Rethinking foreign aid.

• Jurisdiction: United States
• Date: 22 September 2002
• Author: Osborne, Evan

Recent years have witnessed escalating criticism of the industrialized word for declining levels of foreign aid, especially the official development assistance (ODA) that is expressly supposed to facilitate prosperity in the developing world. Criticism of the alleged foreign-aid shortfall is striking because critics fail to ask a more profound question: Do ODA and other forms of transfers to poor nations actually help them prosper? The increasingly loud controversy over inadequate "foreign aid," in turn, hinges on whether it is effective in reducing poverty compared to other things rich and poor countries might do to achieve that aim.

This paper details the substantial changes that have occurred during the past 30 years in trade and aid patterns between the developed and developing worlds. It then provides a statistical analysis of the effects of foreign aid on growth compared to the effects of foreign trade, market-friendly policies, and other considerations. It also augments the findings of the body of economic literature known as "new growth theory" by testing whether its results are robust when developing countries are examined alone. Finally, in light of the findings, it reassesses the relative contribution to development of the Western European nations, the United States, and Japan.

Trends in Aid and Trade

While there is an old controversy over the ability of foreign aid and international trade to help countries develop, in recent years the patterns of the developing world's trade with and aid from developed nations have changed dramatically. This section briefly summarizes those changes.

Official Development Assistance

Official development assistance by wealthy countries, as a percentage of gross domestic product, has declined sharply in recent years and provoked much critical commentary. (1) Figure 1 depicts the ratio of ODA to GDP from 1967 to 1997. The ODA data are collected from OECD governments as well as the European Commission, and include capital projects (e.g., dams and roads), monetary transfers to provide general budgetary support, lending to support nations with balance of payments problems, food and other commodity aid, technical cooperation, and emergency relief. Although they do not allow differentiation among those types of assistance, the potential confounding factor of military assistance is avoided.

[FIGURE 1 OMITTED]

Figure 1 indicates that measured ODA from the United States has declined relentlessly throughout. In 1967, the United States gave almost 0.5 percent of GDP in foreign aid, while by 1997 it gave less than 0.15 percent. In contrast, Europe gave a progressively larger share of GDP in ODA until the mid-1980s before that share begin to continuously decline in the early 1990s, although not as much as that of the United States. Finally, Japan's transfers have been relatively stable throughout the entire period.

During this period the United States has thus changed from being the largest provider of ODA to the smallest. U.S. ODA is now barely a third as much as that of the European nations collectively and, despite Japan's economic malaise of recent years, barely half as much as that of the Japanese. The decline in foreign aid, particularly from the United States, is undoubtedly the major evidence for the claim that the developed world in general and the United States in particular are shirking their duty to assist poorer countries. Hence, the recent UN Monterrey Declaration and President Bush's decision to increase U.S. aid to developing countries, on the condition that they pursue sound policies.

Trade between the First and Third Worlds

Long-term economic growth in developing countries is assumed to be the primary goal of ODA, and therefore the basis for its comparison to openness and sound economic policy in the developing world. In analyzing why foreign trade might also positively affect growth, there are several (nonexclusive) theories to choose from. The most elementary one is comparative advantage: when there is free trade between industrial and developing countries efficient specialization is encouraged. In addition, there are dynamic effects--for example, the economies of scale that result when firms in a small, poor economy begin exporting to much larger, more prosperous global markets, as well as the ability of trade to promote learning of modern industrial techniques and other important knowledge (Kemp and Schweinberger 1991, Ethier 1982, Krugman 1979).

For most of those concerns one measure of the assistance that industrial countries can provide is their imports of products from the developing world. Figure 2 depicts five-year moving averages for imports from developing countries as a percentage of GDP for the United States, Japan, and Europe during the 1967-1997 period. The European pattern is quite similar to its ODA timeline: rising imports throughout the 1970s, followed by a substantial decline beginning in the second half of the 1980s. Unlike the ODA case, Japan's imports from developing countries have not been stable but have instead followed the European pattern, only more dramatically. In contrast, the United States in 1967 imported the smallest proportion of GDP from the developing world, less than half of Europe's share and less than a third of Japan's. By 1997 that pattern had completely reversed, with the United States absorbing the most, by a significant margin, and Japan the least.

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An argument can be made that total imports are an incomplete measure of the development assistance provided by trade with developing countries. Although it does not follow from the traditional theory of comparative advantage, it is nonetheless true that for many development scholars and political leaders in the Third World "development" is synonymous with the creation of a sizable, modern manufacturing sector, as opposed to reliance on exports of primary products. The product-lifecycle theory suggests that as countries industrialize they hand off more labor-intensive industries to countries in earlier stages of industrialization. That theory provides some support for the notion that the development of manufacturing industries frequently accompanies increasing prosperity in the developing world. It is illustrative to examine the absorption of manufactured imports from developing countries by the United States, Europe, and Japan.

Figure 3 depicts the trend lines for manufactured imports. While there were no significant differences in the absorption of manufactured goods in 1970, there has been an increase in all three destinations but a much more dramatic rise in the United States. By 1997 the United States absorbed nearly 40 percent more manufactured imports as a proportion of GDP than either Japan or Europe.

[FIGURE 3 OMITTED]

The pattern for importation generally, and manufactured importation in particular, is thus dramatically different from that for ODA. If we assume that, as a policy matter, importing more from developing nations is preferred to importing less (especially if a major reason for the lack of imports is protection or subsidy of domestic industries in rich countries), then the United States is a comparatively generous provider of trade "assistance" and Japan the least generous, with both Europe and Japan significantly trailing the United States in the absorption of manufactured imports in particular. (2) This suggests that evaluation of development assistance may be incomplete at best when aid but not trade is measured. The contribution of each to economic growth is considered in the next section.

Trade, Aid, and Growth

Theoretical Considerations

Both trade and aid might in principle contribute to economic growth and development, but they need not do so in the same way or to the same extent. Previous theoretical literature has established a clear default hypothesis that trade can never help a developing country as much as the same amount of aid, while the empirical literature has failed to confirm that belief.

Johnson (1967) originally claimed that aid is unambiguously preferable to import absorption as a way to increase national income in a developing country. He viewed exports as an indirect way of providing assistance. The only gain from exporting widgets is the ability to fund lower-cost importation of other consumption goods. Aid, in contrast, can be used much more flexibly and so in theory can be applied in a manner that will yield the greatest benefit at the margin. Johnson's theory was expanded by Thirlwall (1976), who suggested that even after accounting for the fact that a unit of ODA translates into a smaller amount of actual "aid" because donor countries often require that some (even most) of it be spent on purchases from the donor country, the conditions for exports to augment GDP more than the equivalent amount of ODA are quite stringent.

There has been significant empirical research on these claims. The most direct test was Yeats (1982). He analyzed the relation between growth, foreign aid, and exports, and...