By Kinjal Doshi
Foreign aid refers to transfer of real resources from governments or public institutions of the richer countries to governments of less developed countries (LDCs) in the third world. The concept of foreign aid is widely used as a flow of financial resources from developed countries to developing countries. However, the role and effect of foreign aid in the economic development of developing countries are on controversial grounds. Generally foreign aid is advocated for the promotion of economic development in the least Development Countries (LDCs). The purpose of foreign aid to LDCs is to accelerate the economic development to a level where a satisfactory rate of growth can be achieved on a self-sustaining basis. It is generally contended that foreign aid could play a vital role in promoting economic development in the less developed countries. This is explained in terms of savings gap and the foreign exchange gap.
The economic objectives of foreign aid are to alleviate poverty and increase savings, investment and rate of growth in GDP in developing countries. However, development assistance has not always succeeded in achieving the objectives because in many cases donor motives of foreign aid and recipient motives for accepting it are opposing to the economic objectives of foreign aid. There is no evidence that over ages that donor country assists others without expecting something in return (political, economic, and military). According to Todaro, there are likely to be fundamental differences in attitudes and motivations between donor and recipient countries (Todaro, M.P. 1989, p.485).
Does persistent poverty in the developing world express inadequate moral fibre or political will on the part of developed countries, or is it caused by something else? It has been contended that poverty is a moral or political failing on the part of donor countries: poor countries are poor because rich countries do not care, or they are poor because rich countries lack the political willpower to mobilize resources on the poors behalf. In one view, poverty in the developing world exists and persists because of insufficient aid efforts on the part of rich, industrialized countries; thus, the solution to economic development is to bring bad would-be donors to regret and to make foreign aid more politically saleable. In the other view, the problem runs much deeper than a simple lack of assets and technology. Institutions providing incentives for entrepreneurs to accumulate assets and advance technology are at the heart of long-run growth.
William Easterly asks, Can foreign aid buy growth? Evidence suggests that foreign aid as such has not, cannot, and will not solve the problem of global poverty. At the same time, alternative prescriptions aimed at corruption, governance, and improving the institutional environment have not proven to be remedies, either. The billion-plus people who live in extreme poverty in the world today have been poorly served by modern development theory, policy, and practice, and the failure of trillions of dollars of aid payments over the last several decades to produce measurable results suggests that perhaps we should re-examine the theoretical and empirical foundations of development policy. Aid antagonists like Bauer claim that there is a negative relation between aid and growth in LDCs. This is because aid retards growth by substituting for savings and investments rather than supplementing it. While foreign aid advocates argue that aids help to promote growth and investment in LDC.
In the words of Jeffrey Sachs, economic development works. It can be successful. It tends to build on itself. But it must get started. can we create high mass consumption in the developing world by providing enough foreign aid to fill the financing gap between what a country can save and what a country needs for suitable capital investment?
POVERTY AND PROSPERITY
Going by a few cases, The United States, a country with abundant natural resources, prospers. Russia, with abundant natural resources, struggles. Most oil-exporting countries are rampant with corruption and poverty. Meanwhile, Hong Kong, Singapore, and Taiwan, countries with few natural resources prosper. And they have done so for the most part by allowing the invisible hand of the market to work.
Developing institutions that harness the power of the market is the key. Differences in the performance of regions with strong markets versus regions with weak markets persist: Jeffrey Sachs reports that economic growth proceeded at a pace of 1.7% per year in the United States but at only 0.7% in Africa between 1820 and 1998. In 1820, the United States was already a rich country. Where todays developed and developing countries were on relatively equal footing, developed world GDP per capita was almost twice that of developing world GDP per capita. Sharper divergence is evident in the last two centuries as developed countries are now almost seven times richer than developing countries.
As you can see, there is a noticeable negative correlation, that is, increased flows of foreign aid are associated with somewhat lower economic growth. While this does not prove that foreign aid actually impedes growth, it is powerful evidence that such aid does little or nothing to improve it.
An economy will be successful if it allows and encourages risk-taking entrepreneurship. By contrast, anytime the main profit opportunity in the economy is to get around government rules, not much good is going to happen in the real economy. This is the case in many developing countries. The highest returns in many of these countries does not come from trade, investment, or production, but from activities aimed at circumventing demanding government regulations or from diverting resources out of private markets and into the hands of those who have been able to use them best. Long-run development requires that people have incentives to produce something of value. No such incentive appears to exist in many poverty-stricken areas.
Economic development is an institutional rather than an infrastructural or technological problem. People respond to incentives, and the institutions defining those incentives have fundamental implications In the case of the advocates of nation building, people are regarded as bricks rather than human beings, bricks to be manipulated at will for the purposes of the rulers. Failure to recognize that people respond to incentives has led to many of the policy disasters of the last several decades.
INSTITUTIONS AND ECONOMIC FREEDOM
Economic freedom appears to be especially important. Lower economic freedom is correlated with higher poverty: countries with the lowest levels of economic freedom (which include primarily countries in Africa, Latin America, and Eastern Europe) tend to have the lowest levels of per-capita income. Average per-capita income for countries in the top quartile of the Fraser Institutes index of economic freedom is $24402, while average per capita income for countries in the bottom quartile is $2998. Perhaps the most striking characteristic of economically unfree countries is that their unfree status handicaps their economic development. The rich are getting richer and the poor are getting poorer; however, this appears to be related in part to the fact that the poor are handicapped by institutions restricting economic freedom.
William Easterly reports uncertain empirical results suggesting that foreign aid does not have a positive impact on economic growth. A quirk in the aid system such that small countries receive large shares of their income as aid, unrelated to their economic performance or needs allows Easterly to control for the possible endogeneity of foreign aid by instrumenting for aid as a percentage of gross national income with the log of 1980 population. In a regression in which per-capita income growth from 1960 to 2002 is taken to be a function of foreign aid as a percentage of gross national income from 1960-2001 and per-capita income in 1960, the coefficient on the aid measure is statistically insignificant and negative.
As Easterly points out, many failures of development policy have their roots in a general failure to recognize that people respond to incentives; indeed, the message of old growth economics was that long-run growth would be at the rate of technological progress no matter what the incentives are.
Poor countries are poor because they lack the infrastructure necessary to grow and because their labour capital ratio is too low. On one hand, decaying physical infrastructure reduces the reliability of power generation, makes for relatively high transportation costs, and provides inadequate water and sewer services. On the other, a society may not have enough machines and building factories would soak up this labour without causing a decline in rural production.
This reduces problems of economic development to a set of very simple problems. First, external aid can fill the financing gap which causes the relatively low ratio of capital to labour. Second, external aid can fix the infrastructure problems hindering development and can thus create the context for economic development. The governments of the poor countries, through which the aid is directed, often have little incentive to raise the productive potential of the poor, especially when doing so might engender political activism that threatens the current political elite. The aid agencies themselves in this difficult environment do not have much incentive to achieve results, since the results are mostly unobservable. In these circumstances, it is understandable the aid agencies prefer to emphasize an observable indicator of effort, aid expenditures.
Another complication in the foreign aid debate is tied aid which is restricted to obtaining of goods and services from the donor country. While the OECD reports that there may be a macroeconomic justification for this policy in that tied aid restores balance-of-payments equilibrium by offsetting an outflow with an inflow, such tying of aid implies a subsidy to enterprises in donor countries and imposes burdens on aid recipients by increasing prices by 15-30%.
Since aid is a transfer from domestic taxpayers to foreigners, tying it to the purchase of donor-country goods and services may make it politically saleable in the donor country. However, transfers with strings attached are risky as they require countries to purchase goods from providers who may not have a comparative advantage in a global marketplace.
CONCLUSION
Countries with insufficient capital can be brought into modern growth through appropriate, targeted investments in infrastructure. However, the relationship between official development assistance and economic development is questionable, and evidence reported strongly indicates that there is at least no positive relationship between aid and growth. Moreover, the poverty trap thesis that people are poor because they are poor or because they started out poor, find little support.
If not aid, then what? There are many directions we could take if we are interested in the plight of the very poor. First, there have been some aid-related development successes; clearing away the transaction costs and corruption that reduce the effectiveness of aid. In addition, institutions that reward entrepreneurship or at least, enable it are an important step toward allowing countries to enjoy economic development.
REFERENCES
BOOKS:
Bhalla, S. (2002). Imagine there is no country: Poverty, Inequality, and growth in the era of globalisation. Washington: Institute for International economics.
Deodhar.S. (2012). IIM AHMEDABAD: Day to Day economics. Delhi: Random House Publishers.
Harford,T. (2006). The Undercover economist. London: Little, Brown.
Mavrotas, G. (2010). Foreign aid and Development: Issues, Challenges and the new Agenda. Oxford Publishers.
WEBSITE:
Abbott, G. (1973). Two Concepts of Foreign Aid, World Development. Retrieved 10 July 2013 from, http://ideas.repec.org/a/eee/wdevel/v1y1973i9p1-10.html
Easterly, W. 2003. Can Foreign Aid buy growth? Retrieved 11 July 2013 from, https://www.aeaweb.org/articles?id=10.1257/089533003769204344
Leeson, P. 2008. Escaping Poverty: Foreign Aid, Private Property and Economic development. Retrieved 12 July 2013 from, http://www.peterleeson.com/escaping_poverty.pdf
Menon, S. Does Foreign Aid help economic growth? Retrieved 12 July 2013 from, http://smithmenon.hubpages.com/hub/DOES-FOREIGN-AID-HELP-ECONOMIC-GROWTH
Vasquez, I. Cato Handbook of congress: Foreign Aid and Economic Development. Retrieved 10 July 2013, from http://www.cato.org/sites/cato.org/files/serials/files/cato-handbook-policymakers/2003/9/hb108-66.pdf
Chenery, H., Strout, A. 1996. Foreign Assistance and economic development. Retrieved 10 July 2013 from, http://www.jstor.org/discover/10.2307/1813524?uid=3738256&uid=2129&uid=2&uid=70&uid=4&sid=21102458069821
The author is a student of Christ University.