The original goal of the International Monetary Fund was to prevent economic crises arising from currency devaluation competitions. Since then, the organization has undergone significant changes, and its operation seems to raise more questions than it provides solutions.
One of the most frequently analysed outcomes of the recent BRICS summit was the admission of new members. However, the meeting also had other interesting outcomes: several countries clearly expressed their demand for essential changes in global financial institutions created by the Bretton Woods system, such as the World Trade Organization (WTO), the International Monetary Fund (IMF), or the World Bank. What could be the reason for this demand, and is there any basis for the complaints against institutions that have been functioning for decades? This article details the case of the International Monetary Fund.
When everything was good – in the United States
The reasons for the establishment of the International Monetary Fund can be traced back a hundred years on the other side of the Atlantic. America of the 1920s was characterized by remarkable economic growth after the devastating effects of the Great War. Due to the advantages also arising from the size of America’s internal market, mass production became profitable, which accelerated the development of technology, thus boosting the automotive industry, the radio industry, the film industry, the construction industry, and the chemical industry. In the same period, the consumer society emerged, which fuelled economic growth and made the middle class more and more accustomed to prosperity. As a result of these mutual influences, the middle class grew strong and gained significant income, which was invested in the stock market.
A new industry emerged based on the success of stock market investments, where brokers and investors convinced masses to buy corporate shares on credit. Buyers deposited a fraction of the price, typically 10%, and paid for the remaining shares with borrowed money, while the purchased shares served as collateral. The money from loans flowed into the stock markets, causing a surge in stock prices. Encouraged by this process, more people took out loans in a similar way and for the same purpose, driven by the hope of growing profits. However, the process was not sustainable.
Meanwhile, in line with the American minimalist state approach, the government and the central bank hesitated to intervene. When the Federal Reserve eventually decided to act, it might have been too late. On the one hand, the public was warned about the dangers, and, on the other hand, reserve banks were asked to reject credit requests from member banks lending to stock speculators. However, this did not yield the expected results, and the Federal Reserve decided to raise interest rates.
According to the plan, higher interest rates would have, in turn, led to higher interest rates for loans available to local actors. However, due to the gold standard still in effect at the time, the Federal Reserve’s interest rate hike forced foreign central banks to also raise interest rates. This slowed down economies that needed different monetary policies, leading to crises in several European countries. Still, New York stock speculators were not discouraged by such developments. The economic bubble eventually burst in 1929 when stocks began to fall in an unprecedented manner, and banks could not repay individuals’ money. Hundreds of thousands of people lost their savings, factories and companies went bankrupt, and millions became unemployed. Since US economy focused on industry at that time and did not exploit its agricultural capacities, severe famine followed the ongoing catastrophes.
Low We Sat, Yet Greatly We Fell – Europe After World War I
The catastrophic results of World War do not need to be elaborated on for Hungarian readers. The entire continent suffered from the ravages of war, making it much more challenging to rebuild countries and overcome economic difficulties than in America. In the early 1920s, hyperinflation characterized Europe’s economy, especially in Germany, but also in re-shaped countries like Hungary, Austria, Poland, and even in Russia, where the currency depreciated to an unprecedented extent.
However, European industry underwent a widespread modernization process during this period. Many companies tried to introduce and use the modernization processes that had proven successful in the American industrial environment. Accordingly, labour flowed in that direction, especially into the industrial and service sectors. Similar to the United States, agriculture’s share in the economy was relatively neglected in Europe as well, which, from a historical perspective, was a clear risk factor.
After the war, the governments of the newly formed states understandably aimed for rapid economic development and sought to industrialize their countries as soon as possible. The new technologies and manufacturing methods were capital-intensive and required extensive new network infrastructures for markets to be profitable. However, this was not given due to political fragmentation in Europe, as it was in the United States. The lack of coordination and harmonization led to the delayed electrification of the periphery of Europe after 1945 because cross-border technological standards negotiations progressed slowly. This was compounded by the high risks of investments and developments in the years between the two world wars.
However, political fragmentation not only hindered the development of infrastructures and impeded economic growth associated with mass production. A crucial element of European economy at that time was the accumulation of debts among the Allies after the war’s devastation, and they also demanded war reparations from the defeated. In this context, fierce competition arose among nation-states for loans necessary for economic recovery, leading to the introduction of protectionist policies and increased isolation. In other words, achieving European financial coordination and reconstruction was practically impossible.
In this environment, Europe was affected by the previously mentioned American monetary policy move, namely, the Federal Reserve’s interest rate hike. European banks also had to tighten their policies in an environment that essentially needed stimulation. The crash of the New York Stock Exchange worsened the situation, and an international currency devaluation competition began in Europe, triggering the economic crisis beyond the eastern coast of the Atlantic. This had the most significant impact on Germany, Austria, and Poland, where unprecedented unemployment emerged. Moreover, the economies of France, Belgium, and the Netherlands also suffered greatly from the events.
Response to the Great Economic Depression – The International Monetary Fund
The Great Economic Depression did eventually come to an end, with its beginning falling into the period of the Second World War. Similar to its outbreak, the containment of the crisis also originated from the United States, but it is highly debated whether the USA’s monetary or fiscal policy during the war played a significant role.
After World War II, the United Nations initiated economic cooperation in 1944 to prevent the recurrence of a currency devaluation competition and the ensuing economic global crisis experienced in the 1930s. Accordingly, based on the decisions of 45 countries participating in the Bretton Woods Conference, the International Monetary Fund (IMF) was established, and the organization officially began its operations in December 1945.
Over the decades, the IMF’s original objectives have changed, and today it is not just a forum for coordination between central banks aiming to prevent currency devaluation competition. The organization seeks to respond to current economic challenges, including policy advice, providing loans, and capacity development, i.e., technical assistance and training.
The IMF is primarily known for providing loans. The organization offers financial support to crisis-stricken countries, allowing them to regain economic stability, if they implement a set of policies advised by the organization’s consultants, promoting sustainable growth and stability. According to the organization, they continuously refine loan provision to meet changing economic circumstances and the countries’ needs.
The organization is led by a Board of Governors, which is the supreme decision-making body. Each member country appoints a governor and an alternate governor, usually the central bank’s president or the finance minister. The Board of Governors’ work is assisted by the Executive Board, with 24 members elected by the group of 184 member countries. The President of the Executive Board is the Managing Director. The organization’s decision-making is based on a weighted voting mechanism using predetermined quotas, meaning that some countries have “more significant” votes than others. The five countries with the most quotas appoint their own members to the Executive Board: the United States, Japan, Germany, France, the United Kingdom, China, Russia, and Saudi Arabia. Since the initial institutional structure, the United States has held the majority of shares, essentially having a veto since 1945.
In recent decades, the opacity of the decision-making mechanism and the representation of the interests of smaller states have been topics of discussion in academic and political circles. Consequently, several changes have occurred in institutional decision-making and quotas, which we won’t delve into here. However, what is essential to note is that currently, the United States holds more than 16% of the votes, while the European Union countries collectively hold 25% of the votes. With the votes of the United Kingdom, Canada, Australia, and Japan included, the so-called Western countries collectively hold 55.75% of the votes. In contrast, the share of the expanded BRICS+ countries is barely over 19%. All of this can be advantageous for developed economies and EU Member States, but not so much for developing countries. Thus, the overwhelming majority of IMF members feel that their voice is less heard than that of developed economies, especially the United States.
In itself, this might not be an issue if developing economies felt that their national interests were effectively served by the current structures.
What is the issue with the International Monetary Fund?
The structure and operation of the organization entail the risk of reinforcing power imbalances among member states. This is further exacerbated by the IMF rules regarding the “flexibility” of lending. In simple terms, countries with larger quotas can borrow under more favourable conditions than smaller countries.
Concurrently, there are opinions suggesting that lending terms were unfair and served the interests of some developed countries rather than those borrowing the funds. Beyond opinions, empirical studies have examined the economic indicators of borrowing countries that committed to implementing the reforms expected by the international organization. One such study analysed 81 countries that borrowed IMF funds and undertook structural reforms between 1986 and 2016. According to the study, the reforms led to profound and comprehensive changes, generally increasing unemployment, reducing government revenues, raising the costs of essential services, and transforming tax collection, pensions, and social security schemes. However, this also trapped more people in the vicious cycle of poverty.
It is no wonder, therefore, that the confidence of developing economies in the methods of the International Monetary Fund has broken, and more and more are hoping that the terms offered by the New Development Bank created by the BRICS group will be more favourable for them.
In addition to economically questionable measures, it is also noteworthy that some sources claim that larger member states abuse their advantages derived from their position within the IMF and use their influence for political purposes. A recent alarming case involves a suspected agreement between Pakistan and the United States. According to suspicion, Pakistan, on the brink of bankruptcy, did not receive the new support requested from the IMF in June due to severe budgetary problems – largely caused by austerity measures prescribed under the IMF loan. Under Prime Minister Imran Khan’s leadership, Pakistan remained neutral on the Ukraine war. Sources claim that, under pressure from US diplomats, the prime minister was removed on corruption charges, and Pakistan’s stance has changed significantly concerning the Russian invasion. Moreover, Pakistan agreed to secretly sell weapons to the United States for the war in Ukraine in exchange for the Biden administration helping Pakistan get the IMF bailout approved in July; it seems doubtful that significant changes could had be made to the budget during this time. Meanwhile, the interim government supported by the Pakistani military postponed the upcoming elections, a move widely seen as an attempt to prevent Khan’s supporters from regaining power.
In other words, officially unconfirmed sources suggest that the United States assisted in the removal of a democratically elected leader in Pakistan to support democratic processes in Ukraine and provide arms.
Even if all this is untrue, the question still arises whether a similar scenario is entirely inconceivable. What if there is a country on the verge of bankruptcy in urgent need of a bailout, and there is a community of potential partners with practically veto power in a financial institution capable of saving the developing country from bankruptcy? Thus, it is no wonder that, taking all this into account, an increasing number of countries feel the need for an alternative venue and turn hopefully towards the BRICS countries.
Source of image: Flickr