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Monday, January 17

Why Eliot Spitzer is the Man for the Job

Pundita has been asked to explain her nomination of Eliot Spitzer for the next World Bank president. I pick Spitzer because the challenge he faced in dealing with Wall Street parallels the greatest challenge the incoming World Bank president will face--or rather should face. But understanding why Spitzer is the Man for the Job requires a grasp of how the development bank loan model works in practice. So first a crash course:

Contrary to popular understanding the IBRD project loan was created to directly benefit business, not government. This makes sense if you consider that the IBRD was conceived as an economic means to help a country rebuild and develop. The model is the grandfather of the Trickle Down theory.

The loan money is disbursed to a government but the government pays out to contractors to execute the project. That's why a wag once referred to the Bank as "One big procurement scam." However, it's not a scam. In certain situations the model works beautifully; it works as intended when a country has to get back on it's feet. For example, the model helped put many European businesses back on their feet after WW2. That in turn helped build up Europe's postwar economies.

But the IBRD loan model did not change when it was applied to help countries that had never been on their feet in the first place. The only change was the IDA financing. To quickly grasp what's wrong with applying the IBRD loan model to the least developed countries, take this quiz:

1) People in your neighborhood are blowing each other up, hacking each other to death with machetes, and living on bugs for dinner. The solution is to write low-cost loans to widen your neighborhood's street and rebuild the local community center. This is so your local cement business and building contractor can avoid shutting their doors.

TRUE___

FALSE___

2) If you answered TRUE to the above. After five years of implementation of the above loans, people in your neighborhood are still blowing each other up, hacking each other to death with machetes, and living on bugs for dinner. The solution is to write even lower-cost loans so that your local flower vendor and coffeehouse can stay open.

TRUE___

FALSE___

The IBRD is a one-trick magic show. Behind the kaleidoscopic stage business, which is the numberless types of Bank-financed projects--construction, education, environment, agriculture, the list is endless--is one unchanging factor. All those government-sponsored projects underwritten by IBRD and IDA loans are executed by contractors, which the debtor government (with Bank approval) chooses.

Here we come to a snag. If the project loans are really to help the country get on its feet by helping the business sector, the government can't rely exclusively on contractors from developed nations to do the project work. That would be counterproductive. The local contractors must be given work on the projects, even if it's only subcontracts.

Yet even the international megacontractors, such as Bechtel, face big challenges when overseeing the work of many contractors from developed nations. When the oversight task must include many score or hundreds of contractors from an underdeveloped country, the problem with applying the IBRD model to the poorest countries stands up and shouts. The IDA loan is never big enough--cannot be big enough--to finance the kind of oversight that would insure efficient use of the project loan money and block the worst graft.

The Bank does factor in a certain amount of inefficiency on the project and a certain amount of embezzlement when writing the project loan. But that hardly deals with the problem. There are two types of corruption involved with World Bank loans. (And with all development bank project loans.)

First, there is embezzlement of Bank loan funds at the administrative level--the debtor government level. This type of corruption is famously associated with despots who receive Bank loans. The despot's government routinely peels off millions of dollars from Bank loans.

I interject that is not counting outright theft. One of a despot's many tricks is to have a military unit put on black clothing and ski masks then sneak into the project site at night to steal heavy equipment.

The next morning, when the poor World Bank project engineer sees all the cranes and bulldozers gone, a fence from the same military unit shows up and offers to sell some cranes and bulldozers from his brother-in-law's business. Then the despot spends the profit on more military expenditures, so he can terrorize his people and neighboring countries all the more.

Second, there are the many varieties of fraud practiced by shady contractors the world over since contracting began. (This doesn't include the loan money wasted by honest local contractors who are still in the learning phase.)

In theory, the first type of fraud can be blocked by very close Bank oversight, which the World Bank has attempted during the past decade in particular. The sticking point is that despots aren't idiots. They figure the only reason they're getting low-cost loans is because their country is sitting on a natural resource that a World Bank member(s) find useful. And/or their country has reaped the windfall of being in a location that a World Bank member (e.g., a NATO country) finds to be of military importance.

So when the Bank auditors arrive the despot raises himself to his full height and thunders, "Are you calling me a crook?"

Right there is one reason Eliot Spitzer is specially qualified to lead the World Bank. He dealt with that kind of situation all the time when he was chief of Manhattan's Labor Racketeering Unit.

"What? You're calling us racketeers? We'll have to shut down the docks for a week while we talk to our attorneys about suing for slander."

The second type of fraud explains why the Bank has firmly resisted bringing in outside auditors. If you conduct independent forensic investigation of the amount of Bank loan money that is routinely stolen or wasted by contractors connected with Bank projects in least-developed countries, the Bank's credit rating will tank.

Then the Bank would be trying to sell junk bonds to finance their lending. That would not allow the Bank to support their lending practices. In other words, the World Bank would go out of business. At least, that is the Bank's excuse for not dealing with their central problem.

For readers who are familiar with the blowout on Wall Street, the Bank's excuse sounds remarkably like excuses Wall Street trotted out to resist making real changes. When they saw the lynch mobs forming across America, Wall Street firms called on each other to take executive action. However, the proposed actions had nothing to do with the central problem, which is that stock offerings are no longer only "to the trade."

The IBRD project loan model is also "to the trade." The model was not conceived for countries where the most basic governing infrastructures in a modern civil society were never there, or so gone they'd have to build from scratch. Leave aside the crooks; how can you sue a shoddy contractor in a country where contract laws are nonexistent and the judicial system runs completely on bribes, if it runs at all? This leaves no way to impose standards on the work of local industries.

Then visitors from developed countries ask, "Why doesn't anything work here? And by the way, why does the drinking water in these countries always smell like goat poop?"

Yet the Bank has spent decades resisting a change to the IBRD project loan model, in the same way Wall Street spent decades resisting changes to their way of business. In the mid-20th Century, Wall Street's resistance would have been justified. People are responsible for their own investment decisions. So if they lose their shirt--well, that's Wall Street. But Spitzer's call for reform recognizes that stock offerings are no longer only to the trade. Wall Street not only accepts but now depends on investments from many millions of people who know nothing of the business of trading stocks and bonds.

In the same manner, developed countries should not write loans to "least developed" countries when they know the government doesn't have the same institutions in place that allow developed countries to properly utilize low-cost loans. For the least developed countries, such loans only add obstacles to creating a functioning civil society.

Here is a good summary of Eliot Spitzer's thinking about the need for Wall Street to move into the 21st Century:

"Spitzer tells FRONTLINE that his investigation led him to the conclusion that Wall Street's whole business model in the late-1990s, in which stock analysts were fully integrated into the investment banking operations of brokerage houses, was not only "fundamentally corrupt" but, in fact, fraudulent. The only solution, he believes, is for Wall Street to implement the "structural reforms" agreed upon in the [global] settlement, in which analysis and investment banking are walled off."

With little adjustment, those observations could apply to the World Bank. It is time to set up a wall between the IBRD project loan model and the governments of the least developed countries. That would mean considerable pain for many honest businesspeople because the problem went untended for decades. This is another reason Spitzer is the logical choice for Bank president. He learned to turn a selectively deaf ear to the piteous cries of the doomed on Wall Street.

The IBRD loan model was conceived as a crutch, but the model eventually generated a contracting subculture. The subculture is totally dependent on government business derived from Bank loans. This translated into a devastating effect on business progress in the least developed countries.

If companies are so weak that the only way they survive is by getting business from loan projects made to the worst governments in the poorest countries, the Bank must carry out triage.

The bottom line is that the relationship between IDA project loans and companies that service the loans is so entwined that there's going to be severe pain, no matter how you fix the problem. But letting the problem stand is akin to refusing to amputate a limb that gangrene has destroyed.

Of course, Eliot Spitzer's investigation into Wall Street practices had the force of the US legal system behind it. He wouldn't have the same force behind him at the Bank. Yet Spitzer knows the terrain of Establishment resistance to calls for structural reform. He's been there, bought the T-shirt and the DVD. Above all, that is why Eliot Spitzer is the best choice for the next World Bank President. Even if he only took the job for a year, as interim president, humankind would benefit.
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