Institutional Arrangements for the Provision of Development Assistance

1. Institutional Arrangements for the Provision of Development Assistance Joseph Stiglitz May 5, 2000

2. General Approach • Market failures: theory of global public goods/externalities • A public good has • Non-rivalrous consumption • (one person’s enjoyment does not diminish others’) • Non-excludability • (no one can be excluded) • Global public goods have benefits that extend beyond national borders. • International economic, political, environmental stability • International humanitarian assistance • Knowledge • Global externalities - actions that have spillovers beyond national borers.

3. General Approach continued • Agency theory—what are incentives facing development actors? • Agency problems within “donors” • Agency problems within recipients

4. Review of Rationale for “Crisis” Lending (IMF) • Market failures • Insufficient incentives of countries to maintain adequate aggregate demand because doing so leads to “spill-overs” (leakages)—benefits for others • Imperfections of capital markets • Countries could not access funds to finance deficits • Consistent with pro-cyclical patterns of deficits in developing countries • And evidence of credit rationing for poor countries • Credit enforcement • Credit-relevant information • More information is required than conveyed in prices (in contrast to standard competitive equilibrium model) • Imperfect risk markets • Countries that “insist” on trade surplus force trade deficit on others

5. Original Conception of IMF • Focused on two market failures (insufficient aggregate demand and level of liquidity) • Implied response to market failures: • Liquidity lending in times of crisis • “Conditionality” focused on forcing more expansionary policies • This leads to questions about current IMF practices that contradict earlier practices: • Conditionality more often focused on forcing more contractionary policies • Bail-in policies raise questions about theory of liquidity lending

6. Questions about current IMF practices that contradict earlier practices (continued) • Interventions in exchange rate market raise questions about IMF confidence in the market’s overall efficiency • IMF expects failures in exchange rate markets requiring government intervention—is there a special reason? • Possible answer: expectational contagion effects (ambiguous evidence and theory) • Note: in East Asia, “contagion effects” through conventional trade interactions was significant, exacerbated by contractionary policies • What are the benefits and costs? to whom? • If markets can exhibit excessive pessimism ( as in the exchange rate market, requiring government defense of currency), can’t they exhibit excessive exuberance? If so, should there be broader interventions?

7. Questions about current IMF practices that contradict earlier practices (continued) • Another market failure IMF should pay broader attention to is absence of risk markets and imperfections of credit markets In particular, • Relative ability of different parties to bear risk (workers, small businesses least able to bear risks in absence of safety net) • Incentive effects • Maintaining exchange rate to protect those who failed to buy cover reduces incentives to obtain cover • credit enforcement activities reduce incentives for due diligence of creditors

8. Development Assistance • Global public good • It is in the interest of donors to have their money used most effectively • It is in the interest of recipients to use money most effectively • Key issue: What are the conflicts of interest that require conditionality?

9. Basic Framework • Non-humanitarian interests in aid • Sometimes donor is not really interested in maximizing welfare of recipient country (colonial assistance) • Asymmetric trade liberalization • Agency theory • Donor as principal, recipient as agent • Recipient governments may not spend money in ways which maximize development, or may choose trade-offs between development/growth and poverty reduction that do not reflect donor’s preferences • May be true even in democratic governments • But especially a concern with non-democratic governments

10. Agency Theory continued • Donor country taxpayers as principal, administering agency as agent: • Administering agency may have interests that do not coincide with national interests • “rival” principals: supporters of aid agencies include businesses which benefit from aid (construction firms); their interests do not coincide with “humanitarian interests” • In multilateral institutions who is agent? Who is principal? • Capital market liberalization: • May have been more in interests of capital exporters • Exposing developing countries to huge risks • With little evidence of positive effects on growth • And strong theory about why there may be little or no growth benefits • Especially in high savings countries like East Asia

11. IFIs’ Responsibilities in Providing Development Assistance • Basic question: • What is objective of donor countries in giving aid to developing countries? • What institutional structure (assignment of responsibilities) is most likely to achieve those objectives? • Institutional mandate affects “focus” • For example, agency with stabilization as objective is in general more likely to worry about stabilization issues • Note that there is a trade-off among issues (e.g. stabilization, growth, poverty reduction, repayment of creditors) • Should the paramount objective of development assistance be “stabilization?” • Is a “stabilization agency” a “development agency”?

12. Broadening the Mandate • Induces lack of focus, impedes accountability • Likely, in any case, to be difficult to achieve • Organizational culture • Governance structure • Differences among institutions in governance • In some cases, direct accountability not representative of either donor or recipient countries • Direct accountability not representative of global interests, broadly defined, or even global economic interests • Implication: agency problems may be more severe with some assignments of responsibility than others

13. Key Problems in Conditionality • When donor country or agency interests differ from recipient’s, attempt to rely on conditionality • Problems with conditionality: • Fungibility • Asymmetric information • Conditionality can be viewed as a constraint imposed by principal (donor) on agent in order to increase expected value of outcome (expected utility of recipient, assuming altruistic donor, non-altruistic agent)

14. More problems with asymmetric information and conditionality • But donor is less well-informed than recipient, so that restrictions impinge on ability of well-intentioned recipient to achieve objectives • Did insufficient attention to impact of policies on volatility actually lead to increase in poverty? • Mistakes in sequencing identified by ESAF review committee • And at the same time may be ineffective in preventing badly-intentioned recipient from diverting funds to achieve its objectives • Asymmetric information impedes enforcement of conditionality: • There exist excuses for failure to live up to conditions • Exacerbated by political considerations in providing aid, making conditions “not credible” • Both attenuate incentives to fulfill conditions

15. Re-examining Conditionality • Assessing Aid suggests that conditionality has not been effective in “buying” good policies • New strategy: attempt to distinguish “good” borrowers from “bad” borrowers • Based on past performance • Assuming serial correlation • For good borrower: borrower has informational advantage and no need to use conditionality • Incentive to continue to be treated as good borrower may have positive effects • Focus on process, actions, and outcomes (performance)

16. Issues Underlying Development Assistance • What is the relationship among aid, economic development, and development of democratic processes? • Democratic processes are necessary for comprehensive development. They require a process of consensus building and conflict resolution in making meaningful economic choices. Therefore aid should not short-circuit democratic processes • Learning-by-doing: “social capital” associated with democratic decision making is created through successful decision making processes

17. Democratic Processes and Comprehensive Development continued • Restricting choice set through conditionality is widely perceived to weaken democratic processes • Especially since conditionality does not attempt to trace out Pareto frontier, allowing country to make choices along frontier • But rather acts as if policies are Pareto dominant, when they are not, especially once risks of consequences are taken into account • Choice of point in Pareto set reflects special interests • Incentives of donor agencies to restrict debate (limited competition in the market for advice, or at least in the market advice associated with money flows) • Especially when it is seen to undermine consensus-building • And can be especially divisive when distributional consequences of policies seem inequitable

18. Democratic Processes and Comprehensive Development continued • And when policies contribute to social and political turmoil (especially in ethnically fractionated societies) • Again, asymmetric information plays central role: recipient country likely to be in better position to judge circumstances in which adverse consequences will follow • But who in the recipient country? Agency problems: • IFI is in contact mainly with finance ministry • Interests of finance ministry do not coincide with those of country as a whole • Perceptions of finance ministry need not be most accurate

19. Concluding Remarks • Conditionalities often go well beyond those required for ensuring (maximizing probability of) repayment of loans, and probably beyond exercise of fiduciary responsibility that money be “well spent.” In many cases ineffective or even counterproductive.

20. Other Important Questions • Should there be competitive pluralism in supply of funds and technical assistance? A bigger role for regional banks? • Should services be contracted out? • Should IBRD lending continue to be a kind of “middle income” credit union?

21. Key framing issues Issues to keep in mind when modifying institutional arrangements for the provision of development assistance: • International global goods and externalities/market failures • Agency problems/organizational issues/governance issues • At every level—donor, recipient, multilateral institutions • Likely to be no perfect solution