Foreign Aid Effectiveness?

In keeping with one of my major interests, I recently did some empirical work and wrote a research paper on the effectiveness of foreign financial aid. The discourse on financial aid has been largely shaped by the work of Burnside and Dollar (2000), who found empirical evidence that aid is effective, but only in an environment with good policy. As a result of the findings of this paper, a lot of research on foreign aid has been focused on testing the veracity of the aid-policy interaction. Good policy equates to good governance, transparency, accountability and little to no corruption, so saying aid needs good policy to effectively promote growth is a plausible claim. Some researchers have focused on whether or not aid is effective, not necessarily focussing on policy, and the only conclusion one can come to from reviewing the host of empirical papers available is the complete lack of consensus on aid effectiveness.

If one were to stop a handful of people on the streets of African countries and other developing countries (and to a lesser extent, emerging markets) and tell them that aid is in fact helping to promote growth, they might laugh in your face. Now this might be because the average person neither knows when aid is coming in or what aid money has been spent on, which is made possible by the don't-ask-don't-tell situation surrounding fiscal spending in a lot of African countries. Whatever the reason may be, a lot of people including myself have doubt in the effectiveness of foreign financial aid in alleviating poverty and promoting growth.

The result of my data manipulation and numerous regressions was evidence of foreign aid effectiveness in promoting growth in aid receiving countries (evidence against my doubt). Dambisa Moyo (2009) in what was the only qualitative item I included in my research had tried to draw parallels to show the mediums through which aid was impeding growth and had pointed out that with foreign aid comes more consumption, and people then save less, and investment plummets. This is assuming that foreign aid is used for consumption rather than for what it is meant. It also seems to be assuming that aid money is somehow distributed to majority of the people within the country, ignoring the fact that only the few people at the top share these monies, and they will almost usually invest such money in foreign assets. For the more astute readers you would note that the resulting reduction in savings implies that marginal propensity to consume is greater than 1 (people will consume more that the aid share they receive), which is a large claim on its own. Although researchers have found evidence for a kind of relationship between aid and investment, there is no explanation for that relationship. Instead of focusing on the aid-investment medium, some researchers have focused on exchange rate as the means through which aid affects growth, which sounds a whole lot more legitimate. Moyo (2009) explains this relationship as follows: when foreign money comes in, it will come in as foreign currency (most probably in USD) which will obviously have to be changed to the domestic currency, leading to an appreciation of the domestic currency which reduces net exports (that is, it will be cheaper to import goods and domestic exports will be expensive to foreigners- check my previous posts to understand this relationship). So at the end of the day financial aid adversely affects domestic economy since less net exports means lower output which translates into lower growth.

Finally, it is now well discussed that Western countries give aid for strategic reasons. This, in my opinion is a much bigger issue as the aid givers will fail to ensure that aid is being spent as it should be, and they will give aid indiscriminately, notwithstanding bad policy.

The topic of aid is very loaded and there is no clear answer about whether aid leads to growth. Even on the micro level, some have found evidence for growth where other researchers have failed to find evidence. Therefore I have come to the conclusion that due to the high fungibility of aid, some of it might be getting pocketed by corrupt government officials, but not enough to impede the growth effect of the unpocketed sum.