Can Foreign Aid Buy Growth?

Foreign Aid and Economic Growth

Introduction

• Economic research on foreign aid effectiveness and economic growth is often used politically.
• Context is often removed from research results when they are passed between sources, changing the public perception of the findings.

The Burnside and Dollar (2000) Paper

• An academic study by Burnside and Dollar (2000) gained prominence and influenced foreign aid commitments.
• The paper investigated the relationship between foreign aid, economic policy, and per capita GDP growth, utilizing a new World Bank database.
• They used regressions with the dependent variable of growth rates in developing countries, considering factors such as:
  • Initial per capita national income
  • An index measuring institutional and policy distortions
  • Foreign aid
  • Interaction between aid and policies
• The sample was divided into six four-year time periods (1970-1973 to 1990-1993) to address correlation issues between aid and growth.
• Some specifications included:
  • Ethnic fractionalization
  • Assassinations
  • Regional dummy variables
  • Arms imports
• The interaction term between foreign aid and good policy was significantly positive.
• The authors concluded that aid positively impacts growth in countries with good fiscal, monetary, and trade policies but has little effect otherwise.

Impact on Policy Recommendations and International Agencies

• The Burnside and Dollar (2000) paper led to policy recommendations to increase foreign aid to countries with good policies, without further testing.
• International aid agencies cited the paper to advocate for increased foreign aid.
• The working paper version was reported in a World Bank (1998) report and a British Department for International Development (2000) White Paper.
• The Canadian International Development Agency stated that good governance and sound policy are the most important determinants of aid effectiveness, referencing World Bank researchers.

Influence on the Monterrey Conference and U.S. Policy

• The effectiveness of foreign aid was debated before the U.N. conference in Monterrey, Mexico, in March 2002.
• The Burnside and Dollar (2000) paper was often invoked in discussions about increasing foreign aid, especially regarding the U.S.’s low aid-to-GDP ratio.
• The Economist criticized then-U.S. Treasury Secretary Paul O’Neill’s skepticism, citing the research of David Dollar, Craig Burnside, and Paul Collier.
• An article in The New Yorker supported the idea that aid is effective in countries with sensible economic policies, referencing the Dollar and Burnside study.
• The Financial Times noted that expert opinion favored concentrating aid on countries with good macroeconomic policy and governments committed to improving public services and stamping out corruption.
• James Wolfensohn, then president of the World Bank, argued that corruption, bad policies, and weak governance make aid ineffective but these factors had improved, suggesting a doubling of aid flows.
• President George W. Bush announced a $5 billion increase in U.S. foreign assistance in March 2002, emphasizing the need for legal and economic reform to accompany aid.
• The White House created the Millennium Challenge Corporation (MCC) in November 2002 to administer the increase, using 16 indicators of country performance, including versions of the Burnside and Dollar policy measures.
• The White House stated that aid is only effective in sound policy and institutional settings.

Disquieting Signs for Professional Economists

• A regression result was broadly adopted without sufficient scrutiny of its robustness or broader applicability.

Empirical Evidence on the Links from Aid to Economic Growth

• A long and inconclusive literature existed in the 1960s-1980s due to limited data and debate on specifications and mechanisms.
• Hansen and Tarp (2000) provide an extensive review of this earlier literature.
• Boone (1996) found that aid financed consumption rather than investment, which challenged the notion that aid leads to society-wide transformation through investment and growth.
• Boone introduced political determinants of aid as instruments to address reverse causality.
• Many papers have reacted to the Burnside and Dollar (2000) paper, conducting variations on their specification, including:
  • Hansen and Tarp (2001)
  • Dalgaard and Hansen (2001)
  • Guillamont and Chauvet (2001)
  • Collier and Dehn (2001)
  • Lensink and White (2001)
  • Collier and Dollar (2002)
• These papers introduce variables such as:
  • Aid squared
  • Terms of trade shocks
  • Variability of agricultural output and exports
  • Interactive terms combining aid with terms of trade shocks
• Some papers confirmed that aid only works in a good policy environment, while others found the interaction between aid and policy to be insignificant when particular variables were added.
• A limitation of this literature is the challenge of choosing the appropriate specification without theoretical guidance.

Extensions of the Burnside and Dollar (2000) Approach

• Expanding the dataset to include more recent evidence and exploring how results are affected by different definitions of "aid," "good policy," and "growth."
• Easterly, Levine, and Roodman (2003) used the same specification as Burnside and Dollar (2000) but expanded the dataset to include data from 1970-1997.
• They found that the coefficient on the interaction term between aid and policy was insignificant, failing to support the conclusion that aid works in a good policy environment.
• Even within the original Burnside and Dollar (2000) dataset, the significance of the interactive variable was not robust to other plausible definitions of "aid," "policies," and "growth."

Varying the Definition of "Aid"

• Burnside and Dollar (2000) defined aid as the grant element of aid, excluding the loan component of concessional loans.
• The standard definition of aid according to the Development Assistance Committee of the OECD is grants and concessional loans net of repayment of previous aid loans, known as net Official Development Assistance (ODA).
• Using ODA, the interactive term with aid and policy is no longer statistically significant.

Varying the Definition of "Good Policy"

• Burnside and Dollar (2000) used an index number for good policy that includes the budget surplus, the inflation rate, and a measure of openness.
• The weights of these terms were determined by a regression predicting growth without including foreign aid.
• As an alternative, using the black market premium and financial depth (M2 to GDP ratio) as variables in the policy index.
• Experimenting with the change in the trade-to-GDP ratio in the policy index.
• Using combinations of these variables, weighted according to their power in explaining growth in a regression that left out all aid variables.
• The interactive term of aid and good policy was no longer statistically significant in any of the alternative definitions of the policy index.

Varying the Definition of "Growth"

• Burnside and Dollar (2000) defined growth as real per capita GDP growth over four years.
• Using periods of eight, 12, and 24 years for averages of "aid," "policies," and "growth."
• In the 12-year and 24-year specifications, the interaction term between aid and policy no longer enters significantly.
• The result that aid boosts growth in good policy environments is fragile to defining growth, aid, and policy over a sufficiently short period.
• Alternative period lengths from one to 12 years and for the whole period length of 24 years, using the extended dataset of Easterly, Levine, and Roodman (2003), all yielded insignificant results on the interactive term between aid and policy.
• Empirical links from aid to economic growth are far more fragile than suggested by references to the Burnside and Dollar (2000) paper.
• When carrying out an empirical study, it is crucial to consider what is meant by terms like "aid," "good policy," and "growth."

The Theory of Aid and Economic Growth

• The empirical literature lacked a clear theoretical model by which aid would influence growth and which could pin down the empirical specification of the aid-growth relationship.

The Two-Gap Model

• The "two-gap" model of Chenery and Strout (1966) was the standard model used to justify aid:
  • The first gap is between the amount of investment necessary to attain a certain rate of growth and the available domestic saving.
  • The second gap is the one between import requirements for a given level of production and foreign exchange earnings.
  • At any moment in time, one gap is binding and foreign aid fills that gap.
• The model built on earlier work by Arthur Lewis (1954) and Walt Rostow (1960).
• Rostow promised that an aid-financed increase in investment would launch a "takeoff into self-sustained growth."

Model Specification

• The model is:
  • g = \frac{1}{\nu} \cdot \frac{I}{Y}
  • \frac{I}{Y} = \frac{A}{Y} + \frac{S}{Y}
  • Where:
    • I is required investment
    • Y is output
    • g is target GDP growth
    • A is aid
    • S is domestic saving
    • \nu is the incremental capital-output ratio (ICOR)
• The ICOR gives how many units of additional capital are required to yield a unit of additional output.
• The model assumes a stable linear relationship between investment and growth over the short to medium run.
• It grows out of a Leontief-style production function with fixed requirements for capital and labor per unit of output.
• Most economists since Solow (1957) have felt uncomfortable with a Leontief-style production function that does not allow the substitution of labor for capital.

Criticisms of the Two-Gap Model

• On theoretical grounds, there are reasons to doubt whether the ICOR is a constant and thus whether the relationship from investment to growth is linear.
• In a Solow-style neoclassical model, an exogenous increase in investment will raise growth temporarily during the transition from one steady state to another, but no permanent causal relationship exists between investment and growth.
• In endogenous growth models, the ICOR would change with other inputs, and so there would not be a stable linear relationship between investment and growth, nor would the ICOR measure "investment quality" in this case either.
• Another key assumption is that aid will actually finance investment rather than consumption, which will hold true only if investment is liquidity-constrained and incentives to invest were favorable.
• Aid could worsen incentives to invest if the recipient believes that future poverty will call forth future aid (the classic “Samaritan’s dilemma”).

Empirical Testing of the Financing Gap Model

• Easterly (2001) tested the “financing gap” model using time series data.
• The test involved determining how many countries show a significant and positive effect of foreign aid on investment, with a coefficient greater than or equal to one.
  • Of 88 aid recipient countries, only six passed the test.
• The next step was to run a regression for each country where the dependent variable is the growth rate and the independent variable is the rate of investment.
  • Four countries out of 88 passed the tests of a positive and significant relationship between growth and investment, a constant not significantly different than zero, and an ICOR between 2 and 5.
• Tunisia was the only country that passed both tests.

Simulation of Growth Outcomes

• To dramatize the gap between the predictions of the financing gap model and the actual outcome, simulated growth outcomes that would have occurred if aid always caused investment to rise and investment always caused growth.
• The “financing gap” model has dubious theoretical foundations and numerous empirical failings.
• It continues to be used today in the World Bank and other institutions making aid policy.
• The World Bank (2002a) calculated the aid requirements of meeting the “Millennium Development Goal” of cutting world poverty in half, it explicitly acknowledged using the “two-gap model”.

Aid Institutions: Moving the Money

• Economists in aid policy institutions may feel uncomfortable but the idea that "aid buys growth" is an integral part; however aid bureaucracies define their final objective as "poverty reduction" and their immediate output as aid money disbursed..
• A donor organization’s sense of mission relates to the commitment of resources, the moving of money.
• The estimates of total capital needs for development assistance in relation to supply seem to have been the implicit standard by which donor organizations have guided their behavior and judged their performance.
• The World Bank (1998) noted in its report Assessing Aid that a stress on disbursing aid had continued: “Disbursements (of loans and grants) were easily calculated and tended to become a critical output measure for development institutions. Agencies saw themselves as being primarily in the business of dishing out money.”
• The stress on aid disbursements is understandable given the peculiar nature of the aid mechanism.
• The beneficiaries are supposed to be the poor, who have little voice in their own governments, much less in the high-income country governments who control the aid agencies.
• One can hardly monitor growth itself for a given country for a given year, since growth in any given year or even over a few years reflects too many other factors besides aid.
• Even when economic performance is clearly deteriorating despite important and rising aid, the aid bureaucracies try to finesse the issue by promising that better times are “just around the corner.”

Selectivity in Foreign Aid

• The new theme in foreign aid, inspired in part by the work of Burnside and Dollar (2000), is greater selectivity.
• Examples of foreign aid being successful included:
  • The World Bank’s $70 million loan to the Ceara state government in the Brazilian northeast concluded in June 2001.
  • Countrywide success stories like Uganda.
  • Earlier success stories associated with aid included South Korea and Taiwan.
  • Sectoral success stories, like the elimination of smallpox.
• Numerous examples of aid failing. One example is:
  • A Canadian aid project to help farmers in the mountains of Lesotho gain access to markets and develop modern methods of livestock management and grain production.
  • The $45 million World Bank Roads Rehabilitation and Maintenance Project in Sierra Leone, disbursed in the middle of brutal civil war during 1998–2001.
• Aid agencies have two broad sets of tools for this task:
  • Imposing conditions on loans before they are granted
  • Evaluating the effect of loans after they are completed.
• Aid agencies often place conditions on loans and aid including: Macroeconomic stability (low-budget deficits and inflation), noninterference with market pricing, privatization of state-owned enterprises and openness to international trade.
• However, the agencies then often provide additional future loans with little regard for the performance on previous loans. This problem arises for both the World Bank and the International Monetary Fund.
• A common reason for aid to be given even after conditions are violated is that with high political instability, a new government took power and was given a clean slate by the aid agencies.
• President John F. Kennedy (Message to Congress, April 2, 1963) described: “objective No. 1: To apply stricter standards of selectivity . . . in aiding developing countries.”
• The new selectivity is supposed to be about rewarding countries that reform on their own, in contrast to structural adjustment that is now alleged to have imposed reforms on countries. ,

Evaluation

• Despite the potential benefits of learning from past experience, aid agencies seem reluctant to promote honest evaluations that could lead to publicity about failures.
• Aid agencies typically give low priority to evaluating projects after completion.
• There is virtually no systematic evaluation of projects by nongovernmental organizations, and they face some of the same incentives as official agencies to emphasize observable effort rather than focus on less observable results.
• Increasing evaluation of the aid agencies need not be especially costly.
• The development literature has increasingly stressed scientific evaluation of interventions through controlled experiments.

A Realistic Vision for Foreign Aid

• Aid agencies should set more modest objectives than expecting aid to “launch the takeoff into self-sustained growth.”
• The idea of aggregating all this diversity into a “developing world” that will “take off” with foreign aid is a heroic simplification.
• The goal of having the high-income people make some kind of transfer to very poor people remains a worthy one, despite the disappointments of the past.
• But the appropriate goal of foreign aid is neither to move as much money as politically possible, nor to foster societywide transformation from poverty to wealth. The goal is simply to benefit some poor people some of the time.
• If some of the flaws noted in this article can be corrected, the international aid agencies could evolve into more effective and more accountable agencies.
• Improving quality of aid should come before increasing quantity.
• It is positive when some aid dollars can reach some very needy people some of the time. This is possible, for a water aid system benefited a community in Ethiopia.

Appendix

Alternative Definitions of Aid, Policies and Growth

• Alternative Definition of Aid and Defining the Variables:
  *Appendix Table 1, the dependent variable is per capita growth of GDP, from World Bank (2002d).
  *The first column repeats the results of Burnside and Dollar (2000), using their Effective Development Assistance (EDA) definition of foreign aid.
  *An alternative measure of policy effectiveness is the weighted average of the balanced budget, inflation and Sach-Warner variables.
• Alternative Definitions of Good Policy
  *Appendix Table 2 examines alternative definitions of good policy.
  *The first column uses the black market premium and the measure of M2/GDP to create an index of policy effectiveness, but leaves out the Sachs-Warner definition.
  *The second column adds the change in trade share to the policy index in the first regression.
  *The last two columns again use these alternative measures of sound policy, but instead of using an ordinary least squares approach, they use a two-stage least squares approach.
  *Alternative Time Frames for Economic Growth
  *Appendix Table 3 examines alternative definitions of economic growth, achieved by varying the blocks of time.
  *Burnside and Dollar grouped their data into four-year blocks.
  *The first three columns use an ordinary least squares regression and time periods of eight, 12 and 24 years; the remaining columns repeat this exercise using a two-stage least squares regression.
  *In only one case is the interactive term on aid and policy statistically significant.
  *Further, as noted in the text, when this exercise is repeated with the expanded dataset from Easterly, Levine and Roodman (2003), none of the interactive aid-policy coefficients are significant regardless of what blocks of time are used.