Why do countries commonly engage in behavior that
reduces growth and enhances the likelihood of economic crisis? Since overvaluation has
detrimental effects on both the general public and special interests, understanding why
overvaluation is so common will contribute to our theoretical knowledge and provide
policymakers with useful information about how to avoid self-destructive policies in the
future.
The first section of this paper discusses how macroeconomic policy and the
currency regime, in combination, affect the exchange rate level. I then review alternative
explanations for overvaluation, revealing one important weakness of previous theories:
an inability to explain why overvaluation often harms its supposed advocates. The third
section lays out the sectoral logrolling theory of currency policy, which argues that
overvaluation is common not necessarily because important groups benefit from
overvaluation itself, but rather because pivotal actors benefit from the side-effects of
overvaluation. Since overvaluation tends to be associated with currency stability and
high government spending, and most groups prefer these outcomes to unstable currencies
and low spending, overvaluation advocates are able to buy the support of swing groups
by offering them policies that these policies. By contrast, actors who prefer undervalued
currencies have fewer tools with which they can buy support from third parties since few
will be enticed by currency instability and low spending; as a result, they have a hard
time building social coalitions and winning political battles. Overvalued currencies are
so common because actors that care little about currency valuation will commonly
support overvaluation. Logrolling increases the political influence of the pro-
overvaluation coalition relative to the pro-undervaluation coalition.
7
Leblang 2002.
8
Golfajn and Valdes 1999; Kaminsky et al 1997.
3
Convention