July 12, 2002

July 12, 2002 | Lecture on Trade, Economic Freedom

The Millennium Challenge Account: An Opportunity to Advance Development in Poor Nations

President Bush is proposing to increase America's development assistance budget by $10 billion over a three-year period: $1.7 billion in FY 2004, $3.3 billion in FY 2005, and $5 billion in FY 2006. This represents a 50 percent increase in America's development assistance by 2006, provided current funding remains stable. The President plans to administer these funds through the new Millennium Challenge Account.

If this were simply an increase in development assistance, I would be opposed to it. Quite frankly, America's development assistance program has consistently failed to achieve its stated goals. Consider the following facts:

  • America has given over $167 billion (in constant 1999 U.S. dollars) in official development assistance (ODA) to 156 countries, regions, and territories since 1980. 1 Per capita gross domestic product (GDP) data from 1980 to 2000 are available for 97 of these countries. These countries received over $144 billion in inflation-adjusted ODA since 1980. (See Tables 1 and 2.)

  • These 97 countries had a median inflation-adjusted per capita GDP of $1,076 in 1980 but only $994 in 2000, a decline in real terms. (See Table 1.)

This failure is not due to a lack of resources. Between 1980 and 2000, 23 recipients of U.S. ODA received amounts equivalent to one-quarter of their entire GDP in 2000. This is just aid from the United States; it does not include aid from other nations or the World Bank and International Monetary Fund. Compound annual growth in per capita GDP for these countries averaged -0.16 percent, with 12 experiencing negative growth and only four achieving growth over 1 percent. 2

This just illustrates the findings of former World Bank economist William Easterly, who concluded, "Among all low-income countries, there is not a clear relationship between aid and growth." 3 In other words, the focus on the amount of aid is misplaced. Policies matter far more than the amount of development assistance.

SOUND ECONOMIC POLICIES NECESSARY
By design, the President's Millennium Challenge Account is more than just an increase in current development assistance. It identifies three specific criteria (good governance, investment in health and education, and sound economic policies) in which countries must demonstrate progress before they would become eligible for MCA funding. The President should be commended for his efforts to bring accountability to America's foreign aid program.

By far the most important of the MCA criteria is sound economic policies. A 1997 World Bank analysis of foreign aid found that, while assistance has a positive impact on growth in countries with good economic policies, countries with poor economic policies did not experience sustained economic growth regardless of the amount of assistance they received. 4

Economists Richard Roll and John Talbott support this conclusion with evidence that the economic, legal, and political institutions of a country explain more than 80 percent of the international variation in real income per capita between 1995 and 1999 in more than 130 countries. 5 The lesson is that each country bears primary responsibility for its economic success or failure. Aid may help or harm, but cannot determine the outcome.

Some would argue that rising literacy, increasing life spans, and elimination of some diseases is proof of the effectiveness of development assistance and should be its focus. They are wrong. Assistance can have tremendous effects, but without economic growth these achievements are not self-perpetuating. In other words, some benefits accrue, but those are not the benefits of development.

These achievements would also result if countries adopted strong economic policies that lead to greater economic growth. Contrary to the assertions of many advocates, environmental and labor standards should not trump economic growth as an aid priority. The evidence demonstrates that countries with higher per capita incomes have higher education, health, labor, and environmental standards. 6 Economic growth:

  • Supports education. Countries with higher per capita incomes tend to have higher literacy rates. For example, in countries with per capita incomes greater than $10,000, over 96 percent of the population is literate. By contrast, countries with a per capita income between $0 and $1,000 have literacy rates of only 62.5 percent.

  • Raises health standards. Residents of countries with per capita incomes greater than $10,000 have a life expectancy of 77.3 years. By contrast, countries with per capita incomes between $0 and $1,000 have a life expectancy of only 56 years--21 years less than in the highest-income countries.

  • Raises labor standards. Research by the World Bank revealed that, in countries with per capita incomes above $5,000, less than 1 percent of children between the ages of 10 and 14 work. In countries with per capita incomes under $1,000, as many as 21.7 percent of children between the ages of 10 and 14 work. In a paper written while she was a professor of economics at Stanford University, First Deputy Managing Director of the International Monetary Fund Anne Krueger demonstrated that per capita GDP explains 80 percent of the worldwide variation in the incidence of child labor. 7

  • Protects the environment. Environmental sustainability, as measured by the Environmental Sustainability Index (ESI), increases with gains in per capita GDP; the wealthier the economy, the greater the level of environmental sustainability. 8
    These trends hold because, as a country's income increases, so does the ability of its people and the government to dedicate resources toward these goals. In my opinion, this is the reason for the preeminence of economic growth over other goals of development.

ECONOMIC FREEDOM AND ECONOMIC GROWTH
And the way to achieve that growth is for countries to adopt sound economic policies and the rule of law, which are measured in the Index of Economic Freedom co-published by The Heritage Foundation and the Wall Street Journal. As shown in the Index, free countries on average have a per capita income twice that of mostly free countries; mostly free countries have a per capita income more than three times that of mostly unfree and repressed countries.

This happens because countries that maintain policies that promote economic freedom provide an environment that facilitates trade and encourages entrepreneurial activity, which in turn generates economic growth.

Trade is an important element in growth. Increased economic freedom would lower trade barriers in developing and developed countries alike, leading to lower costs and greater efficiency as entrepreneurs determine the activities in which they have a global or regional competitive advantage. It makes no sense to spend billions on development assistance only to erect impediments that prevent poor nations from prospering from their reforms through trade. The African Growth and Opportunity Act is an admirable step in support of trade with poor nations, but such efforts must be expanded.

In addition, sound economic policies attract potentially vast resources that dwarf development assistance. Total foreign direct investment in 2000 was $1.3 trillion, of which over $240 billion went to developing countries--an amount far greater than global ODA of approximately $50 billion annually. 9 The poorest countries receive only a small portion of the developing country total because they lack the economic policies and rule of law that would attract such investments.

Economic growth must be the paramount goal of development because that is where the challenge lies.

  • The average sub-Saharan African country had a per capita GDP of $564 in 2000.

  • In order to reach middle-income status at $1,500 in GDP per capita, that country must average growth in GDP per capita of over 5 percent a year for the next 20 years.

  • The average sub-Saharan African country with a per capita GDP of $564 must grow at 5 percent for over 82 years to become as wealthy as the U.S. is today (at $31,996)!

To give you an idea of how difficult that rate of growth is to achieve, of the 97 recipients of U.S. ODA for which we have data, 37 averaged zero or negative growth in per capita GDP from 1980 to 2000. Another 27 averaged marginal growth between 0 and 1 percent over that span. And only 33 averaged growth in per capita GDP over 1 percent from 1980 to 2000, of which only three (St. Kitts-Nevis, South Korea, and China) averaged over 5 percent. (See Table 1.) Given these facts, it is hardly surprising that few developing countries are closing the gap with the developed world.

But such growth is possible, as proven by the remarkable success of Hong Kong, Singapore, and Taiwan. Not surprisingly, these countries adopted economic freedom early and reaped the rewards.

If the average African nation with a per capita income of $658 in 1980 had grown at the rate of U.S. ODA recipients that are considered free by the Index, it would nearly be a middle-income country today with a per capita income of $1,493, compared to the actual per capita income of $564. (See Chart 1.)

A real-life example in Africa is Mozambique, which has made tremendous progress in transitioning from a socialist economy when the Index was first published to being on the edge of mostly free today. It has done so by adopting sound monetary policies, reducing barriers to foreign investment, and working to liberalize its banking system. The results are impressive. Mozambique's per capita income has increased by a third since 1990 and economic growth has averaged over 8.5 percent from 1997 to 2001, including a year of massive floods that reduced growth to 2.1 percent.

The bottom line is that the impact of development assistance is far outweighed by sound economic policies. Creating an environment that attracts these resources and allows them to be used for economic growth should be the goal. Aid that catalyzes these policy changes can help the process, but it cannot substitute for it. This focus on economic freedom is the essence of development and the reason why MCA funds should:

  • Be allocated based on improvements in economic freedom. Research has shown that development aid can contribute to economic growth only when a country embraces economic freedom. Rewarding poor performers with aid is wasting money that another country could put to better use. Worse, it provides little incentive for countries with poor policies to embrace economic freedom.

  • Be administered through performance-based grants rather than loans. The grants should be disbursed only after a country has demonstrated its commitment to economic freedom and should support projects that advance the goals of the MCA. This would increase the coherence of purpose for the MCA by reinforcing the criteria for disbursing funds and would not burden underdeveloped countries with large debt payments.

Once the Administration chooses a measure of economic freedom as a standard for granting development assistance, it would be easy to verify that aid is being administered to proper recipients. Countries that are making improvements in economic freedom should receive development assistance, while countries failing to make improvements should not.

CONCLUSION
The MCAs must not be weighed down with earmarks, prohibitions, and priorities that, while based on laudable intentions, are not contributing to the effectiveness of America's development efforts. Instead, the agency chosen to oversee the MCA funds should have the discretion to target a small number of countries with proven track records in embracing policies that lead to economic growth. Its decisions should be based on simple, transparent, replicable, and largely quantifiable criteria. Failure to do so will only ensure that MCA funds, however well intentioned, will merely follow in the footsteps of yesterday's aid failures.

Brett D. Schaefer is the Jay Kingham Fellow in International Regulatory Affairs in the Center for International Trade and Economics at The Heritage Foundation. This lecture is based on his testimony before the Committee on Appropriations, U.S. House of Representatives, on June 27, 2002.


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1. The United Nations Development Program defines Official Development Assistance as flows to developing countries that are administered with the primary objective of promoting economic development and welfare of developing countries and carry a grant element of at least 25 percent. From Development and Co-operation Report 1998, at http://www.undp.org.np/keydoc/dcr98/part3/key_def.htm. ODA data are from Organisation for Economic Co-operation and Development (OECD), International Development Statistics 2002 on CD-ROM. GDP data and per capita GDP data from the World Bank, World Development Indicators 2002.

2. These countries were Lesotho at 2.1 percent, Egypt at 2.6 percent, Burkina Faso at 1.7 percent, and Israel at 2 percent.

3. William Easterly, "The Cartel of Good Intentions: Bureaucracy Versus Markets in Foreign Aid," Institute for International Economics, Center for Global Development, March 2002, p. 32.

4. Craig Burnside and David Dollar, "Aid, Policies, and Growth," World Bank, Policy Research Department, Macroeconomic and Growth Division, June 1997.

5. Richard Roll and John Talbott, "Developing Countries that Aren't," unpublished manuscript, November 13, 2001, p. 3.

6. For more detailed analysis, see Brett D. Schaefer and Aaron Schavey, "America's International Development Agenda," Heritage Foundation Backgrounder No. 1546, May 6, 2002.

7. Anne Krueger, "Observations on International Labor Standards and Trade," National Bureau of Economic Research Working Paper No. 5632, 1996.

8. World Economic Forum, Columbia University Center for International Earth Science Information Network (CIESIN), and Yale Center for Environmental Law and Policy, Environmental Sustainability Index, January 2001, at http://www.ciesin.columbia.edu/indicators/ESI/.

9. U.N. Conference on Trade and Development, "World Investment Report 2001," at http://www.unctad.org/wir/contents/wir01content.en.htm

About the Author

Brett D. Schaefer Jay Kingham Senior Research Fellow in International Regulatory Affairs
The Margaret Thatcher Center for Freedom

Related Issues: Trade, Economic Freedom