The Right Way to Rebuild Georgia

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At the recent donors' meeting on Georgia, aid pledges rolled in, totaling $4.5 billion -- about $1,000 for each Georgian citizen. That's the good news. The bad news is that the meeting was restricted to donors and Georgia's government, with Transparency International criticizing its opaque decision-making process.

Lack of transparency and accountability in how money is spent in wars and in the rebuilding that takes place after them, no longer play well with taxpayers. In light of increasing global demand for aid and falling supply (down 12 percent over the last two years), its effective and transparent use is becoming more imperative. And governments that are not accountable to their citizens will most likely fail in this regard.

Before these pledges become commitments, donors should carefully examine Georgia's economic development strategy and assess its plans for humanitarian and reconstruction aid. They should ask whether aid for Georgia contributes to peace and stability or, on the contrary, whether it will impede a political solution to the conflict and keep investors away.

Russia's recognition of Abkhazia and South Ossetia as independent republics, despite their de facto autonomous status within Georgia since the early 1990s, will make it more difficult to find solutions to the problems of internally displaced persons, returnees and the resident population in the conflict zones. But reintegration of conflict-ridden groups into productive activities is a sine qua non for political, economic and social stability.

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So has Georgia's development model been conducive to dynamic and inclusive growth, that is, growth that leads to productive investment, innovative practices and widespread job creation?

To be sure, the International Monetary Fund and the U.S. government have recognized Georgia's unquestionable success in adopting sound macroeconomic policies and reforms to improve the business climate. Foreign investors have responded by pouring resources into the country. With capital inflows amounting to 20 percent of gross domestic product in the years before the war, annual economic growth jumped to more than 12 percent in 2007, with the country experiencing almost 40 percent growth since 2003.

But rapid growth is not enough. Georgia has failed to create the jobs, dynamism and inclusion that are necessary for a peaceful society. Despite some recent diversification, investment flows have been heavily tilted to construction of oil and gas pipelines and other large international projects. Moreover, military expenditure has increased from 1 percent to 7 percent of GDP since 2003, drawing resources away from human development into unproductive investment.

Unemployment is high, income disparities have worsened and corruption remains widespread, notwithstanding important improvements in recent years. Despite official statistics that place less than one-third of the population below the poverty line, experts reckon that roughly half the population is trapped in poverty amid a large urban-rural gap.

The challenge for Georgia is to find a solution to the displaced persons by rehabilitating infrastructure, housing and other services. It is also important to boost job creation so that the conflict-affected population's living conditions can improve. The UN High Commission for Refugees forecasts that 73,000 of the roughly 127,000 displaced persons created by the South Ossetian crisis will probably return to their places of origin by early winter. Given that 220,000 displaced people from previous conflicts in the 1990s now face fading prospects for a return to Abkhazia and South Ossetia, Georgia's authorities must find a viable and permanent solution for roughly 6 percent of the population.

Moreover, capital flows, upon which Georgia is highly dependent, have been interrupted since the conflict started. Without a solution to the refugee problem, efforts to strengthen political stability and security will fail. And, in the absence of stability and security, the objective of the IMF's $750 million standby arrangement to cover the "temporary external financing gap" and to sustain "the confidence of markets and investors" will not be met.

The challenge now is to redesign Georgia's aid package to focus primarily on the provision of "reconstruction aid" that promotes investment and employment. While "humanitarian aid" cannot be neglected, it should be recognized that such aid promotes consumption rather than investment, creating price distortions and work disincentives. Georgia must be weaned from humanitarian aid as soon as the situation allows it.

Reconstruction aid to improve infrastructure, promote startup companies and reactivate small enterprises, services and mining should start right away and should be the main focus of international aid commitments. Laissez-faire will not do it.

Georgia's government and donors should consider using aid to provide subsidies to private enterprises to encourage and lower the cost of employing displaced persons. Without inclusive and dynamic growth, sustainable peace will remain elusive, and in the current environment of higher scrutiny and significant competing needs, donors will be hard pressed to justify committing the large financial aid package that they have pledged.

Graciana del Castillo, associate director of the Center on Capitalism and Society at Columbia University, is the author of "Rebuilding War-Torn States." Edmund S. Phelps, the director of the Center on Capitalism and Society, was awarded the 2006 Nobel Prize in Economics. © Project Syndicate