Should Development Aid Promote Innovation?

-Pratap Thapa 4181441

Introduction
Nearly $3 trillion has been provided as development aid over the last 50 years with the motive of enhancing economic and social welfare of poor and developing countries. The empirical evidence on how well aid has been able to achieve this motive is decidedly mixed, with some research showing little or no relationship between aid and development and others showing a positive impact (Perkins, Radelet, & Lindauer, 2006). This mixed record has led to sharp debates on whether development aid is helpful at all for poor countries to grow in a sustainable way. On the one hand several authors strongly criticize aid and claim it to be not at all effective (Bauer, 1972), (Easterly, 2006) (Moyo, 2009), while there are others who claim aid as an important ingredient in fighting poverty and accelerating economic growth (Goldin, Rogers, & Stern, 2004), (Sachs, 2012), (Stiglitz, 2006). In general, those who say it never works are as wrong as those who say it works miracles (Perkins, Radelet, & Lindauer, 2006). Several initiatives are introduced in recent years to improve development aid such as cash on delivery aid, independent evaluation, selectivity and aid transparency (Morris, 2011). This essay does not address the already ubiquitous issue of aid effectiveness and instead proposes one way development aid should be provided in the future to achieve its objective of accelerating sustainable economic growth of developing countries: Development aid should aim at promoting innovation in developing countries because innovation leads to self-sustained economic growth. In defending the thesis, it is argued that innovation is important driver of economic growth for developing countries. Arguments about what kind of innovation should developing countries pursue, why development aid is needed to foster innovation and under what conditions will such aid for innovation is likely to be successful is presented in the essay. In the final section what limitations of the present system of development aid can be overcome by the proposed system are discussed. Of the several forms of aid, this essay focuses only on the large amount of money transferred from government to government, or via institutions such as the World Bank targeted at providing economic growth of developing countries. The term aid in this essay does not indicate other form of aid such as humanitarian or emergency aid, or aid provided with vested political interests. The development aid provided to promote innovation either in the form of capital investment to private sector or to improve the support framework such as governance and infrastructure is termed as innovation aid in the essay.

Should Development Aid Promote Innovation?

Innovation and Economic Growth of Less Developed Countries

Innovation is one of the most important drivers of economic growth of a nation. The role of innovation in economy of developed nations is well known and documented (Rosenberg, 2004). Although, contribution of innovation in the developing economy is not as straightforward, innovation plays a significant role in economic growth of developing countries as well (Acs, 2007). According to the World Bank, one of the important lessons learnt over the years of studying development process in developing countries is that private- sector growth fueled by innovation is most essential to long term development (Goldin, Rogers, & Stern, 2004). Schumpeters theory of creative destruction also emphasizes the importance of innovation and describes development as the basic transformation of economy brought about by creativity, innovation and entrepreneurial function (Schumpeter, 1964). Innovation stimulates entrepreneurship and small enterprise creation by private sector and in turn creates employment opportunities. Importantly, employment provides the main long-term route out of poverty, and the vast majority of the worlds poor workers are employed in the private sector, not the public sector (Goldin, Rogers, & Stern, 2004). Moreover, few of these private-sector jobs are in large firms; most of the worlds poorest people work in small firms, most notably small farms. Enterprises and employment help improve countrys revenue base in terms of increased tax revenues. This would imply that the nations government will receive more revenues from within the country and can be less dependent on foreign aid for development initiatives (Perkins, Radelet, & Lindauer, 2006) (Goldin, Rogers, & Stern, 2004). Development economists distinguish three major stages of development (Acs, 2007). In the first stage, the economy specializes in the production of agricultural products and small-scale manufacturing. In the second stage, the economy shifts from smallscale production toward manufacturing. In the third stage, with increasing wealth the economy shifts away from manufacturing toward services. Most of the lower and middle income countries which receive development aid are in the first stage of development (Acs, 2007). This first stage is marked by high rates of agricultural and non-agricultural self-employment. Sole Proprietorships account for most small manufacturing and service firms. Studies show that such self-employment although important for sustaining economy, does not lead to significant economic growth because there is no mechanism to link the activity to development. Additionally, the distinction has to be made between necessity entrepreneurship, which is having to become entrepreneur because you have no better option from opportunity entrepreneurship, which is an active choice to start an enterprise based on the perception that an unexploited or underexploited business opportunity exists and innovating to take the opportunity (Acs, 2007). Research shows that rising levels of economic development is seen when more and more people leave necessity entrepreneurship (self-employment) and move towards opportunity entrepreneurship (Acs, 2007).Innovation lies at the core of the opportunity entrepreneurship (Acs, 2007). With continuous innovation, such opportunity based enterprises grow bigger and create more employment, thus removing more people from self-employment and employing them in a specialized task within the enterprise and the country starts to enter the second stage of economic development. Furthermore as Adam Smith wrote in his book Wealth of nations, when the division of labor increases, so will economic development (Smith, 1904). As opportunity entrepreneurship leads to economic growth, the business environment becomes even more favorable for more opportunity entrepreneurship (Acs, 2007) and thus will have a positive feedback on the economy. 2

Should Development Aid Promote Innovation? If we look back at the history of transition of less developed countries to developing and developed nations, innovation has always remained in the forefront. Perhaps the best example of innovation leading to economic development is the green revolution that took place in Asia and South America in the late 1960s and 1970s (Goldin, Rogers, & Stern, 2004). Food productivity doubled in the period of 20 years significantly improving food security for large population and helping to bring certain population out of poverty. Several innovations in seeds, fertilizers, pesticides and mechanization of agriculture took place during this period (Hazell, 2009) .If we look at more recent examples of growing economies like India and China, innovation in Information Communication technology has been one of the most important drivers of their economic growth (Franda, 2002). However, it is important to also note that the green revolution has not been able to replicate the same success in Sub-Saharan Africa despite several efforts (Goldin, Rogers, & Stern, 2004). This brings the point that innovation alone is not sufficient to lead to economic growth and requires other requisites as well. Some of such requirements for innovation to lead to economic growth and how development aid can be of help will be discussed in the following sections.

What kind of innovation?

In the previous section, the impact of innovation on economic development of the nation is presented. When it comes to less developed nations, it is important and to discuss what specific forms of innovation 1 will be important and feasible, given limited knowledge resource and infrastructure. When term innovation is used, quite often we tend to think of the high-tech innovations in the field of information and communication technologies, electronics, biotechnology, nano-technology and pharmaceuticals. It is unlikely that less developed nations will be able to take on such high-tech innovations with the limited resources and infrastructure and. However, other forms of innovation pertaining to strengths of such less developed nations can be attractive and viable. Innovation especially in the labor intensive industries such as textile and agriculture can provide significant competitive advantage to the developing nations, as availability and affordability of labor is better in such nations compared to the developed nations. Similarly, capable developing nations can also plan strategically to innovate in sustainable technologies which most likely to play important role in the future. Again, with in sustainable technologies, developing countries need not necessarily focus at the high-tech end. Innovative use and development of simple technologies developed in the past (like improvised water wheel for irrigation purpose) can help such nations be less dependent on imported fossil fuels and technologies. Similarly, innovative solutions to solve local problems can be an attractive, as local people know best of what they need and what is possible. However, there are no prescriptive one-size-fits-all categories of innovation and

Innovation is defined in various ways by several experts, although the essence of the meaning remains the same. Management guru Peter Drucker defines innovation as change that creates a new dimension of performance. Economist Joseph Schumpeter defines innovation more specifically as the introduction of new goods, new methods of production , the opening of new markets, the conquest of new sources of supply and the carrying out of a new organization of any industry. The use of the term innovation in this essay is in line with these two definitions.

Should Development Aid Promote Innovation? each country should focus on country-specific strengths and resources and innovate accordingly.

Development Aid and Innovation

The aim of development aid to enhance economic and social welfare of developing countries can be translated into two different objectives: transformation objective and solidarity objective (Rajan & Subramaniam, 2007). The transformation objective views development assistance as a temporary catalyst to accelerate economic growth in developing countries and make them self-reliant. On the other hand the solidarity objective views development aid as the assistance to provide humanitarian relief and create access to basic health, education and infrastructure facilities and help improve peoples life today as development activity is going on in their country. Empirical evidence shows that development aid has been able to meet the solidarity objectives relatively better than the transformation objective of accelerating economic growth (Moyo, 2009). This essay argues that development aid needs to change and direct to foster innovation in developing countries to meet its transformation objective and. Part of such Innovation aid should be provided as capital investment to the private sector and part of it should be directed to create suitable governance system and infrastructure to facilitate investment environment. Two questions arise: first is a normative one, is it justifiable to direct development aid towards supporting profit making innovative initiatives rather than providing direct support to the poorest of people? As discussed earlier, innovation is an important tool to achieve economic growth which is the transformational objective of development aid. It should be noted that although aid may not flow directly to the poorest of people when directed at innovation activities, such innovation will ultimately lead to creation of jobs and economic activities to the poor people as well. Part of aid should continue to be provided to meet the solidarity objectives and only a part of what is provided to meet the transformation objective should be directed towards stimulating innovation. The objective of development aid will not change in this case, only the way of execution is changed. From donors trying to help with readymade solutions to change the world, the paradigm shifts to finding people who are doing things and supporting them to change the world. The second question is a descriptive one, why do developing countries need development aid to innovate? To answer this, it is important to look at the factors why less developed countries struggle to innovate. Poor countries are unable to generate sufficient amounts of saving on their own to finance the investment necessary to innovate and initiate growth, or if they do they can only finance only very slow growth (Goldin, Rogers, & Stern, 2004). Aid adds to the total amount of saving, which increases investment and the capital stock, which in turn accelerates the rate of economic growth (Goldin, Rogers, & Stern, 2004). Access to finance has been cited as the most important hindrance to innovation and entrepreneurship in developing countries along with the trade red tape (Easterly, 2006). Similarly investment climate in most of the less developed countries is not lucrative enough to attract much foreign direct investment (Easterly, 2006). To some extent, investors are reluctant invest in less developed countries due to prevalent political instability and diseases (Easterly, 2006) (Rajan & Subramaniam, 2007). Development aid has traditionally been focusing on these issues, and innovation should be promoted as a complement to the existing focus rather than a substitute.

Should Development Aid Promote Innovation?

Conditions required for Success of Innovation Aid

Development aid is a small amount of money. Making grandiose statements and creating huge expectations that development aid alone will be able to solve all the problems is futile and is one of the mistakes advocates of development aid have done in the past. A realistic analysis of what innovation aid can achieve and the necessary conditions for it to be successful is essential. It is also noteworthy that past experience shows neither central planning approach followed by many countries in 1950s and 60s, nor the minimal-government freemarket approach advocated by many in the 1980s and 90s will achieve the goals of development aid (Goldin, Rogers, & Stern, 2004). A middle path is necessary with private sector leading the development process and government providing necessary governance framework, facilitation of physical infrastructure, human capital investments and social cohesion (Goldin, Rogers, & Stern, 2004). This implies that the fund for spurring innovation should be directed both as capital investment to promote innovation as well as to develop and establish necessary support framework. Such support framework would include business incubators and financial institutions for start up support in addition to the fundamental governance, knowledge and infrastructure facilities. Furthermore, such innovation aid will not be feasible and successful for all the less developed countries. Selection must be made for suitable economies where the basic infrastructure is available, political system is relatively stable, basic governance system is established and fundamental knowledge base is created. This would imply that such aid will not be effective in the poorest of nations and the initiative should be taken from lower and upper middle income countries. Countries such as Vietnam, Mozambique, Uganda, Kenya, Senegal and Tanzania where development aid has been relatively successful in the past in establishing proper governance system and providing basic infrastructure (Goldin, Rogers, & Stern, 2004) can be appropriate candidate for such initiatives. Meanwhile, the experience and knowledge gained form such countries should be applied to the least developed countries and development aid in such countries should also start supporting innovation gradually, as the basic infrastructure of such countries improve.

How is innovation aid better than the present system?

Looking at the past empirical evidence there is no apparent simple relationship between aid and economic growth (Perkins, Radelet, & Lindauer, 2006). Nevertheless, some reasons for failure of current system of providing aid especially in Sub-Saharan Africa have been identified. Some of the indentified reasons are mentioned below and arguments about how directing development aid towards innovation can overcome these factors to some extent are explained. One of the problems of current provision of development aid is associated with moral hazard2. Recipient of development aid is not responsible at proper implementation of such aid and does not look to improve its own capabilities (Amegashie & Ouattara, 2007) .This problem of moral hazard can be reduced by increasing accountability of the recipient (Easterly, 2006). Part of the innovation assistance provided as capital investment to private enterprise can be controlled for misuse as the private enterprise can be held accountable for misuse of such funds. However, the problem of accountability will pertain for part of the innovation fund directed to government.
2

Moral Hazard is a situation where there is a tendency to behave irresponsibly and take undue risks because the costs are not borne by the party taking the risk

Should Development Aid Promote Innovation? Similarly, the second problem of present development aid system is imperfect information3 and lack of transparency (Gibson, Anderrson, Ostrom, & Sujai, 2005). Since all the development aid activities do not have clear performance indicators, imperfect information exists and the donor governments are well informed only to the extent of accuracy of reports provided by recipient governments (although some form of audit can be performed by donor organizations). Solution to this problem would be to provide result oriented development aid. Since outcomes of innovation are visible and measurable (through measures like return on investment), the problem of imperfect information will be overcome to some extent. Such clear performance indicators also help to make aid flow more transparent. However, success of such innovation aid would still depend on robustness of the governance system of the recipient countries, and governance as such cannot be directly improved even with the proposed form of innovation aid.

Conclusion
Not just the aid pessimists but also the optimists would agree that development aid needs some changes to attain its transformation objective more effectively. To achieve this aim, development aid should promote innovation in developing countries. Innovation leads to opportunity entrepreneurship and employment leading the country to a self-sustained economic growth as the revenue base of the country increases. Additionally, developing nations need development aid to promote innovation. Development aid should provide capital investment as well as help in establishing and improving the support framework. Providing innovation aid lies within the objective of development aid although provided to private enterprises having profit making intent. Developing nations should focus on innovation pertaining to country specific strengths. Innovation aid may not be equally effective for all countries, lower and upper middle income countries with established governance and infrastructure system are likely to benefit most from innovation support. Innovation aid helps overcome some of the issues associated with present form development aid and hence would become more effective.

Imperfect information is a situation in which the parties to a transaction have different information and one party tends to have more information than the other.

Should Development Aid Promote Innovation? References Acs, Z. (2007). How is Entrepreneurship Good for Economic Growth? MIT Press . Amegashie, J. A., & Ouattara, B. a. (2007). Moral Hazard and the Composition of Transfers: Theory with an Application to Foreign Aid. MPRA . Bauer, P. (1972). Dissent on Development. Harvard University Press. Easterly, W. (2006). The White Man's Burden : Why the West's Efforts to Aid the Rest Have Done so Much Ill and so Little Good. New York: The Penguin Press. Franda, M. (2002). China and India Online: The Politics of Information Technology in the World's Largest Nations. Rowman & Littlefield Publishers, Inc. Gibson, C., Anderrson, K., Ostrom, E., & Sujai, S. (2005). The Samaritan's Dilemma : The Political Dilemma of Development Aid. Oxford Scholarship Online. Goldin, I., Rogers, H., & Stern, N. (2004). The Role and Effectiveness of Development Assistance : Lessons from World Bank Experience. Washington D.C.: The World Bank. Hazell, P. B. (2009). The Asian Green Revolution. International Food Policy Research Institute. Morris, M. (2011, 2 7). Aid Innovations: 21st Century Aid. Retrieved 5 2, 2012, from Development Policy Blog : http://devpolicy.org/aid-innovations/ Moyo, D. (2009). Dead Aid: Why Aid is not Working and How there is Another Way for Africa. London: Farrar, Straus and Giroux. Perkins, D. H., Radelet, S., & Lindauer, D. L. (2006). Economics of Development. New York: W. W. Norton & Company. Rajan, R. G., & Subramaniam, A. (2007). Aid and Growth: What Does the CrossCountry Evidence Really Show? Review of Economics and Statistics . Rosenberg, N. (2004). INNOVATION AND ECONOMIC GROWTH. OECD . Sachs, J. D. (2012, 05 31). Aid Works. Retrieved 6 4, 2012, from Project Syndicate: http://www.project-syndicate.org/commentary/aid-works Schumpeter, J. (1964). Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process. New York: McGraw Hill Book. Smith, A. (1904). An Inquiry Into the Nature and Causes of the Wealth of Nations . London: Methuen & Co., Ltd. Stiglitz, J. (2006). Aid for Trade. http://works.bepress.com/cgi/viewcontent.cgi?article=1008&context=joseph_stiglit z.