What can aid do?

• Author: Skarbek, David B.

Under normal conditions, devoting more resources to X'S production produces more X. This follows from the nature of the physical world, which positively relates quantities of outputs to quantities of inputs used in their production. In principles of economics classes, it is common to highlight that this relationship has nothing to do with the economic problem. The economic problem asks how to produce X in the least-cost way, whether to produce more or less X, and indeed, whether to produce any X at all given the alternative uses of the inputs required to produce it.

Solving the economic problem determines whether a country's economy develops. It is strange, then, that professional economists have had trouble distinguishing the positive relationship between inputs and outputs from solving the economic problem when it comes to evaluating foreign aid. (1) The purpose of this article is to make this distinction, and in doing so to clarify what aid can and cannot do.

Foreign aid's advocates claim aid has been successful. Aids critics claim aid has failed. We explain why both camps are correct. Aid can, and in a few cases has, increased a particular output by devoting more resources to its production. In this sense, aid has occasionally had limited success. However, aid cannot, and has not, contributed to the solution of economic problems and therefore economic growth. In this much more important sense, aid has failed.

Flashbacks from Econ 101

Economic progress requires economic efficiency: resource allocations that maximize resources' value to society. Economic efficiency improves when economic actors move resources from less-valued uses to more-valued ones. Economic actors tend to move resources in this way when they make their decisions in an institutional environment defined by private property rights? In this institutional environment, market prices emerge that communicate information to entrepreneurs about how to use resources in ways that enhance wealth, and entrepreneurs have incentives to act on this information (see Mises 1920, Hayek 1945, Kirzner 1978, Coyne and Leeson 2004). Central planning, which attempts to allocate resources without private property and market prices, cannot allocate resources efficiently because central planners can't learn about resource allocations that maximize resources' value (Mises 1920, Hayek 1945). (3)

Since central planning cannot promote economic efficiency, it cannot promote economic progress. Nevertheless, like anyone else, central planners can increase a given output by devoting more resources to its production. There is nothing surprising about this fact. The nature of the physical world, including the positive relationship between inputs and outputs, is as true for central planners as for anyone else. The distinction between a central planner's ability to increase a particular output by devoting more resources to its production and his ability to solve the economic problem is where most evaluations of foreign aid go awry.

An example from the real world illustrates the relationship, or rather lack of...