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Thursday, April 21, 2011

The IMF and World Bank

Special thanks to Evan T. for submitting Economystified’s first reader request (via facebook)! 

“The IMF and other international banks?!?! How they do what they do, and what effect it has.”

                For an intergovernmental organization with 187 member nations, you would figure most of us would have a better understanding of the function and purpose of the International Monetary Fund (IMF).
                Don’t worry though.  Throughout long periods of its history, the IMF itself hasn’t had a great grasp on what it does or how it does it!  It’s had more identity crises than Madonna, and at times has been just as difficult to keep up on.

                To explain the IMF’s exact mechanics would require a semi-involved discussion of “central banks” – in the US, its that thing everyone keeps calling “The Fed.”  That topic alone could take up an entire blog post (or dozen).  So in the interest of getting an answer out to Evan, let me cut right to the chase:  

                The IMF is an independent entity, tasked with the responsibility of “promoting monetary cooperation” between its member nations (read: its the world’s money changer).  The end goal of the IMF is to keep the global economy stable, and it does this through facilitating exchange rates, balance of payment assistance, consultancy, loans…whatever they figure needs to be done. 

                This stability, by the way, is a pretty important task right now, given the vast interconnectivity of economies we see today and the ever present threat of the big bad “chain reaction.”

                You probably noticed how this is an extremely broad and ambitious goal.  When the IMF started out in 1944, it had less than 30 members, who were concerned mostly with only one issue: taming fluctuations in exchange rates. 

                However, ever since we all dropped off the gold standard and adopted floating exchange rates, that issue (for the most part) just resolves itself.  Yet the IMF has stuck around.

                In recent history, the IMF’s major role has been making short-term, only-when-needed loans to member nations’ central banks, for the purpose of “price stabilization.”  This is just a fancy phrase for curtailing run-away inflation or deflation of the world's currencies. 

                Each IMF member is required to chip into an IMF reserve pool of cash, and loans are made from that kiddie to members who need a “bailout” – God forbid.  Later, as the bailed out country begins to pay off the loan, their payments go back into the group fund, so that it all can be loaned out again.  The goal is to keep the same money constantly circulating, off to where ever it’s needed, then back home again when the job is done.

                But remember, with no clear defined permanent function, in ten years – or ten months – the IMF could be focusing on something completely different.

One major problem the IMF constantly runs into…

                Say there’s an inflation crisis in Nicaragua.  So the IMF loans them $1 million USD to help prop up their currency (right now about 20 Nicaraguan cordoba = $1USD, so this loan is equal to around 20 million cordoba).  This loan will have to be denominated in some “impartial” currency (like Euros, or US dollars).  If not, the Nicaraguan Central Bank could just print 20 million valueless cordoba and pay the IMF back with Monopoly money.

                But if the cordoba continues to inflate even after the loan, and now 25 cordoba buy $1, and then 30, Nicaragua will need to cough up more and more cordoba to pay back that same $1 million USD.  

                IMF loans are either zero interest, have an interest rate equal to the borrower’s “next best offer,” and/or set at just enough to cover legal and administrative costs of the lending.  But if the borrowing nation's economy continues to tumble after a loan is made, the required payments will end up feeling larger and larger, as the quantity of local currency necessary to service the loan balloons.

                While the IMF's operations are mostly short-term and currecy focused, the International Bank for Reconstruction and Development and International Development Association (known together as the "World Bank"), concerns itself with long-therm and asset development programs.

               World Bank lending is available specifically for poorer nations who are looking to build up infrastructure, sustainable energy systems, education, etc.  Think “physical stuff that can continuously generate income.”  Their loans are termed in decades, the IMF’s in years. 

                The World Bank gets its funds from two sources.   1) A revolving fund composed of member contributions (like the IMF system - by the way, the IMF's 187 members are also all members of the World Bank).  And 2) by selling World Bank bonds in the general market, then turning the proceeds over to poorer nations. 

                The World Bank is made up of rich and poor countries, but it’s the entire entity that grantees the bonds.  If you buy a bond from the “World Bank,” and the money winds up going to build a bridge in Ethiopia, and the project is a total success and Ethiopia can pay back the money…then all is good!

                But!!  IF, in the end, that construction project fails, and the loan can’t be paid off (and the cash is never returned to the common coffers), its the wealthier members (US and China and UK and so on) who are stuck making up the difference when your bond comes due.

One major problem the World Bank constantly runs into…

                The other chief component of World Bank service is “technical assistance,” advise and consulting on economic planning, provided by WB economists to the world's poorest nations.  And it’s that service that tends to be the source of many of the World Bank’s troubles. 

                The WB’s take on “economic development” shifts with the intellectual trends of that time and hasn’t been very consistent over the years.  In the 70s it was “planned economies,” in the 80s it was “financial engineering,” in the 90s “trade liberalization” and on and on.                 

                These wishy-washy, sometimes contradictory stances and attitudes has contributed to the failure of loan projects, which sucks for the poor nations, obviously, but also sucks for the wealthier ones, who end up footing the project’s bill.

                Also, you can see here that there’s no direct consequence for the poorer countries to borrow WB money with no intention of paying it back.  Throughout history, weak leaders in less wealthy nations have dug their countries deeper and deeper into debt by taking out WB (and IMF) loans regularly, paying off loans with more borrowed cash, and gradually ruining their nation's credit scores.

                Both the IMF and World Bank are nonprofit entities.  Both were founded at the same time, at the same place and born out of the same geopolitical realities.

                And both have suffered in the past from inconsistent, ill-defined organizational positions and strategies.

                But the IMF and World Bank also have history, and an established presence on the world stage, definitely making them players worth keeping an eye on.


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  2. I just wrote my requisite "What the IMF did wrong in the 1990s" paper of graduate school. You did an excellent explaining concisely here.

  3. Thanks! of course, I have the advantage of being able to write phrases like "paid in monoploy money," since I'm on planet blogs!

  4. One small quibble - you write "has contributed to the failure of loan projects, which sucks for the poor nations, obviously, but also sucks for the wealthier ones, who end up footing the project’s bill." Except that very very few bills have ever been paid for by wealthy nations.

    Most "failed projects" still have to be paid back by the borrower. The only borrowers that didnt pay back were ones that had to go through a multilateral debt relief process (and usually only after already having made years if not decades of payments). Yes some donors put in money for debt cancellation, but it was peanuts compared to the concessions they wrangled out of developing countries - both when the original loan was made and when the debt relief was granted. These concessions tended to massively benefit corporations in wealthy countries - who either took advantage of the required trade liberalisations or bought up cheap assests in required privatisations.

  5. What the commenter is alluding to here is definitely a real concern, but may actually be more of a symptom of a larger malaise, rather than a singular problem in of itself.

    Schemes and mechanisms like the one Peter mentions have been constantly fading in and out of the IMF and WB policy canon over the decades. They are typically chalked up as methods to address the issue of “moral hazard.”

    In this instance, “moral hazard” refers to the problem I had mentioned of developing nations’ leaders being able to go back for IMF/WB loans over and over, with no consequences. Without an incentive to stop going back to the till, a leader can easily tank their country’s credit score by shouldering it with a debt too big for that country to handle.

    (“Moral hazard” does not just apply to international finance. It’s the reason your insurance has a deductible, or that salesmen are paid on commission. Any situation where there is insufficient incentive for an actor to do what is needed of them, there is “moral hazard.”)

    A policy like the commenter has mentioned is just one of many methods used to give the borrowing nation some penalty/consequence for the project failures - typically by forcing them to pay something back into the revolving loan fund even if the project fails. The idea is to motivate the borrower to be more “prudent” with the loan money and more proactive in its success.

    It is important to keep in mind though that all IMF paper is guaranteed by the IMF, not by any of its individual members. What Peter is referring to here is a type of internal programming the IMF uses to adjust plans for how borrowers will pay back into the organization’s common coffers. The IMF group as a whole is still ultimately responsible for any bonds issued.

    Either way, in the long-run, any country that has consistently successful and stable economy (your USs, Chinas, etc.) will carry a disproportionate weight of IMF bonds. In fact, that’s kinda the whole goal of the organization’s structure!

    While these inefficient internal policies do create some serious adverse effects for the developing nation (like the one the commenter mentions), me, I get more worried about the whole “IMF/WB philosophy in eternal flux” issue more than any of these kinds internal structuring problems. That’s because it always seems to be that it’s the policy/practice instability itself that creates the environment in which these problems can develop.

    Problems like what Peter brings up are very real, and can potentially cause serious side effects. But the IMF’s tendency to approach the underdeveloped world like a Petri dish for testing economic theories causes problems consistently. Errors that are built into a system, that should be easily foreseen, bother me much more than weaknesses that just create the potential for adverse or unintended disasters.

    Remember, these loans sometimes are termed in 10, 20, 30 year periods. Within the lifetime of the loan, policy, situations and expectations (for all parties involved) can change. With that amount of prorating, grandfathering and so on, plenty of odd loopholes or complications can arise concerning issues of liens, ownership, etc., even if everyone goes into the deal with the best intentions.

  6. See also: