Political Regimes and Currency Crises

This paper examines why some policymakers willingly adopt financial policies that increase the risk of a currency crisis, and what types of political institutions encourage them to do so. We hypothesize that the risk of currency crisis is lower in regimes where rulers are insulated from broad-based political pressures; have long time horizons; and are unable to deflect blame for crises. Currency crises should therefore be most frequent in democratic regimes and least frequent in monarchic regimes. We evaluate this argument using a time-series — cross-sectional dataset that covers 178 countries over the 1973-2010 period. Our results indicate that monarchies significantly reduce the probability of a currency crisis compared to other types of political regimes. We also demonstrate that this effect is driven primarily by the fact that monarchic regimes adopt more prudent financial policies than other types of political regimes. These findings suggest that perverse political incentives help explain why currency crises are so common, but that certain types of political regimes reduce incentives for imprudent policies and reduce the risk of financial crises