Leaders of the World Bank and International Monetary Fund met in Washington over the weekend for their annual spring meeting. They were under great pressure from the United States to step in to Iraq and help get that country's economy back on its feet. However, if the Iraqis really want to restore prosperity to their country, they might be better off if the World Bank and IMF stay out.
It is worth remembering that the greatest war reconstruction in history -- that following World War II -- took place without any World Bank or IMF around to help, which may explain why it went so well. However, the conventional wisdom is that foreign aid in the form of the Marshall Plan was the key to restoration of the German and Japanese economies following the war. Hence, the IMF and World Bank are just doing what the Marshall Plan did, many believe.
In fact, the flow of aid from the Marshall Plan was far less significant than the policy changes that it imposed. The most important were requirements that aid recipients permit free trade with other recipients and allow their currencies to be freely convertible. This, far more than the aid itself, is what got Europe growing after the war.
Moreover, the actions of key leaders in the occupied countries probably had more to do with the economic success of those countries than anything the Marshall Plan did. In West Germany, Economics Minister Ludwig Erhard eliminated price controls, stabilized the currency, cut taxes and implemented free market policies. In Japan, Gen. Douglas MacArthur had the good sense to follow the advice of American economists who told him to do the same thing there.
Nevertheless, the myth persists that it was foreign aid and foreign aid only that rejuvenated Germany and Japan. The ultimate refutation of this view, however, is that many of the largest Marshall Plan recipients, such as Britain, did not revive for decades after the war, because they did not implement free market policies. Indeed, Britain went in the opposite direction and imposed socialism, which caused its growth to lag far behind Germany's until Margaret Thatcher finally swept away the wartime taxes and controls beginning in the late 1970s.
Unfortunately, the World Bank and IMF were created during the era when people really thought that foreign aid worked. They have institutionalized this view ever since. Indeed, World Bank Chief Economist Nicholas Stern recently said, "Aid has never been more effective than it is now." Yet, his own analysis shows that free trade will do far more to improve the lot of developing nations than more foreign aid. Elimination of trade barriers by rich countries would raise 300 million people in the developing world out of poverty by 2015, Stern reckons.
While the World Bank at least understands that free trade is key to growth, the IMF persists in believing that balanced budgets are the only thing that matters. For this reason, it attacked President Bush's tax proposal last week on the grounds that it will increase the U.S. budget deficit.
The IMF position makes some sense in developing countries, where there is no capital market in which to sell government bonds. Hence, central banks tend to print money to finance deficits, leading to inflation and a depreciating currency. But it makes little sense to criticize the United States on the same grounds, because our central bank is independent of the federal government and the Treasury Department can always borrow as much as it needs to finance deficits. However, the IMF follows a "one size fits all" policy, so everyone must be criticized equally even if it makes no sense.
This does not mean that the IMF is ignorant of its own failures. Indeed, it recently published an important critique of itself. The paper found that the benefits of IMF programs are problematic at best. One of their key features is integrating financial markets into the world economy. Yet the report found that "an objective reading of the vast research effort to date suggests that there is no strong, robust and uniform support for the theoretical argument that financial globalization per se delivers a higher rate of economic growth." Indeed, some countries adopting financial liberalization "experienced output collapses related to costly banking or currency crises," the report noted.
Iraq would do better to follow the path of Germany and Japan and avoid the World Bank/IMF model if it hopes to restore its economy. Instead of relying on foreign aid, as the World Bank does, and raising taxes to balance its budget, as the IMF wants, Iraq should eliminate all price controls, privatize the oil industry, establish secure property rights, lower tax rates and link the Iraqi currency to the dollar. If it does all these things, foreign investment will make foreign aid and IMF programs unnecessary.