Until about 10 years ago, "governance", "institutions" and "corruption" had no place in the international development discourse. Today, there is hardly a development strategy paper that does not strongly emphasize the importance of institutions and hardly a speech by the World Bank President that does not mention corruption.

In the seventies and eighties, the academic development debate on institutions and development revolved around the controversy on whether a democratic or an authoritarian political system would be more beneficial for development. But the more recent empirical studies established that, in terms of economic growth, there have been authoritarian failures as well as successes, and the same is true for countries that have regularly-held elections. In the nineties, the debate turned away from the purely political dimension to focus more on the institutional infrastructure of countries, that the formal and informal rules which govern the interaction between the private and public sectors and the incentive structure within the public sector are as important, if not even more important, for development as the physical infrastructure. This new consensus was supported by strong empirical evidence that showed the detrimental effects of a dysfunctional institutional infrastructure (poor rule of law, lack of credibility and corruption) on investment and growth.

For a long time, both at the policy level and the academic level, it was suggested that corruption could have a positive effect on economic activity since it might grease the wheels of the government machine. For instance, instead of waiting for her turn in the line, the person with the highest time preference may offer the highest bribe and would be helped first. There is, however, a serious flaw in this argument, since efficiency of the government machine is not God-given, exogenously determined. The rules and their interpretations are made by the same government agents who can potentially profit from bribe payments. Cumbersome and intransparent rules will enable them to collect higher payments from their more impatient clients. If the level of enforcement is endogenous to the level of potential corrupt payments, then the greasing argument no longer holds and only the negative incentive effects of corruption remain.

One of the reasons for a surge in interest in corruption in the nineties was its detrimental effects on economic performance, clearly established in empirical studies. From the point of view of the private sector, having to pay bribes instead of taxes involves much more uncertainty. The firm will be hostage to new demands as soon as it has agreed to a first bribe. The less organized the bribe collecting process, the larger the arbitrariness. A theoretical case can be made that the kind of corruption which creates large uncertainties is more damaging than the well-organized corruption which acts more like a transaction cost.

Let us turn now to foreign aid. Studies on its effectiveness confirm what other academic studies have found and what practitioners have long suspected: overall, one cannot demonstrate that foreign aid has helped economic development or significantly improved indicators of quality of life. In other words, there have been as many failures as successes. One way that donors have tried to ensure the effectiveness of their aid programmes is by carefully selecting projects and monitoring their implementation. Fungibility undermines this strategy. Fungibility essentially means that "a dollar is a dollar" and that Governments may adjust their own expenditures taking into account the foreign inflow. For example, if a donor sponsors a schooling programme, the Government may reduce the planned allocations for education and increase some other position; to take an extreme example, say, increase military expenditures. Thus, the effect of this schooling aid should not be measured only in terms of the educational benefit, but also include the effect on other expenditures that it has "crowded in".

Of course, fungibility does not say anything about the quality of projects. An education project sponsored and monitored by a foreign donor might be more or less efficient than one carried out by the initiative of the local authorities. The finding of fungibility does imply, however, that it may be futile to try to isolate projects and target specific sectors. In a country where the overall government policy is not favourable to development, targeting will not improve the effectiveness of aid.

Development policies have worked and foreign aid has been highly effective in a subgroup of countries, those that adopted good economic policies to improve their institutional infrastructure. A stable macroeconomic environment, open trade regimes and protected property rights, as well as efficient bureaucracies, can deliver education, health and, ultimately, higher growth. In countries with sound management, a 1% increase in foreign aid translates into a sustained increase in a growth of 0.5% of gross domestic product (GDP), 1.9% of GDP higher private investment, and a reduction in poverty by 1%. Donor countries and international organizations argue that their aid policies are meant to be selective and enhance "good governance". Critics argue instead that, contrary to the more or less sincere intentions of the donors, corrupt governments receive just as much aid as less corrupt ones; financial assistance often does not reach the really needy in the developing country, but is wasted in inefficient public consumption. Many make an even stronger argument-that not only are corrupt governments not discriminated against in the flow of international assistance, but in fact foreign aid fosters corruption by increasing the size of resources fought over by interest groups and factions. But, in practice, donors tend to give most to political allies: ex-colonies, countries that support the donor in United Nations votes, democracies and strategically important countries. Countries with high corruption often have received more aid than those with low corruption. Development assistance through multilateral channels has been more effective than from bilateral donors.

There seems to be a certain paradox in the conclusions that a sound institutional infrastructure is key to development, while foreign aid will only work in a country with a sound institutional infrastructure. This seems to imply that there are some countries in an "institutional development trap". A possible solution to this conundrum is aid that comes in the form of knowledge and explicit institution-building rather than money. In fact, this is one of the lessons that the World Bank draws after its comprehensive aid assessment exercise: in countries with sound management, put money in; in countries with poor management, disseminate knowledge and information.

Unfortunately, bilateral donors' decisions are mostly dictated by their own interests. It follows that multilateral organizations are in a better position to direct the development agenda; ideally, a multilateral body would channel most aid resources, or at least coordinate most donors' efforts to make sure that aid is allocated to countries where it is effective. This might be a formidable task for the United Nations. But one well worth taking on.