12/15/2017 Aid to the rescue - Free exchange

Free exchange
Aid to the rescue
New research suggests that development aid does foster growth—but at what cost?

Print edition | Finance and economics Aug 14th 2014

FIFTY years ago the first United Nations

Conference on Trade and Development launched a
debate about how much money rich countries
should give to poor ones to reduce poverty and
bolster growth. In the end, the UN settled on a
figure of 0.7% of national income—a target subsequently reaffirmed by endless
international powwows. Although few countries have met it, aid spending in real
terms has nonetheless increased steadily ever since, to $134.8 billion in 2013 (see
left-hand chart). Yet economists are still arguing about how much the aid helps—if
it helps at all.

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12/15/2017 Aid to the rescue - Free exchange

What the UN sees as a potent weapon against poverty, others consider money down
a rat hole. Critics reckon aid hurts its recipients by fostering dependency, propping
up oppressive or incompetent regimes and pushing up the value of poor countries’
currencies, thereby undermining the competitiveness of their exports. If aid
helped, they say, the poorest countries would have been getting steadily richer for
decades, which they have not (see right-hand chart). Those who favour giving aid
argue that it could indeed lift people out of poverty, but rich countries simply do
not give enough. It is like sending fire engines to combat a wildfire: it only works if
you send a lot of them.

Assessing the impact of aid on economic growth is complicated by the fact that the
causality is not always clear. A positive relationship between the two could simply
mean that rich countries reward poor ones for implementing policies that would
have helped their economies whether or not they had brought in money.
Conversely, a negative relationship may just mean that more aid flows to the
countries with the most sluggish growth. In neither instance would aid actually be
driving growth.

To get around this problem, economists have long hunted for a factor that affects
the amount of aid disbursed but is not otherwise correlated with growth—an
“instrumental variable”, in the jargon. Finding one is harder than it seems. Many
proposed candidates—such as the size of a poor country’s population or even the
colonial empire to which it used to belong—have been found by subsequent
studies to have an independent connection to economic performance after all.

A recent paper (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2400752)

by Sebastian Galiani and Ben Zou of the University of Maryland and Stephen Knack
and Colin Xu of the World Bank proposes a new instrumental variable. After
developing countries escape abject poverty, as defined by the International
Development Association, an arm of the World Bank, donors usually cut their
handouts to focus on poorer places instead. The IDA’s threshold is a certain level of
average income per person—$1,205 this year—a definition that takes no account of
how fast income is rising. So if reaching the cut-off takes a toll on growth, the drop
in aid is the likely culprit.

That is indeed what the authors find. By looking at the sums received by 35
countries before and after passing the threshold, they estimate that for every 1% of
national income a country receives in aid, annual growth in real income per person
rises by about a third of a percentage point in the short term.

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12/15/2017 Aid to the rescue - Free exchange

Aiding and vetting

To be sure, most of the countries in question were at a similar level of
development; the sample did not include the very poorest, because their incomes
are still below the threshold. Moreover, there are drawbacks to studies involving
lots of countries, since they combine so many kinds of aid delivered in wildly
varying conditions. But other studies have yielded similar findings.

In a paper published in 2011 Markus Brückner, then of the University of Adelaide,

estimates the impact of aid on 47 countries between 1960 and 2000. Donors tend to
give less to faster-growing countries, he says, which can produce a negative
correlation between growth and aid. By looking at periods when severe weather
and dramatic shifts in commodity prices had big impacts on growth, Mr Brückner
identified variations in foreign aid that were not driven by changes in income per
person. He found that a 1% rise in foreign aid lifted growth in income per person by
about 0.1 percentage points.

Osborne Jackson of Northeastern University in Massachusetts looked at instances

of donors boosting aid across the board when one of the countries they are
assisting suffers a natural disaster (thus, the windfall in countries spared the
disaster is not linked to economic growth). He concluded that aid increases
household consumption, which spurs growth in the short term, but not in the long
run. A study by the World Institute for Development Economics Research has
reviewed all peer-reviewed papers on aid and growth published since 2008. It
concludes that the evidence that aid boosts growth is itself growing rapidly.

Whether that extra growth constitutes good value for money is another question.
Unfortunately, there have been few studies of the cost-effectiveness of aid. A
forthcoming analysis by Chris Doucouliagos of Deakin University and Martin
Paldam of Aarhus University of 141 studies published between 1970 and 2011 finds
that the average estimated effect of aid on growth is positive and statistically
significant, but so small that it may not be terribly meaningful. Advocates of freer
trade or more liberal immigration regimes contend that the economic benefits of
such measures for poor countries far outweigh those of aid. Supporters of the 0.7%
target can take comfort in the growing evidence that aid boosts growth; but they
have more work to do to demonstrate that it boosts it by more, and at lower cost,
than the alternatives.

Studies cited in this article:

“The Effect of Aid on Growth: Evidence from a Quasi-Experiment

(http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2400752) ”, by Sebastian Galiani, Stephen

Knack, Colin Xu and Ben Zou, SSRN working paper, June 2014

“On the Simultaneity Problem in the Aid and Growth Debate

(http://onlinelibrary.wiley.com/doi/10.1002/jae.1259/abstract) ”, by Markus Brückner, Journal of

Applied Econometrics, January/February 2013

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12/15/2017 Aid to the rescue - Free exchange

“Natural Disasters, Foreign Aid and Economic Growth (http://papers.ssrn.com/sol3/papers.cfm?

abstract_id=2329404) ”, by Osborne Jackson, SSRN working paper, February 2014

Sign up or subscribe to read more
“Aid, Growth and Employment

(http://recom.wider.unu.edu/sites/default/files/Position%20paper%20on%20Aid%2C%20Growth%20and%20Employ
Subscribe: 12 weeks for £12
”, UNU-WIDER position paper, May 2014

“Finally a breakthrough? The recent Sign up:

rise in 3 articles
the perestimates
size of the week of aid effectiveness
(http://www.martin.paldam.dk/Papers/Meta-AEL/Structural%20break.pdf) ”, by Hristos

Doucouliagos and Martin Paldam. From the forthcoming “Handbook on the Economics of Foreign

Aid”, edited by Mak Arvin, Edward Elgar, 2015

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