Can Indicator-Based Competition Make Foreign Aid Work?
Video
About This Event

Foreign aid programs of the past decades have attempted to reduce poverty while introducing necessary reforms in recipient countries through “conditionality”--the practice of requiring economic or political policy changes in exchange for aid. It is now generally agreed that these programs have failed. Recipient governments have pretended to reform, and donors have pretended to penalize them, while poverty has gotten worse. Two key lessons have emerged: aid cannot reduce poverty in the face of bad governance, and policy reforms only take hold when they are locally owned.

Recent efforts build on these insights by using indicators to make policy shortcomings more visible and aid allocation more competitive. Created in 2003, the Millennium Challenge Corporation--the first major innovation in the U.S. aid system since the Kennedy administration--allocates aid according to a series of indicators that measure governance, social service provision, and economic freedom. Only countries that score well are eligible; those that score poorly have a powerful incentive to improve. The indicators devised to measure progress towards the United Nations Millennium Development Goals drive the development agenda. Even when not tied to aid, measurements like the World Bank’s Doing Business series or the Wall Street Journal/Heritage Foundation Index of Economic Freedom can have dramatic effects on policymaking in poor countries. Publicizing policy failures and ranking performance seems to make it easier for reformers in developing countries to attempt politically difficult reforms.

Is indicator-based competition the model for an effective allocation of twenty-first century aid? What is the evidence that it promotes policy reforms? If only what is measured gets attention, then what indicators are still missing? Discussing these and other questions will be some of the leading practitioners of indicator-based development policy. Panelists include--from the World Bank--Simeon Djankov, chief economist of the Indicators Group and creator of the Doing Business indicator series, and Aart Kraay, a lead economist on the governance indicators in the Development Research Group; Guido Schmidt-Traub, team leader of the Millennium Development Goal Support Unit in the United Nations Development Program's Bureau for Development Policy; and Sherri Kraham, managing director for Development Policy at the Millennium Challenge Corporation. Ambassador John J. Danilovich, CEO of the Millennium Challenge Corporation, will give the keynote address and AEI visiting scholar Paul Wolfowitz will provide introductory remarks. AEI resident fellow Mauro De Lorenzo will moderate.

Agenda
11:30 a.m.
Registration and Lunch
12:00 p.m.
Introduction:
Paul Wolfowitz, AEI
Keynote:
John J. Danilovich, Millennium Challenge Corporation
12:30
Panelists:
Simeon Djankov, World Bank
Aart Kraay, World Bank
Sherri Kraham, Millennium Challenge Corporation
Guido Schmidt-Traub, United Nations Development Program
Moderator:
Mauro De Lorenzo, AEI
2:30
Adjournment
Event Summary

January 2008

Can Indicator-Based Competition Make Foreign Aid Work?

Foreign aid programs of the past decades have attempted to reduce poverty while introducing necessary reforms in recipient countries through "conditionality"--the practice of requiring economic or political policy changes in exchange for aid. It is now generally agreed that these programs have failed. Recipient governments have pretended to reform, and donors have pretended to penalize them, while poverty has gotten worse. Two key lessons have emerged: aid cannot reduce poverty in the face of bad governance, and policy reforms only take hold when they are locally owned.

Recent efforts build on these insights by using indicators to make policy shortcomings more visible and aid allocation more competitive. Created in 2003, the Millennium Challenge Corporation--the first major innovation in the U.S. aid system since the Kennedy administration--allocates aid according to a series of indicators that measure governance, social service provision, and economic freedom. Only countries that score well are eligible; those that score poorly have a powerful incentive to improve. The indicators devised to measure progress towards the United Nations Millennium Development Goals drive the development agenda. Even when not tied to aid, measurements like the World Bank's Doing Business series or the Wall Street Journal/Heritage Foundation Index of Economic Freedom can have dramatic effects on policymaking in poor countries. Publicizing policy failures and ranking performance seems to make it easier for reformers in developing countries to attempt politically difficult reforms.

Is indicator-based competition the model for an effective allocation of twenty-first century aid? What is the evidence that it promotes policy reforms? If only what is measured gets attention, then what indicators are still missing? At an AEI event on January 14, 2008, some of the leading practitioners of indicator-based development policy discussed these and other questions. Panelists included--from the World Bank--Simeon Djankov, chief economist of the Indicators Group and creator of the Doing Business indicator series, and Aart Kraay, a lead economist on the governance indicators in the Development Research Group; Guido Schmidt-Traub, team leader of the Millennium Development Goal Support Unit in the United Nations Development Program's Bureau for Development Policy; and Sherri Kraham, managing director for Development Policy at the Millennium Challenge Corporation. Ambassador John J. Danilovich, CEO of the Millennium Challenge Corporation, gave the keynote address, and AEI visiting scholar Paul Wolfowitz provided introductory remarks. AEI resident fellow Mauro De Lorenzo moderated.

Paul Wolfowitz
AEI

In the past few years, research has proven that the effectiveness of foreign aid depends on governance. Inefficient and corrupt governments, poorly regulated economies, and complacent civil societies all produce negative results. In contrast, aid provides critical support and impetus for advancement in countries with efficient governments, sound economies, and societies willing to reform. Foreign aid is always most effective under good governance.

The Millennium Challenge Corporation (MCC) was created with this idea in mind. Its mission is to reduce global poverty through sustainable economic growth. It does so using third-party indicators to assess and identify countries with environments that allow aid to be effective. In theory, these indicators should improve the effectiveness of foreign aid, but the execution is difficult.

John J. Danilovich
Millennium Challenge Corporation

The MCC is at the forefront of the foreign aid transition from conditionality to competition. The MCC method serves as a catalyst for changing a country's behavior to make it more receptive to aid. This system gives countries the incentive and independence to implement necessary long-term policy changes that make development sustainable.

Since the MCC's creation in 2004, indicator-based competition has been the basis of its model and aid selection process. Foreign aid is given to countries that perform adequately on a set of seventeen third-party indicators. The MCC believes this is the best way to assess which countries should receive aid.

Policies resulting from the indicators promote private-sector investment and enable democratic practices to develop. This has led to the "MCC effect," in which countries develop reform strategies to meet MCC eligibility. The MCC's Threshold Program was created to help countries on the verge of eligibility meet specific indicators.

The reform process is complex, and with it come difficulties. The MCC's model is dynamic in order to meet the ever-changing challenges associated with reform. The MCC's reliance on third-party organizations for reliable and current information on performance helps maintain a high level of objectivity. Indicator-based competition is an effective and efficient tool of U.S. foreign aid.

Mauro De Lorenzo
AEI

It is important to move beyond the no-aid versus aid arguments in the debate over poverty reduction. Effectiveness of aid depends on aid-receiving governments. There needs to be a focus on political systems and economic frameworks. Aid has done damage to political reforms in developing countries in the past, but it is still needed in certain instances. Indicator-based aid is a way to make foreign assistance more effective and to focus it on specific reform agendas. 

Indicators have always played a role in development. Recently, however, they are playing an increasing role in response to a demand for accountability. These indicators provide incentives that are prompting governments to reform policies. The question is: can indicator-based competition, especially when combined with foreign aid, become a more effective program to award aid and produce results around the world? 

The traditional two-sided argument focuses on the aid giver, but the indicator-based approach focuses on encouraging recipient governments to improve conditions and provide information, ensuring the effectiveness of aid
 
Aart Kraay
World Bank
 
Indicators are a good idea for aid allocation. Donors need to care about the quality of policies in countries that receive aid because this improves results. Indicator-based aid is not a new concept--the World Bank has used an indicator-based model for years. But donors need to recognize that there is no perfect combination of indicators that will produce economic growth. A certain level of uncertainty always exists over which indicators to use.

Broad country indicators are fine for evaluating which countries should receive aid, but they are inadequate in evaluating the aid program's success. Also, each indicator has uncertainties and margins of error that must be acknowledged. Objectivity should not be overemphasized, as the indicators' subjects are naturally subjective. The indicators should be neither too broad nor too narrow and should be used in conjunction with each other. The criticism that indicator data is biased can be avoided by using data from third parties and not from the country under evaluation. Indicator-based aid is a good idea that promotes lasting policy reform, but it is not a solution to end all poverty.

Guido Schmidt-Traub
United Nations Development Program

Poor countries need foreign aid to achieve development. However, when developing countries receive aid, and wealthy countries distribute it, both the recipient and donor should enter into a reciprocal relationship of accountability.

Indicators can help structure this relationship. Indicators clarify the objectives of aid and identify the particular development challenges a country faces. They also serve as benchmarks for a country's progress, specifically for accountability and resource allocation. However, there is a lag between when aid is dispersed and when results are achieved. This makes tracking the effectiveness of aid difficult.

Governance and effective policies are needed in complex development programs. But simpler programs produce results, too. Complex indicator-based assistance is capable of producing results, but some criteria should be loosened so that more countries can qualify for funds.  

Sherri Kraham
Millennium Challenge Corporation

The MCC is a competitive and preconditioned partnership based on the principle that having a stable policy environment creates the most conducive environment for reform. Indicators are used to select countries that will benefit the most from foreign aid and to reward countries with good policies in place. The MCC uses rule-driven competition based on publicly available data. Indicators remove political bias and allow the MCC to objectively assess countries. This indicator system is a transparent system that creates incentives. Transparency increases the role domestic actors can play and the accountability of their governments. This process also opens up dialogue about reform with other countries and organizations. 

However, there are challenges. There is tension between experience and data. The MCC looks at relative performance, but the data it relies on has limitations. The MCC is already working with indicator institutions to improve data. Also, indicators are not suited for all purposes. In the future, the MCC wants to create stronger incentives for countries in the program.

Simeon Djankov
World Bank

There is some concern that focusing on one set of indicators is too simple. In other arenas of policy development, however, there are many successful examples of how indicator-based approaches have worked, even when these approaches were based on just a few indicators. Critics also argue that reform areas are too narrow, but some issues are more important and produce more results than others, giving them greater relevance. Ways to measure traditionally hard-to-measure issues are being explored today. It is not too early to use this data to guide policymaking because indicators have grown and continue to grow in quantity and quality. 

AEI intern Tai Ullmann prepared this summary.

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