Does Aid Make Economic Sense?
26 March 2014
Foreign aid is often seen as different from other forms of investment, and some argue that rather than having a positive effect it tends to distort economies and may potentially slow growth and development. UNU-WIDER research shows that foreign aid has had a positive effect on growth in the long run. Furthermore, aid has been crucial in supporting the broader human development process, and facilitating transitions to democracy.
Many developing countries have enjoyed impressive economic growth in the last few decades. At the same time, we often see views expressed that aid does not work; is a futile endeavour; and should rather be ended. These positions are, however, typically not based on the best evidence available. It is time to move the discussion about foreign aid, growth, and development beyond ideology and preconceived ideas, and focus on what sound evidence can tell.
The evolution of the aid–growth debate
The academic literature on the aid–growth relationship can usefully be divided into five generations, reflecting changes in both economic methodology and paradigms of development. First, in the early years (roughly until around 1980) development was typically seen as a stable and linear relationship between investment and growth, and many studies assumed that aid had a positive effect on growth. The second generation of studies was born in 1987 when Paul Mosley and his co-authors identified the so-called micro-macro paradox. This work raised justified doubts about the underlying growth model, suggesting both that expecting all capital investment to translate into economic output, and expecting all aid to be used as investment, were overly bold assumptions.
These doubts about the assumptions at the core of previous research, as well as the availability of new panel data which allowed researchers to look into the impact of aid both across and within countries over time, motivated the new approach of the third generation from the early 1990s. The attentive reader will probably remember the famous 1994 heading ‘Aid Down the Rathole’, which The Economist used when the study of a London School of Economics professor, Peter Boone, was reviewed. His work did not stand unchallenged for long. World Bank economists Craig Burnside and David Dollar argued already in 1997 that aid works, but only sometimes, and that for aid to have an effect the right conditions, namely good fiscal, monetary and trade policy, had to be in place.
This optimism is not reflected in the fourth generation that became influential around 2005. The then Chief Economist of the IMF Rajan published a paper where he and his co-author argued that at the macro level it is difficult to identify ‘any systematic effect of aid and growth’. Subsequently this apparent non-existence of impact was used widely in the public debate to motivate aid criticism. Yet, absence of evidence is by no means equivalent to evidence of absence. The fact that the relationship does not seem to be statistically significant may have many causes, including problems with the length of time the dataset covers or the care with which the econometric analysis is done.
A wide variety of explanations were put forward to explain the apparent missing relationship including that aid is associated with Dutch Disease (whereby the exchange rate tends to appreciate with foreign currency inflows and undermine exports); political economy dynamics (keeping poor governments in place); or that aid inflows can weaken governance by encouraging corruption and rent-seeking activities in general. The problem with many of these explanations is, in practice, that while they may convey interesting theory and stories, few have actually tried to test them systematically with available data. It is critical to disentangle the mechanisms through which aid may effect growth, and vice versa. Can this be done? Yes. And recent research by UNU-WIDER—which forms part of the fifth generation—has done so. A total of 16 academic studies have been published since 2008 on the aid–growth issue. They provide strong support to ReCom’s findings.
ReCom–Research and Communication on foreign aid
The aid–growth question was taken as the point of departure for the ReCom programme in the efforts to uncover what works and what could work in foreign aid. A series of studies (based on all available analytical approaches) has by now been published in leading academic journals, and they show that:
An inflow of aid at the level of 10 per cent of GDP spurs a more than 1 percentage point increase in annual per capita growth rate on average. Thus, foreign aid has facilitated economic growth at the aggregate level over the long term (i.e. the period 1970-2007).
Views that posit a non-existent or negative impact of development aid on growth have typically been based on misspecified models and errors in data interpretation.
When foreign aid is evaluated as an investment, it has had an annual rate of return of 7.3% since the mid-1970s.
Thus, aid has worked in promoting growth, and has worked well. At the same time, no informed individual will of course argue that foreign aid has worked with equal effectiveness everywhere and that failures have not been experienced. Development, which foreign aid is designed to support, is risky business.
Beyond growth: has aid supported poverty reduction?
Growth cannot and should not be the only measure of performance in foreign aid, as the discussion about the Millennium Development Goals (MDGs) illustrates. It is therefore encouraging that UNU-WIDER’s up-to-date ReCom research has shown that development assistance also has a positive effect on a number of intermediate factors which are seen as drivers of growth and development. UNU-WIDER research finds that an average annual inflow of US$25 of aid per capita in a typical country over the period of 1970-2007 reduced poverty by around 6.5 percentage points, raised investment by 1.5 percentage points in GDP, augmented average schooling by 0.4 years, boosted life expectancy by 1.3 years, and reduced infant mortality by 7 in every 1,000 births. So aid not only increases growth, it helps promote social development.
Is growth important for development?
Yes, it is. As the economic pie grows there is more to share all around, and this ‘more’ can then be used for furthering development to provide the possibility for dignified lives for the many, rather than just the few. After decades of foreign assistance we now know enough to assess properly whether aid works or not through rigorous analysis of the existing data. Clearly there are individual situations where aid has not worked as desired, but this should not be used to attack the premise and principles behind the entirety of foreign aid. Rather, it should encourage researchers, practitioners, and policy makers to redouble their efforts to better understand the reasons why aid has not worked in some contexts, and learn as well from the situations where it has indeed worked well. In this context it is critically important to keep in mind that aid is a public resource which can be put to do things private business money typically will not do. The issue in financing development is therefore not ’Trade-not-Aid’ as sometimes argued. It is ’Trade-and-Aid’. Aid and trade are not substitutes, they are complements. Resources (including aid) can be misused and have no or little effect. And aid is at the end of the day too small to do the job on its own. But aid helps, and can make a difference as the ReCom summary report, looking at what we know about aid as we approach 2015, demonstrates.
Finn Tarp is the Director of UNU-WIDER. This is a reproduction of an article published on the NAI Forum and a revision of an opinion piece which originally appeared in the African Business Review, September-October 2013.