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

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par François Defourny
Facultés N-D de la Paix de Namur - Université Catholique de Louvain - Master in International and Development Economics 2005

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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.

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