Analysis: Artful Aid 3: How to develop

By MARTIN HUTCHINSON, UPI Business and Economics Editor  |  June 14, 2002 at 12:09 PM
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WASHINGTON, June 14 (UPI) -- Too much foreign aid, however charitable and benign in its intent, has gone to line the pockets of Third World dictators, or, worse still, to destroy economic incentives in the recipient countries.

There must be a better way!

This analysis of the international aid and development business comes in three parts. In Part 1 Wednesday, we examined the structure and policies currently followed, and provided a taxonomy of their faults. In Part 2 Thursday, we suggested an improved mechanism for capital flows to the Third World, the banking of economic development. In this Part 3, we look at the grant aid business, and suggest how that too can be better managed.

As set out in Part 2 of this analysis, we believe the international development banking business should be privatized, removing the Western governments from the business of international lending, and returning it in its entirety to the private sector. Apart from its advantages in transparency, this would remove the subsidy element from lending to emerging markets, and ensure that any subsidies were given directly, as grants, not loans. In this part, therefore, I examine the part of the international aid business that cannot realistically be privatized: The business of making international grants.

Economically, there are potentially and actually two different types of aid grants, that have very different purposes. One is purely charitable; it offers no economic benefit to the recipient beyond the satisfaction of an immediate need, which the donor feels compelled to fill, for one reason or another. The other is the result of market failure; supplying relatively poor countries with goods, such as education, that have an adequate return on investment, when the local economy is considered as a whole, but where the return is over too long a time horizon, or spread too thinly among a wide group of beneficiaries, for conventional lending or equity investment to be effective.

The charitable grant should as far as possible be left to the private sector. In general, the Bill and Melinda Gates Foundation will do a better job of, say, delivering AIDS drugs than a public sector bureaucracy, and the diversity of resource sources available in the private sector will ensure that unpublicized needs do not go unmet. There seems little question that there are sufficient private charitable resources available, whether directly through foundations or through organizations like Oxfam, to meet the most urgent needs.

Official charitable grants, on the other hand, use taxpayers' money, much of it from people who themselves are not wealthy, to salve the social consciences of the donor agency officials. This type of aid, if official, is the most abused, whether by being siphoned off by corrupt local officials, or by being tied to political requirements. It also tends to cause economic damage, rather than doing good, because donating free food or free medicines distorts economic incentives in the recipient country. As a general rule, Western governments must get out of this business.

Rectifying market failure is a much more appropriate use of Western taxpayer funds. It is not enough, in a world interconnected by technology, to ignore the poverty of Third World countries. The events of Sept. 11 showed that there is a huge security risk to Western civilizations in doing so.

Of course the terrorists themselves, at least those with international "reach" are relatively few in number, often wealthy or from wealthy countries (e.g. Saudi Arabia, but also, as in the case of Jose Padilla, John Walker Lindh and Richard Reid, citizens of the U.S. or Britain.) However, their safe havens, and the populaces that support them, are generally in "failed states" where a little money goes a long way, such as Afghanistan, Sudan, Somalia or the Palestinian territories.

Eliminate the failed states, and you have not eliminated terrorism by any means -- that is probably impossible -- but you have starved it of favorable soil on which to conduct its operations. Western countries, as representatives of their hard-pressed taxpayers, do not have an interest in alleviating immediate suffering, but they do have a very strong interest in promoting economic growth and social stability worldwide.

In carrying out this function, the aid agencies must focus first and foremost on projects that have an identifiable economic return, even if some of that return cannot be captured by the price mechanism. Education, particularly primary education, is a key area in which such projects may occur.

A Brookings Institute study, reported by my wife Anna Hutchinson in October 2001, showed that in low- and middle-income countries, one out of five children aged 6 to 11 -- an estimated 113 million children -- is not in school, that one child out of four fails to complete five years of basic education, and that one year of extra primary education leads to an increase in output of between 4 and 7 percent. Clearly, getting primary education to those Third World children that lack it is economically productive. Equally, it is unlikely to be financeable by conventional means, even though according to UNICEF the additional cost of providing universal primary education would be a relatively modest $9.2 billion per annum.

Conventional aid, whether financed by grants or loans, would be channeled through the recipient government, no doubt with huge amounts of advice attached, which the recipient government, if it was so minded, could ignore, while diverting part or all of the aid to its own uses. For money which is paid for by Western taxpayers, this is not good enough. Instead, the aid agencies should not simply advise on running schools, but run the schools themselves (or hire Western private sector firms to do so.) That way, there would be clear accountability for the Western taxpayer money being used, while the primary education service being paid for would actually be provided, to the people needing it.

Naturally, such an arrangement would result in a modest loss in dignity, prerequisites and indeed sovereignty for the host government -- though not a huge one. After all, the Catholic church runs schools in many countries today, without much loss of sovereignty being involved. In any case, the loss of sovereignty is much greater in the current system, whereby the International Monetary Fund dictates countries' economic policies, with such countries having no recourse to alternative forms of finance.

In the proposed system, we are talking about grants. The host government would have to agree to the entry of the aid agency school system, but once a few pilot schemes had been carried out, and had been proved to have worked, it is likely that domestic political pressure to allow this highly beneficial intervention would be substantial. The main change would be a diversion of power from the local government to an international aid agency. In cases where the local government is failing to provide elementary education to a substantial percentage of its people, this is surely justified.

Dani Rodrik, professor of international political economy at the Kennedy School of Government, was in Washington last month. At a presentation generally devoted to questioning the "Washington model," Rodrik made a very valid point. The most imperfect market in the world is for people. In principle, economic growth would be greatly enhanced if citizens of poor countries could work for a period in a rich one, acquiring top-quality work habits and know-how which they could then take home with them. It is a reasonable criticism, broadly from the left, of the present "Washington model," and it is on the face of it, unanswerable.

Freeing up international migration would not solve this problem; it would simply result in a huge tide of immigration into the wealthy West, whose economies and societies would probably collapse under the strain. In Europe for example, even in a period of economic growth, the relatively high immigration of the 1990s has coincided with a surge in reported crime rates.

The facts are indisputable -- the mechanism and rationale are unclear. What one can guess is that social restraints are much stronger in a more or less homogenous society; to the extent that immigration reduces homogeneity it reduces the power of social restraints, and hence makes crime increase (for example, there is evidence of substantial crime waves at the opening up of China and Japan in the 19th century.)

In any case, increasing immigration, particularly skilled immigration, to the rich West impoverishes the source countries by removing at the time of their peak productivity the highly skilled and educated people on which large amounts of their educational resources have been spent.

Instead, rich countries and poor ones could, financed where necessary by the aid agencies, set up a well-policed system of indenture, by which citizens of poor countries moved to rich ones for no more than three to five years, acquired rich country skills, and were then compelled to return home (such indentured workers not being permitted to acquire rich country nationality by marriage during their term of indenture or for say three years afterwards.)

This system would be used to replace rather than supplement current levels of immigration. It would provide rich countries with an additional temporary workforce of young, energetic educated people, and would provide the supplying countries to which they returned with a valuable resource of skilled and experienced workers who could teach Western techniques to their local colleagues. It would of course be entirely voluntary, and carefully policed by both supplier and recipient countries to reduce leakage (which would penalize the quota of supplying countries going forward.) In this way, the benefits of labor mobility and know-how transfer could be obtained, without excessive disruption of either rich country or poor country societies.

A third area of particular importance for the aid agencies would be the provision of security for private savings in developing countries. Private savings form the principal source of venture capital and small business finance in most countries, particularly those in which domestic financial institutions are not well developed. In general, because of the unattractive economic policies and political instability of developing countries, private savings in such countries are mostly exported -- more or less illegally -- to tax havens, where they become dormant, producing no benefit to the economy from which they have derived. Moreover, private savings which remain in developing countries are continually subject to harassment, for example by special taxes or domestic currency inflation, or by partial or total expropriation, as by Yugoslavia in 1991 or Argentina last December (and several times before that.)

Aid agencies can assist the formation and maintenance of private savings, primarily by providing deposit insurance to the local banking system. Under such insurance (which should not be for 100 percent of deposits, to avoid moral hazard) the agency would collect premiums from local banks, would pay out to depositors in the event of bank failure and -- most important -- would act as a bank supervision authority.

By doing this, local savers would be given good assurance that their money was safe in the local banking system, and hence would tend to keep it there, increasing the local tax base and, more important, ensuring that small-scale venture capital was readily available in adequate quantities. As with the education scheme, direct action of this kind by the aid agency would be a moderate violation of local sovereignty; as with the education scheme, a few successful pilot projects would make it irresistible to Third World populations as a whole.

There are a number of other areas in which direct action of this kind by the aid agencies would be highly effective -- one thinks for example of health provision, "green revolution" and biotech-led agricultural reform, and the establishment of environmental controls on a "tradable pollution rights" system. In general, aid agency assistance should be directed towards the provision or facilitation of services, rather than simply providing funding to recipient governments. In addition, the aid agencies could work with private sector development banks to provide subsidies to projects where part but not all of the economic return could be captured, so that projects were financed on a part grant, part loan basis, but explicitly rather than implicitly as at present.

A reform of international aid and development banking along these lines would provide a broad diversity of projects and funding methods, with economic incentives being used as far as possible to ensure that aid and development capital actually produced the intended economic development. For recipient governments, the advantage would be that the great majority of their funding, that currently comes in loans from the international institutions, would instead be provided by private development banks, with differing criteria and philosophies of economic development. This would allow host governments to work with those institutions with which their own political and economic priorities were most closely compatible.

In such a system corrupt governments, or those with clearly counterproductive economic or political policies, would receive very little funding. But countries such as Malaysia, where the economic policy differed from the "Washington model," but was still defensible, would undoubtedly find eager lenders and investors.

De-funding the corrupt and incompetent, and devoting resources to the promising is, after all, what economic development is supposed to be about.

Martin Hutchinson occasionally advises governments and international financial institutions on economic development and finance.

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