Conventional wisdom on international development holds that "the rich get richer while the poor get poorer." This saying does not capture exactly what has happened between the rich and poor regions of the world over the past century, but it comes pretty close. In general, poor areas of the world have not become poorer, but their per capita income has grown quite slowly. On the other hand, income in the club of rich countries (Western Europe, the United States, Canada, Japan, Australia, and New Zealand), has increased at a much more rapid pace. As a result, by 1980 an unprecedented level of worldwide inequality had developed. The richest fifth of the world's population—which essentially corresponds to the population of the rich countries—produced and consumed 70 percent of the world's goods and services, while the poorest fifth of the global population, in contrast, held only two percent.

There has been a modest decline in global inequality since 1980 because two large poor countries—China and India—have outperformed the rich countries economically. This shift represents an interesting change that has important lessons for development. However, if one ignores the performance of China and India, much of the rest of the developing world still languishes, and there continues to be an appalling gap between rich countries and poor countries.

Inequality within countries is an important issue as well, but it pales in comparison with inequality between countries across the world. A homeless person pan-handling for two US dollars a day on the streets of Boston would sit in the top half of the world income distribution. Without traveling through rural parts of the developing world, it is difficult to comprehend the magnitude of this gap, which is not just one of income. Life expectancy in the United States has risen to 77 years, whereas in Zambia it has fallen to 38 years. Infant mortality is down to seven deaths per 1,000 live births in the United States, compared to 115 in Zambia. How can these gaps in living standards be understood? And, more importantly, what can be done about it?

Traditionally, one part of the answer to the latter question has been foreign aid. Since the end of the Cold War, aid has been in decline, both in terms of volume (down to about 0.2 percent of the gross national product of the rich countries) and popularity as an effective policy. However, since before September 11, 2001, aid has made something of a comeback, with a number of European countries, notably the United Kingdom, arguing for the importance of addressing global poverty by implementing reforms to make aid more effective. Since September 11, the US government has shown renewed interest as well.

What can come from this renewed interest in foreign aid? Foreign aid bureaucracies have a long history of mistaking symptoms for causes. If this trend continues uncorrected, then it is unlikely that greater volumes of aid will make much of a dent in global poverty and inequality. On the other hand, there is much more evidence about what leads to successful development and how aid can assist in that process. Thus, the potential exists to make aid a much more important tool in the fight against poverty. My argument on this matter is comprised of four points.

First, countries are poor primarily because of weak underlying institutions and policies. Features such as lack of capital, poor education, or absence of modern industry are symptoms rather than causes of underdevelopment. Aid focused on these symptoms has not had much lasting impact.

Second, local institutions in developing countries are persistent, and foreign aid donors have little influence over them. Efforts to reform countries through conditionality of aid from the Bretton Woods organizations have generally failed to bring about lasting reform within developing country institutions. It is difficult to predict when serious movements will emerge, but the positive developments in global poverty in the past 20 years have been the result of home-grown reform movements in countries such as China, India, Uganda, and Vietnam.

Third, foreign aid has had a positive effect in these and other cases, and arguably its most useful role has been to support learning at the state and community level. Countries and communities can learn from each other, but there are no simple blueprints of institutional reform that can be transferred from one location to the next. Thus, helping countries analyze, implement, and evaluate options is useful, whereas promoting a "best-practice" approach to each issue through conditionality is not.

Fourth, the financial aspect of foreign aid is also important. In poor countries that have made significant steps toward improving their institutions and policies, financial aid accelerates growth and poverty reduction and helps cement popular support for reform. Hence, large-scale financial assistance needs to be "selective," targeting countries that can put aid to effective use building schools, roads, and other aspects of social infrastructure.

Institutions and Policies

Economists have long underestimated the importance of state institutions in explaining the differences in economic performance between countries. Recent work in economic history and development is beginning to rectify this oversight. In their 2001 study, "Colonial Origins of Comparative Development: An Empirical Investigation," Daron Acemoglu, Simon Johnson, and James Robinson find that much of the variation in per capita income across countries can be explained by differences in institutional quality. They look at a number of different institutional measures, which generally capture the extent to which the state effectively provides a framework in which property is secure and markets can operate. Thus, indicators of institutional quality try to measure people’s confidence in their property rights and the government bureaucracy’s ability to provide public services relatively free of interest group appropriation and corruption. All countries have some problems with appropriation and corruption, so the practical issue is the extent of these problems. While these differences are inherently hard to measure, some contrasts are obvious; there is, for example, no doubt that Singapore or Finland has a better environment of property rights and clean government than Mobutu’s Zaire or many similar locations in the developing world.

Differences in institutional quality explain much of the variation in per capita income across countries, an empirical result that is very intuitive. In a poor institutional environment, households must focus on day-to-day subsistence. The state fails to provide the complementary infrastructure—such as roads and schools—necessary to encourage long-term investment, while the lack of confidence in property rights further discourages entrepreneurial activity. In this type of setting, any surplus accumulated by individuals is more likely to fund capital flight, investment abroad, or emigration than to be reinvested in the local economy.