration – we develop and test a hypothesis which suggests that the presence of parallel international agreements plays an important role in raising the costs of exit for states which might otherwise withdraw from a monetary union. While existing political economy work on credible commitments in the area of monetary policy has had a heavy focus on countries in the European Union, we broaden the inquiry, using quantitative and qualitative evidence from the numerous African countries which have participated in monetary unions over the last forty years. Our results provide strong support for the parallel agreements hypothesis. A common argument found in the work of both economists and political scientists is that adopting certain institutional arrangements can allow for credible commitment in the area of monetary policy. At the domestic level analysts have observed that central bank independence and/or the establishment of an exchange rate peg may increase credibility of monetary policy. At the international level, authors have suggested that establishing multilateral pegging arrangements, such as the European Monetary System (EMS) or a full-fledged monetary union may lend credibility. While the literature on the credibility-enhancing effect of certain monetary policy institutions is voluminous, analysts have not devoted sufficient attention to a crucial issue; if a state can do away with an institution such as an independent central bank or participation in a monetary union without significant cost, then the credibility effects from establishing these institutions will be marginal. 1