The Political Economy of Foreign Aid: …the secret behind economic failures of developing nations

In an essay for the online magazine Cato Unbound, a senior economist, William Easterly, described the failure of Foreign Aid to the developing world in these terms:

“This is the tragedy in which the West already spent US$2.3trillion on Foreign Aid over the last 5 decades and still not managed to get 12-cent medicines to children to prevent half of all malaria deaths. The West spent US$2.3trillion and still has not managed to get US$4 bed-nets to poor families. The West spent US$2.3trillion and still has not managed to get US$3 to each new mother to prevent 5 million child deaths.”

According to Easterly, the main problems with Foreign Aid have been: 1) an inappropriate development model based on the ‘financing gap’; and 2) bad administration, caused by a lack of accountability from Aid agencies to the people whom they are supposed to serve. Easterly’s argument effectively treats the state as exogenous – assuming that political actors are trying to make Aid programmes work but are failing simply out of ignorance.

In this paper, I discuss the political economy of Foreign Aid and argue that both humanitarian Aid and multilateral structural adjustment and development assistance through the International Monetary Fund (IMF) and World Bank have been designed to fail in their ostensible aims: if they were to be reformed along the lines Easterly suggests, they would lose their political raison d’être.

While publicly funded development Aid has largely failed in its stated objectives, there is substantial evidence supporting the benefits of private Foreign Direct Investment (FDI) and microlending. Both historical and contemporary evidence suggest that the most important pro-development reform governments of African developing nations can make is structuring their political institutions to facilitate credible governmental commitments to private property rights, contract enforcement, and competitive markets.

Publicly funded Foreign Aid is offered in two forms: direct Grants-in-Aid and loans. Some literature argues that loans through the IMF and the World Bank should not be considered ‘Aid’ since they have to be repaid; but this argument ignores the fact that these loans are offered at interest rates substantially below the market rate – otherwise, governments would have no reason for accepting them, given the policy strings attached (i.e. ‘conditionalities’).

Grants-in-Aid are largely conducted bilaterally, Government-to-Government, or through International Development agencies. Grants typically address imminent humanitarian needs such as famine and disaster relief, public health, and housing. The IMF and World Bank, which are principally funded by the G-7 developed countries, theoretically have diverse functions in promoting international financial stability and economic development projects, respectively; but since collapse of the Bretton-Woods international monetary system in 1973, the IMF has broadened its mandate to cover any kind of assistance for governments trying to reform their economies (what the IMF calls ‘structural adjustment’ programmes).

The evidence that Foreign Aid generally has not enhanced economic growth is a well-known one. In the book titled The Elusive Quest for Growth, Easterly demonstrates that in the vast majority of countries, development Aid has not increased the investment share of Gross Domestic Product (GDP); and growth in the investment share of GDP has not caused subsequent increases in GDP per capita. Like Sachs and Radelet, defenders of Foreign Aid point to specific successful projects in which Aid was a component.

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Nonetheless, for two main reasons, it is impossible to draw any universal conclusions from these experiences: 1/ In most cases, it is impossible to control for other factors which may have been responsible for success of the project, rather than Aid (i.e., the counterfactual – how would the project have fared without Aid – is unavailable); 2/ even when an Aid-funded project meets its targets, we do not observe the opportunity costs of the project – all the other worthy endeavours foregone because taxpayer resources went elsewhere. The minimum acceptable effect of Foreign Aid on growth and other desired effects is consequently greater than zero.

Until now, global empirical studies of the effects of Foreign Aid on growth usually find either no general relationship or even a slight negative relationship. One of the main problems with Aid is that many in the governments of developing countries have diverted Aid to private bank accounts of government officials. It is an empirically established fact that more corrupt governments receive just as much Foreign Aid as less corrupt governments, that the United States government even gives more Aid to more corrupt governments – such that the level of Aid a country receives tends to increase corruption in the future.

Furthermore, empirical studies have shown that Aid to most developing nations of Africa goes mostly toward wasteful public consumption; Aid actually inhibits beneficial policy reforms; and Foreign Aid not only increases government spending, but also reduces revenue – presumably because Aid-dependent governments feel less need to promote the kinds of economic growth which generate tax revenue. Again, further studies on the effect of Aid on economic growth have revealed that Aid has a slightly positive effect on economic growth when the recipient country has good policies; but since the evidence suggests that Aid undermines good policies, their finding does not have clear policy implications.

The evidence on the IMF is equally disheartening. Indeed, a study by James R. Vreeland has corrected for the fact that market-friendly governments tend to be the ones who seek IMF loans (and therefore would grow faster than other governments without IMF loans); once this correction is performed, he finds that IMF programmes reduce economic growth by one and a half percentage points for each year the country remains under an IMF agreement. Vreeland also finds that IMF programmes redistribute income from labour to capital, and therefore increase income inequality. Indeed, Foreign Aid usually causes more harm than good.

If Foreign Aid programmes have usually failed, why do they persist? Some critics of Foreign Aid programmes, like Deepak Lal, argue that Foreign Aid is fundamentally unreformable and should – apart from emergency humanitarian relief or perhaps targetted military assistance – be scrapped. Political economy considerations tend to support Lal’s view. However, the resounding rejection of political economists om grounds that Foreign Aid promotes economic development seems to have had little effect on policymakers, who pay lip-service to “good policies and institutions” but have done little to roll-back funding.

Some political economists have criticised the effects of U.S. Aid on India’s development five decades ago. It is implausible to imagine that political leaders in donor countries simply do not know their policies have been counterproductive. It seems much more likely that donor governments have their own interests in mind when lending or granting funds to governments of developing nations.

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Two types of political considerations tend to foster the continuation of Foreign Aid, even when it has failed at its stated objectives of promoting development and reducing poverty. The first is lobbying by those domestic interest groups in developed economies that stand to gain from Aid programs, what international relations experts call “low politics.” The second type of political consideration involved in Aid lies in the realm of international diplomacy (“high politics”).

For instance, the generosity of the U.S. government toward some of the African nations like Egypt provides an example of this sort of Aid – intended to bring other governments around to supporting the U.S. government’s view on international security issues. That the U.S. government frequently supported anti-communist dictatorships in the Third World during the Cold War is well known. However, U.S. Aid still seems to be motivated more by ‘state interest’ than altruism in the post-Cold War period.

Alesina and Weder’s findings – that U.S. Aid goes more often to more corrupt governments than less corrupt ones – has already been mentioned (though the authors, like myself, also do note that U.S. Aid goes more often to democracies than dictatorships). It is implausible that in most cases the U.S. government is seeking to encourage corruption, but it is likely that the U.S. government uses other political criteria to distribute Aid and is relatively unconcerned about the adverse effects on corruption and development.

The political influence on the IMF’s decisions is even more pronounced in the post-1989 than the pre-1989 period. More recent and sophisticated work has supported the general assertion that countries friendly to the U.S. are more likely to receive both IMF and World Bank loans. Detailed case-studies have shown that U.S. pressure has been responsible for lenient terms on IMF loans to countries like Egypt.

This evidence might seem to support the charges by radical critics of globalisation that the IMF and the World Bank are tools of U.S. imperialism in the Third World, mechanisms whereby the Treasury Department imposes economic policies favourable to Wall Street investors and multinational corporations on helpless Third World governments. The truth is considerably more complex. It turns out that governments in developing nations seek out IMF loans precisely because they want the conditions attached to them.

In summary, we should not focus blame for the failure of Foreign Aid programmes on governments of developing countries or governments of developed countries alone. Both sets of governments are responsible. Foreign Aid has been a mutually enriching business for hierarchies of both donors and recipients; unfortunately, the impoverished populations of the developing world are the ones who suffer the most.

The writer is the Executive Director of the Institute of Development and Economic Research (IDER), and a consultant with the University of California, Los Angeles (UCLA) Capacity Building Center (CBC). Tel: 0206991717 | 0302955288


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