March 7, 2003

March 7, 2003 | Backgrounder on Trade, Economic Freedom

Make the Rule of Law a Necessary Condition for the MillenniumChallenge Account

In March 2002, President George W. Bush proposed the creation of the Millennium Challenge Account (MCA), a new foreign assistance program to low-income countries that demonstrate a strong commitment to "ruling justly," "investing in people," and "establishing economic freedom."1 Linking foreign aid to sound policies responds to the overwhelming evidence that aid can make a difference only in countries with sound institutions. Sound institutions foster a more transparent and accountable governing environment, reducing the government's ability to misuse aid funds. In contrast, weak institutions foster corruption, cronyism, and government mismanagement, expanding the possibilities for governments to misuse aid funds.

The Administration has proposed a set of eligibility requirements for MCA aid that use 16 indicators of just rule, investment in people, and economic freedom. Although all of the indicators are important, the "rule of law" indicator--the mechanism by which society enforces rules and protects property--is by far the most crucial. Studies on aid, growth, and prosperity reveal that the rule of law is the only mechanism that curtails corruption, sustains economic growth, and therefore improves people's living standards.2

For this reason, the Administration should require the "rule of law" indicator as a prerequisite to any country's qualifying for aid. In this way, the Administration will ensure that MCA aid is both effective and sustainable.

Aid, Institutions, and Prosperity

The history of aid suggests that the developed world's good intentions of relieving world poverty have not achieved good results. According to the Organization for Economic Cooperation and Development (OECD), from 1960 until 2001, the developing world received $1.2 trillion in official development assistance (ODA).3 This aid was intended to finance a myriad of programs, including programs in education, health, infrastructure, and social and economic services.4 Despite these considerable resources, the average per capita income in recipient countries after 41 years of aid programs was only $2,437.5 The funds did not prove sufficient to foster sustained economic growth and therefore failed to lift the majority of the poorest out of poverty.

There are, of course, development success stories. For example, Hong Kong, Chile, South Korea, Botswana, and Taiwan--to name a few--were all once very poor and are now either developed or on a path of sustained growth. None of them, however, owes its success to aid. For example, from 1960 until 2001, Hong Kong received only $376 million, and South Korea received $4.7 billion.6 Yet both experienced dramatic increases in per capita income so that per capita income was $24,510 in Hong Kong and $13,419 in South Korea in 2001.7

By contrast, Indonesia received $37 billion in aid during the same period, and Bangladesh received $36 billion.8 However, per capita income grew very slowly in both countries. In 2001, per capita income was $994 in Indonesia and $386 in Bangladesh.9 So far, there have been no development success stories among countries that have received large amounts of foreign aid for long periods of time.

The key to prosperity is open markets with a strong rule of law. Open markets allow for the free flow of human and non-human capital, and the rule of law protects private property. In a study of the determinants of per capita income across countries, Richard Roll and John Talbott found that institutional variables explain more than 80 percent of the variation of gross national income per capita across countries.10 Three variables had the highest levels of significance in explaining those variations: "property rights," defined as the strength of the rule of law and the independence of the judiciary; "regulations," defined as the regulatory burden on businesses; and "black market," defined as the amount of economic activity in the informal sector.11

Simply put, the Roll-Talbott study indicates that people invest, work, and consume where regulatory barriers are lowest and, most important, where property rights are protected. Therefore, to encourage permanent investment and sustainable economic growth, governments must enact sound policies, streamline regulations, and--above all--guarantee the protection of property.

Without the rule of law, societies have no mechanism to stop private abuses and public mismanagement. In this environment, aid funds get lost in corrupt bureaucracies. As Bruce Bartlett, Senior Fellow at the National Center for Policy Analysis, has pointed out, where the rule of law is weak, "much foreign aid is simply stolen by elites and almost all the rest has been wasted on projects that yielded no economic benefits whatsoever."12 The merit of the President's MCA proposal is that it recognizes such distortions and attempts to create incentives for countries to use aid funds properly.

WHY The Rule of Law IS ESSENTIAL TO A SUCCESSFUL MCA

The Administration has laid out the methodology to determine MCA eligibility. First, a country must be in one of the bottom two categories of per capita income: below $1,435 and between $1,435 and $2,975.13 Second, a country must qualify in half of the indicators in each of the three categories: ruling justly, investing in people, and establishing economic freedom. (See Table 1.) There are 16 indicators, and to qualify in an indicator, a country must score higher than the median score of the indicator. In addition, a country must qualify in the corruption indicator. In other words, to be eligible for MCA funding, a county must qualify in (1) the corruption indicator, (2) two of the five remaining "ruling justly" indicators, (3) two of the four "investing in people" indicators, and (4) three of the six "economic freedom" indicators.14

By using corruption as the necessary condition, the Administration has confirmed that it is deeply concerned with misuse of aid and wants to use the MCA initiative to encourage countries to use aid appropriately. To achieve that goal, however, the Administration would be better served by making the rule of law, not corruption, the necessary condition. Corruption is a consequence of a weak rule of law, not vice versa. If countries take steps to strengthen the rule of law, corruption will decrease. Therefore, to curtail corruption and guarantee that aid is used properly, countries should be required to qualify in the "rule of law" indicator.

Stronger Rule of Law, Less Corruption. Countries with a weak rule of law suffer from corruption, cronyism, economic mismanagement, and political instability. As noted, the rule of law is the only mechanism that a society has to punish crime, protect private property, enforce contracts, and maintain reforms. Under a strong rule of law, people feel that their personal liberty and the fruits of their labor will be protected. This sense of "safety" is the basis of sustained economic activity because people and businesses will work, save, and invest when they have a guarantee that their property, their investments, and the fruits of their labor will not be taken from them.15 In contrast, under a weak rule of law, there are no guarantees that any effort by citizens will be respected, nor are there limits to government abuses, bribery, special interests, and generalized corruption.

Chart 1 supports this point, showing a strong negative relationship between the level of corruption and the strength of the rule of law. However, the range of corruption levels is wide among countries in each rule-of-law category, suggesting that the corruption level varies even within the same overall assessment of the rule of law. For example, countries with a "very high" level of property protection had corruption scores ranging from 6.9 to 9.7. This may be because some countries have longer histories of property rights protection than others, and fighting corruption may take some time, even after a country makes progress toward strengthening the rule of law. Nevertheless, Chart 1 shows a strong tendency for corruption to decrease as the rule of law strengthens. (For examples of specific countries, see Table 2.)

Corruption Perception Index. On the Transparency International Corruption Perception Index (CPI)--which uses a scale from 1 to 10, with 1 the most corrupt and 10 the least corrupt--the average score for countries with a strong rule of law is 8.53, while the average for countries with a very low score is 2.43.16 (See Chart 2.) Countries with a strong rule of law and low levels of corruption also have an average per capita income of $30,538, compared to a per capita income of $424 in countries with a weak rule of law and a high level of corruption.

The relationship between the rule of law, corruption, and per capita income makes sense because, although virtually all countries have legislation outlawing corrupt activities, most countries do not enforce those laws. Lack of enforcement fosters an unpredictable environment for economic activity, attracting mostly short-term, speculative investment, which is often quickly moved out of the country, as opposed to allowing investment to accumulate over time.

Implications for MCA Methodology. The implications of the relationship between the rule of law and corruption for the proposed MCA methodology are significant. At present, the MCA methodology proposes that corruption, not the rule of law, be the mandatory requirement. The problem with this approach is that, once a country scores above the median in the corruption factor, it can qualify in any two of the other five factors that may not include the "rule of law."

Some may argue that a country that scores above the median in "corruption" will probably also qualify in "rule of law" because of the relationship shown in Chart 1. However, this may not be the case, given the number of corruption levels corresponding with each "rule of law" level. For example, a country with a corruption level of 5 will likely have a high level of rule of law, but it could also have, according to Chart 1, a moderate or even a low level.

Equally important is the message that the Administration would convey by establishing the "rule of law" indicator as a prerequisite. The Administration would be encouraging governments seeking MCA funding to worry primarily about strengthening the rule of law by making the judiciary independent and protecting private property. A reduction in corruption would most likely follow.

Conclusion

The history of foreign aid suggests that the developed world's good intentions of relieving world poverty have not achieved good results. Despite the $1.2 trillion in ODA from 1960 to 2001, few aid recipients have seen reduced poverty rates. In some cases, poverty rates have worsened since 1960, primarily due to poor policymaking and weak institutions in recipient countries. President Bush's MCA initiative--linking aid to sound policies--is an attempt to encourage recipient countries to implement sound policies so that aid actually reaches the poor and helps alleviate their needs.

The Administration has proposed a methodology to establish MCA aid eligibility. Of all the indicators in the methodology, the "rule of law" indicator--society's mechanism to enforce rules and protect property--is by far the most crucial. For this reason, the Administration should make the "rule of law" indicator a prerequisite to MCA aid. In this way, the Administration can ensure that aid under the MCA initiative is both effective and sustainable.

Ana I. Eiras is Senior Policy Analyst for Trade and Economic Development in the Center for International Trade and Economics at The Heritage Foundation.

Footnotes

1. Steve Radelet, "Qualifying for the Millenium Challenge Account," Center for Global Development, December 13, 2002, p. 1, at www.cgdev.org/nv/Choosing_MCA_Countries.pdf.

2. See, for example, Richard Roll and John Talbott, "Why Developing Countries Just Aren't," at www.worlddevelopmentnow.com/id21.htm; Robert J. Barro, Determinants of Economic Growth: A Cross-Country Empirical Study (Cambridge, Mass.: MIT Press, 1997); Robert Cooter, "The Rule of State Law and the Rule-of-Law State: Economic Analysis of the Legal Foundations of Development," in Edgardo Buscaglia, William Ratliff, and Robert Cooter, eds., Law and Economics of Development (Greenwich, Conn.: JAI Press, 1997); Hernando de Soto, The Other Path: The Invisible Revolution in the Third World (New York: Harper and Row, 1989).

3. Organization for Economic Cooperation and Development (OECD), Development Assistance Committee Database, at www1.oecd.org/scripts/cde/viewbase.asp?dbname=cde_dac.

4. Organization for Economic Cooperation and Development, Development Assistance Committee, Aid Activities in Least Developed Countries, 1999.

5. World Bank, World Development Indicators Online, 2002, at www.worldbank.org/data.

6. OECD, Development Assistance Committee Database.

7. World Bank, World Development Indicators Online, 2002.

8. OECD, Development Assistance Committee Database.

9. World Bank, World Development Indicators Online, 2002.

10. Roll and Talbott, "Why Developing Countries Just Aren't." Professor Richard Roll is Allstate Chair in Finance at the Anderson School of Business, University of California at Los Angeles, and John Talbott is president and founder of the Global Development Group.

11. Ibid.

12. Bruce Bartlett, "Foreign Aid Is a Problem, Not a Solution," Daily Policy Digest, March 18, 2002.

13. The White House, "The Millennium Challenge Account," at www.whitehouse.gov/infocus/developingnations/millennium.html.

14. Ibid.

15. Lee Hoskins and Ana I. Eiras, "Property Rights: The Key to Economic Growth," in Gerald P. O'Driscoll, Jr., Kim R. Holmes, and Mary Anastasia O'Grady, 2002 Index of Economic Freedom (Washington, D.C.: The Heritage Foundation and Dow Jones & Company, Inc., 2002).

16. Transparency International's Corruption Perception Index (CPI) is an annual survey of surveys that reflect the perceptions of business people, academics, and country analysts. The surveys are undertaken over the three years prior to each annual publication, and no country is included in the CPI without results from a minimum of three surveys.

About the Author

Ana I. Eiras Senior Policy Analyst on International Economics
Center for Trade and Economics (CTE)