Real incentives for real reform: inducing meaningful institutional change in developing economies.

• Author: Hill, Joshua P.

Between 1995 and 2009, more than $1.4 trillion (in 2008 U.S dollars) was spent on official development assistance (Organization for Economic Cooperation and Development [OECD] n.d.). This sum represents an enormous commitment on the part of the developed world to the promotion of economic growth in the less well-off parts of the world. One of the overriding themes at the G-8 meetings in the summer of 2005 was the necessity of increasing this commitment. The funds are not coming solely from public coffers. A number of private charities make donations that dwarf many governments' contributions.

Considerable debate continues to rage over this money's effectiveness, but aid to date clearly has not accomplished the goals originally envisioned, and several in-depth studies detail aid's failures as well as a host of unintended consequences of present aid programs. (1) There is even evidence that aid has retarded or arrested reform in some countries (Coyne and Ryan 2009).

In this article, I argue that a straightforward and effective aid program can be constructed. This program rests on four fundamental propositions:

1. The developed world has made a substantial commitment to encouraging economic growth in the developing world.

2. The fundamental causes of economic growth are reasonably well understood (De Soto 2000; Acemoglu, Johnson, and Robinson 2004; North 2005). An institutional framework that creates and protects property rights and limits government expropriation lies at the heart of economic growth.

3. Well-developed measures of these institutions--such as the Fraser Index of Economic Freedom of the World (EFW Index), the Heritage Index of Economic Freedom, and the International Country Risk Guide--provide independent, relatively unbiased estimates of the quality of a country's overall institutional framework.

4. People respond to incentives. In developing countries, self-interested rulers have far greater knowledge of their country's institutions and ways of changing those institutions than outsiders do.

   Therefore, I propose the following thought experiment: imagine a fund created to provide an annual prize to the five best leaders in poorer countries. The best would be selected based on the countries that have made the largest jump in the EFW Index. This prize ideally would be funded privately and would be given to rulers directly, regardless of their democratic credentials and without conditions as to what they do with the money. In the following sections, I develop more completely the arguments for such a prize and provide details about its operation.

   Institutions

   Public-choice theory recognizes that political actors are not altruists. Although some may have altruistic tendencies, they are rational actors, like the butcher and the baker. This insight revolutionized how politicians and political life are evaluated. It has not, however, been fully embraced by development organizations or in thinking about poor countries and institutional change. Only by accepting this fact can meaningful progress be made in thinking about economic development.

   Many writings emphasize the importance of institutions. (2) All present strong evidence--empirical, analytical, and narrative--that what matters and has mattered for countries' economic growth is institutions. In other words, the countries that have good institutional structures, those that discover ways of structurally encouraging profitable and productive economic activity, generate greater wealth than do the countries that lack such institutions.

   Institutions--"the rules of the game in a society ... the humanly devised constraints that shape human interaction" (North 1990, 3)--are endogenous to a country. Although they are themselves shaped by a host of factors (including societal structure, norms and mores, religious principles, geographic and climatic conditions, and available resources), their root source lies in the actions of a country's individual residents. All nations' institutional structures change as a result of their citizens' actions and evolve in different ways. Because all of the factors just noted and others cited in the literature of economics are largely unchangeable conditions, they, along with colonial history, may be viewed as an initial endowment. Although there is some evidence that a particular initial endowment increases the likelihood of good institutions, one thing is certain: a nation's populace determines the nation's institutional structure through the choices it makes.

   Many rulers have overseen the implementation of positive reforms and productive institutional evolution. George Washington refused a third term when popular opinion was firmly behind him, instituting a practice of a two-term (at most) presidency, which was finally broken only by Franklin D. Roosevelt in the mid-twentieth century. Jerry Rawlings of Ghana was a despot with a brutal track record, but he eventually oversaw an effective and open handover to elected rule. Many turning points throughout the evolution of nations' institutions clearly show that benevolent rulers can play an important role. However, usually "those who benefit from the existing set of institutions are forced to accept change" rather than being altruistic actors (Acemoglu, Johnson, and Robinson 2004, 80).

   Whether successful reform requires exceptional leaders is, however, not my concern here. Suffice it to say that change can and often does occur without such exceptional people. Exceptional leaders sometimes clearly have spearheaded reform and accelerated or catalyzed the process. However, in other cases, reform succeeded without an enlightened despot's pulling the strings. Although exceptional people do appear occasionally, my argument relies instead on average, unexceptional individuals in a position of political power.

   Daron Acemoglu, Simon Johnson, and James Robinson (2004) argue that the problem in carrying out effective institutional change is not one of irrational actors. Rather, it is difficult to contract effectively for positive institutional change. Because those in power cannot capture a portion of the resultant rents, they have little incentive to risk a present position of wealth and power for an uncertain and possibly lower financial future yield or social status. In short, rulers face a contracting problem. The side payments--the amounts that the rulers capture by bringing about institutional change--are simply not great enough. A ruler confronts this obstacle: even if he is a caring human being, productive institutional change may leave him and those close to him worse off. Douglass North, John Wallis, and Barry Weingast (2009) express this reality when they point out that any change in institutions must be incentive compatible for those in a position to foster or hinder such change.

   In order to foster positive institutional evolution and thereby economic growth effectively, development assistance must change the incentives of a country's elites. This reality and the failure to incorporate it in most development programs explain in large part why such programs have systematically come to naught.

   If what is funded is important, the way in which it is funded is equally important. Michael Kremer (2002) highlights the overreliance of development efforts and international organizations on push techniques in the market for health care. Funding the inputs to research and development often results in unintended consequences. He emphasizes the possible effectiveness of pull techniques that reward the final provision of a drug that meets certain criteria (one targeted at a disease endemic to poor areas or combination therapies that mitigate the risk of drug resistance, for example), and he asserts that a guaranteed profitable market for a product will increase the supply.

   The most notable recent example of the effectiveness of pull techniques is the Ansari X prize for private spaceflight. The objective was to encourage the creation of genuine alternatives to government provision of spaceflight and a rapid leap in thinking and available technology. After only eight years, the prize was given. The recipients spent at least twice the value of the prize in the process of winning, but the prize had a significant effect in concentrating attention and encouraging innovation. It significantly stimulated the desired outcome without specifying or even knowing how it was to be brought about.

   Giving a reward for outcomes (a pull technique) overcomes collective-action problems by introducing an exogenous payoff, thereby solving the problem of insufficient side payments pointed out by Acemoglu, Johnson, and Robinson (2004). (3) To date, however, nearly all aid efforts have involved push strategies, funding the perceived inputs of growth.

   It is clear, as evidenced by the great differences in wealth around the world, that some countries have managed to overcome the collective-action problems associated with positive institutional change. Development efforts must focus on ways to replicate these endogenous changes. However, no two countries have followed identical paths in improving their institutions. Although we know what the end state looks like, we do not and never will have a clear roadmap of how to get there. A one-size-fits-all approach, the micromanagement and central planning historically typical of development organizations, will continue to yield disappointing results. Instead, what is needed are ways to encourage innovation and experimentation. (4)

   A successful aid program therefore must do three things...