In 2002 President George Bush announced a new program of development aid that would be based on inducing countries to change their institutions in order to receive financial aid. After more than 40 years of failed development aid, the West was finally starting to wake up to the real effect of its policies. The Millennium Challenge Corporation (MCC), the government organization in charge of the project, was set up in 2003 to carry out the Millennium Challenge Account (MCA), i.e. President Bush’s new vision for development assistance.
What makes this story different is that MCC is in charge of selecting countries that will receive aid not on the basis of some geopolitical strategy or international pressure, but on 16 indicators to measure political and economic conditions. The goal of the MCA being to promote economic growth and development through the encouragement of three policy categories: (a) Ruling Justly, (b) Encouraging Economic Freedom, and (c) Investing in People.
Early this September, MCC released its Report on the Criteria and Methodology for Determining the Eligibility of Candidate Countries for Millennium Challenge Account Assistance in FY 2006. So far, MCC has paid attention to private ownership and the conditions for entrepreneurial activity, two dimensions that are sine qua non conditions for development. These dimensions are captured to a large extent in the indicators used in Ruling Justly and Encouraging Economic Freedom.
In the Report, MCC notes that the use of highly actionable indicators, such as Days to Start a Business, has created strong incentives for candidate countries to change their policies. “According to the World Bank Group,” explains the Report on page 2, “80% of the business start-up reforms that they have observed are directly attributable to the incentive effect of the MCA.”
This incentive effect is very important. So important, actually, that if the MCC achieves its goal, it is likely to be because of this incentive mechanism alone. Here is why.
The reason why development aid has been such a failure so far is because it has not changed the institutional environment in which individuals make choices. Worse, it has perpetuated societal rules that were conducive to socially-destructive behavior (such as rent seeking, private appropriation of public funds, etc).
Candidate countries present projects that will be implemented with the funds they receive from signing a Compact with MCC. In other words, if they improve their institutions, they will receive funds to implement new policies. The idea being that money spent under good institutional conditions will be growth-enhancing.
This view was born out of the academic debate on the effectiveness of aid. In a famous article “Aid, Policy and Growth” (published in the AER in 2000), World Bank economists Craig Burnside and David Dollar argued that aid has a positive impact on growth in developing countries which have good policies. Later on (NBER working paper #9846) Ross Levine, David Roodman, and Bill Easterly, used better quality data and found no evidence (published in the AER in 2004). Michael Clemens, Steven Radelet, and Rikhil Bhavnani in turn found growth effects for short-term aid (here is the paper). Finally, Raghuram Rajan and Arvind Subramanian in a June 2005 IMF study found no effect and rejected the results of the Clemens et al.’s study.
While this econometric exercise will never provide a definite (empirical) solution, economic reasoning can provide one. It is not possible to conceive of entrepreneurial activity taking place in an institutional environment (and here what matters is the informal environment) promoting theft. For entrepreneurship to take place ownership over factors of production must be respected and contracts must be enforced. In the absence of these institutions, no amount of aid will ever improve the economy (see Easterly’s paper Can Foreign Aid Buy Growth?). It is actually quite the opposite: aid will tend to spread a mentality of public assistance and will reduce the chances of people ever finding endogenous solutions to poverty.
What empirical work can provide is an understanding of the reasons why on the ground good institutions cannot grow (this cannot be known by staying in Washington DC). We theoretically know that aid does not create growth (and there is no need to statistically test this), what we don't know is what on the ground is stopping entrepreneurs from discovering and exploiting opportunities for trade.
This is why the only reason MCC will ever succeed is if it comes to be seen as a reward scheme for good institutional change – not because it provides aid under good conditions (I side with Easterly, Levine, and Rajan on this one but for theoretical reasons only). It would be a huge success indeed if MCC could provide the incentives for institutional entrepreneurs to change their environment: everyone until now has failed.
In my view, what recipient countries do with the money they receive is almost irrelevant. Some candidate countries’ projects are about institutional change, such as a better definition of property rights (see the Compact with Madagascar). This could be a good thing.
However, where projects are not related to the development of institutions, they will fail to raise growth prospects. For instance, infrastructure development, such as building more roads will never improve the conditions for growth (infrastructure is a result of development not a cause). This is also why the third policy category (Investing in People) is bogus, as it is not about institutions fostering entrepreneurship but about education and health policies (and as Easterly showed in the Elusive Quest, these policies have an abysmal record in most developing countries).
Time will tell which effect becomes dominant. If the MCA is about institutional incentives, it will be a success, but if it is about funds disbursed to build more roads, it will be a failure – just old wine in new bottles.
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