How effective is foreign aid?

Economics of Less Developed Countries Lecturer: Michael King

Enrique Garcia Saez 11111151

Summary

Introduction Bauer's critique Easterly's critique to bureaucracy The curse of aid Other empirical evidence: Collier and Dollar Conclusion

Introduction In the years preceding WWII, economic development as a field of economic study did not exist in any meaningful sense . There was not a development community, World Bank and International Monetary Fund did not exist yet. From policy side, a new development community emerged whose objective was improve the standard of living of the Third World. On the academic side, development economics began to work as a separate economic field. These two factors converged and the result was two complementary movements which pursued an improvement of the situation of underdeveloped countries. The last innovations in economic methodology influenced strongly this phenomenon such Keynesian economics and quantitative and statistical tools. One of the most important tools used by this community was the Harrod Domar model. The key of this model is the investment gap, the difference between the level of investment needed to propel economic growth in the recipient country and the level of savings available domestically to devote to this purpose. And this point is where foreign aid appears. Financial efforts to reach the investment gap in poorest countries were going to be financed by taxpayers of wealthy countries. The investment gap was the worry at the beginning, but it changed later and development models were based on the human capital. Then, development economists centralized their points of view on overpopulation, the curse which prevented economic growth in the Third World. This chain of events is denounced by Easterly who empathizes that depending upon the current fashion in growth theory, the development community supplied foreign aid for different purposes. For instance, if the Harrod Domar model is more widespread, the foreign aid will go to finance the investment gap, however, if the theories about human capital are predominant, the foreign aid will finance education spending. Critics of foreign aid have always existed. P.T Bauer was sceptical with this phenomenon since he considered institutions the key of economic growth. This pessimism about foreign aid is more relevant since the nineties after the poor results of development policy on economic growth. Easterly critique is extensive, covering all the failures of foreign aid in the previous decades. A new debate was opened because of an important article: Collier, Dollar (2000). This paper, along with others, provide us with new horizons of analysis about the impact of foreign aid. Results are ambiguous but new angles to investigate effects of foreign aid were noted.

Peter Bauer's critique The development economist Peter Bauer is known for his opposition to foreign aid. During the seventies, eighties and nineties he was criticizing the policy of international organisations for development in the Third World. His two main propositions are:

The problem of underdeveloped countries is not the lack of investment capital or savings:The big projects of international organisations for development are not going to work because they do not take into account the main needs of the underdeveloped economies. According to Bauer, policies for development were based on central planning framework, designing big plans for the whole economy. The question is: if those big plans did not work in the socialist economies (USRR, China), how can the new plans be successful for other countries? We can find some similarities between these elements, for instance, aid policies are planned by a group of planners (development organisations) deciding from the top where the investment goes and what their objectives are. At the beginning, investment on infrastructure was decided; some years later the plan was to invest in education; in the nineties, the decision makers focused their big project on demographic problems. In all cases, the development policies set up their plans from the point of view of the government, from the point of view of central planner, from the public power. The development had to be carried out from the public policies. In fact, the most quantity of foreign aid was transferred to governments of low income countries. Like in central planning economies, the took of decisions have some common points. Easterly provides us with an example of how the money goes from taxpayers in wealthy countries to the poor countries, observing the multiple steps which money has to pass until reaching its destination, fostering bureaucratic costs, corruption and deviation of resources. Bauers critique of foreign aid is based on the same problems of centralized economy: firstly, the impossibility of the state obtaining all the necessary information to carry out an efficient plan, and secondly the lack of incentives of bureaucratic machine to pursue the general interest of the economy. In this regard, foreign aid could go to bad investment projects in poor countries, crowding out other more profitable private projects as resources would go to the first ones. Property rights and some institutions are necessary and sufficient for economic development. Bauers proposition goes beyond the failure of foreign aid. He declared that property rights and some institutions related with free market, trade, liberty, price system, economic calculation, etc, are sufficient for economic development. This proposition is more difficult than the first one and proving it is much harder. The idea behind this proposition is about how the market institutions and property rights coordinate the actions of all agents and how this criteria generates a spontaneous order which encourages the improvement of standard of life. The problem is not the quantity of investment but what project have to be carried out and what projects are bad investment. Price system, market and property rights could direct resources to the more profitable investment projects while government spending could fail because of the lack of information and proper incentives. Testing this proposition is not easy. Intuitively, we could look at the relationship between quality of institutions (indicador) and economic growth. The first

problem appears when we want to establish the causality, could the economic growth generate better institutions? Acemoglu, Johnson, and Robinson (2005) contend that the ex-colonies exhibit a variety of institutions and economic performance. Some, such as the United States, New Zealand, and Australia, exhibit strong private property rights protection. Others, such as the majority of countries in Sub- Saharan Africa, display the reverse. They argue that the property rights institutions these countries inherited from their colonizers determined the variation in their incomes we observe today: In places like the United States, New Zealand, and Australia, the prevalence of diseases, such as malaria, was relatively low at the time of colonization. Thus, colonizers could settle in these places for long periods of time. Since as inhabitants of these countries colonizers would be subject to the long-run effects of the property rights institutions they created, it was in their interest to establish institutions of long-run economic growth-namely, well- protected private property rights. In contrast, in other countries, such as those in SubSaharan Africa, diseases like malaria were rampant and posed a serious threat to the lives of colonizers. In these places, colonizers could not settle permanently. This shaped their colonizing strategy in that it created a very short time horizon for the colonizers. They sought to get in, extract as many resources as possible, and get out. This led colonizers in these places to establish extractive institutions that poorly defined and protected citizens' private property rights. Since ex-colonies' economic performance today cannot be responsible for the property rights institutions that colonizers created in them in the 17 th, 18th, and 19th centuries, and since institutions tend to persist over time, property rights institutions at the time of colonization are a valid instrument for property rights institutions today. The result of testing economic performance and institutions from this perspective is striking: private property rights are the key determinant of nations' levels of economic development . This is true even controlling other kind of variables like latitude, distance from a coast, and climate, which some have argued are causes for the level of economic progress (Escaping Poverty: Foreign Aid, Private Property, and Economic Development, Peter Leeson, 2008).

Easterly's critique to bureaucracy William Easterly is known for his extensive critique of foreign aid. He has developed the Bauer's framework studying in depth the failure of centralized planning, specifically the problems of bureaucracy and the perverse incentives in the foreign aid. The Cartel of Good Intentions (2002) provides a study of why bureaucracy cannot work in the provision of foreign aid. He starts providing a description of how a dollar goes from taxpayers in a wealthy country to a poor person in Ethiopia who wants to repair a pothole: The Ethiopian government looks to foreign aid for financing of public services. This poor person somehow communicates his desires to civil society representatives and/or non-governmental organizations (NGOs), who allegedly articulate his needs through the government of Ethiopia to the international donors. The national government solicits a poverty reduction support credit (PRSC) from the World Bank (also known as the International Bank for Reconstruction and Development, or IBRD) and a Poverty Reduction and Growth Facility (PRGF) from the International Monetary Fund (IMF). To get loans from the IMF and World Bank, the government completes a satisfactory poverty reduction strategy paper (PRSP), in consultation with civil society, NGOs, and other donors and creditors. The government prepares the PRSP in light of the fourteen-point Comprehensive Development Framework (CDF) of the World Bank. The World Bank follows a series of internal steps to approve a PRSC, including the preparation of a Country Assistance Strategy (CAS), a pre-appraisal mission, an appraisal mission, negotiations, and Board approval, all in accordance with OD 8.60, OP 4.01, and Interim PRSC Guidelines... And so on. This tells us the large steps which money have to pass before arrive to the objective (if money arrives). We are talking about large number of bureaucratic organisations which react so slowly to the real problems of poor countries. According to W. Easterly: Bureaucracy works best where there is high feedback from beneficiaries, high incentives for the bureaucracy to respond to such feedback, easily observable outcomes, high probability that bureaucratic effort will translate into favorable outcomes, and competitive pressure from other bureaucracies and agencies. In short, bureaucracy works best when it functions something like a free market.

He described the negative aspects of organisations which manage foreign aid summarized in four aspects: These organisations define their output as money disbursed rather than service delivered, emphasizing the quantity spent instead the results of the programmes, substituting output for cost. Produce many-low-return observable outputs like glossy reports and frameworks on few high return less observable activities like ex-post evaluation. Easterly provides a interesting instance: foreign aid finances observable projects like schools, roads... but it always forgets the maintenance because that activity cannot be observed directly. Engage in obfuscation, spin control, little learning from the past. According to him, international organisations do not read their own reports about the results of aid programmes, there is not learning from experience. Excessive administration (high cost). Puts enormous demands on scarce administration skills in poor countries. He suggests that aid not only could be useless, but could be harmful for poor countries since it has negative secondary effects on the institutions equilibrium.

The reason for this negative outcome is related to the perverse incentives of bureaucracy. The first problem of bureaucracy is that there is no competition to enforce organisations to be more efficient. To solve the first inconvenience, a monopoly controlled by political supervisors can be established through a principal-agent contract. This system is an usual source of perverse outcomes because performance and results can be imperfectly observed. Then, the agent tends to overstate benefits and understate the cost (adverse selection). The problem worsens when there are many agents and many principals, and attributing outcomes is now more difficult as there are more agencies. Moral hazard also appears because agents could not want to solve poverty as the reason by which these organisations receive money is that there is poverty. An improvement of poor countries could mean less resources for these agencies. Ultimately, the bureaucratic system does not work in the case of foreign aid, and according to Easterly, is another proof of how central planning cannot solve the economic problem of Third World. The curse of aid Until now, arguments shown here have criticized foreign aid suggesting that aid is useless and problems of low income countries cannot be solved by direct transfers of resources, or explaining how the current bureaucracies are not able to carry out the objectives of development. At least, this policy has to consider the development of institutions, something which is forgotten in the models of investment gap or education investment. But, what if foreign could have negative impact on economic growth? What if foreign aid could be a curse for poor countries?
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The curse of natural resources is known due to studies such Sachs and Warner (2001), Auty (1990) and Ross (2003). Discoveries of natural resources and financing governments with this kind of revenues could lead to an erosion of institutions since rent-seeking deviates resources from other activities to the fight for these revenues. The incentives to fight for natural resources revenue deteriorate the operation of basic institutions, fostering corruption and eliminating the need for government to obtain resources from taxation. But we can establish the same idea for foreign aid, like a strong exogenous revenue which allows corrupt governments not to depend on taxation or on their citizens. Ultimately, the similarity between natural resources and foreign aid is that they can be appropriated by corrupt politicians instead of finance government budget by measures like taxation (less profitable). In this regard countries whose income depends strongly on foreign aid could suffer the curse of aid. Burkina-Faso's aid income is around two-thirds of total budget, in the case of Mauritania 60%, and Rwanda, Gambia, Niger, Tonga and Mali around one third for the period 19851989. The effects of this phenomenon are usually described like Dutch Disease, which affects negatively other exports while resources of the country are going to the rent-seeking (production of oil, conflicts for the aid). A good example is Somalia's civil war caused by the fight for the control of foreign aid (Maren, 1997). Ultimately, the key is that revenue from outside to the poor countries' governments destabilises the equilibrium between government and taxpayers, something which could hinder the necessary reforms. In words of Brautigan and Knack (2004):
High levels of aid can make it more difficult to solve the

collective action problems that are inherent in reform efforts, create moral hazards for both recipients and donors, perpetuate both a soft budget constraint and a tragedy of the commons with regards to the future budget, and weaken the development of local pressures for accountability and reform . Simeon Djankov, J.G Montalvo and Marta Reynal-Quero (The curse of aid, 2008) find negative correlation between aid and quality of institutions. They use a panel data for 108 recipient countries between 1960 and 1999. The result can be summarized: if the foreign aid over GDP that a country receives over a period of five years reaches the 75th percentile in the sample, then a 10-point index of democracy is reduced between 0.5 and almost one point, a large effect . They find that this negative impact is bigger than oil discoveries. These results are striking and go beyond the uselessness of foreign aid, transfers to poor countries' governments could be also negative to the institutional development.

Other results of empirical evidence After all these arguments and results criticizing foreign aid, we find other interesting approaches which are more optimistic about the consequences of aid. We can remark the work of Collier and Dollar (2000), who separate data into two groups: countries with good policies and countries with bad policies. The criteria to establish this distinction is the data from CPIA, where it is possible to find some measures of macroeconomic policy. Another feature included on the test is allow for diminishing returns to aid, a point inspired by the law of diminishing marginal returns. Results are positive for countries which have good policies (1% of GDP by 0.9% of gross investment over GDP) and ambiguous for the rest. This study aims to establish an objective criteria (poverty-efficient) to deliver aid between recipient countries. According to Collier and Dollar, policies have to be taken into account to distribute aid, being a mechanism to avoid lobbying. Although they recognize that the criteria of poverty could be more efficient if we consider peace and social stability an aim. Then, the guideline to deliver resources based on poverty-efficient criterion clash with the ethic principle of helping the poorest countries (avoiding conflicts). These framework could seem clash with the previous results (Bauer, Easterly, the curse of aid) but if we observe deeply the conclusion of this improvement, we find out that policies are the key, and when policies work, aid could work. Therefore, institutions and institutional development are the key. According to the Collier and Dollar test, Jose Maria Larru (2008) develops a interesting model to explain those results. Suppose a democratic government. This model consists in maximizing a function of some variables: spending on public workers (ensuring the reelection), capital investment (on the rest of the society) or corruption. Considering that the objective of government is to be reelected, rulers will try to ensure the necessary support for the reelection, mainly by taking on new employers and increasing their wages. Another option is to improve the economic performance of the country, however, the effect is more indirect than an increase the number of public workers. The result is that the first dollars which the government receives are going to finance more public workers (rent-seeking) to ensure the sufficient influence for the next elections. However, as government increases their influence, there are more incentives to spend more money in necessary capital investment. In this framework, aid for poorest countries could be go to unproductive activities because of government's incentives. The bright spot is that other recipient countries (not so poor) which do not have to increase the size of state to remain reelected could use the aid to investment capital. A proposal from the author is providing aid for poorest countries directly to the people, and not for the government. All of this is consistent with the results of Collier and Dollar's test. Government policy matters.

Conclusion We have shown many arguments to be more sceptical about the success of foreign aid. This could be seen as opposing development policy. However, the critique enforces international organisations to be more transparent, efficient and consider the role of incentives on the results. Critiques such Easterly's papers show up that something is not working. He often claims that critics with the aid are playing an important role for transparency and against corruption (Sachs & Easterly's debate). We can summarize the main problems of the provision of aid:

Lack of information: what kind of investment is a question which the market solve in wealthy societies. However, foreign aid policy makers don't have the necessary information to know what are the most important needs of recipient countries' citizens. Perverse incentives: Adverse selection (bureaucracy) and moral hazard appear on the intermediaries which have to carry out the investment. Not desired effects or counterproductive effects: the curse of aid is an instance which teaches us some unexpected consequences of some policies such (destabilizing equilibrium between people and institutions, negative allocation of resources).

Considering these points, we can conclude that foreign aid has to be influenced by the field of public choice and game theory, considering the interaction of incentives of rulers and bureaucrats. Another tool that could be used to improve the effectiveness is the method of trial and error, giving up the big global planned projects with ambitious goals. It is difficult understand what is going to work and what isnt, the strategy is to be pragmatic, take the projects which have positive results and leave what does not work. It can seem obvious but, the same failed guidelines have been followed for many years. In this regard, improving the evaluation ad transparency is so important (Easterly's critique of failing to learn from our mistakes). Finally, many authors consider the chance to provide aid to the people in some cases, avoiding the step of government corruption. In the case of humanitarian aid this is already working.

References

Andrei Shleifer . Peter Bauer and the Failure of Foreign Aid (2007) Cato Journal Peter T. Leeson . Escaping Poverty: Foreign Aid, Private Property, and Economic Development (2008) The Journal of Private Enterprise Djankov, Montalvo and Marta Reynal-Quero, 2008. The curse of aid. Easterly, William. The cartel of good intentions. The Problem of Bureaucracy in Foreign Aid (2002)
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Bourguignon, F. and Sundberg, M. Aid Effectiveness: Opening the Black Box. American Economic Review (2007) Burnside, Craig and Dollar, David. Aid, Policies, and Growth (2000) American Economic Review Collier, Paul and Dollar, David. Development Effectiveness: What have we learnt? (2001) Jose Mara Larru Ramos. Corrupcin y ayuda al desarrollo. Evidencias, teora y aplicaciones para Espaa (2008)

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