Friday, October 19, 2007

Policy Brief 1: Is Foreign Aid Effective?

(Policy Brief Submitted October 2007, for Econ 346 - Economic Development, Lafayette College)

Foreign aid has become a topic of concern on the international stage. Development economists are assessing whether foreign aid is actually effective, either through poverty reduction or growth. There is little evidence that households actually lose out when foreign aid is distributed thereby making the aid ineffective, but this is not the focus of this paper. The following brief presents conditions found to be the important prerequisites of growth based on economics literature. Considering (a) the existence of market failures in developing countries (Dercon 2003) and that (b) “raising aid effectiveness is a matter of improving the framework conditions, of setting new priorities and of finding new operational means” (Langhammer 2004), this brief recommends restructuring foreign aid so it is specifically allocated to (1) improving governmental structures and accountability, (2) funding social entrepreneurs, and (3) improving educational systems.

Consequently, I make two assumptions. Firstly, I refer to foreign aid in terms of growth, and not poverty reduction. There is a difference; while growth emphasizes forward-thinking and sustainability, poverty reduction has a more “current” focus of shortening the gap between the poverty line and those living under it. Secondly, I define an “effective” scenario as one in which, households living in the country receiving foreign aid are left less-dependant on further foreign aid, and are moving towards a more equitable society.

Economic growth is generally known as the increase in value of the goods and services produced in a particular country’s or region’s economy. Conventionally, this is measured using the real Gross Domestic Product (GDP), which is adjusted for expected inflation. Whether or not foreign aid is effective in increasing GDP, and thereby supplementing economic growth, is uncertain. This does not indicate that foreign aid is ineffective. What it means is that some policies may be more effective in achieving growth compared to others.

There has been a lot of speculation in the last century about the potential of increased investment leading to growth. The Harrod-Domar model offers some insight into how giving aid leads to an increase in savings (including capital accumulation), which is then technically invested, which then yields a higher GDP, signaling growth. This relates to how economists today use the “financing gap” approach to economic growth. However, there are too many unrealistic assumptions in this model. The economy is assumed to be closed, in absence of a government, and has fixed savings rates. Furthermore, William Easterly conducted a study (2001) that essentially resulted in Tunisia being potentially the country in which there was a possible correlation between aid to investment, and investment to growth. The Solow growth model differs from Harrod-Domar, in that Robert Solow proposed that long-term growth can only be attributed to technological change (1956). Yet, while the Harrod-Domar model is recognized as flawed, it is more accepted than Solow’s model, even though it is extremely difficult to empirically prove both these models. In short, economists and policy-makers do not have a solid model for growth that can be applied universally. Given the economic, social and political (and in some cases, environmental) hardships in developing countries, any model for growth would have to be flexible enough to be interpreted on a country-by-country basis. Without applications being relative, we cannot be sure that every country will respond to foreign aid in the same way.

In addition, several renowned economists, such as William Easterly, have noted that people respond to incentives. This should be the number one consideration when thinking about foreign aid. If there is no incentive for people to whom aid is distributed to create sustainable solutions, aid will not increase growth as has been expected.

Amartya Sen defines “development” as the level of access to freedoms and capabilities to function in an economy (2000). He recommends that households in developing countries need to be provided with the appropriate ‘freedoms’ to be able to make rational choices. The more capabilities the poor have, the more choices they can make, and - assuming all choices made are rational – the more efficiently they can meet their needs.

Thus, combining the ‘people respond to incentives’ motif, and Sen’s definition of economic development, foreign aid has the potential to result in growth only when it is distributed specifically to improve government efficiency through clearly-defined organizational structures and accountability, social entrepreneurs and educational institutions.

Foreign aid should partially be invested in strengthening a government because this creates capital. One Wall Street Journal article brought attention to the world’s ‘intangible wealth’ (2007). According to the article, based on studies conducted by the World Bank, average capital owned per capita in the world does not account for all the capital that exists in the world. There is a huge portion, known as intangible capital, which is attributed to “intangible factors such as the trust among people in a society, an efficient judicial system, clear property rights and effective government”. As the World Bank, the IMF and economists such as Deborah Brautigam and Stephen Knack have suggested, there is a correlation between efficient government and growth (Brautigam, Knack 2004). Also, Craig Burnside and David Dollar are known for advocating that “growth in developing economies depends to a large extent on their own economic policies”. If we relate intangible capital to this, it can be derived that if governments can increase accountability by maintaining a solid framework of organization and hierarchy, this in itself will create a flow of capital through increased circulation of information and the various trust-relations between government officials and the people they work with and serve.

Given a solid framework of law and order, social entrepreneurs are given increased capabilities to function efficiently. In an interview with Riz Khan on Al Jazeera, William Easterly made clear that social entrepreneurs in poor countries have potentially the best ideas as to where foreign aid should go. Government bureaucrats in developing countries slow down the aid-distribution process, even when in cases where corruption is not considered a major problem (for most African nations, though, it is). Social entrepreneurs, on the other hand can easily distinguish where and how to distribute resources. They are also heavily involved with building human capital and keeping up with advances in technology. Social entrepreneurs have a solid idea of what exactly is needed through supply and demand mechanisms, since they are already involved – both, economically and culturally – in market activities. Due to this, innovation in poor areas can “leapfrog” through technology. This means that while more developed regions in the world experience the development in technology, poorer areas are implemented with technologies of current times.

Distributing aid to social entrepreneurs and for the cause of improving government organization has the potential to see that current problems are being solved. While governments maintain law and order, and see through the efficient execution of policies, social entrepreneurs can determine through their social networks how to service immediate basic needs in sustainable ways (after all, entrepreneurs think profits, too, and would like their initiatives to be self-sustaining). Yet, with increased aid being distributed through social entrepreneurs, there comes the question of sustainability in the longer-run, given innovations in technology.

An investment in efficient educational systems is therefore necessary for preparing for future problems. Aid could be given to subsidize the cost of going to school, or could be used to provide education in rural areas that have traditional community-based schools. Attempting to provide education to as many children and growing youth as possible encourages a different kind of saving: this saving has to do with human intellectual capital (Easterly 2003). Increasing educational capabilities has the potential to provide an increased number of local skilled workers, which in turn, will sustain the current investments in growth by strong, improved government legislature and social entrepreneurship. This is in tune with Sen’s ‘development as freedom’ idea: The government’s focus should be on maintaining current freedoms; the entrepreneurs create new freedoms; and the people recognize and utilize these freedoms to progress.

Easterly summed it up best in his interview with Riz Khan. “Home grown development is what works” as opposed to development ‘brought in’ by outside countries. Essentially, distributing foreign aid specifically to better governments, encourage social entrepreneurship and increase educational capabilities is one step closer to home-grown development. In this way, foreign aid is being used firstly to speed up home-grown ideas to reduce poverty, and secondly to secure the future by preparing younger generations to be more skilled in order to sustain growth.

Central to the foreign aid debate is the question of whether the aid is getting to the people that need it most. But in order for aid to flow efficiently through the various protocols and eventually be received by households in the form of increased freedom and decreased dependency, research shows that there needs to be a strong infrastructure of a driven government, but also a driven market. Therefore, foreign aid seems to only be effective when it is allocated specifically to improving government structures and accountability, to social entrepreneurs with innovative and per-country-customized growth solutions, and to the improvement of education.

Endote: A full Works Cited document can be obtained from me via e-mail.