The IMF’s Role in the Post–Bretton Woods Era
The International Monetary Fund (IMF) was originally a Bretton Woods organization. At the Bretton Woods Conference of 1944, it was clear that the post–World War II international monetary system was going to depend on a multilateral arrangement.
The earlier periods of metallic standard didn’t have the multilateral nature of the Bretton Woods era, which was thought to have led to unilateral changes in exchange rates, undermining the fixed exchange rate regime. Additionally, the international monetary system chosen for the post–World War II period was a variation of the gold standard — namely, the reserve currency standard.
This system envisioned establishing the gold parity with the reserve currency, the dollar, and pegging all other currencies to the dollar.
The role of the IMF
The Bretton Woods Conference created the IMF as a multilateral organization to oversee the pressures of current account imbalances in countries whose currencies were pegged to the dollar. The IMF tried to uphold the Bretton Woods system by providing funds to current account-deficit countries. However, as early as the late 1940s, the IMF didn’t have enough funds to manage the Bretton Woods system.
Despite this fact, the IMF wasn’t abolished with the Bretton Woods system in 1971. Developed countries were adopting flexible exchange rates, and developing countries were unwilling to let their currency float. Given their mostly expansionary fiscal and monetary policies and political uncertainty, these countries expected large depreciations in their currency if they let them float.
Developing countries wanted to have a nominal anchor — something stable in their sometimes highly unstable economies. Additionally, these countries wanted to manage their exchange rates to support their development strategy of import substitution.
The IMF had another important reason to stick around, too. As the Bretton Woods system ended, the first oil price increase of 1973 hit all countries, especially developing countries. The IMF fit naturally in the role of the provider of additional liquidity to developing countries. Consequently, as developed countries were adopting flexible exchange rates, the age of unilateral pegs started for developing countries.
The IMF and unilateral pegs
With many developing countries deciding on unilaterally pegged exchange rates, the IMF was on familiar ground. Although using unilateral pegs is different than pegging currencies to the dollar under the reserve currency system, currency pegs need outside financing (albeit for different reasons).
In the Bretton Woods system, persistent and large current account deficits initiated a loan from the IMF. In the post–Bretton Woods era, unilateral pegs periodically led to reserve depletion in countries, which necessitated a loan from the IMF.
In a unilateral peg, the country pegs its currency to a hard currency such as the dollar. For the peg to be credible, the country cannot make extensive use of monetary policy, especially expansionary monetary policy involving increases in the money supply.
In many developing countries, this scenario was (and, to some extent, still is) difficult to accomplish. Most of their central banks aren’t independent from the fiscal authority, and the fiscal authority can exercise strong control over the monetary authority. Therefore, whenever the fiscal authority wants to increase its spending without increasing taxes, monetary policy is the easiest way to get these funds.
Of course, an expansionary monetary policy leads to higher inflation and, at times, hyperinflation, which reduces the credibility of the peg. When the peg loses its credibility, investors expect that the peg will be broken and the currency will depreciate.
To avoid future losses, holders of the domestic currency exchange the domestic currency at the pegged rate for the hard currency, such as the dollar, which leads to the depletion of the central bank’s reserves. At this point, the country can’t make payments on its debt or for its imports. Then it’s time to go to the IMF and get a loan.
Unlike the IMF’s financial assistance during the Bretton Woods era, IMF loans during the post–Bretton Woods era are associated with conditionality.
The reason for attaching conditionality to the IMF support during the post–Bretton Woods era is that a unilateral peg loses its credibility for only one reason: The country was following incompatible fiscal and monetary policies under the peg. In other words, rapidly increasing public-sector spending pressures monetary policy to be expansionary, creating expectations that the peg will be broken and the currency will depreciate.
In 2009, the IMF introduced a major overhaul in its programs and conditionality. Since then, the IMF also provides financial support to countries that are experiencing a financial crisis that didn’t stem from pegged exchange rates.
Consider the example of Greece, a member of the European Union and the Euro-zone. In 2010, the IMF approved a €30 billion three-year loan for Greece to help the country get out of its debt crisis. This example is one of the largest financial supports the IMF has provided to any country.
Because Greece is in the Euro-zone, there is no pegged exchange rate situation here. (This is more a problem of implementing independent and expansionary fiscal policies as a member of a common currency area.)
The recent cases involving Greece, Italy, Spain, Ireland, and others in the Euro-zone don’t imply exogenous crises. These countries’ financial problems didn’t come out of nowhere. The Euro-zone countries in crisis have varying degrees of expansionary fiscal policies, uncoordinated public finance schemes, and proneness to banking crises.
In a way, the IMF has remained the same since its inception: an institution that provides financial support to countries with home-brewed economic problems.