Global Policy Forum

To Drop or Not to Drop?


By Tim Allen and Diana Weinhold

London School of Economics and Political Science
May 2001

The pope, Salman Rushdie, the World Bank, Bono and John Kenneth Galbraith might seem unlikely bedfellows, but they all have one thing in common--they support the abolition of Third World debt. Such voices are united under the mantle of Jubilee 2000, an organization committed solely to this cause. But will dropping the debt actually alleviate poverty?

Tim Allen and Diana Weinhold explore the arguments of one dissenting voice in this clamor. William Easterly, a leading economist at the World Bank, investigated the claims and proposals of Jubilee 2000 and found them to be wanting.

During the 1990s, the debt of developing countries was highlighted as never before. The World Bank claims to have pioneered the new response, which assumes that removing debt overhang is essential for the alleviation of world poverty. However, it has been the remarkable Jubilee 2000 coalition that has succeeded in capturing the headlines. It has been hailed by Anthony Gaeta, a spokesperson of the World Bank, as "one of the most effective lobbying campaigns I have ever seen," and it has probably helped push the World Bank towards a more radical agenda than would otherwise have been possible.

As the turn of the millennium approached, it seemed that almost everyone supported the Jubilee slogan "Drop the Debt," from Tony Blair and Bill Clinton to John Kenneth Galbraith, Salman Rushdie, Bono and the pope. Indeed, it became difficult for journalists wanting to cover the topic to find a dissenting voice. The few who were willing to raise difficulties sometimes found themselves abused on radio and television by the campaign's supporters--often with the compliance of the makers of the programmes. Yet some of the claims made about debt are not as straightforward as is commonly supposed, and there are arguments that comprehensive cancellation may not in fact be the most effective way of alleviating poverty.

In order to try to sift through the rhetoric, we review some of the key economic debates, focusing in particular on the challenging hypothesis on high-discount-rate behavior put forward by an important dissenting voice within the World Bank, that of William Easterly.

The mission of Jubilee 2000
The notion of debt cancellation being linked to a "jubilee" in the year 2000 is derived from the Book of Leviticus in the Bible. Every 50 years, social inequalities are to be rectified. Initially the Jubilee 2000 coalition--or, at least, high-profile individuals within it--called for a one-off, unconditional cancellation of all the debts of poor countries. The message was, to paraphrase Bono's famous speech at the Brit Awards in February 1999, "Drop the debt. Just do it. You don't have to give money. Just tell them to do it."

Those that were called upon to do the dropping were mainly rich governments and multilateral organizations, which were supposed to be extracting debt repayments on "our" behalf. Jubilee 2000 produced statistical information to back up their demands. For example, it was asserted that debt kills 134,000 children per week and that for every pound sent in grants, £9 comes back in debt repayments. Evidence for such assertions is hard to find, and most analysts would accept that there are actually net capital transfers into impoverished countries rather than out of them. But it is small wonder that passions were aroused.

Subsequently, many of those speaking on behalf of the coalition retreated from the more extreme claims (although they can still be found in the Jubilee 2000 website) and concentrated on the multilateral and bilateral debts of the world's 50 or so poorest countries. They also accepted that some form of conditionality was necessary to ensure that resources were allocated to health and education, rather than, for example, an expansion of military capacity or luxury items for corrupt elites. Even those within the coalition, like the Institute for African Alternatives, who argued that all of the African debts and most of the Latin American debts were either unpayable or illegitimate, accepted that assurances would have to be secured to ensure that funds were used for socially progressive purposes. It was also accepted that debt cancellation could not occur in such a way as to prevent developing countries from borrowing again in the future.

Nevertheless, the Jubilee 2000 coalition has never become a homogeneous organization. As Kevin Watkins of Oxfam (another coalition member) pointed out in an interview with one of the authors of this article, the campaign's main strength, and also its main weakness, has been its capacity to mobilize people with a variety of views and backgrounds around the single issue of debt cancellation. Watkins expressed concerns that the very achievement of mobilizing so many around the issue could be counterproductive in the long run. It was one thing to get people on to the streets to protest about debt; it was another to keep them there and maintain the momentum.

He was also bothered by the tendency of campaigners to link all kinds of debt, from loans with a grant component, to export-guarantee arrangements, to debts incurred to commercial banks. There are two main problems with this. First, a result of debt cancellation might be a decline in Official Development Assistance (ODA). The very soft loans made through the International Development Association (IDA) facility of the World Bank are largely financed out of ODA, and repayments of capital are reloaned. It might be argued that such circulating finance is not the most effective way of deploying ODA, but simply canceling existing loans would mean that crucial resources needed by the most impoverished countries might no longer be available.

Second, vague and overblown assertions about debt in general make it unclear which specific institutions are being criticized for not agreeing to cancellations. A consequence is that those who might be appropriate targets for the campaign, such as the IMF (which Watkins calls "the Achilles heel of the Bretton Woods institutions"), can turn the tables and suggest that they support it.

The World Bank joins the fray
Stealing Jubilee 2000's thunder has very much been the approach of the World Bank. Staff has suggested that their Heavily Indebted Poor Countries (HIPC) Initiative, jointly set up by the bank and the IMF in 1996, was the precursor of the Jubilee 2000 campaign. Indeed, the bank has sometimes come close to presenting itself as part of the coalition. As Andrew Rogerson, the World Bank's spokesperson in London, put it:

We were in the lead of those who recognized that poor countries have unbearable debt burdens and simply will not find a solution without significant amounts of debt reduction. This is not just debt relief in a sense of postponing the debt burdens but actually reduction of their stock.

More recently, the World Bank's president, James Wolfensohn, went out of his way to welcome a Jubilee 2000 rally in Washington, stating that "it will send an important signal to the international community," and that he was "very grateful for the enormous contribution Jubilee 2000 has made to debt relief." When asked what was the difference between the bank and Jubilee 2000, Rogerson replied:

Well, the devil is in the details. The debate is not about whether some countries need some debt reduction but how deep this reduction should be. Is there a level which is sustainable? How long will it take to get this reduction of debt in place, and what safeguards should there be?

The use of the term "debt overhang" in official bank documents (and in statements by Jubilee 2000 activists) is significant. Sometimes it is invoked in a rather vague way, but it does in fact have a specific, technical meaning. It refers not just to a very large debt but to a debt large enough to create a disincentive to invest in productive activities. This remains a controversial idea in economics. But it is important to note that, if there is a true debt overhang, it is easy to see why it might be in the creditors' interest to offer debt relief. It would allow productive investments to be made, potentially benefiting both creditors and the impoverished country alike. This is a reason that "dropping the debt" has attracted some strange bedfellows. According to Jubilee 2000's Alex Singleton, even an economist at the famously neoliberal Adam Smith Institute has expressed support.

However, the possibility of productive investment still leaves the issue of whether or not relief will really lead to poverty alleviation, which, as World Bank staff are keen to emphasize these days, "is what we are all about." Thus the bank has continued to stress the need for careful negotiation and conditionality, rather than a one-off arrangement with all impoverished debtors. Jubilee 2000 has been more or less forced to follow suit (even the most radical activists have come to accept that some form of conditionality is essential, although they would prefer it not to be regulated by the World Bank and IMF). In the real world it just cannot be assumed that governments will act in a benevolent way, that they would actually like to spend more on social-development programmes but cannot, because of exogenous debt-servicing requirements. It is also essential not to be seen as, in effect, rewarding governments that have been profligate and/or corrupt by turning debts into retrospective grants.

So, leaving aside the strategic problems associated with concentrating on a single issue, and the more "over-the-top" claims of some of the activists, is it the case that debt relief combined with conditionality alleviates poverty?

The answer is that there is not much evidence with which to make such a judgment. However, within the bank, one of the lead economists, William Easterly, has examined the limited data available and has come to pessimistic conclusions. In 1999 he presented a theoretical and empirical case, which argued that debt relief in the past has not been successful in reducing debt burdens or increasing welfare, and therefore it is unlikely to do so in the future.

In our view, his arguments have to be taken seriously. There is little point in demonizing debt as an end in itself (after all, developing countries will surely want to borrow again as soon as cancellations are made). Given the scarcity of development-assistance finance, a good case has to be made for "dropping the debt" as an especially effective means of reducing deprivation. In spite of all the claims to the contrary, it seems that has not really been done.

Reward the deserving
An influential body of economic literature has recently documented the persistent inability of international aid to have much effect on growth or poverty in developing countries. Indeed, the current emphasis on "good governance" is in no small part due to the evidence that aid funds have been more effective when "good policies" are already in place.

Econometric analysis has shown that, in the cross section, aid does in fact have a positive aggregate impact on growth and social welfare, but only in those countries with "good policies" as defined by the World Bank. The intuition of this result is quite simple: to the extent that aid is fungible, any aid funds, regardless of the specific programme they underwrite, can be thought of as a general subsidy to government expenditures. Thus if a developing area needs a new school, and this need is filled successfully by an aid project, the aggregate positive effect may be quite limited if the government is thus able to divert (other) funds it otherwise would have spent on education into less socially or economically productive sectors.

Doubt has also been cast on the idea that "good governance" can be promoted by conditionality. Although governments may often "commit" to certain policies ex-ante, politically it has been very difficult for the World Bank and the IMF to withhold funds if governments do not follow through ex-post. For example, in their 1998 contribution to the World Bank research working paper on macroeconomics and growth policy, David Dollar and Jakob Svensson econometrically analyzed the conditions which improve the probability that a World Bank structural-adjustment programme will be successfully implemented (note that this does not mean it necessarily had a successful outcome, simply that it was implemented broadly as initially envisioned). They found that the only robust determinants of success were those related to the domestic political-economic environment of the recipient country, and not to factors under the control of the bank.

It would seem that aid works best in the company of good policy, and good policy is primarily the result of internal domestic political and economic factors and is not easily influenced from abroad. The policy implication of this line of reasoning is that the larger part of available aid finance should be targeted to those countries that have already demonstrated the political will and ability to reform. For the remaining countries, the prescription would be to emphasize technical assistance to facilitate internal reform and local knowledge accumulation. If the analysis is correct, such an approach would ensure that the greatest number of people in the developing world benefit from a given quantity of scarce aid funds.

However, this view of aid should not be adopted uncritically. Despite the commonsense attraction of the results, there are a number of methodological issues that need more investigation. The lion's share of empirical research in this area has used aggregate level cross-country data susceptible to the standard pitfalls of constructing a dynamic interpretation from cross-section relationships. The interactions between development finance, other forms of capital transfer and country regime need more scrutiny as well. Moreover, aid funds are often targeted at poor, rural areas. In many developing countries, especially in Africa, these regions operate in an "informal" sector of the economy, and so any gains may not, by definition, show up in official aggregate statistics.

Nevertheless, the main result that aid, on average, does not appear to be effective cannot simply be set aside. If generalized debt relief (as opposed to debt relief targeted to only "good policy" governments) has the effects hypothesized by some Jubilee 2000 activists, then it would be quite a remarkable finding. Overall beneficial outcomes from debt relief would mean that conditionality clauses associated with debt relief were more effective than previous attempts, or that debt relief induced governments into "good policy" regimes through other incentives.

There is, in fact, some theoretical support for these propositions. Jeffrey Sachs's "Conditionality, debt relief and the developing country debt crisis," from the NBER project report "Developing Country Debt and Economic Performance," pointed out that the presence of debt overhang makes it less likely that conditions for reform will be implemented. Adjustment can be both socially and politically costly, especially in the short run, and governments have much less incentive to absorb these costs if the reforms primarily produce income for foreign creditors. Thus conditionality could be made more effective (in the sense of actually being implemented) if debt relief were included in conditional aid or lending programmes. However, other theoretical arguments counter that the incentives created by debt-relief initiatives may actually delay the adoption of reforms.

The Easterly findings
William Easterly points out that by offering progressively favorable terms over time, successive debt-relief initiatives could create a moral hazard--i.e., incentives to borrow in the expectation that part of this debt will be forgiven. More subtly, incremental debt relief also can create incentives to delay policy reforms, waiting for a progressively higher "price" at which to "sell" the policy changes.

In theory, a government might be able to obtain $10 million in debt relief for a reform today but thinks that it may be able to get $11 million for the same reform in a year's time. It could therefore choose to reduce its debt now and reform, or keep the $10 million in debt for one year, pay interest on it and wait until next year to reform. If the rate of interest on the debt in this case is less than 10 percent, it clearly pays to wait the year.

Easterly also notes that there can be another perverse incentive, created by the allocation of debt relief in response to policy changes (rather than the quality of policies). Countries with worse initial policies have more scope for improvement, and if debt relief responds exclusively to policy changes, it may result in assistance going to countries with worse policies on average.

While Sachs hypothesizes that heavy debts (whose origin is left unspecified) could cause a government to pursue "bad" policies (i.e., failure to invest in socially profitable projects), Easterly points out that how and why the country became highly indebted in the first place may provide a good clue as to how it might behave upon receiving some debt relief. A key point that Easterly makes concerns "high-discount-rate behavior." This refers to activities which disproportionately downplay the importance (i.e., discount) the future. If excessive external debt is the result of high-discount-rate behavior on the part of the government (as opposed to external shocks or other exogenous forces), then, if there is any remaining capacity to borrow, debt relief will probably prompt the government to do so, thus accumulating the same amount of external debt again. On the other hand, if the country cannot borrow (due to poor creditworthiness), Easterly suggests that the government has another option, which will similarly allow greater consumption today at the expense of future. Instead of paying to maintain assets such as factories, highways and other infrastructure, it could use those resources for current consumption.

Easterly hypothesizes that if a government has run up excessive debt due to high-discount-rate behavior, and this characteristic does not change with debt relief, then it will display the same bad policies that explicitly or implicitly tax the private sector after debt relief as before. But if the old government is replaced by a new government with a longer-term horizon, then debt relief could successfully provide a painless transition to a higher ratio of net worth to consumption. Easterly comments:

A once and for all program is greatly superior to a gradual program of increasing relief. The once and for all program has to attempt to establish a credible policy that debt relief will never again be offered in the future, and that it is only giving debt relief to countries with a shift in intertemporal preferences. If this is problematic, then the whole idea of debt relief is problematic. It results in more resources going to countries with bad policies than poor countries with good policies. Why should HIPCs receive four times the aid per capita of less indebted poor countries, as happened in 1997? If there is any expectation that donors will continue to favor the highly indebted in the future, then debt relief will not be successful.

Thus, according to Easterly, if debt relief frees enough resources to reduce a debt overhang and if the current government is reform-minded, then a one-time-only debt-relief programme could produce beneficial developmental outcomes. However, if the internal conditions which led to a high debt burden continue unchanged in the recipient government, then there is a chance that not only will debt relief not make a difference to the country's condition; it could cause a delay in the implementation of reforms.

So the question of debt relief remains complex. Paradoxically, Easterly arrives at a position that is, on the one hand, not so different from that of Jubilee 2000's call for one-off cancellation (although for very different reasons, and not for all impoverished country debts at the same time). On the other hand, his analysis places him at odds with the approach to negotiated and staged cancellations adopted under the HIPC initiative--the World Bank, his very employer's policy, commonly touted as a precursor to Jubilee 2000's campaign.

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FAIR USE NOTICE: This page contains copyrighted material the use of which has not been specifically authorized by the copyright owner. Global Policy Forum distributes this material without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. We believe this constitutes a fair use of any such copyrighted material as provided for in 17 U.S.C § 107. If you wish to use copyrighted material from this site for purposes of your own that go beyond fair use, you must obtain permission from the copyright owner.