Foreign Aid

Political Economy of the Global SouthProf. Tyson Roberts

Review of the “Resource Curse”

• Negative effects of natural resource endowments– Reduced economic growth– Inferior institutional quality such as property

rights, rule of law, democracy, …• Mechanisms– “Dutch Disease”– Revenue volatility– Political/institutional deterioration

However, these negative effects are not deterministic

• How can “Dutch Disease” be avoided?– Invest (in the future) rather than consume (in the

present)– Indonesia and Malaysia invested in agricultural

production and industry – increases competitiveness

– Mexico mainly promoted its state oil company – fell behind in competitiveness

However, these negative effects are not deterministic

• How can revenue volatility be addressed?– Stabilization funds– For example, Chile’s Copper Stabilization fund

However, these negative effects are not deterministic

• How can “political deterioration” be avoided?– Natural resource revenues stabilize regimes

(including democracies), they do not necessarily lead to transition to dictatorship

– Resource rents lead to more corruption in low-quality institutional environments (e.g., dictatorships), but not in high quality

– Botswana had (fairly) good institutions before diamond revenues came on stream

– Sequence matters

How to address the resource curse?

• Two strategies:– Take resources away from government or bypass

government (e.g., give revenues directly to citizens)

– Keep revenues in hands of government but change government policies (e.g., natural resource funds)

Foreign Aid

Competing Views of Foreign Aid“Big Push” vs. Dependency

• “Big Push”– Poor economies are trapped in poverty (finance

gap)– Need major aid inflows to push out of trap

• Dependency– Aid flows make poor economies dependent;

undermine incentives to improve– Aid => rentier state

Answers to the dilemma?

• Empirically-supported aid• Conditional aid• Selective aid

“Big Push”

• Harrod-Domar Model:– y=f(k)– Constant returns to capital– Growth determined by savings rate

Poverty Trap – Finance Gap

• However, poor countries cannot afford sufficient savings– Low income => low savings => insufficient

investment => low income• If rich countries transfer savings to poor

countries, poor countries will grow until they can afford to self finance => “takeoff”– High income => high savings => high investment

=> high income

Poverty Trap

Is X money?If so, sending money should push aid recipients out of poverty trap

Other determinants of growth

• Solow Model (based on Cobb-Douglas)– y = Akαlβ ; α + β = 1– Diminishing returns to capital & labor– Growth determined by exogenous technology

• Improve labor (aid for education, health)

Increase in education often has no effect on growth

Source: Pritchett 2001

Why might education not lead to growth?

• Piracy: Educational capital goes into privately profitable but socially unproductive activities– Entrepreneurs exploiting monopoly opportunities

or government contracts– Bureaucrats in patronage-based states

• Insufficient demand: Slow growth in demand for educated labor

• Poor schools: Education system provides few skills

Other determinants of growth

• Solow Model (based on Cobb-Douglas)– y = Akαlβ ; α + β = 1– Diminishing returns to capital & labor– Growth determined by exogenous technology

• Improve technology – Improve incentives to invest with better policies

• How to improve policies? Conditionality (?)

Source: H. Doucouliagos, M. Paldam 2008

Problems with Conditionality

• Structural Adjustment Loans in 1980s emphasized conditionality – aid now for policy changes

• Many governments received the aid and then didn’t change the policies, because of vested interests and lack of “ownership” in policy design

• Donors continued to give aid

Donor goals of aid

• Altruistic– Economic growth, human development,

democracy• Commercial– Trade and investment

• Geostrategic– UN votes, military allies

• Organizational

Determinants of aid flows

• Altruistic– Income level, political liberalization

• Commercial– Trade flows, colonial history

• Geostrategic– UN votes, military allies

• Organizational– Small population, history of aid

Burnside & Dollar (2000):Aid x Good Policies => Growth

What is Good Policy? (According to B&D 2000)

• Open economy (few trade restrictions)• Macroeconomic stability (low inflation)• Low budget deficits

B&D’s results were driven by outlier cases, esp. Botswana & Zambia

If additional observations are included, the relationship between AidxPolicy and Growth turns negative

Why might aid have negative effect on growth?

• Dutch Disease– Aid makes economies less competitive

• Aid volatility– Volatlile aid undermines ability of governments to

plan, encourages short-time horizon thinking (roving bandit vs. stationary bandit)

• Rentier State/Enclave Economy/Fungibility– Aid enables bad policies & bad institutions

Burnside & Dollar (2004)Aid + Good Institutions => Growth

• Donor behavior changed after Cold War– 1980s: Aid went to countries w/good & bad

institutions– 1990s: Good institutions attracted more aid

• Institutions condition affect of aid (in 1990s)– Aid + good institutions => positive growth• India, Botswana

– Aid + bad institutions => negative growth• Pakistan, Zaire/DRC

Aid x Good Institutions => Growth

• Doucouliagos & Paldam 2008– Aid x institutions: robust– Aid x policy: not robust

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Some conditions under which aid has been found to be beneficial for development

• Civil liberties (Isham, Kaufmann, and Pritchett 1995)

• Good policies (Burnside & Dollar 2000, Economides et al 2004)

• Good institutions (Burnside & Dollar 2004)• Democracy (Kosack 2003)• Sufficient human capital (Kosack and Tobin

2006)

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Trends in foreign aid

• Post-WW2: IBRD, Marshall Plan• 1960s: Bilateral aid focused on former colonies• 1973: McNamara Revolution, focus on poverty

reduction• 1980s: Structural adjustment, focus on economic

liberalization policy, conditionality• 1990s: Increased focus on institutional quality,

selectivity, and donor-government partnership– HIPC, Millenium Challenge Account– Increased funding for non-government bodies

Lessons of Foreign Aid

• Selectivity works better than conditionality• Government ownership of policy increases

probability of implementation

Recommendations to address “Resource Curse”

• Countries with good institutions: Help with natural resource extraction (and give aid)

• Countries with poor institutions/policies and seek to develop natural resources: Do not give aid until institutions improve

• Countries with poor institutions that already have natural resource production: boycott

Possible solutions• Tracing production / embargos / consumer action campaigns – the

Kimberley Process and “blood diamonds”• Creating greater transparency of who is paying what to whom and

holding gov’ts to account for those funds (EITI)• Developing national savings mechanisms• Privatization• Anti-corruption commisions & improved sector legislation and

regulation.• Direct distribution of benefits to people• Choosing not to exploit the resource in the first place• Reduce demand for oil from the US, etc.• Clean Trade Acts & Clean Hands Trusts

Sources: www.sebstrategy.com, www.cleantrade.org, Birdsall & Subramanian 2004, Ross 2011

Solutions

Solutions

• Pay oil revenues into independent escrow account for national development– Worked for Norway -- Didn’t

work for Chad

Why?

EITI compliant & candidate countries

Solutions

• Privatization didn’t work so well in Russia