How effective is foreign aid?

Foreign aid is controversial in development economics. Three distinct camps may be distinguished:

• One believes that official assistance is ineffective, and has harmed poor countries throughout the years.

This views official aid as creating dependency, fostering corruption, and encouraging currency overvaluation (Easterly 2014 and Moyo 2010). It also prevents countries from taking advantage of the opportunities provided by the global economy.

• Another camp believes that aid levels have been too low, and that large increases would help reduce poverty.

This camp, however, believes we need a rethinking on the way in which aid is provided (Sachs 2009 and Stiglitz 2002). In particular, specific interventions, such as anti-malaria programmes, should be emphasised.

• The third camp is less vocal, and includes authors such as Collier (2007), who has emphasised the role of a number of ‘traps’ in perpetuating destitution, and Banerjee and Duflo (2011) who argue that the use of ‘randomised control trials’ may help devise effective and specific aid programmes in the war against poverty and underdevelopment.[1]

These schools of thought have historical precedents.

Foreign aid policies from a historical perspective

Foreign aid is a relatively new concept in economics. The classics – Smith, Ricardo, and Stuart Mill, for example – didn’t address the subject in any significant way. If anything, classical economists thought that the colonies would catch up – and even surpass – the home country quite rapidly.[2] In Chapter VII of The Wealth of Nations, Adam Smith provides a detailed discussion on the “causes of the prosperity of the new colonies.”[3]

The first legal statute dealing expressly with official aid was passed by Parliament in the UK in 1929.[4] In 1940 and 1945, new laws dealing with aid to the colonies were passed in the UK. These Acts increased the amount of funds available, and made commitments for longer periods of time – for up to ten years in the Colonial Development and Welfare Act of 1945. More important, the Act of 1945 established that aid plans had to be prepared “in consultation with representatives of the local population.”[5]

In the US the first law dealing with foreign assistance came quite late, with the adoption of the Marshall Plan in 1948.[6] In his inaugural speech on 20 January 1949 – the so-called ‘Four Point Speech’ – President Harry Truman put forward, for the first time, the idea that aid to poor nations was an important component of US foreign policy. He said that one of the goals of his administration would be to foster “growth of underdeveloped areas.”[7]

In spite of Truman’s vehement allocution, aid commitments to poor countries were considered temporary. In 1953, when Congress extended the Mutual Security Act, it explicitly stated that economic aid to US allies would end in two years; military aid was to come to a halt in three years.

In the early 1960s – and largely as a result of the escalation of the Cold War – the US revised its posture regarding bilateral assistance, and, jointly with other advanced countries, founded the Development Assistance Committee (DAC) at the newly formed Organisation for Economic Cooperation and Development (OECD). The main objective of the DAC was – and continues to be – to coordinate aid to the poorest countries.[8]

Foreign aid policies and academics’ views on development

Academic research has helped shape international aid policies. During the 1950s and 1960s, aid agencies’ work was influenced by the Harrod–Domar growth model and by W. Arthur Lewis’ unlimited supplies of labour model. As a result, most agencies funded very large capital-intensive projects, and neglected policies, projects, and programmes related to labour, human capital, and productivity.

This changed in the late 1960s and 1970s with the ascendance of Solow’s neoclassical model of growth, and the development of the ‘basic needs’ approach to welfare economics. Aid policies changed focus, and a higher percentage of funds were devoted to social programmes (health and education), programmes aimed at directly reducing poverty, and programmes that strengthened skills and human capital.

Further changes in aid policy came with research that related openness and exports’ expansion to productivity growth. The work of Anne Krueger and Jagdish Bhagwati was particularly important. During the 1980s and 1990s, international assistance became increasingly conditioned on the recipient countries liberalising their economies through the elimination of quantitative import restrictions and the lowering of import tariffs.

The development of the ‘dependent economy’ macroeconomic model, with tradable and nontradable goods, in the late 1970s and early 1980s, helped put emphasis on the crucial role of the real exchange rate in the resource allocation process. Works by Robert Mundell, Rudi Dornbusch, and others pointed out that real exchange rate overvaluation was costly and at the heart of devastating currency crises. These works, in conjunction with research undertaken by Robert Bates and Elliot Berg, among others, influenced aid agencies’ views regarding currencies, incentives, exports, and agriculture. The very poor performance of the agricultural sector between 1965 and 1985 in most regions – and in particular in Africa – also affected thinking in the aid agencies, and contributed to a new view that emphasised ‘getting prices right’.

In the 1990s, two research lines influenced aid policy.

• Work on incentive compatibility and strategic behaviour persuaded aid officials in donor countries to become more flexible, and to incorporate recipient governments in the design and management of aid programmes.

This approach received the name of ‘programme ownership’, and has been at the heart of improved relations between donors and poor nations in the last two decades.

• New research on capital mobility and the international transmission of crises, resulted in a more nuanced and pragmatic view regarding the use of capital controls.

Many agencies – including the IMF and the World Bank – supported a limited use of capital controls (especially controls on capital inflows) and so-called macro-prudential regulations, as a way of avoiding destabilising forces and currency crises.

Econometric studies

Academic and aid-community economists have used a battery of econometric methods to analyse whether aid is effective in the sense of generating higher growth and better economic outcomes.[9] Some of these studies have tried to tackle issues of reverse causality, and have used a series of instruments – some more convincing than others – in an attempt to deal with the fact that slower growth (in very poor countries) may attract additional aid.

Some research focused on whether aid only works under certain conditions, or whether a minimal degree of institutional development is required for international assistance to bear fruit (Burnside and Dollar 2000, 2004). Many of these studies have considered nonlinear functional forms, and have investigated if there are meaningful interactions between aid and other variables, such as the degree of literacy, the level of corruption, the extent of macroeconomic stability, institutional strength, the quality of overall economic policies, and geography.

In general, most studies have relied on cross-country or panel data, and have attempted to distinguish between short- and long-term impacts. A number of authors have used ‘Dutch disease’-related models to analyse the extent to which increased aid results in currency overvaluation, poor exports performance, and crises – see Rajan and Subramanian (2011).

Fragile and inconclusive results

Overall, the results from this large body of research have been fragile and inconclusive.

After analysing 97 studies, Doucouliagos and Paldam (2008, 2009) concluded that, in the best of cases, it was possible to say that there was a small positive, and yet statistically insignificant, relationship between official aid and growth.

This conclusion was also reached by Rajan and Subramanian (2008) in an analysis that corrected for potential endogeneity problems, and that considered a comprehensive number of covariates. In particular, according to this study there is no clear relation running from more aid to faster growth; this is true even in countries with better policy environment and stronger institutions – see also Rajan and Subramanian (2008) and Quibria (2014).

Bourguignon and Sundberg (2007) have argued that one should not be surprised by the inconclusiveness of studies that rely on aggregate data.

According to them, aid affects economic performance, directly and indirectly, through a variety of channels. Treating all aid as homogeneous – independently of whether it is emergency assistance, programme aid, or project-based aid – is misleading. In their view it is necessary to break open the ‘black box’ of international aid, and deconstruct the causality chain that goes, in intricate and non-obvious ways, from aid to policymakers, to policies, and to country outcomes. This type of analysis would explore a number of specific ways in which international assistance could impact economic performance. In particular, according to Bourguignon and Sundberg (2007) it is important that studies that try to determine the impact of aid on growth consider issues related to technical assistance, conditionality, level of understanding of the economy in question, and the government’s ability to implement specific policies.[10]

Bitter policy controversy

In spite of its intensity, the academic debate pales in comparison with recent policy controversies on the subject. The level of animosity in this veritable war of ideas is illustrated by the following quote from an article by Jeffrey Sachs published in 2009:

“Moyo’s views [are] cruel and mistaken… [Moyo and Easterly are] trying to pull up the ladder for those still left behind.”[11]

Easterly’s reply, also from 2009, was equally strong:

“Jeffrey Sachs [is]… the world’s leading apologist and fund-raiser for the aid establishment… Sachs suffers from [an]… acute shortage of truthiness…”[12]

The Easterly–Sachs debate has generated public attention because it has been couched in rather simple terms. These are simple narratives based on ethnographic arguments that resonate with large segments of the general public. But behind the different positions there are hundreds of academic studies – most of them based on advanced econometric techniques – that have tried to determine the extent to which foreign aid is effective. The problem, as noted, is that much of this body of empirical work has resulted in fragile and inconclusive evidence.

Intermediate positions

For an increasing number of economists, the issue of aid effectiveness is neither black nor white. Indeed, a number of authors have taken intermediate positions. For example, in an influential book that deals with the plight of the poorest of the poor, Collier (2009) has argued that both critics and staunch supporters of official aid have greatly exaggerated their claims and distorted the empirical and historical records.

Collier’s reading of the evidence is that over the last 30 years official assistance has helped accelerate GDP growth among the poorest nations in the world – most of them in Africa – by approximately 1% per year. This is a nontrivial figure, especially when one considers that during this period the poorest countries have had an aggregate rate of per capita growth of zero. That is, in the absence of official assistance, the billion people that live in these nations – the so-called ‘bottom billion’ – would have seen their incomes retrogress year after year.

Banerjee and Duflo (2011) argue that there is need for a “radical rethinking of the way to fight poverty.” In their view, the acrimonious debate between the Easterly and Sachs factions has missed the boat. Banerjee and Duflo join a growing group of researchers in arguing that this controversy cannot be solved in the abstract, by using aggregate data and cross-country regressions. The evidence, in their view, is quite simple – some projects financed by official aid work and are effective in reducing poverty and moving the domestic populations towards self-sufficiency and prosperity, while other projects (and programmes) fail miserably. The question is not how aggregate aid programmes have fared in the past, but how to evaluate whether specific programmes are effective.

Persuasive ‘aid narratives’

In Edwards (2014b) I discuss the effectiveness-of-aid literature from a historical perspective, and I argue that international aid affects recipient economies in extremely complex ways and through multiple and changing channels. Moreover, this is a two-way relationship – aid agencies influence policies, and the reality in the recipient country affects the actions of aid agencies. This relationship is so intricate and time-dependent that it is not amenable to being captured by cross-country or panel regressions; in fact, even sophisticated specifications with multiple breakpoints and nonlinearities are unlikely to explain the inner workings of the aid–performance connection.

Bourguignon and Sundberg (2007) have pointed out that there is a need to go beyond econometrics, and to break open the ‘black box’ of development aid. I would go even further, and argue that we need to realise that there is a multiplicity of black boxes. Or, to put it differently, that the black box is highly elastic and keeps changing through time. Breaking these boxes open and understanding why aid works some times and not others, and why some projects are successful while other are disasters, requires analysing in great detail specific country episodes. If we want to truly understand the convoluted ways in which official aid affects different economic outcomes, we need to plunge into archives, analyse data in detail, carefully look for counterfactuals, understand the temperament of the major players, and take into account historical circumstances. This is a difficult subject that requires detective-like work.

References

Banerjee, A and E Duflo (2011), Poor Economics: A Radical Rethinking of The Way to Fight Global Poverty, New York: Public Affairs.

Barder, O (2005), “Reforming Development Assistance: Lessons from the UK Experience”, Center for Global Development Working Paper 70.

Bates, R (1981), Markets and States in Tropical Africa: The Political Basis of Agricultural Policies, 2nd edition from 2005, Berkeley: University of California Press.

Bhagwati, J (1978), Anatomy and Consequences of Exchange Control Regimes, Cambridge, MA: Ballinger.

Bourguignon, F and M Sundberg (2007), “Aid Effectiveness: Opening the Black Box”, American Economic Review 97(2): 316–321.

Burnside, C and D Dollar (2000), “Aid, policies, and growth”, American Economic Review: 847–868.

Burnside, C and D Dollar (2004), “Aid, policies, and growth: reply”, American Economic Review: 781–784.

Collier, P (2007), The Bottom Billion: Why the Poorest Countries are Failing and What Can Be Done About It, Oxford: Oxford University Press.

Doucouliagos, H and M Paldam (2008), “Aid effectiveness on growth: A meta study”, European Journal of Political Economy 24(1): 1–24.

Doucouliagos, H and M Paldam (2009), “The aid effectiveness literature: The sad results of 40 years of research”, Journal of Economic Surveys 23(3): 433–461.

Easterly, W (2009), “Sachs Ironies: Why Critics are Better for Foreign Aid than Apologists”, Huffington Post, 25 May.

Easterly, W (2014), The tyranny of experts: Economists, dictators, and the forgotten rights of the poor, Basic Books.

Edwards, S (2014a), Toxic Aid: Economic Collapse and Recovery in Tanzania, Oxford: Oxford University Press.

Edwards, S (2014b), “Economic Development and the Effectiveness of Foreign Aid: A Historical Perspective”, NBER Working Paper 20685.

Guillaumont, P and L Wagner (2014), “Aid effectiveness for poverty reduction: lessons from cross-country analyses, with a special focus on vulnerable countries”, Revue d’économie du développement 22: 217–261.

Krueger, A (1978), Liberalization Attempts and Consequences, Cambridge, MA: Ballinger.

Moyo, D (2010), Dead Aid: Why Aid Makes Things Worse and How There Is Another Way for Africa, London: Penguin Books.

Mundell, R A (1962), “The appropriate use of monetary and fiscal policy for internal and external stability”, Staff Papers – International Monetary Fund 9(1): 70–79.

Quibria, M G (2014), “Aid effectiveness: research, policy and unresolved issues”, Development Studies Research: An Open Access Journal 1(1): 75–87.

Radelet, S (2006), “A Primer on Aid Allocation”, Center for Global Development Working Paper 92.

Radelet, S, M Clemens, and R Bhavnani (2005), “Aid and Growth: The Current Debate and Some New Evidence”, in P Isard et al. (eds.), Macroeconomic Management of Foreign Aid: Opportunities and Pitfalls, Washington, DC: IMF.

Rajan, R and A Subramanian (2008), “Aid and Growth: What Does the Cross-Country Evidence Really Show?”, Review of Economics and Statistics 90(4): 643–665.

Rajan, R G and A Subramanian (2011), “Aid, Dutch disease, and manufacturing growth”, Journal of Development Economics 94(1): 106–118.

Sachs, J (2005), The End of Poverty: Economic Possibilities for Our Time, New York: Penguin Press.

Sachs, J (2009), “Aid Ironies”, Huffington Post, 24 May.

Smith, A (1977 [1776]), An Inquiry into the Nature and Causes of the Wealth of Nations, Chicago: University of Chicago Press.

Stiglitz, J (2002), Globalization and Its Discontents, W M Norton.

Truman, H (1949), Inaugural Address, 20 January.

World Bank (1981), Accelerated Development in Sub-Saharan Africa: An Agenda for Action (The Berg Report), Washington, DC: World Bank.

Footnotes

[1] For a detailed discussion of these issues see Edwards (2014b).

[2] The analysis in this section doesn’t pretend to be exhaustive. I don’t attempt to deal with every aspect of aid-related controversies. Readers interested in the intricacies of international assistance may consult some of the very thorough surveys on the subject, including two comprehensive articles by Radelet (2005, 2006) and Quibria (2014), and the extensive literature cited therein.

[3] In many ways this analysis is remarkably modern. Smith argues that the main reason why the English colonies of North America had done significantly better than the Spanish dominions of South America was that “the political institutions of the English colonies have been more favourable to the improvement and cultivation of this land than those of the [Spanish colonies].” Smith goes on to list a number of policies implemented by the British – including tax, inheritance, and trade policies – that, in his view, explain the economic success in what was to become the US; in parallel, he discusses how poor policies enacted by the Dutch and the Spanish – and to a lesser extent by the French – stifled growth and progress in their dominions. Although this chapter runs for almost 100 pages, there is not even a mild suggestion that the home nation should provide systematic financial assistance to its colonies.

[4] The Colonial Development Act created the Colonial Development Fund with resources of one million pounds sterling per year. Although this Act intended to improve the social conditions in the colonies – especially in the rural sector – its main objective was to promote British exports at a time when the overvaluation of the pound had greatly reduced British competitiveness. Until the passing of this legislation the colonies were supposed to be, largely, self-financing, and any aid was confined to emergencies.

[5] Barder (2005: 3), emphasis added.

[6] The Marshall Plan, which was announced by US Secretary of State George C. Marshall in a speech at Harvard University on 5 June 1947, played an important role in defining US policy towards foreign aid.

[7] He then added that “more than half the people of the world are living in conditions approaching misery… For the first time in history, humanity possesses the knowledge and the skill to relieve the suffering of these people.”

[8] In 1946 France created its first aid agency (FIDES), which in 1963 was replaced by the Ministry of Cooperation. The Nordic countries created their own aid agencies in 1962.

[9] See Guillaumont and Wagner (2014) and Quibria (2014) for comprehensive recent reviews. See, also, Johnson and Subramanian (2005), Rajan and Subramanian (2008), Collier and Dollar (2004), Bourgouignon and Saunders (2007), and Quibria (2014), and the literature cited therein. See Booth (2012) for a discussion on aid effectiveness and governance.

[10] See Quibria (2014) and Edwards (2014a, 2014b) for discussions of these issues.

[11] Sachs (2009).

[12] Easterly (2009, 2014).

Published in collaboration with VoxEU.

Author: Sebastian Edwards is the Henry Ford II Professor of International Economics at the University of California, Los Angeles.

Image: A Bozo fisherman casts his net from a pirogue in front of Saaya village in the Niger river inland delta February 7, 2007. REUTERS.