When Paul Wolfowitz takes over the presidency of the World Bank this month, he will face the challeng­ing task of turning the World Bank into a more trans­parent, more accountable, and more effective organization. Despite its good intentions and hun­dreds of billions of dollars in development assistance over five decades, the Bretton Woods institution has failed to reach its goal of "a world free of poverty."[1]

A major part of the problem is that the World Bank's mission is based on the false assumption that economic growth and development can be achieved by providing aid. This flies in the face of five decades of development experience and the bulk of economic studies, which indicate that economic freedom and the rule of law are far more important than assistance as determinants of growth. Moreover, providing assis­tance in bad policy environments is at best ineffective. At worst, it is counterproductive because it gives cor­rupt governments economic resources to maintain bad policies that retard development.

Despite its failures, support for the World Bank and provision of development assistance remain strong among member states. Given the continued presence of the World Bank, the United States should acknowl­edge the Bank's weaknesses and work to focus the Bank on activities that facilitate development.

To that end, the U.S. should work with Wolfowitz to focus World Bank assistance on the world's poorest nations and cease lending to wealthier nations that have access to capital markets.[2] Assistance should focus on countries with sound policies and demon­strable commitment to economic freedom and the rule of law. Finally, the Bank should disburse aid through results-based grants rather than loans, to militate against unsustainable debt, and should finance projects that will produce easily measur­able results. These changes will refocus the Bank's resources on low-income countries without ready access to capital markets and create incentives for countries to implement the sound policies that are necessary for development.

Lessons from the Past

At the end of World War II, the United States and the United Kingdom feared that private markets might not provide the resources necessary to recon­struct Europe. In order to forestall this possibility, they pushed to "establish an international frame­work to prevent a recurrence of economic recession and to promote reconstruction in war-torn Europe."[3] A central component of this framework was the World Bank-then composed solely of the International Bank for Reconstruction and Devel­opment (IBRD)-which was intended to finance the reconstruction of war-torn countries. Although the World Bank followed its mandate closely and contributed to the effort, private markets defied expectations and played the major role in the reconstruction of Europe and Japan.[4]

After the postwar reconstruction, the World Bank shifted its focus to poor nations and newly independent former colonies in the hope that it could facilitate development with capital infusions. Despite the best of intentions, many World Bank recipients today remain just as poor as-if not poorer than-they were when lending begun.[5]

The facts are compelling. Despite enormous amounts of economic assistance totaling $261.36 billion between 1980 and 2003,[6] the World Bank has not been able to consistently catalyze strong growth in per capita income in low-income coun­tries. Of the 105 recipients of International Devel­opment Association (IDA) credits between 1980 and 2002 for which per capita gross domestic product (GDP) data are available:

• 39 countries experienced negative compound annual growth in real per capita GDP;
• 17 experienced marginal compound annual growth between zero percent and 1 percent;
• 33 experienced compound annual growth of more than 1 percent in real per capita GDP; and
• Only 12 achieved growth over 4 percent.[7]

The World Bank's record in sub-Saharan Africa is particularly bad, with half the recipients experiencing negative compound growth in real per capita GDP.[8]

Solutions for the Future

Five decades later, the lessons are clear: It is not lack of aid that is preventing these countries from addressing their problems; it is anti-market eco­nomic policies, corruption, and the absence of the rule of law. The preponderance of economic studies confirms that aid may help the poor to cope tem­porarily with some of the consequences of poverty but that countries beset by a weak rule of law, cor­ruption, heavy state intervention, and other char­acteristics that retard growth will not experience long-term sustainable economic growth even if they receive economic assistance. In order to develop, poor countries must adopt policies that promote economic freedom and the rule of law, which in turn are known to be associated with higher levels of economic prosperity.

While the World Bank often states that lending is based on a commitment to policy change, it seldom disburses aid based on existing policy.[9] Instead, the Bank has sought to provide assistance in stages in return for commitments from the recipient to adopt reforms-a policy known as conditionality. Under conditionality, assistance is provided, but reforms seldom materialize. As a result, countries assume ever-greater debt but lack the policies necessary to grow, thereby undermining their ability to repay their debts.

Foreign assistance, through an international finan­cial institution or otherwise, has the potential to help poor countries achieve specific goals, but it cannot replace the political will to implement policy change. Developing countries must make their own internal reforms for their own reasons; reforms imposed through external pressure are likely to be short-lived or poorly implemented. The World Bank's challenge is to help poor nations that demonstrate a commit­ment to good policy to create opportunities for devel­opment by removing barriers to economic growth.

With these lessons in mind, Paul Wolfowitz has a unique opportunity to set the World Bank on a more effective path when he assumes the Bank's presidency. Key aspects of a more effective institu­tion include the following.

Clarifying the World Bank's Mission
Having a clear-and realistic-mission is extremely impor­tant because it helps to focus the institution on the right strategy to achieve its goal. The World Bank's self-professed dream of "a world free of poverty,"[10] although admirable, is far beyond its institutional means. This type of institutional overreach leads to unrealistic expectations and is the source of the idea that the Bank should be responsible for curing the ills that afflict poor nations. As a result, the Bank has spent inordinate time and resources addressing the symptoms of poverty rather than its causes.

For instance, poor health care, lack of sanitation, starvation, illiteracy, low life expectancy, and other tragic realities in poor nations around the world are symptoms of poverty. Handing out money to projects that address some of these concerns can alleviate the situation only temporarily. Develop­ment efforts that focus on alleviating these conse­quences while leaving the underlying causes unaddressed are doomed to fail.

The World Bank's focus should be on encourag­ing poor nations to bolster the rule of law and to increase economic freedom. It is these policies that will remove obstacles to economic growth and pave the way toward reducing poverty. The increased wealth resulting from economic growth would allow parents the luxury of educating their children instead of making them work to help provide for their families, enable individuals to value green spaces for their aesthetic value rather than just their potential as fields for crops or trees for fuel, permit the workforce to worry about the quality of the work environment rather than the lack of employ­ment, and give families the means to engage in pre­ventive health practices that lead to longer lives. By concentrating on increased economic growth, the development strategy permits greater opportunities for individuals to escape poverty and provide for their families.

Focusing Assistance on Low-Income Coun­tries Without Access to Capital Markets
The goal of the World Bank should be to help every nation attain a credit rating and improve its rating to the point that it can borrow on international cap­ital markets at reasonable interest rates. The resources available through international capital markets, foreign direct investment, and increased trade dwarf those available from multilateral and bilateral assistance. Developing countries must tap these resources if they are to develop.

Private capital will be invested where there is potential for profit, provided the risks do not exceed the expected returns. Nations with bad eco­nomic policies and weak rule of law are greater credit risks than nations with good policies. This risk is reflected in the higher interest rates that they are charged in financial markets and the relatively low levels of direct investment they receive. This is good insofar as it provides incentives for countries to adopt policies that will lower risks to private creditors-policies that also encourage interna­tional and domestic investment and entrepreneur­ship. Regrettably, the World Bank retards this transition by providing subsidized loans to coun­tries that have access to capital markets, thereby undermining these market incentives.

As shown in the Appendix, the World Bank dis­bursed 56 percent of its funds in 2004 through IBRD loans, which are targeted to relatively wealthy countries.[11] At least a third of IBRD recipients have an investment grade credit rating (BBB or better) according to Standard & Poor's. Only 44 percent of the World Bank's funds in 2004 were disbursed through IDA credits, which are generally available only to countries with a per capita income less than $865.[12] Of the 62 recipients of IDA credits in 2004, 17 were low-middle-income countries, and 14 had a gross national income (GNI) per capita above the World Bank's 2003 threshold (the most recent available at their Web site) for IDA lending. Only 40 percent of all World Bank (IBRD + IDA) funds disbursed in 2004 went to low-income coun­tries (defined as countries with a per capita income of $765 or less) without access to capital markets. Clearly, the World Bank is not focusing its resources on the poorest of the poor.

Mexico and Argentina both have per capita GNIs of over $3,800, yet received 20 percent of IBRD loans in 2004. (See Appendix.) Moreover, Argen­tina remains eligible for World Bank loans despite having grossly violated the property rights of thou­sands of domestic and foreign investors by default­ing on its debt. Despite its relative wealth, a terrible credit history, and political instability, Argentina received 3.5 times more money from the World Bank in 2004 alone than was received by the poor nations of Ethiopia, Burundi, and Eritrea com­bined. (See Appendix.)

Some may wonder why countries borrow from the World Bank when they have access to capital markets. The answer is that the World Bank subsi­dizes its loans by charging interest rates far below those available from the private sector.

For example, Indonesia is currently borrowing from both lending arms of the World Bank. Through IDA credits, Indonesia does not pay any interest, only a fee of 0.75 percent. Even under the more market-based lending of the IBRD, Indonesia pays approximately 0.75 percentage point over U.S. Treasury bonds.[13] By comparison, as of April 29, 2005, Indonesia's Global Bond (the latest dol­lar-denominated bond issued by the government of Indonesia in March 2004) was trading at 3.126 percentage points above U.S. Treasury bonds of similar maturity.[14] Under those circumstances, borrowing from the IBRD saves the Indonesian government 2.376 percentage points versus what it would have paid in the capital markets. This inter­est rate spread is very significant when dealing with hundreds of millions or billions of dollars.

By providing subsidized loans to countries like Indonesia, which has a per capita GNI that is above the threshold for low-income countries, the World Bank not only undermines incentives to make free-market reforms and sound fiscal decisions neces­sary to reduce credit risk, but also diverts resources away from poor nations to countries that could borrow elsewhere. The Bank should end this prac­tice and focus its efforts on low-income countries that lack or have only marginal access to capital markets.

Selecting Countries Carefully
In trying to help countries cope with some of the symptoms of pov­erty, the Bank should help in a way that gives the poorest countries' leaders incentives to adopt eco­nomic freedom and the rule of law. One way to do that is by emulating the Millennium Challenge Account (MCA). The MCA is a new approach to U.S. foreign assistance that makes assistance avail­able only to countries "that govern justly, invest in their people and encourage economic freedom."[15] In other words, MCA money will be awarded only to countries with relatively good policies.

This idea of establishing preconditions in order to receive foreign assistance-rewarding good pol­icies already in place rather than providing money in hope of encouraging reform-is supported by economic studies indicating that aid is most effec­tive in countries that embrace policies that create incentives for people to behave more productively, thereby encouraging economic growth.[16] More­over, additional research by the World Bank indi­cates that increases in overall growth and average incomes result in proportionate increases in incomes of the poor.[17] In other words, World Bank research confirms that focusing on economic growth is an effective strategy to reduce poverty.

Of course, this approach works only if the World Bank actually stops lending to countries with poli­cies that impede economic growth and develop­ment. The Bank should target its assistance toward countries with relatively good policies. This does not mean that recipients must be models of good policy and the rule of law on the level of Chile or Singapore, but that they must have better policies than many of their peers. Not only will this provide greater assur­ance that the assistance will be more effective, but it will provide incentives for other nations to adopt policies that will increase their opportunities for eco­nomic growth and development.

Giving Grants Instead of Loans
The failure of development assistance to facilitate economic growth has left many poor nations with a large debt burden. It is the small return on development assis­tance over the years and the justifiable belief that new loans were often approved to finance existing debt (creating a rising spiral of debt that does not contribute to growth) that fuels criticism of World Bank lending and lies at the heart of calls for debt forgiveness. As with many development programs that treat the symptoms of poverty rather than its cause, debt forgiveness treats the symptoms of a heavy debt burden rather than its cause. It is not debt that is preventing these countries from addressing their problems; it is anti-market eco­nomic policies, corruption, and the absence of the rule of law that has prevented them from using bor­rowed sums profitably and has undermined their ability to repay.

However, the world's poorest countries that lack access to capital markets do face problems that could be assuaged through assistance. In such situations, it makes little sense for the World Bank to provide loans that are unlikely to be repaid and that are intended to alleviate the immediate consequences of poverty, such as immunizing children, rather than to spur growth. Such activities should be funded by performance-based grants rather than loans.

In 2000, the International Financial Institution Advisory Commission (IFIAC), appointed by Con­gress to assess the performance of international organizations and chaired by Allan H. Meltzer of Carnegie Mellon University, proposed a system of performance-based grants for the World Bank. Under the new system, the poor country's govern­ment and the World Bank would jointly finance projects to address some of the consequences of poverty. According to the report:

[T]he share of the cost paid by the country would depend on its per capita income level and credit rating. The poorest nations without capital-market access would receive grants equal to 90% of the service cost, while the development agency's contribution would fall to 10% as the country income level or capital-market access increased.[18]

Although pressure from the Bush Administration led the World Bank to begin providing grants through IDA in 2003, many member states con­tinue to resist transforming Bank assistance wholly to performance-based grants. World Bank officials resisted the change, in part from fear that grants would undermine project effectiveness because they would not have to be repaid.[19] This is unlikely since, under the IFIAC proposal, the recipient of the grant would actually have to match a portion of the grant. Moreover, the grant would fund projects proposed by the recipient only after an outside auditor verifies that the proposed project has been completed. Thus, failure to implement would hurt a priority identified by the recipient. Finally, future grants would depend on the recipient's adherence to the agreed terms of the grant, creating strong incentives to implement the project as planned and permit independent evaluation of the project.

Officials at the World Bank also fear that grants, because they are not repaid, will undermine the bank's resource base and create a greater reliance on frequent contributions from member states. Con­verting IDA credits to grants could take additional funding, but not as much as critics claim.

One alternative is for IDA contributors to pro­vide resources for an IDA endowment to be invested in low-risk instruments similar to a pen­sion fund. History shows that the U.S. Congress regularly approves funding for the IDA. Originally, this amount could be similar to that of a typical IDA replenishment, which donors fund every three years. The IDA replenishment, approved in April 2005, was for $34 billion.[20] For example, at an 8 percent rate of return, an investment of this size would yield $2.7 billion annually. Sentiment for support of an IDA investment fund should exceed that for the current system because the original investment would not be disbursed as grants; only the earnings from the investment would be distrib­uted, thereby eliminating the need for future donor contributions.

An alternative source for the IDA endowment would be simply to use the IBRD paid-in capital and uncommitted, undistributed IDA funds.

Regardless of which option is used, the IDA endowment could be a perpetual resource for future IDA grants. Moreover, as current IDA credits are repaid, they could be added to the IDA invest­ment fund to increase the endowment and generate additional resources for grants. As noted by Adam Lerrick, director of the Gailliot Center for Public Policy at Carnegie Mellon University:

As borrowers repay past IDA credits, these resources would be available to the endowment. At a conservative 8 percent investment return, each $100 increment would produce $8 in additional income for grants. At every moment during [a] 40-year transition period, a larger volume of development pro-grams, gross annual flows, and net annual flows would be supported under the grant structure than is the case under the traditional loan delivery system.[21]

As long as the bank performs well, it should retain donor support. If the IDA fails to perform as envisioned, the donors could reclaim their portions of the investment. Market discipline is good for the World Bank as well as for recipients.