Failure of the Current Aid Regime

The United States is the largest bilateral donor to the developing world, contributing $10.9 billion in official development assistance (ODA) in 2001--roughly equivalent to the entire economic output of Kenya.7 Yet U.S. official development assistance has failed consistently to achieve its stated goals to "assist peoples of the world in their efforts toward economic development."8

After receiving millions of dollars in U.S. development assistance over the years, most recipients are poorer today than when they first received it. From 1980 to 2000, some 23 recipients received development assistance that amounted to 25 percent of their GDP in 2000, but their compound annual per capita GDP growth averaged an appalling -0.16 percent. Despite the massive infusion of economic aid, they are no closer to achieving strong, reliable economic growth today than they were two decades ago.

The failure of U.S. official development assistance is not, as some have argued, due to lack of funding. According to former World Bank economist William Easterly,

In 1951, the U.N. Group of Experts calculated exactly how much aid poor countries needed to achieve an annual growth rate of 2 percent per capita, coming up with an amount that would equal $20 billion in today's dollars.9

Over the past 50 years, the United States alone has contributed over $500 billion (not adjusted for inflation)--25 times the U.N. threshold. Adjusting for inflation and interest, this infusion cost American taxpayers an estimated $2 trillion.10 Developed countries together spend more than $50 billion annually on official development assistance--more than twice the amount the U.N. Group of Experts identified.11 Yet the original U.N. target of generating sustained economic growth in the developing world has not been achieved.

In many cases, this failure is the inevitable consequence of aid's having been directed toward governments that embrace misguided policies that undermine economic development, or corrupt regimes that misallocate or steal the funds. Under a succession of corrupt dictators, for example, Nigeria has received over $190 million in U.S. development assistance from 1980 to 2000, despite being ranked consistently as one of the world's most corrupt countries.12 Per capita GDP in Nigeria is $254.

More money in cases like this only reinforces the policies that retard economic growth in developing countries, contributing to their current predicament and increasing their dependence on international donors. As Harvard Professor George Lodge notes, "at times foreign aid has even worsened the plight of the poor, by sustaining the corrupt or otherwise inefficient governments that caused their misery in the first place."13

Although much development assistance has been given to these countries, America all too often either fails to demand tangible evidence of reform before disbursing the assistance or halves the disbursement if reform is not adopted. According to Representative J. C. Watts (R-OK),

Too often, foreign aid is given in the form of a blank check. No strings are attached. But herein lies the problem. Historically this assistance fails to integrate countries into the global economy, serving more as a Band-Aid approach rather than an engine of growth.14

A recent Columbia University paper supports this assessment, stating that "Where institutions are weak, money alone does not produce sustained development."15 And a 1997 World Bank report concludes that

aid has a positive impact on growth in developing countries with good fiscal, monetary, and trade policies. In the presence of poor policies, on the other hand, aid has no positive effect on growth.16

The Index of Economic Freedom analysis confirms that the most reliable and consistent determinant of economic growth is economic freedom, not aid. The Index has identified 10 independent factors that measure the level of economic freedom. (See text box.)

The lesson is clear: However well-intentioned it may be, development assistance alone is not sufficient to stimulate economic growth and development. If aid is to be effective and a positive contributor to development, donors must be more selective in its distribution. They must reward only those recipients that willingly adopt good policies and institutions.

Lessons for The Millennium Challenge Account

President Bush launched the Millennium Challenge Account on May 14 to help address the structural problems that plague U.S. development assistance programs. The MCA will increase the level of official development assistance by $5 billion annually, phased in over a three-year period: a $1.7 billion increase in fiscal year (FY) 2004, $3.3 billion in FY 2005, and the full $5 billion in FY 2006.17 Thus, the MCA will not affect existing development assistance. (See Chart 1.)

More important, the MCA will link the development assistance with economic reforms and good governance. President Bush announced that the MCA, as a separate and distinct development assistance program, will be available only to countries that meet three criteria--that display good governance, invest in the health and education of their people, and enact sound policies that promote economic freedom. The Administration is currently developing ways to measure compliance with these three broad eligibility criteria as well as a system to administer the account.

In its efforts to do this, the Administration should take into account previous lessons learned from the development assistance track record and incorporate these lessons into the criteria for the MCA.

First, reform cannot be imposed from outside; it must have domestic support. Otherwise, recipients will merely revert to previous policies once development assistance ceases.

Second, providing money before reform is a recipe for inaction and dependency. The International Monetary Fund (IMF) learned this lesson after its policy of "conditionality"--that is, providing loans on condition that recipients would later implement a reform agenda--proved to be a failure. The IMF repeatedly disbursed funds to countries that have a history of violating previous reform conditions. For example, Argentina's present economic collapse can be attributed to poor economic policies exacerbated by decades of conditional IMF loans. As noted in a previous Heritage study,

Since 1983, successive Argentine governments have failed to meet the conditions attached to each IMF loan. In addition, the $30 billion in loans that the IMF has given to Argentina over the past 18 years has failed to foster economic growth or stability.18

IMF loans create a moral hazard by diminishing the consequences of bad investment decisions. Argentina continued to request more money instead of making prudent, albeit politically difficult, reforms because economic assistance was readily available without the need for prior reform.

Third, governments and international institutions are often swayed into giving assistance for political reasons, regardless of a country's economic policies. Politics should not influence the distribution of assistance from the MCA fund. The criteria for eligibility should be objective and transparent so that both donor and recipient can ascertain progress and the reasons why one country qualifies over another.

These lessons dictate a specific policy of rewarding countries with a demonstrable record of improving or maintaining progress in objective criteria. An example may be an inflation target or reduction in corruption in the customs service as identified by independent observers. Such a priori criteria would help ensure that the sound policies necessary for development assistance to be effective are in place.

Only after progress is verified should countries receive U.S. funding for programs that include--but are not limited to--judicial reform, vaccinations, or micro-finance. Means of implementing these programs should be flexible to fit the circumstances of each country as closely as possible. The government may perform the program, or non-government organizations may bid on contracts to fulfill the objectives. A combination of both is also possible. Nevertheless, the Administration should design a system that directs funds to countries best able to use them through cost-effective programs that help the most people.

Competition for funds is an excellent method of achieving this objective. It is not an issue of spending less, since a fixed amount has already been apportioned to the MCA; rather, it is an incentive mechanism to develop programs that work. It is better not to allocate the full amount rather than repeat past aid errors by rewarding poor policy decisions, which would negate any benefits that development assistance might bestow.

The Administration should take this logic one step further and have countries meet moving benchmarks in order to maintain MCA-eligibility. For instance, if the Administration decides to use inflation as one measure of economic freedom, a country should have a 10-year average inflation rate of 12 percent to qualify for MCA funds. After five years of economic aid, the inflation target should be lowered to 6 percent. The country's development programs should also be based on pre-defined goals upon which continued funding is dependent. For instance, micro-finance programs should be evaluated on maximizing the number of new participants without sacrificing the default rate.

It is likely that the U.S. Agency for International Development, which administers America's official development assistance, will oversee the MCA. The Administration should establish the necessary guidelines to ensure that the account remains separate and distinct from traditional development programs. Such independence will allow the MCA to develop new strategies and methods of providing development assistance. This approach may require a separate budget and a special administrative team tasked specifically with the account. Establishing a "Chinese Wall" between the MCA and traditional development assistance programs is necessary for conducting any comparative analysis that could help reform existing programs.

Why Economic Freedom is Paramount

Adherence to policies that promote economic freedom should be the most heavily weighted of the three broad criteria that countries must meet in order to qualify for MCA funding. Only economic freedom, which depends on the rule of law, leads to higher per capita income and the alleviation of poverty. While improvements in health and education are not prerequisites of economic development, they are its consequences.

Economic freedom is the most consistent and reliable determinant of economic growth. The 2001 edition of the Index of Economic Freedom concluded that "countries with the most economic freedom also have higher rates of long-term economic growth and are more prosperous than are those with less economic growth."19

By analyzing 50 economic indicators classified under 10 independent factors, the Index comes up with a composite score for the country that ranges from 1.00 to 5.00, with 1.00 signifying a "free" economy and 5.00 an economically "repressed" one. The Index found that citizens of "free" countries, with scores between 1.00 and 1.95, enjoy a per capita income that is twice as high as their counterparts in "mostly free" (2.00 to 2.95) countries.20 "Free" countries have an average per capita income of $23,325, whereas the average per capita income in a "mostly free" country is only $11,549.21 Countries that are "mostly unfree" (3.00 to 3.95) have an average per capita income of $3,238. Countries that are economically "repressed" (4.00 to 5.00) have an average per capita income of $3,829, less than one-sixth of that of economically "free" countries. (See Chart 2.)

This difference occurs because open markets promote healthy competition, which requires the institutionalization of transparency and the rule of law and also results in the most efficient allocation of resources. Contrary to popular myth, economic growth benefits the poor directly. In the words of a World Bank working paper on the effects of economic growth on the poor, "As overall income increases, on average [the] incomes of the poor increase exactly the same amount."22 The study concludes that economic growth does not worsen inequality.

Policies that promote economic freedom often coincide with or directly result in good governance and permanent improvements in health and education standards. For example, an environment conducive to commercial enterprise requires fair and equitable dispute settlement in the form of an independent judiciary, which is also essential for good governance. In addition, corruption is most severe in areas where commercial interests are at stake because of such policies as excessive taxation, government procurement, and tariffs. Free-market policies that encourage open competition and minimal government intervention render corruption unprofitable or remove opportunities for corruption, creating a natural incentive for good governance.

A wealth of objective research shows that the higher per capita income that accompanies economic freedom also corresponds with higher health and education standards. Countries with higher per capita income can afford to invest in hospitals, better sanitation services, and a clean water supply. This correlation may help to explain why populations in higher-income states live longer. Countries with a per capita income greater than $10,000 have an average life expectancy of 77.3 years. For countries with a per capita income from $5,001 to $10,000, life expectancy is 73.6 years; for countries with a per capita income from $1,001 to $5,000, it is 68.1 years; and for countries with a per capita income less than $1,000, it is 56.0 years.23

Richer countries also have higher literacy rates than poor ones. Countries with per capita incomes greater than $1,000 have literacy rates of over 96 percent, while countries with per capita incomes of less than $1,000 have literacy rates of 62.5 percent.24 Countries with higher per capita incomes can build more schools, hire more teachers, design better course syllabi, and educate more children because those children are less pressured to stay out of school to work to help support their poor families.

World Bank research confirms that higher per capita incomes also result in lower rates of child labor. Countries with per capita incomes of less than $1,000 have child labor rates of 21.7 percent, while countries with per capita incomes between $1,000 and $5,000 have child labor rates of 5.6 percent. Countries with per capita incomes greater than $5,000 have rates less than 1.0 percent.25 A Stanford University study concludes that per capita GDP explains 80 percent of the worldwide variation in the incidence of child labor.26

There is also very strong statistical evidence that economic growth results in better environmental protection. A World Bank study of 11 developing nations found that certain economic policies like reducing government deficits, promoting market liberalization, and fostering international openness have a positive effect on the environment.27

Policies that restrict economic freedom prevent the market from allocating resources efficiently, resulting in profligate use of resources, which leads to environmental degradation. For example, 30 percent or more of China's pollution is due to the economic inefficiencies that result from its centralized economy.28 As Jerry Taylor of the Cato Institute explains:

economic liberalization leads to economic growth which in turn generates new economic opportunities and sources of livelihood, thereby alleviating poverty and reducing pressures on the environment due to over-exploitation of fragile resources by the unemployed.29

Taylor's study points out the strong correlation between deforestation and poverty. The biggest reason for deforestation in developing countries is the need for agricultural land. Richer economies with more modern technology and agricultural practices can produce more output using less land. Another major reason is that the poor still use wood for fuel because electricity is either unavailable or too expensive. This observation may explain why deforestation abated after per capita income exceeded $4,760 in Africa and $5,420 in Latin America.30

Similar correlations exist between per capita income and access to safe drinking water and sanitation, improvements in air quality, decline in land degradation, and other objective measures of environmental standards.

Measuring Economic Freedom

In the face of such overwhelming empirical evidence, the Administration should establish comprehensive criteria to measure fully the level of economic freedom in countries that seek MCA eligibility. A good model exists in the Index of Economic Freedom, which ranks more than 150 countries each year. The Index may not necessarily be the only method the MCA should employ to measure economic freedom, but it could serve as the initial model.

Cross-referencing the 2002 Index countries with the list of 79 IDA-eligible countries provides a preliminary pool of seven countries with "mostly free" economies (with overall scores of less than 3.00) that could be eligible for the MCA funding: Armenia, Bolivia, Cambodia, Ivory Coast, Mali, Mongolia and Sri Lanka. Three more countries are on the cusp: the Central African Republic (3.05), Mozambique (3.05), and Uganda (3.00).

Several other developing countries like Botswana (2.90), Guatemala (2.80) and Peru (2.75) are not IDA-eligible. Although they may be poor, they already have in place policies that are conducive to economic growth and thus have a greater chance to maximize the effects of development assistance. Countries like these deserve consideration for MCA assistance.

The Administration should consider incorporating into the eligibility criteria for the MCA the Index's 10 factors that measure economic freedom. Among the 50 key economic indicators that the Index tracks within those 10 major factors are the following:

1. Trade Policy. Openness to trade is a catalyst for increased economic growth because competition forces producers to make better products and gives consumers more choices of products at lower prices, effectively raising their purchasing power. Tariffs and non-tariff barriers are invisible taxes and clearly hinder a nation's prosperity. The variables that the Index uses to measure this factor are the average tariff rate, non-tariff barriers, and corruption in the customs service.31 For example, although Vietnam has a long way to go to achieve an open trade policy, "as the nation has opened up, it has experienced a large increase in per capita income and no significant change in inequality," note economists David Dollar and Aart Kraay. Thus, "the income of the poor has risen dramatically, and the number of Vietnamese living in absolute poverty dropped sharply from 75 percent of the population in 1988 to 37 percent in 1998."32
2. Fiscal Burden of Government. High taxes and various other mechanisms that transfer private income to government coffers discourage productive enterprise and stifle economic growth. Measuring income and corporate tax rates as well as government expenditures as a percentage of GDP gives a good indicator of a country's fiscal burden of government.
3. Government Intervention in the Economy. Excessive government intervention in the economy crowds out private industry, thereby thwarting economic growth. It also makes corruption more lucrative as government officials are given control over or are otherwise able to influence contracts or industries. The Index determines this factor by measuring government consumption as a percentage of the economy, government ownership of businesses and industries, the share of government revenues from state-owned enterprises, government ownership of property, and the economic output produced by the government.
4. Monetary Policy. A constantly depreciating currency erodes the value of investment and savings. Investors will look elsewhere, taking potential jobs with them, if they constantly fear that the currency is unstable and prices continue to rise. Since "the value of a country's currency is shaped largely by its monetary policy,"33 the monetary policy factor seeks to determine whether a country allows market pricing or distorts it. This factor examines a country's average rate of inflation over a 10-year period.
5. Capital Flows and Foreign Investment. Developing countries cannot maximize their comparative advantage, be it in the form of a competitive labor market or specific natural resources, if they restrict capital flows that seek out such market efficiencies. Restrictions on foreign investment therefore limit a country's ability to achieve its economic potential. "It is particularly important for developing countries to remain open to direct foreign investment," explains the Economist, "which is the least volatile form of capital flows and in recent years, by far the most important quantitatively, amounting to $170 billion in 2001."34 This factor analyzes the foreign investment code, restrictions on foreign ownership of business, restrictions on the industries and companies open to foreign investors, restrictions and performance requirements on foreign companies, foreign ownership of land, equal treatment under the law for both foreign and domestic companies, restrictions on the repatriation of earnings, and the availability of local financing for foreign companies.
6. Banking and Finance. Regulations on banking and finance limit the availability of credit and raise its cost (interest rates). This affects foreign investors, entrepreneurs, and even households. Low-income households, particularly farming communities, are more vulnerable to income fluctuations because seasonal harvests depend on forces like inclement weather and volatile market prices. These households rely on consumption-smoothing financial services so they can save during a bumper crop and borrow during droughts to maintain relatively stable living standards. The banking and finance factor examines government ownership of banks; restrictions on the ability of foreign banks to open branches and subsidiaries; government influence over the allocation of credit; banking regulations; and freedom to offer all types of financial services, securities, and insurance policies. Hong Kong (with a per capita GDP of $24,218) is a global banking center with very few restrictions.
7. Wages and Prices. In an open market, supply and demand determine prices and allocate limited resources efficiently. As the Index points out, market-determined prices allocate resources to their highest use.35 Artificially setting wages and prices causes economic distortions--like high unemployment, shortages in essential commodities, and overpriced surplus inventory--that hurt developing countries. This factor analyzes "the extent to which a government allows the market to set wages and prices" by examining minimum wage laws, freedom to set prices privately without government influence, government price controls and the extent to which they are used, and government subsidies to businesses that affect prices.
8. Property Rights. The protection of private property is the bedrock of commercial enterprise. Entrepreneurs and investors will not engage in productive activity if the fruits of their labor can be stolen or confiscated arbitrarily. Nobel Prize-nominee Hernando de Soto believes that capital is "created by people whose property systems help them to cooperate and think about how they can get the assets they accumulate to deploy additional production."36 De Soto argues further that poverty persists not because the poor lack capital--the world's poor own $9.3 trillion in property--but because inadequate property rights laws fail to recognize their assets. Without formal titles and legal systems to protect them, poor people are left with "dead wealth." Untitled land is difficult to buy or sell, and it cannot be used as collateral for investment. Property taxes are impossible to collect if there is no one from whom to collect them. Government bureaucracy is often to blame: In the Philippines, making an urban land claim requires a 168-step process that takes up to 25 years.

The property rights factor examines freedom from government influence over the judicial system, the commercial code defining contracts, sanctions of foreign arbitration of contract disputes, government expropriation of property, corruption within the judiciary, delays in receiving judicial decisions, and legally granted and protected private property. Indonesia, the world's fourth most populous nation, is blessed with bountiful natural resources yet has a per capita GDP of $994 partly because of a corrupt judicial system. In Indonesia, court rulings are recognized as "arbitrary and inconsistent."37

1. Regulation. A high level of regulation calculates into increased overhead costs for entrepreneurs and investors and is an impediment to economic growth. Finland, for instance, has a low level of regulation; the World Economic Forum has ranked Finland as "the world's most competitive economy and best overall business environment."38 This factor examines licensing agreements to operate a business; ease of obtaining a business license; corruption within the bureaucracy; labor regulations such as established work weeks, paid vacations, and parental leave as well as other selected labor, environmental, consumer safety, and worker health regulations; and regulations that impose a burden on business.
2. Black Market. Black markets often thrive because of high regulation in the legal market, government corruption, or high taxes. A high level of black market activity deters investment in a country. Investors do not want their products to be pirated or sold on the black market and thus will direct their investments to other countries. The black market factor examines smuggling, piracy of intellectual property, agricultural production, manufacturing, services, transportation, and labor that are supplied on the black market.

Using these Index factors, the policies of the 79 IDA-eligible countries and others can be more easily evaluated to see whether they meet the three broad eligibility criteria for MCA development assistance established by the President--they must "govern justly, invest in their people and encourage economic freedom."39

Conclusion

Despite an abundance of development assistance that has been disbursed over the past two decades, half of the world remains poverty-stricken. While advocates call for more development assistance, many countries are poorer than they were decades ago, before they received the aid. In many cases, development assistance funds have not been used efficiently or have fallen into corrupt hands.

The era of giving aid to any outstretched hand must end. Just as the United States has reformed welfare to help people end the cycle of poverty, so should the United States reform its development assistance program to ensure economic growth and prosperity rather than dependency in recipient countries.

Future allocations of development assistance should be given only to those countries that demonstrate sound economic policies. President Bush's Millennium Challenge Account proposal seeks to accomplish this by reversing the traditional aid formula to one of reform before aid, not to give aid to get hoped-for reforms. As President Bush has stated, "The new compact recognizes that economic development assistance can be successful only if it is linked to sound policies in developing countries."40

For economic development assistance to be effective, the Administration must focus the MCA eligibility criteria on economic reform. While many nonprofit organizations are lobbying to emphasize health care, environmental standards, and education--all very noble causes--these are actually the benefits of prosperity; they do not address the origins of poverty. Recipient countries must first build a firm foundation of economic freedom in order to reap these benefits.

--Paolo Pasicolan is a Policy Analyst in the Asian Studies Center, and Sara J. Fitzgerald is a Policy Analyst in the Center for International Trade and Economics, at The Heritage Foundation.