Aid and Growth: The Policy Challenge

• Author: Raghuram Rajan
• Position: Economic Counsellor and Director of the IMF's Research Department

We need more than aid to break the cycle of poverty

Now that developed countries and international financial institutions have committed themselves to writing off the debt of highly indebted poor countries, the challenge will be to convert these resources into actual growth and faster progress toward the Millennium Development Goals. While for some it may seem that the war against poverty can be won simply by getting rich countries to provide more debt relief and aid, the view of experts-including those behind recent reports by the U.K. Commission for Africa and the Millennium Project-is that this is just one of the necessary ingredients. It's early days yet in the campaign to make poverty history. If it's to succeed, we have to recognize the failures of the past as well as be open-minded about the solutions for the future. And the first thing to recognize is the chequered history of aid.

Aid and growth

The best way to get the poor in low-income countries out of poverty is to strengthen economic growth in those countries. To the layperson, this may mean just sending these countries more aid. Yet one point about which there is general agreement among economists is that there is little evidence of a robust unconditional effect of aid on growth.

Before going further, let me say that the word "effect" implies causality. This is different from correlation. It's possible to find in the data a negative correlation between aid and economic growth, but this doesn't mean that more aid causes less growth. For instance, if aid tends to go to countries that are doing badly, you would get aid and growth being negatively correlated even though aid doesn't cause poor growth: the direction of causation is the reverse. This is why economists use a technique called instrumental variables analysis to tell causality from simple correlation. In recent papers that I have written with Arvind Subramanian of the IMF's Research Department, we describe how we found a negative correlation between aid and growth when we didn't use instrumental variables, but how this essentially disappeared once we used the technique (Rajan and Subramanian, 2005 a and b). This means that aid skeptics may have been mistaken in viewing negative correlations found in the past as supporting their view. But unfortunately, we don't find a robust, significant positive correlation either.

Does this mean that aid can't, in any circumstances, boost growth? Of course not! The layperson's thinking does, of course, have some significant basis. Poor countries are short of resources and ought to be able to put aid inflows to good use. There are case studies of countries that have grown using aid, and specific aid projects that have helped the poor enormously. What we economists haven't identified is a reliable set of economic circumstances in which we can say that aid has helped countries grow. And this isn't for want of trying.

For example, an influential study suggested that aid leads to growth, but only in countries that have good governance (Burnside and Dollar, 2000). This certainly seemed a very reasonable conclusion-a necessary condition for aid to help growth is obviously that aid receipts shouldn't...