What exactly is the IMF and what does it do?

Last month the managing director of the International Monetary Fund (IMF), Dominique Strauss-Kahn, was arrested in New York. The extensive coverage of that case has led to increased scrutiny of the IMF as an institution. The IMF is an important institution in international banking and finance, but few people realize what the IMF does and why it matters.

The IMF was created near the end of World War II. In July 1944, delegates from the Allied nations met at the Mount Washington Hotel near Bretton Woods, N.H.. The conference was called to set up an international financial system that would stabilize the world economy once the war was over. The need for stability had been clear as early as World War I, when most major nations abandoned the gold standard. The successive turmoils of the Great Depression and World War II made reestablishment of a gold-based system impossible. The Bretton Woods agreement put the world back on an international gold standard.

Three major international institutions were created as a result of the Bretton Woods Agreement. The World Bank was established to aid in the reconstruction of countries in Europe and Asia that were severely damaged by the war. The General Agreement on Tariffs and Trade (GATT), now known as the World Trade Organization (WTO), was set up to negotiate reductions in high tariff barriers that had been erected during the 1930s. Finally, the IMF was established to help maintain the stability of the fixed exchange rate system.

Most fixed exchange rate systems are subject to speculative instability that is very similar to a bank run. When a run occurs on a bank it is because of widespread beliefs on the part of depositors that the bank lacks sufficient cash on hand to pay out the small number of depositors who would normally withdraw their money in the short-run. As George Bailey explained so well in “It’s a Wonderful Life,” the deposits in a bank are backed mostly by loans and only a small amount of cash is kept on hand. When depositors fear the cash is going to run out, they all run to the bank and withdraw. This quickly depletes the cash on hand and the bank can become insolvent. Historically, to reduce the likelihood of bank runs, we have instituted deposit insurance and created lenders of last resort, i.e. central banks. They provide cash that the bank does not have on hand during a run and allow depositors to be paid off if they wish. Knowing that the lender of last resort exists and will act if needed is often sufficient to stop a bank run from happening in the first place.