Aid and Growth
| Author | Steven Radelet, Michael Clemens, and Rikhil Bhavnani |
| Position | Senior Fellow/Research Fellow/Research Assistant at the Center for Global Development in Washington D.C. |
New evidence shows that aid flows aimed at growth have produced results
Controversies about aid effectiveness go back decades. Critics such as Milton Friedman, Peter Bauer, and William Easterly have leveled stinging critiques, charging that aid has enlarged government bureaucracies, perpetuated bad governments, enriched the elite in poor countries, or just been wasted. They cite widespread poverty in Africa and South Asia despite three decades of aid, and point to countries that have received substantial aid yet have had disastrous records-such as the Democratic Republic of the Congo, Haiti, Papua New Guinea, and Somalia. In their eyes, aid programs should be dramatically reformed, substantially curtailed, or eliminated altogether.
Supporters counter that these arguments, while partially correct, are overstated. Jeffrey Sachs, Joseph Stiglitz, Nicholas Stern, and others have argued that, although aid has sometimes failed, it has supported poverty reduction and growth in some countries and prevented worse performance in others. They believe that many of the weaknesses of aid have more to do with donors than recipients, especially since much aid is given to political allies rather than to support development. They point to a range of successful countries that have received significant aid such as Botswana, Indonesia, Korea, and, more recently, Tanzania and Mozambique, along with successful initiatives such as the Green Revolution, the campaign against river blindness, and the introduction of oral rehydration therapy. In the 40 years since aid became widespread, they say, poverty indicators have fallen in many countries worldwide, and health and education indicators have risen faster than during any other 40-year period in human history.
Throughout this debate, however, most analysts have missed a critical point by treating all aid as if it were alike in its impact on growth. In a recent Center for Global Development study, we try to rectify this gap by exploring the impact on growth of aid flows that actually are aimed at growth.
Over the past three decades, three broad views have emerged on the relationship between aid and growth:
Aid has no effect on growth, and may actually undermine growth. There are several reasons why aid might not support growth. It can be wasted on frivolous expenses such as limousines or presidential palaces, or it can encourage corruption. It can undermine incentives for private sector production, including by causing the currency to appreciate, which weakens the profitability of tradable goods production (an effect known as "Dutch disease"). Similarly, food aid, if not managed appropriately, can reduce farm prices and hurt farmer income. Aid flows potentially can undermine incentives for both private and government saving. They can also sustain bad governments in power, helping to perpetuate poor economic policies and postpone reform.
This view has been supported by a range of empirical studies, mostly published from the early 1970s through the mid-1990s. While these studies have been influential, many are of questionable quality, especially using today's research standards. For example, most assume only a simple linear relationship between aid and growth in which each new dollar of aid has exactly the same impact on growth as the first (eliminating the possibility of diminishing returns) and ignore possible endogeneity (in which faster growth might attract higher aid, or both might be caused by something else), among other issues. A recent paper by Raghuram Rajan and Arvind Subramanian (2005), which also assumes a simple linear relationship for most of its results, stands in sharp contrast to the bulk of recent research on the issue, as discussed below.
Aid has a positive relationship with growth on average (although not in every country), but with diminishing returns. Aid could support growth by financing investment or by increasing worker productivity (for example, through investments in health or education). It can bring new technology or knowledge, either imbedded in capital goods imports or through technical assistance. Several early studies found a positive relationship between aid and growth, but this strand of the literature took a significant turn in the mid-1990s when researchers began to investigate whether aid might spur growth with diminishing returns-that is, that the impact of additional aid would decline as aid amounts grew. Oddly, since economic theory and research had recognized the importance of diminishing returns on investment since the 1950s, research on aid and growth until the mid-1990s tested only a linear relationship, a specification that (surprisingly) persists in some studies even today.
Although they have received comparatively less popular attention, most of these studies (some...
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