Progress in poverty reduction depends primarily on policy and institutional changes in low-income countries. The World Bank's previous approach to inducing these changes relied on negotiated conditions on loans, or conditionality. The empirical evidence suggests that this approach was largely ineffective-where change occurred, it was chosen by governments rather than induced by conditions on loans. Various countervailing pressures undermine the effectiveness of loan conditionality. An alternative approach to inducing change is to empower, through knowledge and participation, domestic constituencies to make change. This approach is likely to be more effective in promoting policy change-and essential in promoting institutional change, now usually the frontier of economic reform. This shift in focus is part of the rationale for the Bank's Comprehensive Development Framework.

The lesson of the 20th century is that successful development requires markets underpinned by solid public institutions-institutions that protect property rights, regulate market participants, maintain macroeconomic stability, provide social insurance, and manage conflict. A variety of institutional setups could serve these functions, but any imported blueprints should be filtered through local practice and needs. International rules and the loan conditionality imposed by international financial institutions ought to leave room for development policies to diverge from the dominant orthodoxies. Today's advanced industrial countries owe their success to having developed their own workable models of a mixed economy. Developing nations need to fashion their own brands. Economic development will ultimately derive from homegrown strategies, not imitation of U.S.-style capitalism.

Creative destruction, driven by experimentation and the adoption of new products and processes when investment is sunk, is a core mechanism of development. Obstacles to this process are likely to be obstacles to progress in standards of living. Underdeveloped and politicized institutions are a major impediment to a well-functioning process of creative destruction. They result in sluggish creation, technological "sclerosis," and spurious reallocation of factors of production. These ills reflect the macroeconomic consequences of contracting failures in the presence of sunk investments. Recurrent crises are another major obstacle to creative destruction. The common inference that increasedl iquidationsd uringc risesr esulti n increasedr estructuringi s unwarranted.O n the contrary, there are indications that crises freeze the restructuring process, an effect associated with the tight financial market conditions that follow a contraction. This productivityc ost of recessionsa dds to the traditionalc osts of resourceu nderutilization