Exchange rates fluctuations and bilateral trust

Pegged exchanged rate agreements have often been recalled as an instrument to increase the reliability of governments and their reputation, as also the introduction of the single currency was presented as a crucial step for the economic and political integration between European countries. But do stable exchange rate also increase trust between countries, or the contrary ? In this paper, we find a significant and positive effect of exchange rate fluctuations on bilateral trust between countries, suggesting a negative relationship between “stable” exchange rate and trust. As a measure for bilateral trust, we use Eurobarometer survey carried between 1970 and 1996. In addition, we carry a small survey in which we find that bilateral trust between citizens of different countries, is highly correlated with the trust in the respective foreign institutions (measured in terms of perceived corruption and property rights protection). We suggest two possible explanation for our results: (1) since exchange rate fluctuations increase uncertainty, there is more demand for trust (2) because pegged exchange rate increases free riding behaviors of government, this lead to an erosion of the trust between the two countries.