What are the pros and cons of foreign aid?

What are the pros and cons of economic aid to poorer countries?

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  Development aid (also development assistance, international aid, overseas aid or foreign aid) is aid given by governmental and economic agencies to support the economic, social and political development of developing countries. Development aid may come from developed or developing country governments as well as from international organizations such as the World Bank. It is distinguished from humanitarian aid as being aimed at alleviating poverty in the long term, rather than alleviating suffering in the short term (Foreign aid, on the other hand, includes both development aid and humanitarian aid. Some governments include military assistance in the notion "foreign aid", although many NGOs tend to disapprove of this). Historically the term used for the donation of expertise has been technical assistance. Official Development Assistance The nations of the Organisation for Economic Co-operation and Development (OECD), made up of the developed nations of the world, have committed to providing a certain level of development assistance to underdeveloped countries. This is called Official Development Assistance (ODA), and is given by governments on certain concessional terms, usually as simple donations. It is given by governments through individual countries' international aid agencies (bilateral aid), through multilateral institutions such as the World Bank, or through development charities such as Oxfam. The offer to give development aid has to be understood in the context of the Cold War. The speech in which Harry Truman announced the foundation of NATO is also a founding document of development policy. "In addition, we will provide military advice and equipment to free nations which will cooperate with us in the maintenance of peace and security. Fourth, we must embark on a bold new program for making the benefits of our scientific advances and industrial progress available for the improvement and growth of underdeveloped areas. More than half the people of the world are living in conditions approaching misery. Their food is inadequate. They are victims of disease. Their economic life is primitive and stagnant. Their poverty is a handicap and a threat both to them and to more prosperous areas. For the first time in history, humanity possesses the knowledge and skill to relieve the suffering of these people.“ Development aid was aimed at offering technical solutions to social problems without altering basic social structures. The United States was often fiercely opposed to even moderate changes in social structures, for example the land reform in Guatemala in the early 1950s. The literature that has evaluated the role of foreign aid in development falls into two broad categories. A substantial empirical literature attempts to analyze the effects of foreign aid on economic growth using statistical models and aggregate data on economic and foreign aid for large numbers of countries. A second body of literature attempts to understand the role of foreign aid in development in a more qualitative fashion, relying on in-depth research or case studies of particular foreign aid programs. The empirical literature thus far is inconclusive. The qualitative literature generally argues that foreign aid can help development if the policy environment is favorable to growth. Ever since the pathbreaking analysis by Hollis Chenery and Alan Strout, there has been considerable interest in what might be called the econometrics of foreign aid. Those authors developed the "two-gap" model of development.(16) According to that model, to achieve a given growth rate, a developing country must have adequate savings for investment and sufficient foreign exchange to buy the capital goods necessary for development from the international market. If a country is deficient in either area, then foreign aid can fill the gap either by providing foreign saving to supplement inadequate domestic saving or by providing the necessary foreign exchange to buy the goods and services in the international market that the country requires for development but cannot produce on its own. Thus, by specifying a particular growth rate and holding productivity constant, one can determine the amount of aid needed to achieve that growth by subtracting the domestic saving rate from the growth rate or subtracting export earnings from import requirements. The larger of the two gaps is the amount of foreign aid the country needs to achieve the given growth rate. Foreign aid will "fill two gaps at once" because foreign aid provided as foreign exchange can be used to buy imported capital goods and can supplement domestic saving directly. Chenery and Strout analyzed data for 50 developing nations. For each country, they measured the growth rate of GNP, the rate of investment, the rate of domestic saving, and the propensity to export and import. Using those values, they identified countries that were likely to benefit from an infusion of external resources because their own saving were inadequate, as well as others for which greater aid might be of limited value. But Chenery and Strout assumed that foreign assistance would be productive if inadequate saving or foreign exchange was the constraint on growth. A number of other economists have attempted to measure statistically the extent to which foreign aid encourages economic development. Two separate, though related, issues are of interest to analysts and policymakers: Do the projects funded through foreign assistance programs yield a positive economic return, and do the projects achieve the objective set for them? To explore the first issue, the multilateral lending agencies, for example, regularly assess the returns on the projects funded by their loans and periodically compile them into an overall assessment of effectiveness. According to their analyses, foreign aid projects, as a whole, appear to yield favorable rates of return. A 1995 study by the World Bank found an average rate of return of 17 percent on projects completed between 1990 and 1994. Assessments by the Asian Development Bank and the Inter-American Development Bank have yielded similar results. To determine whether projects achieve their objectives--for example, the construction of a road or hospital--a team of researchers reviewed project evaluations from the early 1980s. They concluded that projects, on average, produce satisfactory results. As evidence, they cited the findings of eight major agencies that had evaluated a large number of their projects. Their evaluations indicated that two-thirds to three-quarters of the projects broadly achieved their objectives. Not all analysts would accept project results as definitive proof of the effectiveness of aid. Project evaluations, though useful in judging the performance of lending institutions and their staffs, do not capture the overall economic effects of aid, whether positive or negative. Proponents of aid might argue that the transfer of technology and knowledge that accompanies many major aid efforts could have important spillover benefits that the agencies' assessments do not capture. For instance, a major construction project may equip workers with skills that they will retain and continue to use after that particular project is completed. Conversely, the construction of a dam to generate hydroelectric power may succeed in the sense that electricity is produced, but it may have disastrous environmental consequences for the neighboring villages, wildlife, and other natural resources. Critics of foreign assistance argue, however, that the receipt of such aid discourages domestic saving. They believe that projects that represent good investment opportunities will be financed in any event using private foreign or domestic funding. The receipt of foreign assistance may simply divert those funds into consumption, for no net gain in total domestic investment activity. For those reasons--and also because aggregate national data are more accessible to the academic scholar than are project data--most empirical studies of development have attempted to determine whether receiving foreign assistance can be shown to be positively related to higher rates of national saving, capital formation, or economic growth. A typical study would gather aggregate national statistics for those variables for some 50 to 100 developing countries. Data would be in the form of annual averages for growth rates, saving rates, and inflows of aid and foreign investment. Data are expressed as a percentage of GDP to avoid weighting the larger nations more heavily in the results. The results of such studies are far less definitive than were analyses of large numbers of project evaluations. If aid does not add significantly to total national saving, it is not likely to promote growth. Early studies, confirmed by more recent investigations, found that foreign assistance contributed little, if any, impetus to saving and instead increased domestic consumption. One reason could be that for most countries, aid flows are simply too small to make a difference in overall national saving rates . Such a conclusion is not inconsistent with the broader aims of foreign assistance programs--improv-ing the health and welfare of the population, promoting democracy, and so forth. But it is inconsistent with the narrower proposition that receipt of aid promotes economic growth. Although the majority of studies have failed to find a link between aid and economic growth, some analysts have obtained more positive results. In particular, a positive correlation between aid, saving, and growth has been established for the group of developing countries in Asia. The overall negative findings can be attributed mainly to the failure of aid to countries in Africa to improve their economies. Gustav Papanek attributes the negative results of studies of foreign aid to statistical biases. In particular, the fact that aid is targeted toward the poorer nations might bias downward the measured correlation between saving or growth rates and the amount of aid received. Using more complex models, some analysts found a positive and significant relationship between the formation of capital and public and private investment flows. In a recent article, N. Gregory Mankiw of Harvard University, after examining empirical models of nations' growth, suggested that the roughly 100 nations for which data on economic performance over recent decades are available offer too few observations to allow scholars to discriminate among the many factors said to contribute to growth, notably including foreign aid. According to Mankiw, the empirical evidence from this body of research is simply too limited to enable analysts to reach strong conclusions. CBO found that the qualitative literature on foreign aid and development strongly suggests that the usefulness of development assistance varies with the quality of a country's governance and the economic policies it pursues. In countries whose policy environment is highly unfavorable to growth, aid is less likely to be productive and contribute to long-term development. According to one group of scholars, "in terms of growth prospects and performance, no amount of foreign assistance can substitute for a developing country's internal policies and incentives for increasing output and improving the efficiency of resource allocation."(19) Development assistance has enabled some countries whose policy environment was not quite as severe to achieve temporarily higher rates of growth than if they had not received aid at all. Although foreign aid may allow developing countries to postpone correcting their economic policies, it may also encourage them to adopt needed economic reforms. Finally, foreign assistance can help strengthen development in countries whose policies do not distort the allocation of resources in the economy.(20) Studies by the World Bank have tended to confirm those broad conclusions. In its 1991 World Development Report, the bank found decreasing rates of return for its aid projects as the overall policy environment deteriorated along various economic indicators (see Table 9). And the World Bank's Wapenhans Report --an extensive inquiry into the effective implementation of aid projects--noted that its "findings support the need for linking strategy, especially in social sectors, even at the project level, to the overall framework of policies at the country level. Even very well designed projects cannot succeed in a poor policy or regulatory environment." Policy Dialogue and Conditionality. In light of the crucial importance of governance and economic policies, foreign aid may be able to help developing countries make appropriate political and economic reforms. Donors can encourage policy reform through two primary means: policy dialogue (donors give aid to create opportunities for policy discussions and interactions with the recipient on key issues such as macroeconomic policy) and conditionality (donors release the aid only if recipients meet certain economic criteria, such as reducing fiscal deficits below certain levels or reducing tariffs by a particular percentage within a specified time frame). In practice, policy dialogue and conditionality are often two sides of the same coin. In the background of even the most benign policy dialogue is the mutual understanding between donor and recipient that aid can be terminated at any time, even if that is unlikely. Yet conditionality in the absence of dialogue is unlikely to occur and is probably too blunt an instrument for achieving the desired objectives of reform. Thus, many aid relationships involve some element of both policy dialogue and conditionality--if policy reform and development are the objectives of the aid--but the balance between the two varies from country to country and donor to donor. The record on the effectiveness of policy dialogue and conditionality is mixed. In the 1950s and 1960s, for example, U.S. aid to some Asian countries involved both policy dialogue and elements of conditionality. That approach yielded some positive results in South Korea and Taiwan but was much less successful in India. More recently, multilateral institutions, particularly the World Bank, have used both tools to encourage recipients to make macroeconomic reforms, and those efforts have also had mixed results. The main mechanism they use is known as structural adjustment lending, a process by which donors make loans to recipients in successive tranches as policy reforms are carried out. Those reforms are usually negotiated between donors and recipients. How successful those efforts have been, however, is not clear. Policy dialogue and conditionality have perhaps been most effective when recipients knew they had to make reforms and wanted to make them but needed some extra political cover to do so. Such economic reforms as cutting government spending, reducing subsidies, and lifting trade barriers are inherently unpopular because they take benefits away from some groups --and in some cases, politically powerful ones. Under those circumstances, foreign aid may lend credibility to a reform effort and soften the negative consequences such reforms may have. More specifically, officials in the recipient country may have realized that such reforms are necessary--either through a dialogue with donors or on their own--but would like the presence of "conditions" so that the onus of making such unpopular changes is shifted to a foreign entity, thereby reducing the political pressure on themselves. According to some scholars, cases of such "phantom" leverage are quite common. Increasing Resources for Investment. The main macroeconomic mechanism by which aid can promote growth is to enlarge the pool of capital available for investment and growth. Even in a favorable policy environment, however, foreign aid may permit domestic resources to be diverted from investment to consumption, with no net effect on growth. Empirical studies of this issue, as was indicated earlier, have yielded inconclusive results. Studies of individual countries are equally inconclusive: aid seems to contribute to saving in some cases but not in others. Providing Public Goods. Foreign aid might help raise the level of investment in the economy by easing the constraints on public funds available for necessary public investments--that is, goods that are important for production and for which the returns cannot be captured and used to repay borrowing; public investments may include infrastructure such as rural roads. Foreign aid might also limit the strains on the domestic tax base and prevent costly distortions. For example, the re-cipient might levy tariffs to fund those public investments if it does not receive aid. According to the Agency for International Development, the success of foreign aid in supporting public investment also varies widely. The Inter-American Highway in Central America was funded largely through foreign aid (though it was not called that at the time), and it has contributed enormously to improving the prospects of growth for Central American countries. But such projects have also failed. Many aid-financed projects languished after their completion, because the recipient government was unwilling or unable to provide adequate maintenance. Increasing Human Capital. Foreign aid might be able to help a country develop its human capital--for example, by supporting elementary education or basic health care. Investment in human capital in developing countries is often more difficult to finance than are physical capital projects. Even in relatively rich countries, private investors are wary of lending for skills and education without a government guarantee for a return on investment. Foreign aid, however, may be able to provide targeted funds for enhancing human capital and thereby raise the economy's stock of skills and, perhaps, stimulate growth. Foreign aid can claim some credit in this area. Aid resources have helped strengthen agricultural production by funding new crop varieties, irrigation programs, and extension practices. They have also played a role in sponsoring research, education, and immunization programs that have led to the control of various diseases such as smallpox, polio, diphtheria, and measles. But simply investing more in physical or human capital will not necessarily lead to fast economic growth. Many countries have invested heavily over long periods but have not grown quickly. Productive investment in human--as well as physical--capital still depends on the policy environment. In the words of the 1995 World Development Report, "Greater investment in human capital can neither compensate for nor overcome an environment inimical to economic growth." In addition, the particular investment choices also matter. For example, the World Bank argues that excessive spending on education bureaucracy and school infrastructure, rather than on teaching staff and supplies, undermines the quality and quantity of schooling. So may investing too much in higher education relative to basic literacy or elementary education. The skills being taught should match the needs and economic opportunities of the country. Facilitating the Transfer of Technology. Another channel through which aid might foster growth is technical assistance and technology transfer. That type of aid promotes growth not by accumulating greater resources but by making existing resources more efficient and effective. Technical assistance programs may also include educating and training government officials who play a large role in creating the policy environment and using foreign aid. Helping developing countries to organize institutions that protect property and minority rights is another example. As in other cases, the success of such programs will probably depend on the political and economic environment in which they operate. For example, according to some analysts, "assistance to encourage agricultural production had a substantially higher payoff in the presence of realistic exchange rate and trade policies." Critisms: Cons ---Aid effectiveness refers to the degree to which development aid works, and is a subject of significant disagreement. Dissident economists such as Peter Bauer and Milton Friedman argued in the 1960s that aid is ineffective. Many econometric studies in recent years have supported the view that development aid has no effect on the speed with which countries develop. Negative side effects of aid can include an unbalanced appreciation of the recipient's currency (known as Dutch Disease), increasing corruption, and adverse political effects such as postponements of necessary economic and democratic reforms. There is also a lot of debate about which form development aid should take in order to be effective. It has been argued that a lot of government-to-government aid was ineffective because it was merely a way to support strategically important leaders. A good example of this is the former dictator of Zaire, Mobuto Sese Seko, who lost support from the west after the cold war had ended. Mobuto, at the time of his death, had a sufficient personal fortune (particularly in Swiss banks) to pay off the entire external debt of Zaire. Another major point of criticism has been that western countries often project their own needs and solutions onto other societies and cultures. As a result of this criticism, western help in some cases has become more 'endogenous', which means that needs as well as solutions are being devised in accordance with local cultures. It has also been argued that help based on direct donation creates dependency and corruption, and has an adverse effect on local production. As a result, a shift has taken place towards aid based on activation of local assets and stimulation measures such as microcredit.Aid has also been ineffective in young recipient countries in which ethnic tensions are strong: sometimes ethnic conflicts have prevented efficient delivery of aid. In some cases, western surpluses that resulted from faulty agriculture- or other policies have been dumped in poor countries, thus wiping out local production and increasing dependency. In several instances, loans that were considered as irretrievable (for instance because funds had been embezzled by a dictator who has already died or disappeared), have been written off by donor countries, who subsequently booked this as development aid. In many cases western governments placed orders with western companies as a form of subsidizing them, and then later shipped these goods to poor countries who often had no use for them. These projects are sometimes called 'white elephants'. A common criticism in recent years is that rich countries have put so many conditions on aid that it has reduced aid effectiveness. In the example of tied aid, donor countries often require the recipient to purchase goods and services from the donor, even if these are cheaper elsewhere. Other conditions include opening up the country to foreign investment, even if it might not be ready to do so. The Massachusetts Institute of Technology's Abhijit Banerjee and Ruimin He have undertaken a rigorous study (PDF) of the relatively few independent evaluations of aid program successes and failures. They suggest the following interventions are usually highly effective forms of aid in normal circumstances, subsidies given directly to families to be spent of children's education and health, education vouchers for school uniforms & textbooks, teaching selected illiterate adults to read and write, deworming drugs and vitamin/nutritional supplements, vaccination and HIV/AIDS prevention programs, indoor sprays against malaria, anti-mosquito bed netting,suitable fertilizers, clean water supplies.