The Effect of Security Alliances on Exchange-Rate Regime Choices

Because an exchange-rate arrangement by nature involves more than one country and because it has various economic and political implications, it is affected inevitably by interstate political relations. Most previous research explains the exchange-rate regime choice as a function of individual country attributes, ignoring the role of interstate political relations and the anchor-currency choice. In this paper, I examine how security alliances influence a country's choices over the flexible-fixed regime and the anchor currency. Alliances increase the ex ante attractiveness of pegging to one's ally, because security ties can reduce concerns over relative gains, motivate active collaboration by the anchor-currency ally to defend the regime, and signal to the currency market the durability of the regime. Hence, a country is biased toward pegging to its ally, relative to either pegging to a nonally or choosing the flexible regime. I test the argument for both the Bretton Woods and the post- Bretton Woods periods. I find that alliance ties affect both the anchor currency and the flexible-fixed regime choices, as expected. But these effects appear to function through the defense-pact alliance alone and are most pronounced for the developing countries.