Paul Wolfowitz

The traditional approach to foreign aid is based on conditionality: aid is given to developing countries with the understanding that the country will then meet certain criteria. But an "indicator-based" approach to foreign aid is adding a level of competition to the process. With indicator-based competition, a recipient country has to prove before the aid is given that it has the governance and policies in place to use the funds effectively.

On January 14, AEI held a conference to explore this subject and, in particular, to examine the effectiveness of the Millennium Challenge Corporation (MCC), the U.S. government agency leading the indicator-based approach to foreign aid. To discourage the inept handling of aid money that is prevalent under the conditionality approach, the MCC employs seventeen indicators to measure a country's ability to manage and use aid money.

John J. Danilovich, a former U.S. ambassador to Costa Rica and Brazil and now chief executive officer of the MCC, described indicator-based competition as the "best way to identify best performers best-suited to use taxpayer money." The MCC has found that indicator-based competition is responsible for bringing down the cost and time it takes to start a small business in a developing country, and it encourages sustainable development. Additionally, indicator-based competition gives reformers in poor countries the political space and incentive to carry out reforms.

Aart Kraay, an economist at the World Bank who studies governance indicators, asserted that an indicator-based approach to foreign aid is effective. Despite its reputation as a rather recent development, a version of this approach has been used to good effect at the World Bank for over twenty years, Kraay said. He cautioned that we should not take too narrow a view of the indicators in use but rather recognize that there is a certain level of imprecision to the system because indicators are actually proxies for the things we care about, not ends unto themselves.

World Bank economist Simeon Djankov created the widely used "Doing Business" indicator series six years ago. During the panel, he addressed the concern that the MCC's current approach is too simplistic because it uses only seventeen indicators. But Djankov pointed to other organizations in the past that have focused on far fewer than seventeen indicators and have been very successful. He did warn that indicators should not be focused on specific areas to the detriment of others.

Development in poor countries cannot be accomplished exclusively through private market forces and, in certain instances, must be accompanied by aid, said Guido Schmidt-Traub of the United Nations Development Program. Indicators help clarify the objectives for the aid as well as underscore the depth of the challenges. Schmidt-Traub raised the issue of countries that need help but that may never qualify for aid through an indicator-based system because they would need aid to get to the indicators' level.

Sherri Kraham, a managing director for development policy at the MCC, discussed the mechanics and focus of the organization and the challenges facing it. While acknowledging that indicator-based competition is only one tool among many for delivering foreign aid, Kraham spoke of the tangible success the MCC has been measuring over the last few years.

Paul Wolfowitz of AEI, a former president of the World Bank, introduced the discussion by calling for foreign aid to be based on good governance and economic freedom. AEI's Mauro De Lorenzo, who organized the conference, highlighted indicator-based competition's positive shift of the locus of development from aid agencies to local governments in developing countries.

For a video and podcast of this event, visit www.aei.org/event1627/.