William Easterly. 2001. The Elusive Quest for Growth, cap.

The Loans That Were, the Growth That Wasn't.

On August 18, 1982, Mexican finance minister Jesus Silva Herzog announced that Mexico
could no longer service its external debt to international commercial banks. Mexico, and
many other middle? income countries, had overborrowed from commercial banks, and now
banks were unwilling to make further loans. We thought we had a good solution: aid and
lending to developing countries conditional on their making policy reforms. Instead of aid
financing investment, it was now aid financing reform. "Adjustment with growth" was the
popular slogan of the time. In the 1980s, the World Bank and IMF gave an average of six
adjustment loans to each country in Africa, an average of five adjustment loans to each
country in Latin America, an average of four adjustment loans to each country in Asia, and
an average of three adjustment loans to each country in Eastern Europe, North Africa, and
the Middle East. There was much lending, little adjustment, and little growth in the 1980s
and 1990s. Growth in Africa, Latin America, Eastern Europe, the Middle East, and North
Africa went into reverse in the 1980s and 1990s. Only Asia escaped. Adjustment lending
did not create the right incentives-for either the lenders or the recipients-to restore
growth.
Some Successes.
Ghana, loans between 1980 y 1994. Reforms in 1983. Mauritius, loans between 1980 and
1994. Thailand, loans between 1980 and 1994. Korea. And in Latin America, adjustment
lending was eventually successful in the 1990s, after initial disappointment in the 1980s
(Peru and Argentina).
Lending Without Adjustment
Indiscriminate lending created poor incentives for making the reforms necessary for
growth. Zambia is an example. Countries with triple-digit inflation received as much official
lending as countries with single-digit inflation. This lending could be justified if the loans
went to a country with initially high inflation in order to help bring the inflation down. But
in Zambia (and a number of other countries), lending continued and even increased as
inflation remained high or went even higher.
Trouble in Transition
Another case of failing to bring inflation under control with adjustment loans was in the
critical years from 1992 to 1995 in Russia after it introduced a free market on January 1,
1992. After inflation was already ignited into the thousands of percent with the freeing of
prices, and the Russian central bank was printing money helter-skelter to finance credits to
state enterprises, only then did the IMF and World Bank give adjustment loans to Russia.
And as with many adjustment loans elsewhere, inflation was still not brought under
control. It would not be until 1995 and another IMF adjustment loan that inflation was
finally stabilized. Meanwhile, critical years were lost in which the Russian public became
disenchanted with free markets, the political consequences of which continue to haunt
Russia today.
Other Policies.

The same phenomenon of aid going to countries with bad policies is true of other policies
besides inflation. Mauritania had an average black market premium of above 100 percent
for every year over the 1982 to 1989 period. The black market premium is the percentage
amount by which the exchange rate of the currency in the black market is above the
official exchange rate. Adjustment loans would usually carry the condition that the official
exchange rate be one at which exporters can be competitive. Adjustment loans would
usually carry the condition that the official exchange rate be one at which exporters can
be competitive. Bank and the IMF gave Mauritania six adjustment loans between 1982 and
1989. Another type of condition that Bank and Fund loans often include is the restructuring
or shutting down of loss-making government enterprises.
A recent World Bank study found that aid does not influence countries' choice of policies.
Aid appears to be determined by the strategic interests of donors, not by policy choices of
the recipients.
How to Pretend to Adjust
A government that was irresponsible before the adjustment loan has unchanged
incentives to be irresponsible after the adjustment loan. Only a change from a bad
government to a good government will truly change policies.
Today's deficit is a way to borrow against the future. The deficit is financed with new debt
that makes possible higher government receipts today at the cost of having to make
higher payoffs of the debt tomorrow. There are many ways the government can free up
money today in return for higher outlays tomorrow. For example, it can cut current
spending on maintenance of roads, yielding extra money it can use for patronage and
consumption.
Eating the Future
The fundamental principle remains the same: a government that eats away at the future
by incurring debt will also eat away at the future in other ways. The government can also
get revenue today by selling off profitable state enterprises, at the cost of forgone future
revenue.
Countries that receive adjustment loans get more revenue from selling off state companies
than do countries without adjustment programs. Countries with adjustment programs also
pumped oil out of the reserves in the ground faster than during periods without
adjustment programs. Governments can also simply shift other expenditures and revenues
across time to meet today's cash deficit targets.
Another sleight of hand is to reduce current expenditure today in return for a future
liability. For example, the government could switch from granting subsidies to state
enterprises to guaranteeing the bank loans made to these enterprises to cover their
losses, creating the appearance of a deficit reduction. When the enterprises eventually
default on their debt, the government pays off the debt and so winds up paying for state
enterprise losses just as it had when subsidies were explicit.
Governments can make state enterprise losses disappear by having public financial
institutions (whose balances deficit definitions seldom include) subsidize the state-owned
firms.

All of these stories show that countries can improve in the short run and appear to be
meeting the loan conditions, when in fact they are only postponing the problem. So in the
future, they get new adjustment loans to deal with the now larger problem of adjustment.
The IMF, World Bank, and other donors worried so much about the debts (the liabilities) of
these economies that they paid insufficient attention to incentives to expand the assets of
those same economies-namely, their ability to generate future income through economic
growth.
A recent study by Przeworski and Vreeland (2000) found a negative effect of IMF programs
on growth.
Incentives for Donors and Recipients
Lenders face incentives that cause them to give loans even when the conditions of the
loans are not met. Recipients face incentives that cause them not to make reforms even
when they get conditional loans. Many different kinds of incentives cause these problems.
First, the donors wouldn't be donors if they didn't care for the poor in the recipient country.
But this solicitude for the poor makes their threat of cutting off lending if conditions go
unmet not very credible.
The donors' concern for the poor creates even more perverse incentives for the recipients.
Since countries with larger poverty problems get more aid, those countries have little
incentive to alleviate their poverty problem. The poor are held hostage to extract aid from
the donors. How could one correct this problem of perverse incentives? Paradoxically, the
poor in the recipient country will be better off if the aid disbursement decision is delegated
to a hard-hearted agency that doesn't care about the poor.
Lenders create another perverse incentive for loan recipients by making loans respond to
the change in policies. This creates a kind of zigzagging adjustment in which countries
continually adjust and then go back on adjustment.
What Could Have Been
A recent World Bank study found that aid would have had a positive impact on growth if
the recipients had had good policies. It found too that aid does not have a significant
impact on growth on average. However, when policies such as the budget balance and
inflation are good, aid does have a positive impact.
Looking Forward
We should tie aid to past country performance, not promises, giving the country's
government an incentive to pursue growth-creating policies. The better a country's
policies are for creating growth, the more aid per capita it gets. We should rank all poor
countries according to their policy performance and then give more aid to a country the
higher it is up the list.
To enforce the conditions on policy performance for receiving aid, countries should enter
into "aid contests," whereby they would submit proposals for growth-promoting use of the
aid money. In their proposals, they would document policy performance achieved thus far
and announce plans for future progress on policy performance.
If aid were given to the most deserving countries (those with the best policies), we could
at last get donors' and governments' incentives aligned for growth. The ultimate sign of

failure of adjustment lending is to admit that the debts cannot be repaid because it shows
that the money was not used productively.