Focus on Free Markets: How to Cut Foreign Aid

(Archived document, may contain errors) A Special Report to the Appropriations Committees No. 3 2/15/95 FOCUS ON FREE MARKETS: HOW TO CUT FOREIGN AID Kim R. Holmes, Ph.

D. Vice President and Director of Foreign Policy and Defense Studies Mr. Chairman, it has been recognized for years now by nearly everyone-from the right, left, and center of the political spectrum-that the U.S.

foreign aid program is critically flawed. In addition to having too many goals and too little focus, U.S. development assistance programs have done little to ad- vance economic growth in the developing world.

Far more important than economic aid in determining whether a developing country emerges from poverty is that country's own economic policies-in short, how free its economy is. This fundamental fact has been overlooked by the designers of America's for- eign aid program. It is time to begin looking at it.

Without question, this Congress has a unique opportu- nity to reform foreign aid. This opportunity must be seized. The American people will support a foreign aid program, but only one that serves American interests and promotes international economic growth.

We at The Heritage Foundation have examined the issue of foreign aid closely. We have published The Index 9f Economic Freedom, a study that measures the comparative economic freedom of 101 countries.2 The Index scores countries on ten factors, including taxation levels, trade barriers, regula- tions, and openness to foreign investment. The purpose of this study is to introduce a new under- standing of economic development.

Hitherto, most development economists and the U.S. foreign aid bu- reaucracy believed that a laundry list of factors ranging from health, education, and even population controls must be manipulated by governments for economic development to occur. The Index takes a different approach.

It is based on the premise that economic freedom is the most important factor in eco- nomic development-or, as we prefer to call it, economic growth. As we discovered in the Index, how free an economy was, and not the amount of economic assistance it had received, was the most impor- tant and consistent determining factor in a country's level of economic development and its rate of eco- nomic growth. This being the case, we concluded that the purpose of economic aid should be to pro- mote economic freedom and to create the economic growth that will someday make this aid unneces- sary.

I Substantial portions of this were delivered as testimony before the House Appropriations Subcommittee on Foreign Operations, January 31, 1995. 2 Bryan T. Johnson and Thomas P.

Sheehy, The Index of Economic Freedom (Washington, D.C.: The Heritage Foundation, 1995). But The Index of Economic Freedom is more than a study of the factors contributing to economic de- velopment. It also can be instrumental in evaluating America's development assistance programs.

The Index can be a useful tool with which to decide whether particular countries deserve development assis- tance and, if so, what kind of aid is best for them. - The assumption behind the Index and indeed our entire approach to reforming foreign aid is that U.S. foreign assistance programs should serve three fundamental purposes: 0 To enhance U.S.

national security. To advance American national interests. To promote economic growth around the world, which creates markets for American goods and contributes to democratization and international stability.

While we believe that U.S. foreign assistance should be used under certain circumstances for humani- tarian purposes and to help friendly foreign countries in an emergency, we also believe that U.S. for- eign aid programs should be understood primarily as an extension of U.S.

foreign policy and designed to advance its goals. Thus, some forms of assistance to advance the process of democratization, if they are effective and given to deserving countries, would be compatible with the U.S. goal of promoting international stabil- ity.

But economic development assistance, which by and large has failed, should be carefully scruti- nized and curtailed. To the extent that current military and security assistance programs serve the na- tional interest, they, too, should be continued. Economic support for Israel, Egypt, Russia, and the Newly Independent States (NIS) of the former Soviet Union by and large should be retained, although in the cases of Russia and the NIS, some cuts can be made safely.

However, so-called economic sup- port funds for Israel and Egypt should not be understood as a means to promote economic develop- ment, for they surely do not serve this goal, but rather as a form of security support assistance and as a political demonstration of U.S. support for the Middle East peace process. With these assumptions in mind, we have prepared a list of recommendations for your committee to consider as it reviews the foreign aid program.

I need not remind the members of the committee that the balanced budget amendment, if it passes the whole Congress, will bring every federal spending pro- gram under close scrutiny. Foreign assistance programs should be no exception. With that reality in mind, I have combined the total savings from all the recommendations made in this testimony into two budgetary options which I hope you will consider.

OPTION A ($2.58 billion savings). This option represents the minimum amount which should be cut from this year's foreign aid budget. It includes: Reducing bilateral economic development assistance programs by 50 percent for a total fiscal 1996 savings of $1.8 billion.

Trimming aid to Russia and the NIS by $200 million. Shrinking funding for multilateral development banks by 25 percent for a total savings of $481 million. Abolishing the Agency for International Development for a savings of $100 million in administrative costs.

OPTION B ($5.67 billion savings). The new budget environment may require that you consider more drastic reductions than outlined in Option A. If this turns out to be the case, you can look to our Op- tion B menu of cuts.

This option includes: Eliminating nearly all economic development assistance for a total fiscal 1996 savings of $3.6 billion. of Ending all aid to Russia and the NIS for a savings of $839 million. Cutting 50 percent of U.S.

funding for the World Bank, the International Monetary Fund, and other multilateral development banks for a savings of $963 million. Cutting economic support funds for all countries except Israel and Egypt by 50 percent for a savings of $167 million. Abolishing the Agency for International Development for a savings of $100 million in adrninistrative costs.

GIVING AID A FREE-MARKET FOCUS: PROPOSALS FOR REFORMING FOREIGN AID The U.S. foreign aid program must be fundamentally overhauled. In this new political environment of fiscal restraint, foreign aid must not only take its fair share of budget reductions, but also be reshaped to give its remaining programs new life, new meaning, and a new mission.

With these goals in mind, we recommend that: V Economic Development aid be made contingent upon a recipient country's commitment to free markets as determined by The Index of Economic Freedom. There is a stark contrast between the tremendous economic progress made by such countries as Hong Kong and Singapore that have pursued free-market development strategies and other poorer countries like Tanzania and Ethiopia that have pursued a statist approach to economic develop- ment. Indeed, it should come as no surprise that two of the greatest development success stories of the last few decades, Hong Kong and Singapore, share the highest Index of Economic Freedom score of 1.25.

These are two outstanding examples of countries that have elected to unleash the en- trepreneurial energies of their peoples by pursuing free-market economic policies. The results have been spectacular. The per capita GDPs of Hong Kong and Singapore have grown nearly eightfold since the mid- 1960s.

Over the same period the per capita GDPs of Ethiopia, Chad, and Angola grew hardly at all, primarily because their economies were unfree. No one can argue seriously that economic assistance from the advanced industrial democracies is the principal reason for the economic growth rates of Hong Kong, Singapore, or even other "Asian Tigers" like Taiwan or South Korea. To be sure, some of these countries (like South Korea) have re- ceived massive amounts of military aid, but no reputable economist would contend that spending money on tanks and guns is an economic development strategy.

No, the reason the economies of these countries have grown is that they have chosen market economies. Economic development aid not only does little to advance economic development, but even can be detrimental to the welfare of the countries receiving it. Tanzania is a case in point.

Once a cause ciflabre of Western donors, by the early 1970s Tanzania had become one of the most heavily aided countries in the developing world. The U.S. Agency for International Development (AID) was heavily involved in Tanzania, providing financial support and technical assistance for forced rural collectivization, one of Tanzania's many disastrous socialist schemes.

Today, Tanzania is the world's second poorest country, worse off than it was at the time of its independence. Foreign aid unquestionably contributed to the destruction of Tanzania's economy. It encouraged and enabled governments to pursue harmful statist economic policies that made economic growth next to impos- sible to achieve.

Another case in point is Chile, only the outcome has been markedly different. Over the last sev- eral years, Chile has had one of the fastest growing economies in the world. It is now the leading "Latin Jaguar." Yet foreign aid had nothing to do with Chile's development success.

Indeed, the seeds of this success were laid only after the government of General Augusto Pinochet was cut off from virtually all foreign aid following its 1973 coup d'etat. Here is how this success story happened. In 1970, Chile was the world's second largest per cap- ita recipient of foreign aid.

It was also stagnating economically. In 1973, Salvador Allende's last year as president, Chile's GDP shrank by 5.6 percent. Around 75 percent of Chile's GDP at this time was controlled by the government.

However, after Pinochet came to power, most of Chile's foreign aid was cut off. Unable to rely on the crutch of foreign aid, Pinochet embarked on a privati- zation and market reform program that transformed Chile's economy. By 1990 government control of the economy had dropped to 25 percent.

Moreover, Chile's infant mortality rate was reduced from 78 to 17 per 1,000 births between 1970 and 199 1, and its life expectancy rate rose from 64 to 72 years between 1970 and 1990. These improvements occurred because of economic growth, not because of foreign aid programs. The Index of Economic Freedom is designed to help identify instances in which development aid is playing the type of destructive role that it once played in Chile.

By helping to determine which countries are economically free, the Index can help policymakers decide which countries deserve economic aid-i.e., those that are making progress toward a free market-and which countries do not deserve it-i.e., those that are unfree and are not making progress toward a free market. Gov- ernments with unfree economic policies-those possessing very high taxes, protectionist trade poli- cies, hostile foreign investment climates, and burdensome economic regulations, for example- will only waste economic aid. In fact, economic aid too frequently is a crutch upon which the gov- ernments, become dependent and which prevents them from making the economic reforms neces- sary to create economic growth.

The Index of Economic Freedom has been recognized by many concerned with the future of the U.S. foreign aid program as the best means of identifying those countries with a commitment to free-market-generated economic growth. George M.

Ferris, Jr., Chairman of the 1992 President's Commission on the Management of AID Programs, urged AID to establish an Index of Economic Freedom for the purpose of allocating development aid among countries. Last year, minority mem- bers of this committee, including a few of you here today, encouraged AID to develop and use an Index of Economic Freedom as a tool for its development aid allocation decisions. Unfortunately, AID has resisted doing so, despite the fact that it has the requisite data readily available.

Instead of putting the Index at the heart of America's development assistance program, AID allo- cates aid according to a hodgepodge of criteria that are not nearly as important as economic free- dom. Take, for example, AID's criterion of democracy and lawful governance. To be sure, democ- racy is important to economic growth and stability in the long run, but democracy alone is no guar- antee of economic development.

Singapore is no democracy, yet its free economy generates very high rates of economic growth. By the same token, Russia is slowly developing democratic institu- tions, yet its economy is mostly unfree and stagnating. Economic freedom is far more important to economic development than democracy.

In fact, in most cases, economic freedom is the best foundation upon which to build democracy. In the long run free economies produce growth and a middle class that come to demand civil rights, political representation, and protection for their property. In short, as has been seen in Taiwan, South Korea, Chile, and many other countries, economic liberalization creates pressures for political liberaliza- tion.

Some countries like Singapore lag behind, but not all countries march in lock-step toward de- mocracy. While the pace of change may differ, most countries that are economically free tend over time to become politically free as well. It is probably only a matter of time before Singapore fol- lows the path of Chile.

Fortunately, Singapore and other authoritarian regimes that pursue free-market policies do not need or receive U.S. economic aid. Thus, the moral question of whether we should be aiding an un- democratic free-market country does not often arise.

However, this question could arise if an un- democratic government making progress toward economic reform were to ask for aid. They could ask us for assistance to help them in their transition toward a free-market economy even though they are undemocratic. We may be facing such a question with respect to Russia sooner than we think.

Should we give economic aid to a government that is abusing the human rights of its people? The short answer is "No, unless it serves some higher national interest." This has been a long-stand- ing tradition in U.S. foreign aid policy. It was practiced widely during the Cold War and, if na- tional security considerations warrant, should continue in the post-Cold War era as well.

However, there should be fewer instances in which national security considerations call for dispensing eco- nomic assistance. While we can justify giving economic aid to less-than-savory governments for na- tional security reasons, our development assistance strategy should not include aiding countries that are egregiously abusing their citizens. While a case could be made that supporting economic freedom would lead to political freedom in the long run, in extreme cases we cannot wait until that day comes.

Unlike private trade, government aid is too direct a symbol of official and moral sup- port. Discretion will have to be exercised if a recipient government becomes abusive of its people. Another flawed AID criterion is "need" as determined by social indicators.

If this criterion is ap- plied, all poor countries are more or less deserving of economic aid. In fact, the poorest countries would be the most deserving. But what if the recipient country's own economic policies are mainly responsible for its poverty? If all we are doing is putting a Band-Aid on misery that it is self-in- flicted, how can we say that we are making a substantial difference? And if our aid is being used by corrupt governments to perpetuate the very economic policies that are causing the poverty, how can we continue in good conscience to dispense aid that amounts to little more than a subsidy of economic misery? Looked at this way, we are not satisfying the needs of poor people, but acting as accomplices to governments that are keeping them poor.

To be sure, one can find a U.S.-supported health or education program abroad that has "done some good" for some people in the developing world. Just as first aid relieves the pain and suffer- ing of a sick patient, economic aid can relieve in a limited way the pain and suffering of people who are economically victimized by their own governments. But economic first aid is not a devel- opment strategy.

It is does not produce economic growth. Free economies not only produce eco- nomic growth, but also produce the wealth needed to improve health and education standards for the greatest number of people. A free economy does far more to educate people and raise health standards than U.S.

economic assistance. In short, it does more to meet the "needs" of the people. Far from being too "narrow" a criterion for dispensing economic aid, as AID Administrator Brian Atwood charges, the Index of Economic Freedom encompasses the broadest possible num- ber of factors that determine econon-dc development.

The best way to address social "needs," clean up the environment, raise health standards, stabilize population growth, and promote democratiza- tion is to produce economic growth. And the best way to produce economic growth is to advance economic freedom. This is a development strategy that is no less sophisticated for its simplicity of purpose.

In fact, it is far more sophisticated than the ahistorical analysis that passes for economic development theory. Progress toward establishing free markets should be the sole determinant in allocating develop- ment aid among countries. This is the approach of Senator Mitch McConnell's foreign aid reform proposal unveiled this past December.

The McConnell proposal would condition development aid on the adoption of free-market policies by recipient governments as determined, in fact, by many of the factors of the Index of Economic Freedom. Vice President Al Gore's 1993 "Reinventing Government" report notes that "AID does not have a single, clearly defined and articulated strate- gic mission." A free-market focus is what the U.S. development aid program desperately needs.

Cut development aid spending. The conclusions of the Index of Economic Freedom suggest that U.S. economic development as- sistance programs should be cut.

Even if a case could be made that all economic assistance were needed to promote economic development around the world-a case that cannot be made seriously -the new budget environment would argue in favor of reductions in U.S. development assistance programs. I recommend to you the two following budgetary options.

Our analysis is based on the figures from last year's foreign operations budget. OPTION A ($1.8 billion savings). We assume that development aid should be given under the right conditions-i.e., directed at countries moving toward free markets and used by them to assist them in the transition.

Under these conditions, development aid can make a difference, although not a very large one. If used wisely, primarily to promote private enterprise, it can encourage an en- vironment in which a free market can grow. With this assumption in mind, we have prepared a rec- ommendation that cuts most bilateral assistance programs by 50 percent.

We anticipate from these reductions a savings of $1.8 billion in fiscal 1996. In our range of options, we consider Option A to be the absolute minimum which should be reduced from this year's development assistance budget. Under no circumstances should the Clinton Administration's development assistance programs be fully funded.

To assist you in deciding which countries' aid should be cut in Option A, we have supplied you with a list of development aid recipients scoring poorly on the Index of Economic Freedom. These are countries that received either a "mostly unfree" or "repressed" score on the Index. Our j udg- ment is that you should scrutinize these countries very closely and consider them prime candidates for reductions in-or outright elimination of-economic development funds.

They should be at the top of the list in your efforts to meet the 50 percent reduction target. OPTION B ($3.6 billion savings). The new budget environment may require that you consider more drastic reductions in the development assistance accounts.

If this turns out to be the case, you can look to our Option B menu of cuts in these accounts. In this option nearly all development as- sistance aid is eliminated. Thus, all funding would be cut for the African Development Foundation, the Development Assistance Fund, the Development Fund for Africa, Eastern Europe and Baltic as- sistance, population control, and other development programs.

Savings from this option would amount to $3.6 billion for fiscal 1996. As you move to reduce development aid spending, you certainly will hear examples of develop- ment aid programs that "have made a difference" in the lives of people throughout the developing world. Without question, there have been "successful" development aid programs.

Yet what is the measure of success? Have these programs really made a difference to national development, or have they been an oasis of achievement in an otherwise barren environment? The best designed and executed agricultural project will mean little in a country that is destroying itself through fool- ish economic policies. Whether you choose Option A or Option B, you should be aware that critics of cuts in develop- ment aid will try to portray you as lacking compassion. They will use the same arguments that some people marshaled to justify America's failed welfare system-that "you don't care about peo- ple" or that "some people" have been helped by the aid.

You should not be deterred by such argu- ments. Economic aid that does not encourage economic growth or that serves no discernible strate- gic interest of the United States is not only a waste; it is downright harmful to the people we are pretending to help. Like our own welfare recipients, foreign governments develop a kind of corrupt- ing dependence on U.S.

government funding. Although the programs are different, the results are the same: We encourage behavior that is self-destructive. Major cuts in development assistance do not amount to neo-isolationism.

Neither Option A or Option B touches military or security assistance programs. Nor do they affect aid to Egypt and Israel. They affect only aid that purports to spur economic development.

Since it turns out that most of this aid has been a failure, eliminating it would have no discernible impact on international sta- bility or international economic development. America's overseas commitments would be reaf- firmed not only by the continuation of military and security aid, but by the far more important mili- tary alliance and security commitments that the United States has made to friends and allies over- seas. In the end, it must be realized that the only reliable development strategy is one that recognizes the true power of the market and the private sector.

In his excellent report, Development and the National Interest (1989), former AID Administrator Alan Woods estimated that the American pri- vate sector invested $12 billion a year in overseas development efforts. However, the best "aid" any country can give another is free trade. The some $4 billion of bilateral development aid the U.S.

provides to the developing world is a drop in the bucket compared to the trillions of dollars that change hands every year in private trade. No wonder that one of the most desired prizes from the U.S. these days is not economic aid, but a free-trade agreement.

Most developing countries have come to realize that their future rests not with AID or the World Bank, but with NAFTA and other free-trade agreements. Trim and rename Economic Support Funds. The rationale for Economic Support Funds (ESF) differs from that for development aid.

ESF is given to advance U.S. political and security interests. While ESF, like development aid, does little or nothing to advance economic development-in fact, an argument can be made that it actually re- tards economic growth-we recommend continuing ESF for Egypt and Israel.

However, we be- lieve that ESF funds should be renamed to reflect their purpose more accurately. Since they are in- tended primarily to support our security interests, we believe they should be renamed "Security Supporting Assistance," which is what they were called before the name was changed to Economic Support Funds in 1978. Israel and Egypt are by far the biggest recipients of U.S.

foreign aid. This year, Israel and Egypt will receive $1.2 billion and $815 million, respectively, in Economic Sup- port Funds (ESF). These two countries command the bulk of ESF funding.

OPTION A (no savings). No cuts in ESF are recommended in Option A. OPTION B ($167 million savings).

In this option we recommend a 50 percent reduction of eco- nomic support funds for all countries except Israel and Egypt. In 1995, $334 million of ESF was appropriated for such countries as Cyprus, Turkey, Morocco, Cambodia, and Ecuador. A 50 per- cent cut would damage our relations with these countries, but it would not irreparably harm our fundamental national security interests.

Such a reduction would realize a savings of $167 million. Revamp and cut aid to Russia and the Newly Independent States (NIS). It is axiomatic that the U.S.

has a vital stake in Russia's future. Russia faces momentous chal- lenges. Whether or not foreign aid can improve Russia's chances of succeeding in developing free- market and democratic systems is uncertain.

I am inclined at this time to give the benefit of the doubt to continuing a foreign aid program for Russia. I arn sufficiently convinced that, on balance, Western engagement in terms of foreign aid helps keep the reforming spirit-however it may flicker-alive. But this is a close call.

Moreover, the point at which aid to Russia should be ended, including a drastic reversal on reform, could come overnight. What is crystal clear is that the case for continued Russian aid has been weakened by the poor performance of AID. Without taking local conditions into account, AID applied its Third World ex- perience to Russia, allocating the bulk of contracts to its "traditional" contractors, as opposed to or- ganizations and professionals with appropriate regional, industry, and language experience.

These multi-million-dollar nongovernmental organizations-including CARE, Save the Children, the Academy for Educational Development, Experiment in International Living/World Vision, and the Urban Institute-had little or no experience in the former Soviet Union. Unfortunately, their organ- izational culture, shaped by years of working in the developing world, has hindered their work in the region. Meanwhile, Russian nongovernmental organizations, even the most pro-reform ones, are often excluded from the AID bidding process.

Indeed, the AID contracting process is arcane and often understood only by those with long-term relationships with the Agency. This effectively screens out worthwhile organizations which lack an inside track. Tom Dine, AID's Assistant Coordinator for the NIS, has publicly stated that if he could have one wish fulfilled, it would be the abolition of AID's contracting office, which has been primarily responsible for perpetuating the cozy relationship with traditional contractors.

OFHON A ($200 million savings). Two recommendations are made in Option A. The Con- gress should: 0 Reduce aid to Russia and the NIS from $839 million to $639 million.

The pace of aid de- livered to this region so far has been slow, in part because these countries are incapable of di- gesting the aid that already has been appropriated. This region should not escape budget cuts. A good place to look is the Officer Resettlement Program (ORP) which helps to build housing for Russian army officers returning from abroad.

The idea was to prevent a restive and angry Rus- sian army from challenging Yeltsin's democratic regime. However, the Russian military has been mainly responsible for the debacle in Chechnya. It stands to reason that if aid should be cut, they should be at the top of the list.

Thus, a $ 100 million rescission should be imposed on funds already appropriated but not spent on the Officer Resettlement Program, and another $ 100 million should be cut from fiscal 1996's budget, not only for next year's appropriation for the ORP, but also for other aid programs, such as the Eurasian Foundation, which have not per- formed as well as expected. URL Reprogram $75 million from health and environmental