Does aid make economic sense?

Author:Tarp, Finn
 
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26 March 2014

Foreign aid is often seen as different from other forms of investment, and some argue that rather than having a positive effect it tends to distort economies and may potentially slow growth and development. UNU-WIDER research shows that foreign aid has had a positive effect on growth in the long run. Furthermore, aid has been crucial in supporting the broader human development process, and facilitating transitions to democracy.

Many developing countries have enjoyed impressive economic growth in the last few decades. At the same time, we often see views expressed that aid does not work; is a futile endeavour; and should rather be ended. These positions are, however, typically not based on the best evidence available. It is time to move the discussion about foreign aid, growth, and development beyond ideology and preconceived ideas, and focus on what sound evidence can tell.

The evolution of the aid-growth debate

The academic literature on the aid -growth relationship can usefully be divided into five generations, reflecting changes in both economic methodology and paradigms of development. First, in the early years (roughly until around 1980) development was typically seen as a stable and linear relationship between investment and growth, and many studies assumed that aid had a positive effect on growth. The second generation of studies was born in 1987 when Paul Mosley and his co-authors identified the so-called micro-macro paradox. This work raised justified doubts about the underlying growth model, suggesting both that expecting all capital investment to translate into economic output, and expecting all aid to be used as investment, were overly bold assumptions.

These doubts about the assumptions at the core of previous research, as well as the availability of new panel data which allowed researchers to look into the impact of aid both across and within countries over time, motivated the new approach of the third generation from the early 1990s. The attentive reader will probably remember the famous 1994 heading 'Aid Down the Rathole', which The Economist used when the study of a London School of Economics professor, Peter Boone, was reviewed. His work did not stand unchallenged for long. World Bank economists Craig Burnside and David Dollar argued already in 1997 that aid works, but only sometimes, and that for aid to have an effect the right conditions, namely good fiscal, monetary and trade policy, had to be in place.

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