Rethinking Foreign Aid within an Institutional Context

Is foreign aid able to promote growth? Does it really help developing countries to escape out of poverty and to enforce democratic patterns? Acemoglu and Robinson argue, it does not. Not in the way, aid policy is implemented today. In the literature, there is still an ongoing debate whether foreign aid has a positive impact on economic growth in developing countries or if it is even harmful than helpful. In this context, does the institutional framework matter?

 

Some decades ago, the micro-macro paradox stated by Mosley et al. (1987) describes what is also often suggested today. That foreign aid has a positive effect on the micro level but is ineffective on a macro level. A solution of this discussion is still unclear. Regarding the impact of foreign aid on GDP growth, the literature suggests a lot of different concepts and models, if and if yes, through which channels foreign aid affects GDP. And furthermore if this effect is positive, neutral or even negative. The highly influence paper of Burnside and Dollar (2000) is the fundamental basis of the allocation of foreign aid in the last decade and also today. They find evidence that foreign aid to developing countries have little impact on GDP on average. But if developing countries have a stable and well-functioning macroeconomic framework, then aid has a positive influence on growth. On the opposite, if there exist weak institutions, with high corruption and less effective policies in fiscal, monetary and trade terms, then foreign aid has no effect or even a negative one. On how aid is allocated to developing countries, the World Bank and important donor-giving institutions are led by these findings.

If there is evidence for this kind of policy, why then the allocation of foreign aid is still questioned? Why we should then rethink the allocation of foreign aid? While a focus on the aid-growth relation is not sufficient, the effectiveness of aid is highly influenced by the institutional framework. But furthermore, recent studies suggest that underlying transmission channels should be taken into account. They might be a huge different whether the impact of aid is positive or negative in a specific developing country with different levels of institutional frameworks. Institutional quality is seen as one important determinant of the impact of foreign aid.

 One critique is that the World Bank takes institutions into account, but in an exogenous way. Therefore, policy implications following this concept, is a higher allocation of foreign aid to developing countries with good institutional framework whether countries having weak conditions, receive less money. But shouldn’t especially those countries receive more aid in order to help them to establish good institutions? If this is the case, then there is the need of rethinking the implemented policy strategies of donor giving institutions. In this context, also foreign aid might not affect GDP growth directly, but also through different transmission channels as the design and stability of the institutional framework and the implementation of domestic policies. The effect on economic and political institutions might be harmful and following having a negative impact on growth. Rent-seeking activities might play an important role. If there exist a weak institutional framework, then social groups with access to the government budget are more likely to use this money to increase their own utility by transfers to their own budget. These activities imply high costs to the economy and less democracy. Another problem could be the high dependency on foreign aid. A high amount of foreign aid might reduce democracy in developing countries. This might be the case due to less need for accountability of the government, hindering necessary economic reforms. If the collection of taxes are higher or lower under an autocratic or more democratic regime is controversial. Literature suggest, that under an autocratic regime, tax revenues are lower with a higher amount of foreign aid, because autocratic leader might use foreign aid to reduce unfavourable taxes in order to increase their image across the population.

If institutions are weak or even getting weaker because of foreign aid, it also stops the incentive and the motivation of the population to increase their own conditions because of low opportunities. Lack of the provision of public services as education and health services as well as there are threatened differently from the government. Following low institutional quality result in remaining poverty.

In implementing foreign aid policies and the allocation of it, the exogenous but also the endogenous effect of the institutional framework and its underlying transmission channels need to be taken into account. Nevertheless, this seems to be huge challenge due to different levels of institutional quality, rule of law or property rights in different developing countries where also the regime type matters., democratic, autocratic and everything in between. How could this allocation be done? And how to improve the effectiveness of foreign aid?

One solution could be the real evaluation of the impact of projects and interventions in recipient countries. Until now, institutions and international agencies have shown little interest in evaluating the real impact of it. Therefore, there might be too many interventions, which have no or negative effects, but nevertheless they are regarded as successful. On how money is given to developing countries could also be done differently. Depending on the regime type and on how stable institution are in one specific country If aid is giving from top down, having weak institutional framework might not lead to the expected and wishing outcome, as promoting growth and democracy, due to the existence of corruption, as we have seen before. Moreover, we should widen the idea of foreign aid from the bottom up, building strong and stable institution which can enforce a well-functioning market, leading to sustainable growth, democracy and reduction of people living poor.

We need to look more specifically on developing countries. On their institutional framework and on how foreign aid affect its institutions today and also evaluating this effect and learning from the past.

References

Acemoglu, D., Robinson, J. 2014. Why foreign aid fails – and how to really help Africa. The Spectator. http://www.spectator.co.uk/2014/01/why-aid-fails/.

Acemoglu, D., Robinson, J. A. 2012. Why Nation Fail: The Origins of Power, Prosperity, and
Poverty.

Addison, T., Tarp, F. 2015. Aid Policy and the Macroeconomic Management of Aid World
Development Vol. 69:1–5.

Burnside, C., Dollar, D. 2000. Aid, policies, and growth. American Economic Review. 90(4):847–68.

Easterly, W., 2007. Was Development Assistance a Mistake? The American Economic Review,Vol. 97, No. 2:328-332.

Easterly, W., Aid to Africa Debate : https://www.youtube.com/watch?v=vzy8dafM89E.

Tarp, F. 2006. Aid and Development. Swedish Economic Policy Review. 2006 13:9-61.

World Bank. 2005. Review of World Bank Conditionality. Washington, DC: World Bank Group.World Bank.

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