Making Development Work

"OUR DREAM IS A World Free of Poverty" reads the sign at the entrance to the World Bank headquarters. That's quite a lofty goal. So how do we achieve it? The short answer is that no one is certain. The long answer is that there is a way to substantially improve on the basic model for economic development--using a new kind of market and paying for performance. Not too long ago, foreign aid was viewed as a path to economic growth for the developing world. In some quarters, most notably the development banks and the United Nations, it still is. But there is dissension in the ranks. Scholars have been chipping away at the aid-buys-growth paradigm for over 30 years--with some going so far as to suggest that state aid could actually hurt the poorest of the poor. Over the past decade, revisionists have asserted that foreign aid can be helpful, but only if countries pursue good policies. So, if a country has good domestic economic policies and open trade, aid can help; but aid can do little in the presence of poor policies. Some scholars have questioned even this view, noting that measuring the impact of foreign aid depends on the definitions of terms like "aid," "policies," and "growth." Foreign aid, consisting of labor and capital that flow to particular countries, will tend to be good if those assets are spent wisely and bad if they are not. The real question is how to spend those assets wisely. At one level, this is a difficult question because it involves trying to get governments that may be near-sighted or corrupt to take a longer view. It asks them to think about investing in areas such as education, health, and roads instead of squandering resources on wasteful activities. Solving this problem is difficult. One can point to several success stories in getting developing countries to clean up their acts, but there are numerous failures. The potential perverse incentives of aid are well known. Recipient-country governments that use aid productively may not receive any more. Aid bureaucracies that solve problems effectively could put themselves out of a job. These perverse incentives prevent policymakers from spending aid wisely. Furthermore, like many government programs that give out money, aid programs rarely evaluate how well the aid is actually spent. The Meltzer Commission notes, for example, that three to ten years after final disbursement, the World Bank reviews the broad policy impact of just 5 percent of its programs. To some extent, these problems can be overcome by setting up rules for giving out aid. One such rule, currently in vogue, is that aid should be given to really poor countries that promote good policies in general. Another rule is to make sure that aid actually does what it is intended to do by paying the project implementers based on actual results. Both of these rules may make sense, but both have problems. Just giving aid to well-behaved poor countries may mean that donor countries have to write off a large part of the developing world. Paying for performance sounds great in theory, but it may be difficult to do in practice. While problems with foreign aid are legion, the problems in developing countries are too important to be ignored. In 2000, an estimated 2.7 billion people were living on less than $2 per day. These people could potentially benefit from aid from rich countries and international institutions. The question is how to make the best use of that aid. (1) A new development model AID AGENCIES WANT to spend their limited resources wisely, but they frequently fall short. To allocate resources to their most highly valued uses and get the maximum bang for each aid dollar spent, an agency needs to do two things. The first is to get reasonable information on the likely costs and benefits of different projects. The second is to implement projects effectively. Assume that we can solve the information problem. We will shortly explain how to do so by making use of a new kind of market, an "information market. …