THE THEORY AND PRACTICE OF FOREIGN AID

Dr. Boris Begović

President of the Center for Liberal-Democratic Studies (CLDS)Professor of economics at the School of Law, University of Belgrade, Serbia

Analyzing foreign aid

• Normative analysis

• What is the rationale for foreign aid?

• Positive analysis

• What are the reasons why countries give foreign aid?

• Mechanisms of foreign aid

• Empirical results of the aid effects

Normative analysis: Poverty traps

• Vicious circle mechanism of poverty traps

• Poverty Low Savings and Investment Low Growth Rate Poverty (again)➔ ➔ ➔

• Described by Rosenstein-Rodan (1943), Rostow (1960), Sachs (2005)

• Similar two-gap growth model

• Low savings and hard currency gaps prevent dynamic growth in developing countries

• Key assumption in poverty trap theories

• Imperfection of international capital markets

• Appeal of foreign aid

• Simplicity of aid as an investment substitute

• Presumption of sustainability of growth once a country leaves poverty trap (Walt Rostow’s “take-off”)

Poverty traps are the main rationale for foreign aid

Do poverty traps really exist?

• Some remain unconvinced: So what if poverty traps don’t exist? Increased investment through foreign aid is still good

• This rationale implies solving a problem without understanding its causes

• The crucial issues of increased investment

• Project selection

• Commitment of investors

• Efficiency of investment

• Kraay and Raddatz (2007) offered an empirical refutation of poverty traps

For poverty traps to exist, subsistence levels across countries must be different – but they are the same

Positive analysis

• Supply side: Why donor countries give foreign aid?

• Alesina and Dollar (2000) show political considerations, e.g., 57% of France’s aid goes to its former colonies

• Kuziemko and Werker (2006) link aid to political support from recipient countries, e.g., U.N. Security Council membership increases aid from the U.S. by 59%

• Donors are not responsive to public policies of recipient countries, both good and bad

• Alesina and Weder (2002) show no link between the level of corruption and aid

• Demand side: Why countries receive foreign aid?

• Tornell and Lane (1999) demonstrate a voracity effect: the more aid you get, the more aid you need

Mechanisms of foreign aid: Funding of investment projects

• Weaknesses of this rationale for aid

• Marginal productivity (efficiency) is smaller than in investments funded by private capital

• No market criteria for investment project selection or demanded rate of return

• Issues of accountability in foreign aid

• Investors not accountable to the recipient country constituency

• More accountable to constituencies in donor countries, but those constituencies have no immediate interest in efficiency of aid projects

Mechanisms of foreign aid: Budgetary support

• Weaknesses of this rationale for aid

• The claim: aid reduces tax burden while keeping budgetary balance increases private investment

• BUT this depends on the model of behavior of recipient governments

• Boone (1996): models of behavior

• Elitist government

• Egalitarian government

• Government oriented toward free market

Budgetary support leads to increased public expenditure with the same or bigger tax burden and no increased

private investment

Empirical results: The bigger aid, the smaller growth rate

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