Institutions, Expectations, and Currency Crises

Abstract

Currency crises are costly phenomena that have been exceptionally difficult to explain and predict. We comprehensively examine the relationship between political institutions and currency crises and emphasize the causal linkage between institutions, expectations, and crises. Specifically, we argue that institutional variables—particularly divided government and government turnover—increase the variance of expectations held by speculators thereby increasing the likelihood of currency crises. We test these hypotheses using three existing economic models of currency crises and find that institutional variables are not only statistically significant, but also substantially improve the ability of these models to forecast crises.We are grateful to Helen Milner, Charles Cameron, William Bernhard, and seminar participants at the University of Wisconsin and the University of Southern California for helpful comments. Lisa Martin and our referees provided feedback that helped dramatically improve our arguments and exposition. Andy Rose, Steve Kamin, Mathieu Bussiere, and Marcel Fratzscher generously provided data and advice that helped us replicate their findings. David Leblang acknowledges financial support from the National Science Foundation (SES-0136866).