Why the Ideas of the World Bank Come Up Short

This article appeared in Investor's Business Daily, May 9, 2005.

Paul Wolfowitz's appointment as president of the World Bank should revive the debate about the aid agency's effectiveness. One way of improving performance is by giving good advice.

For example, economic growth is the most powerful way to reduce poverty, and the World Bank recognizes that a healthy private sector is the only way to increase growth. Thus, the Bank advises poor countries to improve their business environment.

But the World Bank too often recommends the sophisticated policies found in rich countries without seeming to recognize that poor countries cannot successfully implement them. The result is often a worsening of private-sector performance.

Instead, the Bank should take into account the institutional weaknesses typical of developing countries: low skills, corruption, and the influence of special interests. Following are some examples.

It is generally accepted that governments need to privatize state-owned companies. But politicians with World Bank support often adopt complex methods of privatization. The politicians hope to keep partial government ownership and control or to enrich themselves and their cronies. A simple and transparent method is to sell 100 percent of the company to the highest cash bidder. The winning bidder is likely to have the best plan for improving the company's performance.

Governments also use privatization to create a large stock market by selling shares to many small investors. The recent corporate scandals both in Europe (Parmalat) and the United States (Enron and WorldCom) should raise doubts about the wisdom of the World Bank encouraging widespread share ownership in countries where holders are unlikely to be protected because of weak rule of law and poorly performing regulatory bodies.

Fierce competition is necessary to spur private businesses to improve performance. The private sector, naturally, tries to convince the government to limit competition -- for example, by imposing high tariffs on imports and restricting entry by new firms.

The bank does advocate the removal of these barriers to competition. It also recommends that governments create competition agencies with wide discretion to intervene in the private sector.

The outcome is that private companies are likely to manipulate these agencies to reduce rather than to increase competition. For example, companies allege that their competitors are engaged in predatory or discriminatory pricing when their only crime is reducing prices.

Historically, developed countries allowed only two options to bankrupt firms: a voluntary restructuring negotiated between the firm and its creditors or liquidation by bankruptcy court. The recent trend, however, is to encourage a third option: The government or bankruptcy court decides whether and how the firm will be restructured -- Chapter 11 bankruptcy, for example. The usual justification for this option is that it will preserve jobs.

Allowing this option in developing countries where bankruptcy courts are even more subject to political pressure permits backward and inefficient companies to survive. One of the biggest obstacles to modernizing the Russian economy is that politically directed bankruptcy procedures let old, former state-owned companies dominate markets and keep out modern ones.

Perhaps the biggest obstacle to reducing poverty has been the miserable performance of banks. State-owned and private banks in developing countries have frequently become pyramid schemes whose assets are mostly bad loans.

As a result, two-thirds of developing countries during the last 25 years have experienced one or more banking crises in which large numbers of banks have failed. Governments have spent more that US$1 trillion in bailing out these banks so as to protect depositors.

The World Bank's response to this massive government failure is to recommend the type of bank regulation and deposit insurance used in most developed countries. This is surprising, given the fact that two-thirds of developed countries have also had widespread bank failures, like the S&L scandal in the United States. If developed countries have difficulty in making this regulation work, can Bangladesh or Tanzania?

Is there an alternative? One that holds promise is used by New Zealand. That country regulates bank deposits as it does any other financial security, such as stocks and bonds, and does not guarantee bank deposits. In other words, depositor beware.

When asked about the inability of governments in developing countries to implement sophisticated policies to improve the business environment, the World Bank says that it will provide training and technical assistance. Maybe this will be successful someday. It is easy for World Bank experts to recommend what they know -- namely, the policies in the developed countries.

But it takes courage and imagination to recommend innovative policies that developing countries can implement now.