Political Institutions, Policy Instability, and Financial Dollarization

The most recent generation of currency and nancial crisis literature blames the borrowing decisions of real and nancial sector actors; in particular, it argues that the de facto dollarization of liabilities is inherently risky and can trigger a host of economic ills that impede economic development. This paper presents and tests an institutional theory of de facto nancial dollarization. It argues that dollarization represents the rational response of domestic investors to policy instability individuals will store value in alternative currencies when they fear the expropriation of wealth through future volatility. The empirical evidence supports the hypothesis that dollarization provides a hedge against policy instability in the absence of checks on executive authority. The nding, which is robust to an instrumental variables approach that exploits historical institutional variation, suggests that democratic institutions in uence nancial development through previously unidenti ed channels. ∗PhD student, IR/PS and Department of Political Science, University of California, San Diego, La Jolla, California, 92093-0521. Email: [email protected]