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Backgrounder #838 on Economy

July 8, 1991

A Message to the New World Bank President

By


(Archived document, may contain errors)

838 July 8,1991 A MESSAGE TO THE NEW WORLD BANK PRESIDE INTRODUCTION LewisT. Preston, retired chairman of J.P. Morgan and Company, this spring officially was selected as new president of the World Bank, having been nomina ted by George Bush. The America nominee always has been made World Bank president. This September 1, Preston will succeed Barber B. Conable, who has headed the Bank since June 1986.

Preston takes command of the Bank at a time that may see the most sig nificant global economic change in post-World War II history.The collapse of communism in Eastern Europe and the Soviet Union, and the election of reform-minded leaders in Argentina, Br a zil, Mexico, and other developing countries have created accelerating momentum away from socialism and toward free markets.The question for Preston is will the World Bank, with its vast resources and enormous clout in theThird World, meet today's economic challenges dicatioqit is doubtful that it will meet the challenge. In this period, Bank loans have propped up socialist economies and increased the debt for many less developed countries.To make matters worse, the Bank often has given bad economic advice t o poor countries. Yet Preston need not become a prisoner of the Bank's immediate past. He can draw on the Bank's earlier good work and change the Bank's policies and lending practices. He can steer the Bank back toward being a free market champion and thu s enable the Bank to spur economic growth in countries too long accustomed to stagna tion or decline Changing Course. If the Bank's record of the past quarter-century is any inFaulty Loans. Formed in 1944 to lend money to war-tom European countries and Jap a n for public works projects such as roads, bridges, and power plants, the World Bank in the 1960s and 1970s shifted its lending to less-developed countries. It began in the 1980s to offer structural adjustment loans to countries with serious debt problems in exchange for what the Bank thought were positive economic reforms. In many cases, however, the Banks project loans failed to improve economic conditions. The loans merely propped upmoney-losing state-run enterprises. In addition, the minor reforms made by recipient countries in exchange for loans frequently are more than offset by those countries non-market policies. And many of the economic conditions that the Bank attaches to such loans, rather than helping these countries create growing, prosperous e conomies, end up strengthening the government officials and institutions that created the economic problems to begin with.

When Preston takes over, he will find a schizoid World Bank -part of it anchored in its past of failed policies and part of it encour agingly pulling in the free market direction which offers prospects of economic development to poor nations. The Banks conflicting and contradictory directions are reflected in its two most recent annual reports. The World Development Report 1989 stresses the need for private financial institutions, like banks capital markets, and private enterprises. It points out that developing nations benefit from stable, non-inflating currencies, private banking, and legal protection for the rights of borrowers and le nders all of which promote economic growth the Banks World Development Report 19

90. The 1990 report suggests that to deal with poverty, governments of less-developed countries should adopt the kind of welfare state and socialist policies that have led to economic dis aster in the past.The 1990 report advises, for example, that government directed credit and lending programs, re-distributive social welfare policies transfer payments and public employment schemes are necessary to alleviate poverty. The repo rt fails to mention that the sort of extensive levels of govern ment regulation and taxes needed to carry out these policies cause many of the problems they are meant to cure.

Preston should study both reports carefully. His experience at one of the Wests most successful and respected financial institutions will tell him that the 1990 report represents the failed thinking of the past and of too many of the Banks staffers. He will know that the 1989 report is a much better guide for future Bank policy Contr a dictory Reports. The 1989 analysis however, seems contradicted by i 1 World Development Report 1990 (Washington, D.C The World Bank, June 1990 Hereinafter referred to as the World Bank Report 2 As he settlesinto his-important new-post, Preston should anno unce his in tention to endorse the free market approach to economic growth and to reform the World Bank to enable it to become an agent of such growth.

Specifically, he should 1) Develop an index of economic opportunity or freedom to embody free market goals to guide the Banks structural adjustment lending. The U.S.

Congress is considering such an index to guide American foreign assistance.

With this index, the World Bankwould declare that the best use of World Bank funds would be made by those countries that legally protect the private property rights of all citizens insure that prices for all commodities, products, and services are set by voluntary agreement of buyers and sellers keep tax rates low and stable establish a private agricultural sector with o ut government control of production, distribution, and pricing of farm commodities limit government regulation of businesses establish private banking and financial institutions endorse free trade with low or no tariff and non-tariff barriers to imported g ood and services; and impose no restrictions on foreign investments 2) Create guidelines to ensure that World Bank structural adjustment loans go only to countries instituting consistent and comprehensive economic reforms 3) Freeze World Bank project lend i ng and initiate a full investigation and public debate among the World Bank members over how countries can meet their finance needs without further addiction to borrowing THE WORLD BANKS DISAPPOINTING RECORD This September, Preston will find a Bank that h a s strayed far from its original purpose and is now struggling to become a constructive force in the world economy. Officially named the International Bank for Reconstruction and Development, the World Bank was founded in 1944 by the 44 nations who met in B retton Woods, New Hampshire. Today, the Bank has 153 mem bers; only about 18 nations are not members. The Bank was founded to pro vide money to the war-ravaged countries of Western Europe and Japan for such infrastructure projects as roads, bridges, elect r ical plants, and other public facilities and enterprises. The founders felt that commercial banks would be reluctant to lend to these countries, many of which had defaulted on World War I and post-World War I debts 3 ,According to the original Articles of Agreement, the World Bank was to facilitate investment of capital for productive purposes to promote private foreign investment by means of guarantees and when private capital [was not available on reasonable terms, to supplement private investment all ov e r the world? Its loans, however, were directed to the more advanced developing countries where prudent banking practices could be applied follow established banking practices in determining which countries would receive funds and for what projects. But wi t h the emergence of new, less developed countries from old colonial empires, and under the presidency from 1968 to 1981.of Robert S. McNamara, the World Bank was pushed on a new course. In retrospect, this was a disaster mainly for poor recipient countries . McNamara correctly wanted the Bank to fight world poverty; he in correctly did this by transforming the Bank into a global welfare agency, dis pensing cash handouts which, by and large, increased the poor countries de pendency on foreign assistance and d id little to strengthen their economies.

The Bank, moreover, increasingly lent money to governments with little con cern for whether the money would be used wisely. And the World Bank ac tively supported central economic planning and even socialist policies.

Typical is what happened toTanzania. There the government confiscated lands, created Soviet-style collective farms and government marketing boards to set prices and distribute crops for export and domestic use.The World Bank supported these efforts wit h $261 million in loans throughout the late 1970s.The result: Tanzanias agricultural sector and economy were in ruins by the 1980s.

In the past couple decades, too, World Bank loans have gone to such ac tivities as Hungarian government-owned railroads, In dian government owned coal mines, Mexican government-owned steel companies, and to Peruvian government-owned gold mines? These loans, and hundreds of others, not only supported destructive economic policies, they addicted many less developed countries to borrowing and helped precipitate the debt crisis in the 1980s.

Agonizing Reappraisals. During the 198Os, however, this debt crisis and the resurgence of free market policies in Reagans America and Thatchers Britain, prompted some agonizing reappraisals at the Bank. As a result, some of the worst policies were reversed. Most noticeably, the Bank put more resources into structural adjustment loans (SALS) to pay governments, so to speak, for reforming their economies.The problem is that the SALS typical Globa l Welfare Agency. In the 1950s and 196Os, the World Bank tended to 2 Reprinted in IBJ?D, the International Bank for Reconsmction and Development, 19461953 (Baltimore: Johns 3 Melanie S.Tamqen, World Bank Snookers US. Congress Again, Heritage Foundation Bae h grnmier Hopkins Press, 1954 No. 649, May 23,1988 4 ly push minor reforms while leaving in place the macro-systems that cause many of the problems. The Bank, for example, lends money to a government and, in exchange, the government instructs its marketing boards to bring the prices of its commodities closer to the free market 1evel.The result: The Bank bolsters the very government institution that should be abolished.

Meanwhile, the small benefits from SALdriven reforms often are more than offset by the oth er problems with the economy. Where a market system is not already in place5-or ,where comprehensive and consistent reforms are not cur rently underway, SALS do little good THE POVERTY REPORT In its World Development Report 1990: Poverty, the World Bank e s timates that 1.2 billion people were living in poverty in the ploping world in 1985 with the greatest proportion in sub-Saharan Africa. It identifies as charac teristics of the poor in less developed countries lack of assets and limited sources of income. It states, correctly, that low GDP [gross domestic product] growth makes it difficult to reduce poverty and that raising the in comes of the poor requires broadly based economic gro~th.~Then, how ever, the Bank stumbles in its conclusion, suggesting that a comprehensive approach to poverty, therefore, requires that the basic strategy be supple mented by a system of well-targeted transfers and safety nets that have been tried and failed in the past,These include the following 1) Subsidized Credit.

The pover ty report calls attention to the benefits of government-subsidized credit for loans to small groups of the poor in less developed countries in con trast to loans to individuals.The report states that well-designed [credit programs can give disadvantaged g r oups access to credit and still remain financially viable. Institutions of this kind should be suppyrted with limited subsidies to help cover their initial administrative costs. Here the report points to the Bangladesh Grameen Bank. With government funds, local vil lagers operate small branches of the Grameen Bank throughout the country.

These branches grant small loans to groups of the poorest Bangladeshis. Be tween 90 and 95 percent of these loans are repaid.

The Grameen Bank indeed is an example of how the poor, when given an opportunity, can manage their own economic affairs. It is also a credit to the energy and commitment of its founder, Muhammed Yunus. Yet the World The World Banks Poverty Report offers a menu of welfare state policies 4 World Bank Report, p. 28 5 World Bank Report, p. 51 6 hid 7 World Bank Report, p. 69 5 Bank report missesthe major lesson to be learned from the fact that the Grameen Bank needs foreign aid funds. Bangladesh government reg u lations and an army of bureaucrats prevent businesses from expanding beyond a cer tain size.This means many small enterprises compete for the same market with few able to make the profits or savings needed to expand. In an economy with a stable currency, p rivate banking, and minimal government regulations government capital for banks usually is not necessary. Small-scale entrepreneurs use their own savings to fund their businesses, and their profits to expand them. In most less developed countries, governm ent interference with the same market hinders this growth process.

Another problem is that credit subsidies require government-operated banks or government selection of private banks to receive and pass along sub sidies. With such subsidies inevitably come government regulations, fraud and red tape. There is no evidence that governments, especially in less developed countries, can pick the best banks for the subsidies.To the con trary, in the highly politicized environment of such countries, politics typic ally determine where the subsidies go.

This, in fact, is recognized by the World Banks 1989 report. It points out that government-subsidized financial institutions have had a very poor history in maintaining stable lending policies. These institutions tend to lend to ineffi cient public-owned companies, while using the printing press to increase the money supply to cover the bad loans? One year earlier, in the World Banks WorZd Development Report 1988, a similar lesson is drawn. This report finds that subs idized credit in Latin America, which has been used to support mas sive and inefficient state-owned enterprises, has been a major factor in many of those countries remaining underdeveloped 2) Government-Controlled Agriculture.

With the stark evidence of Af rica and the Soviet Union, no one today can dispute the fact that government-run agriculture has been a catastrophe. Yet the 1990 World Bank report advocates various forms of food subsid[ies general food price subsidies, food rations, food stamps, food di s tribution policies, and food supplementation schemes. These policies can be used to raise the real incomes of the direct beneficiaries, and they provide a safety net to protect a wider group of the poor against collapses in their real incomes.1 9 8 See Wo r ld Development Report 1989 (Washington, D.C The World Bank, 1989 and Edward L. Hudgins and BryanT. Johnson, Why The World Bank Should Read Its Own Report, Heritage Foundation Backgrounder No. 727, September 22,1989 9 See World Development Report 1988 (Was h ington, D.C The World Bank, 1988 10 World Bank Report, p. 92 6 Here, apparently, the World Bank ignores the evidence so clear to everyone else and continues to endorse state control of agriculture as a means to help the poor.To make matters worse, the 199 0 report balks at strongly endorsing the policy that most would help farmers and consumers in poor countries: abolition of government marketing boards and establishment of private ownership and control of all farms and food distribution.

In most African co untries and in many other poorer nations, individual ownership of farms is restricted if not prohibited. Governments require all crops to be sold to state-owned marketing boards, which set the price for crops.The government usually pays farmers below mark e t prices for their crops and then either distributes the cheap food in urban centers where most government employees and political supporters live or exports the food and pockets the profits. African governments even require farmers to use govern ment tra nsportation to send their crops to market.

Food Production Decline. When governments offer below market prices to the farmer, farmers typically produce only what is necessary for the needs of their immediate families. Those who produce more, usually do so to sell their goods in the informal sector or black market. As a result of these economic policies, sometimes backed with World Bank loans, Afrip's per capita food production declined 25 percent between 1960 and 1985 countries have begun doing on their ow n. Between 1985 and 1987, for ex I ample, Nigeria decided to come to grips with its failed policies. It shunned l new World Bank loans and instead abolished all of its marketing boards.

Nigeria also ended some restrictions on foreign investment. As a resul t Nigeria's gross domestic product grew 5.2 percent in 1988 and 8 percent in 1989 By comparison, between 1980 and 1987, the GDP shrank an average of 1.6 percent Agricultural output grew almost 4 percent in 1988 after the marketing boards were abolished. P r oduction of cocoa, the country's second highest export crop, which had been declining, increased al most immediately by one-third after the boards were ab01ished.l~ The lesson of this for the World Bank should be clear: freeing markets, not government con t rol of agriculture, is the best way to aid the poor What the World Bank's 1990 report ignored is what some African 11 Melanie S.Tammen The Failure of State Agriculture in Sub-Saharan Africa Foundation for Africa's 12 Zbid 13 Trends in Developing Economies I990 (Washington, D.C The World Bank, 1990 pp. 395-403 14 See Michael Johns A U.S. Policy for Nigeria: Supporting Political and Economic Freedom Heritage Future, Alexandria, VA, 1988, pp. 17-20 Foundation Bockgrounder No. 730, October 13,1989 7 3) Black M a rket Crackdown All less developed countries have extensive informal sectors or black markets for clothing, furniture, housing construction, transportation and al most all other goods and services.These informal markets sprout when government regulation an d taxes become so oppressive that individuals must evade the system to survive. Rather than recognizing and treating the cause of black markets, the 1990 World Bank report treats the symptoms. It advo cates stricter law enforcement against free market entr epreneurs.

It is the poor, of course, who suffer most from tight government control of the economy.The elites can afford to pay the bribes to the politicians and bureaucrats to obtain the permits to do business or to obtain the access to scarce goods. But the poor usually cannot and thus suffer. In Peru, for ex ample, economist Hernando De Soto found that to obtain a license for a small business, legally and with bribes paid only to keep the process from stopping completely, took 289 days of full-time effo rts. To obtain a piece of abandoned government land and permission to built would take six years and eleven months.

In most less developed countries, informal sector activities account for be tween one-third and one-half of the GDP. Workers in this sector are the true entrepreneurs who, to survive, must evade state economic regulation. The World Banks call for stricter law enforcement against the informal sector ig nores the honest efforts of entrepreneurs 4) Social Welfare.

The World Bank Report for 1990 contends that a strategy for fighting poverty should be supplemented with a system of well-targeted transfers and safety nets.16 The report adds: Public spending that is well designed and ac curately targeted can play an important part in the fight agains t poverty.17 The Bank in effect advocates a welfare state with government spending on health, education, income transfer, and population control developing countries simply do not have the resources for such a welfare state. History teaches that wealth fir s t must be created before it can be dis tributed 15 Though surely well intended, this policy prescription is deeply flawed. Most 15 Hernando De Soto, The Other Path (New York Harper and Row, 1989 16 World Bank Report, p. 51 17 World Bank Report, p. 4 8 The .Bank report suggests more public sector employment, especially in rural areas.l8 But a major problem in most less developed countries is bloated public payrolls.The Bank ignores the best source of job creation: the free market.

Further, public employment schemes, as well as any social welfare pro gram, require government spending. This usually means higher taxes, which hinders the creation of jobs and businesses in the private sector. In the end economic growth is stifled.lg 5) Land Reform.

The World Ban ks 1990 report supports efforts to seize property from the rich and redistribute it to the poor, arguing that individual land registra tion and titling may be undesirable, and that common pasture and forest resources are important for poor rural household s.m This ignores the near universal evidence that when land is the responsibility of individuals, the land tends to be better cared for, because it is the individual who profits from its best use and who suffers if the land is abused.

This point is demonstrated graphically by a photograph of Africas Sahel desert taken in the early 1970s from a U.S. satellite. It shows a 400-square mile dark green pentagon-shaped area standing out clearly against lighter sur rounding sand and shrub. The dark green area is lush vegetation; the sur rounding area is barren. The distinctive differences between the two areas are not geography or climate. The differences are 1egal.The large, lush green area is private property on which the owner raises cattle a nd makes certain that grazing from one year to the next rotates from one part of the land to another so that the vegetation is not depleted. The surrounding area is common property. As such, no individual has the incentive or the authority to care for the resources in this areaF1 6) Foreign Aid Supports.

The World Bank concludes its 1990 report with a call for increased support for poor countries from the Bank, the International Monetary Fund, the U.S.

Agency for International Development and other nation s.The Bank ignores the fact that no link has been found between increased foreign aid and in creased economic growth. Rather, existing evidence proves the opposite. Tan zania, for example, has received more foreign assistance per capita over the past quar t er-century than nearly any other country. Yet it is one of the poorest countries in the world. By contrast, Asian countries such as the I I 18 World Bank Report, p. 97 19 See Bruce Bartlett, he State and the Market in Sub-Saharan Africa, The World Economy , September 20 World Bank Report, p. 65 21 Cited inAccess lo Energy newsletter (Boulder, Colorado January 1990, p. 2 1989 9 Republic of China onTaiwan.received little or no assistance.Today, they are prospering RECOMMENDATIONS When Lewis Preston takes over as World Bank president in late summer he will face the twin challenge of dealing with countries desperately seeking free market solutions to their economic problems and with a Bank staff often mired in the failed policies of the past. Preston can transfo r m the bank from an institution that often has been the cause of economic stagnation to one that helps spur economic growth. To do this, he should instruct his staff of World Bank experts to 1) Develop an index of economic opportunity or freedom to embody free market goals to guide the Bank's structural adjustment lending.

Preston should recognize that institutionally there is little to keep the World Bank from repeating past mistakes. An index by which loan requests would be judged would create such an ins titutional force. Countries would receive World Bank loans if they received a passing score on an index measur ing the extent to which the count grants economic opportunity or freedom.

The index would measure Protection of private property rights. A funda mental ingredient for economic growth is the right of individuals to own, use and dispose of goods and services as they see fit, without (or with minimum) inter ference from government or other individuals. Property gives in dividuals the material means t o support themselves without government handouts and to establish enterprises. When property is owned by in dividuals, they have a strong incentive to put it to its most profitable use.

Where property rights are denied, or their protection is not en ured, in dividuals have little incentive to engage in productive activity Free pricing systems. Governments in many less developed countries im pose price controls. These distort markets, creating shortages when prices are kept below the market level or a surpl u s of goods that no one can purchase when prices are kept above the market level. Resources are wasted and inefficiencies created. As a result, growth falters or halts Low, stable tax rates. High taxes punish individuals for being produc tive. Low taxes al low maximum economic output and usually bring in more revenues to treasuries than higher taxes. Stable tax rates allow businesses to plan ahead 22 See Edward L. Hudgins Private Property: The Basis of Economic Reform in Less Developed Countries,"

Heritage F oundation, Backpunder No. 70, May 24,1990 10 Private.agricultura1 sectors. The public marketing boards of sub Saharan Africa have been a failure. By contrast, countries with private sector agricultural markets, such as Mainland China and South Korea have i ncreased agricultural production. Freeing farmers from govern ment control gives them the power and the incentive to meet their countries agricultural needs regulators in less developed countries make it difficult and costly for entrepreneurs legally to s t art businesses. Lengthy delays in issuing licen ses, confusing and contradictory application procedures, and the ar bitrary power of government .officials to control businesses hinder the creation and expansion of many businesses and force others into the in formal sector. Regulatory reform in less developed countries would help channel the energy of entrepreneurs into its most productive use Private banking and financial institutions. Private banks, free from political pressure, tend to channel funds to t h e most promising enterprises, Small, local banks especially give small-scale businesses a ready source of capital Free trade policies. When governments in less developed countries restrict imports to protect certain industries and privileged workers, they deprive other sectors of their economies of capital and necessary im ports. This creates even more unemployment and damages other in dustries. Further, such protected industries, because they need not com pete with foreign firms, usually produce poorer qu a lity products that lose money. Free trade would allow resources in these countries to go to the industries that are most competitive and increase economic growth foreign investment. Governments that restrict or prohibit investments from other countries cu t their citizens off from a crucial source of funds which can be used to build factories and infrastructure. Such govern ments usually must turn to borrowing, often from the World Bank, to cover investment costs. Such borrowing in the past has been a major cause of the debt crisis. Removing all restrictions on foreign investments would open the doors of most less developed countries to needed capital Limited government regulation of the economy. Government Encourage foreign investment. Foreign aid often tak es the place of 2) Create guidelines to insure that structural adjustment loans go only to countries instituting consist en t and comprehensive economic reforms.

The World Bank has a history of throwing good money after bad. Policy changes attached to loan s, even if sound, usually are more than offset by other economic policies of the recipient countries. Governments that are not willing to commit themselves fully to comprehensive and consistent free market reforms should not qualify for loans. Such loans d o not help their economies and often remove pressure to make fundamental changes. The World Bank especially needs new guidelines as the Soviet Union and other socialist countries seek assistance in exchange for promises that they will 11 reform their econ omies. By establishing such guidelines, Preston would help the Bank itself to avoid promoting contradictory policies debate among theworld Bank members over how countries can meet their finance needs without further addiction to borrowing.

World Bank proje ct lending in the past has allowed countries to cut waste ful spending, privatize money-losing state enterprises, and adopt growth oriented market reforms. In addition, such loans have drowned countries in a sea of debt.The World Bank must re-evaluate its basic purpose. If its project lending is to continue, it must show why no other means is available to less developed countries and establish strict guidelines to avoid the errors of the past. Preston should initiate a complete review of the Bank's purpose and a public discussion among the members concerning the Bank's future 3) Freeze project lending and initiate a full investigation and public CONCLUSION LewisT. Preston takes command of the World Bank at a time of world wide economic and political change. Socialism and government direction of economies have ruined one country after another and led to political revolu tions. Such countries now look to the West for guidance and assistance. In the past, the Bank has been giving bad advice to less developed co untries. As a result, many poor countries became addicted to loans and aid, while refusing to reform their own economic environments. Preston has an opportunity to change the Bank's course by rejecting the philosophy found in the latest World Bank report.

Global Transformation. Western governments and international institu tions such as the World Bank have an opportunity to transform the global economy. It would be a tragedy if the Bank failed those people who genuinely want to replace stagnant, socialist economies with dynamic free markets.

Lewis Preston has the chance to make the World Bank the means of placing prosperity in the reach of all individuals and in all less developed countries.

Bryan T. Johnson Policy Analyst 12

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