The Effectiveness of Aid to Development. Focus on the Aid-Growth literature.

Graduate Programme in International and Development Economics

Facultés Universitaires Notre-Dame de la Paix, Namur
Université Catholique de Louvain

Academic Year 2005-2006

The Effectiveness of Aid to Development
Focus on the Aid-Growth Literature
François Defourny

Promoter: Professor Jean-Philippe Platteau Tutor: Christian Tritten

Project presented as part of the requirements for the award of the Master in
International and Development Economics

Table of Contents

1. Introduction

2. The objectives of aid to development

3. Aid effectiveness

4. The aid-growth relationship

5. The aid-growth literature

5.1. The optimism of Hansen and Tarp (2000)

5.2. The swinging pendulum of Clemens, Radelet and Bhavnani (2004)

6. New look at the aid-growth literature

6.1. The first part of the literature

6.2. Two turning points for a new aid-growth literature

6.2.1. Boone: the methodological turning point

6.2.2. Burnside and Dollar: the ideological turning point

7. The second part of the literature: reactions to Burnside and Dollar (1997) 7.1. The indicator for «good» economic policy

7.2. Sensitivity to model specification

7.3. Other conditioning variables than economic policy

7.4. Sensitivity due to the data base

7.5. Problem with the definition of aid

7.6. The detrimental consequences of the selectivity principle

8. Contemporary consensus and controversy

9. Conclusion

Acknowledgments

I wish to thank sincerely Christian Tritten for his precious availability. His assistance and his advices have been particularly helpful. I also would like to acknowledge Professor Jean-Philippe Platteau for the enlightening comments he made. Finally, I am grateful to Professor Michel Mignolet, Marie-Eve Mulquin and all my colleagues of the CREW who gave me the necessary flexibility to realise this work.

Introduction

The question of the effectiveness of aid is a particularly sensitive issue as it may have colossal implications for many developing countries. However, it is quite difficult to have a clear opinion about the ability of international assistance to contribute to development. The existing literature seems to be abundant but very diverging. Between optimistic donor's rapports, contradictory scientific publications and militant pleas of some NGOs the question is apparently difficult to answer. We decided to investigate in this direction to clarify as far as possible this important issue.

After a brief presentation of the diversity of aid objectives, we will see how the effectiveness of aid to development has been circumscribed to its impact on economic growth. We will then analyse two articles which tried to synthesize the existing literature on this topic. Next, we will propose our own interpretation of this literature. We will discuss the important shortcomings and failures of the ongoing debate about the efficiency of foreign assistance. Finally, we will observe the surprising fragility of nonetheless influent studies with crucial policy implications.

The objectives of aid to development

The concept of international assistance appeared in the 19^th century but the real expansion of foreign aid to development started with the launch of the Marshall plan and the creation of the Bretton Woods institutions in the aftermath of World War II. Since then, the history of international cooperation has been largely influenced by the evolution of geopolitics and development thinking.¹ Initially widely considered as a weapon against the soviet influence the objectives of foreign aid took various directions following the donors and their motivations. Hence, aid has been attributed for many different purposes and in many different forms. Even if we stick to official objectives of bilateral development agencies, they appear to be very diverse.² They go from self-sustaining growth to poverty reduction through good governance. But the variety gets even larger as we consider donor's real intentions. Amongst

1 See Kanbur (2003 p 4-9)

2 See Lensink and White (1999, p 15-16)

the latter, some are hardly avowable³. As Boone (1996, p306) writes: «Despite the popular belief that aid is primarily motivated to assist the poor, substantial evidence points to political, strategic, and welfare interests of donor countries as the driving force behind programs.»

For Alesina and Dollar (1998), there is general agreement about what matters for aid allocation, namely poverty of the recipients, strategic interests, colonial history, trade, political institutions, etc. But the dominant variable can be very different from a country to another. After looking at several studies analysing the determinants of foreign aid, Boone (1996) concludes that aid flows primarily reflect donor's interest rather than recipient needs. In this sense, Alesina and Dollar (2000) find evidences that assistance allocation was essentially dictated by political and strategic consideration much more than by economic needs and policy performance of the recipients. In a more recent study, Berthelemy (2004) find that the vast majority of donors behave in a rather selfish way.

3. Aid effectiveness

The question of whether aid globally works or not has always been highly controversial and the debate is constantly and rapidly evolving. The diversity of goals, donors and types of aids makes the concept of «aid effectiveness» quite unclear. In consequence, the efficiency of aid has been approached from different methodological and ideological point of views. Some studies have concluded that aid was only able to increase bureaucracy, enlarge inequalities or develop corruption. On the other hand, many economists have argued that growth would have been lower and poverty worse without international assistance.

As well mentioned by Kanbur (2000, p15): «Given the great ideological divides in development doctrines and in aid policy, and given the ambiguities in the theoretical analysis of the impact of aid [...] empirical literature on aid evaluation has taken on special significance.» This empirical literature can roughly be divided in two main streams. The first one investigates the effects of foreign aid on receiving countries. The other one studies the determinants of foreign aid allocation and the behaviour of donor agencies. Both have led to

3 Hjertholm and White (2000, p81) attempt to synthesize the core evolution of aid throughout the last decades. But their schematic synthesis does not reflect the large diversity of objectives going form very altruistic behaviour to perfectly selfish interests.

numerous analysis and fierce debates. However, for the purpose of this work, we will essentially focus on the first part of this literature.

4. The aid-growth relationship

In order to make cross-country studies feasible, it was necessary to choose some kind of «common denominator» able to reflect the general efficiency of aid despite de diversity of its objectives. The aid-growth relationship is incontestably the most common relationship used in the literature to measure the macroeconomic effectiveness of foreign aid. Concretely, in the regressions, positive and significant coefficients on the aid variable is interpreted as evidence that aid was effective in enhancing growth. As Quibria (2004, p17-18) expresses: «Although poverty reduction has been accepted as the overriding objective of international development assistance, this concern has not found adequate reflection in the current research: paradoxically, much of the current research effort has been couched in terms of economic growth rather than poverty reduction.» In fact, this «second best» indicator of efficiency is essentially motivated by the poor availability of data in most developing countries⁴. It can also be explained by the unfortunate tendency among economist to consider growth and poverty reduction to be synonymous. The following statements of Easterly (2003, p34) reflect this misunderstanding: «the aid bureaucracies [these days] define their final objective as «poverty reduction, [which is] today's more politically correct name for `growth'.»

Nevertheless, this decision to consider the efficiency of aid only in terms of its ability to enhance national growth entails important limitations. Restricting the evaluation of aid effectiveness to its impact on national growth means that we make somehow the underlying assumption that economic growth benefits to the targeted people, namely the inferior social classes. In other words, we make the well known hypothesis that growth «trickles down» to the poor. In the late nineties, different studies found a positive relationship between growth and poverty reduction⁵. Some kind of consensus emerged then about the positive contribution of growth to poverty decline. But, this hypothesis is not equally valid everywhere⁶. As Rodrik

4 The reliability of such a statistic may be deeply questioned, as we know the importance of informal activities in developing economies.

5 We refer to Dollar and Kraay (2000) and Gallup, Radelet and Warner (1999) for the concept of relative poverty, whereas Ravallion (2000) and Collier and Dollar (2001, 2002) analyze the impact of growth on absolute poverty. They all come to the conclusion that growth is «good for the poor».

6 This is especially the case in some countries where economic growth is mainly fed by the exploitation of natural resources. (e.g. the well known «oil curse»)

(2000, p1) writes: «the poverty-reduction payoff from growth depends in part on the specific circumstances and policies in each country.» Furthermore, if the majority of authors agree on the idea that growth increases small revenues, the extent of this gain is still subject to fierce debate. In many cases inequalities appear to widen with economic growth⁷. So, if growth has been accompanied by an improvement in Gini coefficients in countries like Taiwan, Bangladesh and Egypt, it may also worsen social inequalities in others such as Chile, China, and Poland. This argument leads us to the discussion about the different concepts of absolute, relative and even subjective poverty. It cannot unconditionally be said that one kind of poverty should be targeted rather than the others in order to improve people's welfare. For statistical ease, «absolute poverty» is usually preferred by economists. It does not mean that it is the best indicator of (dis)satisfaction. On the other hand, is increasing inequality necessarily detrimental if it at the same time everyone has a higher income? At least, this question requires careful thought.

In addition, looking at this aid-growth relation to estimate its ability to reach its objectives may lead to other limitations. As we will see later there exist many kinds of assistance and some categories of aid may not target economic growth at all. We find it particularly frustrating to limit the assessment of support to fields like human rights, cultural emancipation, gender equity or nature protection to there impact on growth. In comparison, it is a bit like restricting the benefits of scientific research to its marketable value.

Finally, even if the analysis is limited to economic variables, one can wonder if it is appropriate to limit the concept of development to economic growth. It is a frequent mistake in the economic literature to confuse economic growth, development and welfare⁸. What is the contribution of economic growth to development when human indicators are pointing in the opposite direction? This important issue wanders from the purpose of our work. It is nevertheless important to remain critical when we narrow the scope of an analysis for technical reasons.

Despite all these arguments that reduce seriously the explanatory power of the aid-growth relation, the overwhelming majority of attempts to measure global aid effectiveness have been couched in terms of impact on growth. As Amprou and Chauvet (2004, p45) say, the real

7 See for instance De Janvry and Sadoulet (2000) for the case of Latin America

8 We refer to Cassiers and Delain (2006)

issue of foreign aid is poverty reduction. But very few econometric studies departed from the aid-growth relationship to analyse the real effectiveness of aid. This has given birth to a fierce and apparently inconclusive debate that deserves some critical analysis. For this reason, we will stick to this aid-growth relationship as well. In the following, we should keep in mind the previous limitations to interpret cautiously what we mean by «aid effectiveness».

5. The aid-growth literature

The literature on aid-growth linkages started during the 1 960s with the rising question of whether aid works. «There are some periods when assessing aid effectiveness becomes particularly intensive. These coincide with cycles of doubt on the efficacy of aid as an instrument of foreign development.» (Kanbur, 2003, p 15) Over time, the successive empirical studies have given some strong contradictions. Some authors have tried to structure chronologically the debate. This seems to be an important step to clarify the ideas on this issue. We will here discuss two of these reviews.

5.1. The optimism of Hansen and Tarp (2000)

In a quite optimistic article, Hansen and Tarp (2000) distinguish three generations among 131 cross-country regressions. They essentially consider the methodology applied to measure the efficiency of aid. The first generation looked at the impact of foreign aid on domestic savings. Already, the question turned into debate. After more than a decade of consensual optimism, Griffin (1970), Griffin and Enos (1970) and Weiddkopf (1972) launched the discussion with their pessimistic conclusions. They found rates of growth negatively linked with the amount of foreign capital inflows. They argued that aid may retard development by decreasing domestic savings. To retort to this «revisionist» literature, Papanek (1972) was the first to regress growth on aid. After disaggregating capital flows into foreign aid, private capital and other inflows, he found a strongly significant positive correlation between aid and growth for a sample of 51 countries observed from 1950 to 1965. Provided the convincing arguments of Papanek, Hansen and Tarp (2000, p7) conclude: «The overwhelming evidence from these studies is that aid lead to an increase in total savings, although not by as much as the aid flow... aid spurs growth.»

The second generation of studies switched to the aid-investment relationship to estimate the impact on growth. This period was also considered by Hansen and Tarp (2000) to be optimistic since all but one article show a positive impact of aid on growth. The only exception was the much cited Mosley et al. (1987, 1992). In consequence, the conclusion of the authors was that the aid-investment link was positive, leading probably to a higher growth rate. As we will see later, Hansen and Tarp's positive perception of the early literature is a bit surprising. Other authors conclude at best that the first decades of research about the aid-growth linkages was rather inconclusive⁹.

Finally, by the end of the nineties, analyses became more and more sophisticated. With one emblematic article of Burnside and Dollar (1997), this can be considered as the third and last generation of studies. Hansen and Tarp (2000) review a few of these recent papers¹⁰ but found only one outlier¹¹ concluding that aid has no effect on growth. All the remaining articles they analyse found a significant impact of aid on growth either conditional on appropriate economic policy or not. This allows them to say about aid that: «There is a significant effect on growth, either alone or in combination with a policy variable.» (Hansen and Tarp, 2000, p16). Before providing our own discussion on all this literature we would like to account for another way to analyse its evolution.

5.2. The swinging pendulum of Clemens, Radelet and Bhavnani (2004)

In another exercise to distinguish successive trends in the empirical literature of aid effectiveness, Clemens, Radelet and Bhavnani (2004) focus on the outcomes of the different authors in their quest to define different phases. For them the literature is comparable to a swinging pendulum alternating between optimistic and pessimistic periods. We think this conclusion is a little bit excessive since they tend to drop a number of contradicting regressions in order to provide a more convincing characterisation of a period¹². After a first period of dominating optimism, they found a surge of criticism in the early seventies against aid to development¹³. Immediately after, this revisionist literature has been counter-attacked

9 See for example Easterly (2003, p26)

10 Burnside and Dollar (1997), Hadjimichael et al. (1995), Durbarry et al. (1998), Hansen and Tarp (1999)

11 Boone (1996)

12 For example, the second phase of Clemens, Radelet and Bhavnani (2004) running from 1972 to 1980 is thought to be an optimistic period regarding the aid-growth relation. Nevertheless, the articles of Gupta (1975) and Newlyn (1973) presented very ambivalent results.

13 Griffin (1970), Griffin and Enos (1970)

by Papanek (1972) with his positive correlation between aid and growth. Thereafter, a period of controversy¹⁴ lasted until the key paper of the last decade, namely the very pessimistic one of Boone (1996). Since then, the literature can be divided into its sceptic supporters and its opponents arguing that foreign aid has an unconditional positive effect on recipients' growth.

As we can see, these two approaches offer interesting structures to analyse the past literature. However, they sometimes interpret a particular article in a way that suits them best. In other words, they tend to choose the best interpretation of a study in order to remain consistent with the proposed framework. An illustration of this practice is the appreciation of the link between the article of Boone (1996) and the one of Burnside and Dollar (1997). On the one hand, Hansen and Tarp (2000) clearly oppose the pessimistic Boone (1996) and the rather optimistic Burnside and Dollar (1997). On the other hand, Clemens et al. (2004) range Burnside and Dollar (1997) among the studies that «take Boone to be more or less correct».

This leaves us with an ambiguous feeling. Is it impossible to find one single conclusion about the impact of foreign aid on economic growth? Rajan and Subramanian (2005, p5) summarize explicitly our intuition about this empirical literature: «The literature has sometimes followed a cycle in which one paper finds a result, and is followed by another paper with a twist, either overturning or qualifying the previous result, followed by another, and so on. This has had some undesirable effects on policy with advocates selectively using results to bolster their preferred view on aid.» In the next part we will try to reconsider the entire aid-growth literature in a historical perspective.

6. New look at the aid-growth literature

Contrary to the two previous analyses, we prefer to divide the aid-growth literature in two major periods separated by two almost simultaneous turning points in the second half of the nineties. If we want to clarify a little bit the debate about aid effectiveness, we need to focus on the recent literature published after the mid-nineties. This does not mean that earlier articles are useless but they were quite contradictory and have been abundantly criticised. Nevertheless, we think necessary to discuss this early literature despite all its shortcomings to understand the transition to the last generation of studies.

14 Mosley (1980), Mosley et al. (1987) and Boone (1994) were then opposed to Gupta & Islam (1983) and Levy (1988)

6.1. The first part of the literature

In the early nineties, after a few decades of inconclusive assessments of aid, emerged some kind of «micro-macro paradox» as named by Mosley (1987). There was indeed a striking contrast between the relative optimism of a majority of studies conducted at the micro level and the relative pessimism regarding the ability of aid to increase growth performance at the country scale. Projects appeared to be successful whereas there was no visible impact of aid at the macro level. At that time, a few pessimistic studies such as Bauer (1993) have been particularly influential in promoting the idea that aid is wasted or even detrimental for recipient's development¹⁵.

If we except Hansen and Tarp (2000, p16) which is, to our knowledge the only article to consider that «A very few highly influential studies in each generation have argued the negative», the majority of authors agree about the pessimistic evolution of the first decades of aid-growth research:

McGillivray (2006, p16): «For many decades the research literature on the country-level impacts of aid often sent ambiguous messages as to whether aid was effective in promoting growth and reducing poverty... The overall consensus about these impacts was rather pessimistic ... «

Clemens et al. (2004, p7): «(after a decade of controversy)... Many researchers have taken Boone (1996)'s findings as confirmation of the «macro-micro paradox»... «

Kanbur (2003, p16): «Throughout the assessments of aid that have been carried out over the last few decades, there seems to have emerged a micro-macro paradox.»

Lensink and White (1999, p64): «Overall, the strict macroeconomic studies... seem to be inconclusive with respect to the effectiveness of aid... Most authors argue that the macroeconomic impact of aid was modest or that aid did not have any affect on economic growth.»

Hudson (2004, p1 85): «Hence, until recently, the dominant view within economics had become pessimistic with respect to the pas effectiveness of aid...»

In the early nineties, the «micro-macro paradox» due to the general pessimistic conclusions of macro studies led to an unprecedented crisis of legitimacy of aid to development. In consequence the overall aid flows to developing countries fell drastically. Nowadays this paradox is well understood. Indeed, a particular project may reach its own objectives and create simultaneously important distortions. If the evaluation at the local level is not

15 Schwalbenberg (1998) argues that their evidence is largely anecdotal and denies their finding that aid has led to the adoption of damageable economic policies.

conducted at «shadow price» its conclusion may be positive even if the global balance sheet is in deficit.

Moreover, the high number of pessimistic macro studies can be explained as well by analysing the framework of this early literature. Growth models have been important in influencing the specification of empirical relations. Until recently, the most widespread models used to examine the macroeconomic impact of aid were the different types of «gap models»¹⁶. In short, these models consider the availability of capital goods as the constraining factor to enhance economic growth in less developed countries. In this sense, aid may spur growth by raising investment. In other words, foreign aid fills the gap created by insufficient savings or exports.

This early literature has been extensively criticized. Apart from the poor quality of the data available for these different articles, the criticisms focused essentially on two unrealistic assumptions of the «gap models». The first problematic hypothesis concerns the assumed linear relationship between investment and growth through a constant capital-output ratio. As Easterly (2003, p31) emphasises: «Most economists since Solow (1957) have felt uncomfortable with a Leontief-style production function that does not allow the substitution of labour for capital.»

The second critical assumption of the «gap models» has been exposed by Boone (1996). It is the strong hypothesis that aid necessarily finances investment rather than consumption. Morrissey (2005) points out that there is probably not more than one third of total foreign aid devoted to productive investment. The largest part of aid is actually dedicated to health expenditures, education, emergency aid or debt cancellation which will have very little impact on growth in the short run.

As a consequence of these two core assumptions, until the mid-nineties, economists only tested linear relationships between aid and growth despite the improvements in growth literature. As Durbarry et al. (1998, p1) document: «Many aid-growth investigations ignore many of the recent advances in growth theory». Easterly (2001) tests the credibility of such

16 There exist different variant of the «gap models». The most employed one is the so called «two gap model» of Chenery and Stout (1966), combination of the trade gap model (Balassa, 1964) and of the saving gap model (Rosenstein-Rodan, 1969; Fei and Paauw, 1965).

gap models for a sample of 88 recipient countries. For only one case, Tunisia, the «gap» approach seems to hold empirically.

There are definitely many reasons to expect a nonlinear aid-growth relationship. Diminishing return of aid is actually very plausible. First, Hadjimichael et al. (1995), Durbarry et al. (1998) or Lensink and White (1999) refer to the limited absorptive capacity of recipient countries¹⁷. Hence, there can be «too much» aid intended for a particular country if aid inflows can not be productively utilized. This can for example happen if country's management capacities are not sufficient. Another explanation of these diminishing returns could be the fact that aid does not flow neutrally into a country. The recipient economy can be made worse of because of the immiserization problem¹⁸. This may happen when domestic inputs required for a particular project are greater than its net output. In other words, this is the case of a very costly project leading to a net loss for the «beneficiary» country¹⁹.

Secondly, Lensink and White (1999) present several early studies pointing at a negative relationship between foreign aid and domestic savings. They also argued that development aid could enable countries to hold an overvalued currency and thereby stimulating capital flight and depressing the competitiveness of a country. Finally, aid may encourage unproductive public expenditures so that the positive impact of foreign assistance could be off set by government reaction. This has been called the fungibility problem²⁰. All these arguments demonstrate the weak theoretical background and the abundant empirical failings of the first part of the literature.

Therefore, in the early nineties, the only realistic statement was given by White (1992, p121) «We know surprisingly little about aid's macroeconomic impact. The combination of weak theory with poor econometric methodology makes it difficult to conclude anything about the relationship between aid and growth.»

17 There can be first diminishing and even negative returns to aid. This can be illustrated by the aid of a Laffer curve. Estimates of the turning point at which the impact of aid on growth turns negative vary extremely: Some authors (Dalgaard and Hansen, 2001; Burnside and Dollar, 1997) estimated this turning point below 20% of GDP whereas others (Lensink and White, 2001; Gomanee et al., 2002) found it higher than 40%.

18 The famous «Dutch disease» is a particular case of this problem. (See Kanbur, 2003, p1 1)

19 This could be the case of development agencies' projects requiring important co-financings from the «beneficiary» country but leading to relatively small output.

20 However Lensink and White (2000) underline that fungibility is not necessary a problem if recipient countries pursue appropriate growth objectives.

6.2. Two turning points for a new aid-growth literature

Actually, two major turning-points took place in the literature during the second half of the nineties. Though they are very different in their philosophy, together, they gave birth to a new generation of aid-growth empirical studies leading to both improved methodology and modifications in the conclusions.

6.2.1. Boone (1996): the methodological turning point

Boone's (1996) pessimistic conclusions are quite in line with most of precedent articles and so it confirms Mosley's idea of the «micro-macro paradox». As we already mentioned, he finds that aid does not increase growth nor benefits the poor because it tends to finance consumption rather than investment. So, the main result of aid seems to be an increase of the size of governments. Nevertheless, this article is a kind of turning-point in the sense that it is probably the first one to initiate the movement of a methodological revolution. Compared to previous studies the new generation of articles brings several significant innovations.

First, they are now working with panel data covering a larger number of countries and years. As Hudson (2004, p1 87) explains, data are more reliable than ever: «The problems relating to data are declining gradually over time as both more and better quality data becomes available.» Secondly, authors are now taking account of innovations in matters of growth theory. Variables reflecting the quality of institutions and economic policies of the beneficiary countries are now included in the regression. Third, it has become the rule to address explicitly the possibility of endogeneity of aid²¹. Last but not least, the inclusion of regressors such as aid^² and aid×policy enables a non-linear aid-growth relationship²². Quibria (2004, p9) confirms this major innovation: «Perhaps the principal contribution of the Boone study has been to stimulate further professional interests in a research area that was fast approaching rapid diminishing returns.»

21 The amount of aid allocated to a country is not independent from its initial level of GDP since aid appears to go primarily to poor countries.

22 Cfr. Arguments discussed earlier

6.2.2. Burnside and Dollar (1997): the ideological turning point

In 1997, in this context of aid's legitimacy crisis and constantly decreasing international assistance flows, Burnside and Dollar wrote their «extraordinarily influential paper»²³: Aid, Policies and Growth. Initially known as a World Bank working paper it was only published three years later in the American Economic Review. By means of a new data base of the World Bank, they want to revisit the pessimistic conclusions of Boone (1996) and other recent articles. In this sense, it gave a new impulse to the debate. The following statements confirm this new dynamism:

(Roodman 2004, p2): «The work of Burnside and Dollar has brought corroboration and challenges.»

Easterly (2003, p26): «The Burnside and Dollar (1997) paper gained prominence because it addresses the scepticism implied by Boone and by the lack of consensus from the early literature». Although, from a methodological point of view their innovation was quite minor, their conclusions brought new arguments to the discussion about aid effectiveness.»

Quibria (2004, p9): «The paper that has done the most to stimulate the interest in the topic is the one of Burnside and Dollar (1997).»

McGillivray (2005, p2): «The turning point in the literature is defined by two, very well-known studies. The first is Burnside and Dollar (1997) and the second is a Assessing Aid: What Works, What Doesn't and Why (World Bank, 1998). The latter report results presented in the former.»

Their major novelty is the inclusion in the equation of an interaction term between foreign aid and economic policies. This «aid×policy» interaction term enables to make a distinction between countries with adequate economic policies and those with unfavourable ones. Hence, the simple correlation of aid and growth appears to be close to zero²⁴ but this is only true for country with mean policy level. Indeed, the impact of aid on growth appears to be significantly positive in good policy environments. Their conclusion is that aid effectiveness in the growth process is directly dependent on the quality of economic policies²⁵. Whereas Boone's (1996) conclusions offered no opportunity to increase aid effectiveness, Burnside and Dollar (1997) suggest a more encouraging discourse since better selectivity in aid allocation should enhance its impact on economic growth.

Obviously, such a finding has led to important political consequences: «This work has clear implications for how to make foreign aid more effective... If they (donors) want to have a

23 See Easterly, Levine and Roodman (2003, p1)

24 In this sense Burnside and Dollar (2000) is in consistent with Boone (1996). 25 They also found that foreign aid suffers from diminishing marginal returns.

larger impact on growth and poverty reduction, then they should place greater weight on economic policies of recipient.» (Burnside and Dollar, 1997, p4) In the years that follow this publication many development agencies adapted their allocation behaviour to adopt the selectivity principles recommended by Burnside and Dollar. The Economist (June, 1999) also expressed this concept of selectivity that became so popular at that time: «Countless studies have failed to find a link between aid and faster economic growth.... Rich countries should be more ruthless about how they allocate their largess, whether earmarked or not. Emergency aid is one thing. But mainstream aid should be directed only to countries with sound economic management. In other words, aid could work if properly directed.» Such strong statements gave rise to abundant reactions. As we will see, the application of the selectivity principle as suggested by Burnside and Dollar (1997) was probably not a very opportune decision.

7. The second part of the literature: reactions to Burnside and Dollar (1997)

Because of its important political implications Burnside and Dollar (1997) have provoked a huge amount of comments and criticisms. Because of its emblematic role, it has attracted much attention²⁶. But most of the remarks that follow do not exclusively concern this initial article. Therefore they can be extended to several other articles of the same nature²⁷. We think important to present that critical literature since these reactions constitute the core of the ongoing debate. Dalgaard et al. (2004, p197) write about this: «It should be clear by now that much of the current discussion centres on the question if bad policies - in addition to being detrimental to growth - imply that aid is wasted.»

7.1. The indicator for «good» economic policy

Burnside and Dollar (1997) estimate the quality of economic policies by compiling a simple economic policy index²⁸ out of three measures of inflation, trade openness and budget deficit. This method presents several shortcomings revealed in the following studies. Berthélémy and Varoudakis (1996) demonstrate the limited impact of trade openness for economies with underdeveloped financial system. Lensink and White (2000) suggest that the relation between

26 It is important to notice that the following reactions to Burnside and Dollar (1997) may be either more pessimistic or more optimistic regarding the effectiveness of foreign aid.

27 For instance, «Assessing Aid: What Works, What Doesn't and Why» of the World Bank (1998) was completely in line with Burnside and Dollar's conclusions.

28 This economic policy index was later referred as the Burnside and Dollar policy index.

inflation and growth is probably non-linear and so could not be catch by a fixed index. Amprou and Chauvet (2004), emphasize that budgetary surplus is not automatically favourable for growth. Easterly (2003) criticizes the subjective and opaque aspect of the trade openness variable²⁹ used by Burnside and Dollar (1997). When he replaces the latter by more sophisticated alternatives, despite a significant correlation between the new policy variable and growth, the «aid×policy» interaction term looses its significance.

Furthermore, restricting economic policy of a country to these three variables may be a little too synthetic. Indeed, Dalgaard and Hansen (2001), Hansen and Tarp (2000, 2001), Hudson and Mosley (2001) and Lensink and White (2001) all test, in different ways, the relationship between aid and the «Burnside and Dollar policy index». They all found insignificant results. This means that the identification of which policies really matter for growth remains problematic. In the following literature, authors usually prefer the concept of «economic and institutional performance» illustrated by the much more evolved CPIA index³⁰, measured by twenty institution and policy components³¹.

More fundamentally, as Quibria (2004) expresses, what donors usually require as «good» polices may sometimes be historical, contextual and path-dependent and so not widely accepted. Their selectivity process is culturally biased. Hence, the basis for assessing one country's performances should be the concrete and measurable results of foreign aid and not «subjective assessments of policies and institutions against the benchmark of the imaginary ideal setup» (Quibria, 2004, p.34).

7.2. Risky interpretation and sensitivity to model specification

First, Lensink and White (2000) and Guillaumont (1999) indicate that the «aid×policy» interaction term needs to be interpreted carefully. It can mean both that the impact of aid on growth appreciates with the quality of policy, and that the impact of policy on growth increases with the quantity of aid.

29 This indicator has been introduced by Sachs and Warner (1995)

30 CPIA = Country Policy and Institutional Assessment

31 This policy index has been criticised as well. See Dalgaard, Hansen, and Tarp (2004) for three pertinent remarks.

Furthermore, some authors demonstrated the high sensitivity of Burnside and Dollar's results to model specification. Among those, Hansen and Tarp (2001) and Dalgaard and Hansen (2001) modify Burnside and Dollar (1997) regressions in different ways. For example, when they add an «aid^²» term to the equation, the «aid×policy» interaction term looses its significance. On the other hand, aid appears to be effective on average, independently from policy variables. They also observe diminishing returns.

For Beynon (2001, p29): «There remain significant unexplained determinants of growth in all these models.» Hansen and Tarp (2001) also argue that there probably exists other unobserved country-level effects that give incorrect explanatory power to the «aid×policy» term. Indeed, if the regression fails to catch fully and properly all the determinants and constraints that influence economic growth, the estimated coefficient of aid will be biased. In this sense, Morrissey (2005, p1) underlines: «As aid is more likely to flow to poor countries that suffer growth-retarding characteristics (that are not specified), there is a greater likelihood of incorrectly drawing the conclusion that aid is ineffective.»

7.3. Other conditioning variables than economic policy

The literature contains a large number of variables, other than economic policy, that are presented to have a significant impact on economic growth. In consequence, there is a high attendant risk that any individual model does suffer from omitted variable bias and inconsistent estimators. As Gunning (2004, p54) says: «The idea is that the effect of aid on growth is conditional on a wide variety of country characteristics, not just on the policies pursued.» We will briefly present the major contributions to the discussion.

For Guillaumont and Chauvet (2001), aid is more effective in economically vulnerable countries³². In those countries, exposed to external shocks, it appears to be more difficult to maintain consistent economic policies. They conclude that aid should be allocated in priority to countries suffering from external shocks, terms of trade difficulties or natural disasters in order to help them to stabilize. Suspend their assistance because of poor policies would be very damaging. In the same sense, Collier and Dehn (2001) say that aid has more impact on growth in countries suffering from extreme fall of export prices.

32 Economical vulnerability can be measured by the instability of the agricultural production, the instability of exports earnings, long-term terms of trade trend and the size of the population.

Bloom and Sachs (1998) and Gallup et al. (1999) all find that geography has a significant impact on growth³³. From this, Dalgaard et al. (2004) investigate the aid-growth relationship for countries with part of their territory in the tropical areas. An advantage of this variable is the absence of endogenity worries. On average, aid seems to influence positively growth outside the tropics but not in them. In consequence, Dalgaard et al. (2004) see tropical area as an exogenous «deep determinant» of growth. If we refer to the principle of selectivity of Burnside and Dollar (1997), it would obviously be particularly unfair to penalise tropical countries because of their geographic situation.

The literature contains an extensive variety of other variables that have been found to condition significantly the efficiency of aid. Hence, Svensson (1999) highlights that aid is more effective in places with democratic institutions, whereas Islam (2003) pretends exactly the opposite, namely totalitarian governments reinforce the impact of aid on growth. For Petterson (2004), the degree of fungibility of aid in the recipient country is decisive. Collier and Hoeffler (2002) find out that countries emerging from conflict have larger absorptive capacities.

All these variables plausibly influence the aid-growth relationship and there probably exist others. However, Roodman (2003) find that for most of these studies, the significance of the results were very sensitive to observations and extensions of dataset. In any case, the conditional efficiency of aid seems to be much more complex than suggested by Burnside and Dollar (1997).

7.4. Sensitivity due to the data base

Several authors have criticized the sensitivity of Burnside and Dollar's results to small changes in the database. For instance, Easterly et al. (2003), use exactly the same specification as Burnside and Dollar (1997) but added new available data to the sample. Hence, the former database has been updated to 1997 and earlier gaps have been filled. As a result, the «aid×policy» interaction term becomes negative and insignificant. In other words,

33 Tropical land area, tropical disease and landlockedness seem to depress economic growth.

there is no support anymore for the finding that «aid is more efficient in a good policy environment».

In the same logic, Hansen and Tarp (2000) indicate the excessive sensitivity of Burnside and Dollar's conclusions. Actually, the significance of the «aid×policy» term depends only on five observations excluded deliberately from the sample³⁴. As these five «outliers» are re-included in the database, the conclusion of more efficient aid in presence of sound economic policy is not valid anymore. Moreover, Dalgaard and Hansen (2001) show that there is little logical basis for choosing these particular outliers over other observations. On the basis of predetermined criteria these five observations would probably have qualified. Then, they demonstrate how the exclusion of five alternative outliers may produce a regression that shows a positive impact of aid on growth. Once again Burnside and Dollar's (1997) conclusions appear to be seriously weakened.

7.5. Problem with the definition of aid

The definition of aid chosen by Burnside and Dollar (1997) is the «Effective Development Assistance». This original concept involves only the grant element of aid and excludes for instance, the loan component of concessional loans. In fact, the most usual definition of aid comes from the Development Assistance Committee of the OECD and is called «Official Development Assistance» (ODA). This second concept includes grants and preferential loans net of repayments of earlier aid loans. For example, this second definition of aid considers debt cancellation as effective aid to development whereas the first one does not. Both approaches make sense and their correlation is obviously high. But when using the alternative measure, Easterly (2003) find the crucial «aid×policy» interaction term not to be significant anymore. In the same vein, to test the robustness of Burnside and Dollar's (1997) findings, Ram (2004) splits the aid variable into multilateral and bilateral flows. This distinction is certainly justified, since their allocation procedures are significantly different. He also tries an alternative concept of policy. All this leads him to reject the hypothesis of aid effectiveness conditioned by sound economic policy.

34 They are: Nicaragua (1986-9, 1990-3), Gambia (1986-9, 1990-3) and Guyana (1990-3).

More fundamentally, most studies contain two weaknesses when they deal with the aid-growth relationship. First, they usually analyse the relationship between total aid and growth whereas an important part of this aid is not intended to promote growth. As we already mentioned, no more than thirty percent of global aid flows are allocated to productive investments. For the rest, food assistance and humanitarian assistance are not likely to have any positive impact on growth. As pointed out by Morrissey (2005), the second limitation has to do with time considerations. Most authors using panel data for cross-country analysis analyse the aid-growth relationship over periods of four years. As pointed out by Clemens et al. (2004), this is a very short period for such an analysis. Financing health or education may only influence growth over more than a decade. Nevertheless, the longer the period of observation, the more difficult it is to isolate the specific influence of aid.

To overcome this dilemma, Clemens et al. (2004) make the distinction between three different kinds of aid flows following their expected impact on economic growth. If aid is considered globally, it is logical to find a small relation with growth. On the other hand, if we restrict the analysis to the category of aid that is plausible to enhance growth in the short run, then the impact appears to be more than two times larger than earlier, even for a four years period of observation³⁵.

Finally, there may be another explanation for the low return of aid to development. This issue is strangely little discussed in the scientific literature but recently exposed by some NGOs³⁶. The major NGO ActionAid International argues that about two third of funds devoted to international cooperation is actually «phantom aid» that never reaches its target³⁷. This can be overpriced and ineffective technical cooperation, tied aid, debt relief, administrative costs or budget for the hosting of refugees. Actually, donor countries try to present the largest cooperation budget as possible. But the presence of some particular amounts within the official budget of development assistance is highly discussable. Though they recognize the existence of «phantom aid», the amount computed by ActionAid International has been largely contested by the OECD and other bilateral aid agencies. We will not enter further into this debate. In any case, an important percentage of Official Development Assistance is lost,

35 Unfortunately, Clemens et al. (2004) do not include an «aid×policy» interaction term in their regression. For that reason, the comparison with Burnside and Dollar (1997) is limited.

36 See ActionAid International, June 2005, «Real aid: an agenda for making aid work».

37 The target is considered to be the improvement of the living conditions of poor people.

wasted or diverted from its objectives. This has of course important consequences on the macroeconomic assessment of aid effectiveness.

7.6. The detrimental consequences of the selectivity principle

The political recommendations of Burnside and Dollar (1997) may have harmful implications to the neediest populations. As expressed by Quibria (2004, p1 1), «Despite the putative merit of selectivity, its implications for equity in poor countries can be quite adverse.» In fact, there seems to be a high correlation between low income and poverty on the one hand and limited administrative and institutional capacities on the other. If aid resources are allocated only to countries that can design and implement «good» policies, this would exclude automatically some poorer countries which need foreign assistance the most. On the other hand, selectivity will favour allocation to very few large countries with relatively «good» policies and administrative capacities. In other words, selectivity would affect countries where aid can have the greatest impact in terms of equity.

More fundamentally, these results beg two important questions. On the one hand, we may wonder whether it is really appropriate to measure aid effectiveness through its impact on economic growth. On the other hand, is it really optimal to have different kinds of aids with different objectives?

8. Contemporary consensus and controversy

After all these reactions, Burnside and Dollar's results appear to be seriously weakened. The idea that «foreign aid has a positive impact on recipient's economic growth provided that those countries have sound economic policies» is not so well accepted anymore³⁸. Actually, while it is difficult to deny that «good» policies and institutions could enhance aid effectiveness, there is still a strong controversy regarding what constitutes good policies or institutions. Nowadays, an incontestable majority of studies find some positive impact of aid on economic growth irrespectively of policy variables³⁹. We lack time to present in details

38 Still, some studies confirm Burnside and Dollar (1997): Burnside and Dollar (2004), Collier and Dollar (2001 2002), Collier and Dehn (2001), Collier and Hoeffler (2002).

39 Some of these optimistic articles have already been mentioned amongst the reactions to Burnside and Dollar (1997), in the previous section.

this optimistic literature⁴⁰. In order to illustrate this real consensus, we will rather present some extracts that speak for themselves:

Dalgaard (2005, p1): «Recently, there appears to be an emerging consensus that aid does increase growth - on average. By the same token it is also well accepted that aid does not seem to be equally effective in all countries.»

Dalgaard et al. (2004, p1): «In the last few years, the pendulum has swung, and a gradually forming consensus view has emerged that aid `works'... Nevertheless, controversy remains since it also seems clear from the data that foreign aid is far from equally effective everywhere.»

Morrissey (2005, p5): «At one extreme is the Burnside and Dollar (1997) view that aid is only effective in a good policy environment. At the other extreme, is the Hansen and Tarp (2001) view that aid is effective irrespective of policy... An intermediate position is that better policies will improve growth performance and therefore may be associated with more effective aid.»

McGillivray (2005, p1-4): «The overwhelming majority of recent, widely circulated empirical studies find that economic growth would have been lower in the absence of aid... Inclusive Burnside and Dollar (1997), 36 studies have been conducted during 1997 to 2004, therefore. Thirty-four of these studies conclude that aid works»

Beynon (2001, p29): «In summary, while the question of whether aid is effective irrespective of policy remains disputed, there is at least agreement that aid works better in good policy environments.»

Hansen and Tarp (2000, p16-17): «When all studies are considered as a group, the positive evidence is convincing. The micro-macro paradox is non-existent. Microeconomic studies indicating that aid is beneficial are consistent with the macroeconomic evidence.»

Quibria (2004, p3 1): «The single most robust conclusion that has emerged from recent cross-country regression studies is that aid has in general been effective in developing countries across a wide variety of policy environments. This result repudiates the idea of conditional effectiveness, a much-vaunted notion that argues that aid works only in countries with good polices and as such should be directed only to those countries.»

These few examples are convincing enough. Although the dominating tendency in the present literature is bringing aid back into favour, there is also some kind of agreement around the idea that aid's productivity is subject to diminishing returns.

In addition, beside this optimistic stream, we should not neglect a few influent outliers. Among this pessimistic resistance we find Easterly et al. (2003), Rajan and Subramanian (2005), Jensen and Paldham (2003), Ovaska (2003), Brumm (2003), etc⁴¹. These studies are beneficial in the sense that they stimulate the debate and the production of new analysis.

40 Not exhaustive list of recent optimistic aid-growth studies: Durbarry et al. (1998), Hansen and Tarp (2000, 2001), Lensink and Morrissey (2000), Lensink and White (2001), Dalgaard and Hansen (2000), Guillamont and Chauvet (2001), Hudson and Mosley, (2001), Lloyd et al. (2001), Lu and Ram (2001), Chauvet and Guillamont (2002), Dalgaard et al. (2004), Cungu and Swinnen (2003), Dayton-Johnson and Hoddinott (2003, Gomanee et al (2003), Ram (2003, 2004), Economides et al. (2004), Clemens at al. (2004), Heady et al. (2004), Outtara and Strobl (2004), Roodman, (2004).

41 The «pessimistic» articles published in the Cato Journal are amongst the most aggressive against foreign aid. However, we have never seen them cited in any other article. They seem to be a bit too committed to be really reliable.

Though, they also deteriorate the handsome consensus abovementioned. On the other hand, they should not attract too much attention as they clearly represent a small minority of the literature.

Another observation about the optimistic consensus seems to be important. If the majority of studies agree on the fact that foreign aid enhances economic growth, there is no harmony at all on the extent of this improvement. This debate about the degree of unconditional efficiency of aid remains largely inconclusive. Furthermore, as we have seen earlier, some authors may observe a better effectiveness of aid in presence of some conditioning variables. All this together encourages us to qualify the statement that «aid works».

9. Conclusion

Our initial objective was to identify some conclusions about the macroeconomic effectiveness of aid to development. Since important implications are at stake, it has given birth to an abundant literature. Our first statement has been that the overwhelming majority these studies focus on the impact of foreign aid on recipient country's economic growth. After four decades of various publications, the discussion seems, at first sight, to be rather inconclusive. A couple of articles have already tried to clarify the debate but they are not really compatible. So, we decided to design our own framework of the literature.

Actually the whole aid-growth literature can be divided in two major periods separated by a double turning-point in the second half of the nineties. The first part has been dominated by inconclusive debate but it ended with the pessimistic agreement around the «micro-macro paradox». At the present time, this early literature appears not to be very reliable as it is characterised by particularly weak theoretical basis, poor econometric methodology and fragile databases. Then, some kind of methodological (Boone, 1996) and ideological (Burnside and Dollar, 1997) turning points took place in the late nineties. These two influential articles really boosted the production of new studies. Especially the innovative statement that aid works only if sound economic policy, has given rise to numerous reactions. The related principle of selectivity has extensively been discussed and criticized. Nowadays, though there remain a few pessimistic resistances, the large majority of recent scientific articles express the idea that foreign aid does globally work in enhancing economic growth.

Nevertheless, intense discussions remain about the extent of this efficiency as well as about the factors that could improve it.

More fundamentally, there are also some disagreements about the opportuneness to restrict the essential of the discussion on development effectiveness and economic growth. First, there exist many kind of aid to development. Only a limited part of the entire assistance targets investment that could have an impact on growth in the short run. Using the aid-growth relationship as a macroeconomic evaluation tool does give little indications about the efficiency of the majority of aid flows. Secondly, although there is an undeniable link between growth and poverty reduction, the two concepts are not synonymous. Unfortunately, economists are often inclined to confuse both notions or to accept the underlying assumption that growth is automatically beneficial for the poor. This has not been verified everywhere. Therefore, we may ask the question of the value of such an improved growth if it does not help the poor to catch up.

Throughout all of this work, we have tried to relate many aspects of the aid-growth literature. Actually, the contradictions we find between similar articles are mainly due to some striking shortcomings of this empirical approach based on cross-country growth regressions. First of all, the results appear to be extremely sensible changes in model specification. Concretely, the estimation of growth regressions is troubled by many technical econometric problems such as endogeneity, error correlation, parameter heterogeneity or influential observations. Furthermore, non-economic and structural factors may have constraining implication on aid effectiveness. Even if all these limitations do not prevent to recognise its global utility, aid is definitely not equally efficient everywhere. This may be due to either aid's characteristics or recipient country's features.

In consequence, it is particularly difficult to derive any robust policy recommendations. In light of all these technical difficulties, it should be wise to abandon this cross-country approach in favour of individual in-depth studies of countries that specify a growth model appropriate to the observed economy. In this context, we may also wonder whether it is really useful to look for global estimations of the effectiveness of foreign aid as a whole. We personally think of cross-country growth regressions to be quite inappropriate to assess aid effectiveness. Despite some improvements, the criticisms addressed to the early literature

remain mostly valid for recent studies. Doubtful theoretical background, unreliable data and technical difficulties are still topical.

The temptation is large to look for one single answer to the question of whether aid works or not. Whatever the conclusion, this approach is often misleading and it could have severe detrimental effects. Indeed, few influential aid-growth regressions have given colossal political implications despite their poor explaining power and their weak robustness. Since development process is not just economic growth, future investigations should concentrate on the impact of foreign aid on other issues such as poverty or health indicators. Provided the important contextual disparities of recipient countries, preference should also be given to individual case analysis. In any case, there remains much work to do and forthcoming studies should be very careful in their conclusions as they are very likely to provoke contradicting reactions.

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