TCS Daily

When Good Aid Goes Bad

By Hans H.J. Labohm - July 26, 2005 12:00 AM

Page after page of professional economic journals are filled with mathematical formulas leading the reader from sets of more or less plausible, but entirely arbitrary assumptions to precisely stated but irrelevant conclusions.

--Wassily Leontief (American economist and Nobel laureate)

Fortunately this is not always the case. But it is true that scientific journals spawn en masse articles littered with mathematics, which are intelligible only for a small circle of specialists. At first sight this also seems to apply to a recent World Bank Policy Research Working Paper, "Foreign Aid and Market-Liberalizing Reform", by Jac Heckelman and Stephen Knack, because it is cluttered with endless strings of correlation coefficients. Yet, from these calculations better insights emerge as how to promote development and growth. It would a pity if the paper went unnoticed by a wider readership.

In it, the authors investigate the link between aid and economic freedom, as measured by something called the Fraser Economic Freedom index. This composite index, designed by the Fraser Institute, closely matches the so-called "Washington Consensus": a set of market-oriented policy prescriptions often associated with the World Bank and the International Monetary Fund. The freedom index is based on numerous specific policy indicators, which are grouped into several categories and weighted to create an overall index value. The main categories include: size of government; legal structure and security of property rights; access to sound money; exchange with foreigners; and regulation of credit, labor and business.

Heckelman and Knack note that market-oriented economic policies -- reflected in limited economic activity by government, protection of private property rights, a sound monetary policy, outward orientation regarding trade and efficient tax and regulatory policies -- have been strongly linked to faster rates of economic growth. Foreign aid is often provided in the belief that it encourages liberalizing reforms in these areas. But the outcome of their study does not substantiate that belief.

On the contrary, their results show that, on balance, aid has discouraged policy reform over the 1980-2000 period, as measured by the economic freedom index. Disaggregating by decade, aid's adverse impact on policy reform is much more pronounced for the 1980s than for the 1990s.

Why is there on balance a negative relationship between aid and policy reform (and also growth)? Because donor aid policies are aimed at different objectives. On the one hand aid allocations may intentionally favor recipients with better (or improving) policies and institutions fostering growth. This is for instance the case with the World Bank's IDA (International Development Agency) allocations, which potentially create a positive bias in the impact of aid on policy liberalization. On the other hand there are many other cases where donors focus their aid on countries with poor and/or worsening policy environments, either as an inducement to reform, or as a response to humanitarian crises in poor-performing countries.

But even in case donors aim at policy improvement, things can go awry. The policy conditionality that international financial institutions (IFIs) often attach to "structural adjustment" loans is a case in point. Today, many experts believe that conditionality of this type has been ineffective. If countries have to be bribed to reform in the first place, they have every incentive to implement the reforms to the minimum extent necessary to collect funds, and then to reverse the reforms -- with the possibility of promising these same reforms again in the future in exchange for additional aid.

One frequently-cited example is Kenya. During a 15-year period its government sold the same agricultural reform to the World Bank four times, each time reversing it after receipt of the aid. Another example concerns 22 loans by the IMF and the World Bank to Pakistan between 1970 and 1997. These were tied to budget deficit reductions, which repeatedly failed to materialize. But if there is serious willingness and determination within recipient countries to change tack and to embark on liberalizing policies, aid can offer a positive contribution, also by bolstering the position of reform advocates in government.

Often, the logic of adjustment lending is that recipient governments can use aid funds to compensate politically powerful groups who would suffer, at least in the short run, from policy and institutional reforms. Aid can in effect purchase their acquiescence to liberalizing reforms, increasing the survival probability of reform-minded governments. However, aid can also help non-reforming governments survive, by reducing the cost of not reforming. By providing an alternative source of revenue, aid can relieve pressure on recipient governments to establish the efficient policies and institutions necessary for attracting private capital.

But aid can also have more pervasive unintended adverse effects on economic policy and public sector management. In this context the authors refer to Milton Friedman, who has argued that because most aid goes to governments, it tends "to strengthen the role of the government sector in general economic activity relative to the private sector". Aid is commonly used for patronage purposes, by subsidizing employment in the public sector, or in state-operated enterprises, as foreign aid can provide funds for government to undertake investments that would otherwise be made by private investors.

In Tanzania, for example, large and rising aid levels in the 1970s and 1980s helped sustain large government subsidies to state-owned enterprises. As high aid levels increase the rents available to those controlling the government, resources devoted to obtaining political influence increase; thus, as Peter Bauer has noted, "a pervasive consequence of aid has been to promote or exacerbate the politicization of life in aid receiving countries". In extreme cases, aid may even encourage coup attempts and political instability, by making control of the government and aid receipts a more valuable prize, with adverse effects for the security of property rights.

Heckelman and Knack conclude that although their findings may be welcomed by aid skeptics who believe a world without development aid would experience more "real" reform toward market-oriented policies, there are several important qualifications which suggest a more favorable view of at least some donor programs.

First, their decade analyses indicate that donors' attempts to influence policy have become more effective (or less counterproductive) over time. Donors now more readily acknowledge the primacy of domestic political economy factors in determining the direction and pace of reform, and recognize that aid is likely to facilitate reform only where a significant commitment exists within the government. Policy advice can even be effective in countries with small aid programs, measured as a share of GNI, because key economic officials in reforming countries often benefited from donor-sponsored overseas training programs which account for only a tiny fraction of aid volumes.

Also, donors' impact may go beyond country-specific aid and advice. The IFIs and other donors disseminate ideas globally, potentially contributing to the spread of market-oriented reforms through provision of intellectual public goods.

Moreover, donors often have other objectives instead of or in addition to policy reform to stimulate private sector development. Education and health policy, for example, are not reflected in the Fraser index. Other objectives, including humanitarian, gender equity, environmental, and bilateral donors' foreign policy goals, may also justify aid programs. Donors may view their aid programs as successful on these terms even if they are counterproductive in generating market-friendly policy reforms.

What do we make out all of this? Aid can help to fight poverty, which should be its primary goal. There is now a better understanding than before of which types of aid are conducive to that goal. Aid is of no avail if governments of recipient countries are not committed to good governance and market-friendly policies. All this calls for more selectivity in aid, both as regards aid forms and target countries.


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