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- Historical and Theoretical Context
- Aid Allocation
- Aid Impact
The Development Assistance Committee (DAC) of the Organisation for Economic Co-operation and Development (OECD) defines “development assistance” (or foreign aid) as financial flows that qualify as official development assistance (ODA). ODA is calculated as the sum of grants and loans to aid recipients that are (a) undertaken by the official sector of the donor country, (b) with promotion of economic development and welfare in recipient countries as the main objective, (c) at concessional financial terms, where the grant element is equal to at least 25%. In addition to financial flows, technical cooperation costs are included in ODA; but grants, loans, and credits for military purposes are excluded, and transfer payments to private individuals are in general not counted. The same goes for donations from the public, commercial loans, and foreign direct investment (FDI). It is common to treat ODA and foreign aid as equivalent, but this can be misleading. Assistance funded by nongovernmental organizations (NGOs) including church-based agencies has grown significantly in the past 25 years and now amounts to about one third of ODA.
Only official aid to “traditional” developing countries counted as ODA until 2005. For these (Part I) countries, there is a long-standing United Nations (UN) target from 1970 that they should receive 0.7% of donors’ gross national income (GNI) as aid. Assistance to the “more advanced” Eastern European and “more advanced” developing (Part II) countries was recorded separately by DAC as “official aid,” not included as part of ODA. DAC countries have over the years accounted for some 95% of all ODA flows, but the distinction between Part I and Part II countries is no longer used. All flows that fulfill the established criteria are now included in the aggregate measure of ODA, but NGO-funded contributions are not added.
In 2009, the total amount of ODA disbursed by donors to developing countries and multilateral organizations reached US$123.1 billion according to the OECD/DAC 2010 statistics. (For the data in this and subsequent paragraphs, see OECD, 2010).
This means that the average citizen in the donor countries contributed around US$149 as ODA. This can be compared with a figure of around US$64 in 1960-1973 and US$99 in 1992. However, the UN target of 0.7% of GNI is with few exceptions far from being reached. Donors disbursed 30.4% of total foreign aid to multilateral organizations in 2006, and some 70% of this flow was disbursed to developing countries, with the European Union and the International Monetary Fund and World Bank as the dominating sources followed by the UN and the Regional Development Banks.
It is a widespread perception that foreign aid amounts to a very significant resource, in both absolute and relative terms, and that aid is not insignificant measured relative to developing country production and income. At the same time, aid is much less sizeable when measured in relation to GNI or government budgets in the donor countries or in comparison with population size of aid-receiving countries. Moreover, aid has been on a declining trend since the early 1990s as a share of GNI in recipient countries. Most recipient countries receive aid to the order of 1.8% of their GNI per year with a median of 3.2%. This corresponds to a distribution of aid per capita with a mode of US$17.9 per year and a median of US$31. Accordingly, the relative size of the aid inflow varies significantly among recipients, and while the 13.2% size of the aid to GNI ratio in, for example, Tanzania may seem high, this share reflects not only the size of the aid flow but also the very low level of income. With this background, modest expectations are advisable when analyzing the overall impact of past aid on development.
In subsequent paragraphs, the historical and theoretical context of foreign aid is reviewed first. This is followed by overviews of the empirical evidence on the allocation of aid and its impact on furthering growth and development in aid-receiving countries. The conclusion provides discussion and summary remarks.
Historical and Theoretical Context
Foreign aid in its modern form has roots back to the early 1940s and intensified after the disruption that followed World War II. The international economic system had collapsed, and war-ravaged Europe faced a critical shortage of capital and an acute need for physical reconstruction. The response was the European Recovery Program, commonly known as the Marshall Plan. During the peak years, the United States transferred some 2% to 3% of its national income to help restore Europe. The Marshall Plan, which was administered by the Organisation for European Economic Co-operation (OEEC), the predecessor of the OECD, was implemented on schedule, and its success fuelled highly optimistic expectations about the future effectiveness of foreign aid.
After the success of the Marshall Plan, the attention of industrialized nations turned to the developing countries, many of which became independent around 1960. Economic growth in a state-led planning tradition became a key objective during the 1950s and 1960s, and it was widely believed that poverty and inequality would be quickly eliminated through growth and modernization (“trickle-down”). Theoretical thinking on economic development at the macrolevel was informed by both the Harrod-Domar growth model (which was extended into the two-gap model of Chenery and Strout) and the Lewis dual-sector model framework; whereas standard microeconomic cost-benefit analysis (CBA) was relied on in project analysis. The Harrod-Domar model is based on the assumption that investment is the key constraint on growth, whereas the Lewis model is concerned with the transfer of labor from the “traditional” (rural) to the “modern” (industrial) sector. CBA, on the other hand, assesses cost and benefits of individual microeconomic project interventions based on shadow prices for inputs and outputs and derives net present values and internal rates of return.
The major part of the rapidly increasing bilateral flows during the 1950s came from the United States. New bilateral donor agencies (other than the United States) were mainly established in the 1960s, with the Commonwealth-inspired Colombo Plan from 1950 being an exception. A transition toward more independent, multilateral relations also began to emerge during the 1960s. This created a constituency for foreign aid, and the non-aligned movement gave an articulated developing country focus to this voice, as did the various organs of the UN. The International Bank for Reconstruction and Development, or World Bank, established at the Bretton Woods Conference in 1944, came to play a central role in development assistance and international policy formulation, especially following the creation of the International Development Association in 1960.
The original Marshall Plan was built around support to finance general categories of imports and strengthen the balance of payments (i.e., program aid), but from the early 1950s, project aid became the dominating aid modality. Some donors continued to supply program aid, but aid was increasingly disbursed for the implementation of specific capital investment projects and associated technical assistance.
The multilateralism of aid became somewhat more pronounced after the mid-1970s. Multilateral channels were at the time seen as more efficient and less political than bilateral aid, so the UN, World Bank, and other multilateral agencies expanded their activities considerably. The 1970s also saw an increased focus on employment, income distribution, and poverty alleviation as essential objectives of development and foreign aid. The effectiveness of trickle-down was widely questioned, and new strategies referred to as basic human needs and redistribution with growth were formulated and propagated alongside more radical dependency theories of development. Nevertheless, the typical project aid modality remained largely unchanged.
The golden era of the 1960s and 1970s came to an abrupt end at the beginning of the 1980s. The second oil shock in 1979 reversed economic conditions, and there was a huge increase in interest rates due to the economic stabilization policies in the developed countries. The international debt crisis erupted, and macroeconomic imbalance became characteristic. On the political scene, Ronald Reagan and Margaret Thatcher came to power in the United States and the United Kingdom, respectively, and at the World Bank, Anne Krueger became vice president and chief economist, replacing Hollis Chenery. Economic circumstances in the developing countries and relations between the North and South changed radically. The crisis hit hard, especially in many African countries. Focus in development strategy and policy shifted to internal domestic policy failure, and achieving macro-economic balance (externally and internally) became widely perceived as an essential prerequisite for renewed development.
“Rolling back the state” turned into a rallying call in the subsequent structural adjustment efforts, and reliance on market forces, outward orientation, and the role of the private sector, including NGOs, was emphasized by the World Bank and others. In parallel, poverty alleviation slipped out of view in mainstream agendas for economic reform but remained at the center of attention in more unorthodox thinking such as the “adjustment with a human face” approach of the United Nations Children’s Fund (UNICEF). At the same time, bilateral donors and international agencies struggled with how to channel resources to the developing world. Quick-disbursing macroeconomic program assistance, such as balance of payments support and sector budget support (which were not tied to investment projects and which could be justified under the headings of stabilization and adjustment), appeared an ideal solution to the dilemma of maintaining the resource flow and the desire to promote policy reform. Financial program aid and adjustment loans (and eventually debt relief) became fashionable and policy conditionality more widespread. In other words, a rationale that corresponded well with the orthodox guidelines for good policy summarized by the “Washington Consensus” had been found for maintaining the aid flow.
Accordingly, total aid continued to grow steadily in real terms until the early 1990s, but after 1992, total aid flows started to decline in absolute terms until the turn of the millennium. Many reasons account for the fall in aggregate flows after 1992, including first of all the end of the Cold War. The same can be said for the weakening patron-client relationships among the developing countries and the former colonial powers. The traditional support of foreign aid by vocal interest groups in the industrial countries receded. Bilateral and multilateral aid institutions were subjected to criticism and characterized at times as blunt instruments of commercial interests in the industrial world or as self-interested, inefficient, rent-seeking bureaucracies. Moreover, acute awareness in donor countries of cases of bad governance, corruption, and “crony capitalism” led to skepticism about the credibility of governments receiving aid.
The potential role of foreign aid in all this attracted attention, and the fear that aid can generate undesirable dependency relationships became clear during the second part of the 1990s and persisted into the 21st century. In parallel, the perception that policy conditionality was failing to promote policy reform started to assert itself. This assessment prompted World Bank and independent academic researchers to start digging into the aid-growth relationship using modern econometric techniques. Even more recently, efforts to develop randomized program evaluation techniques (including a variety of experimental approaches) appeared based both on micro-CBA studies from the past and an increasing understanding of the need for developing proper counterfactuals in economic analysis of foreign aid and associated policy interventions.
Over the years, foreign aid has been justified in public policy pronouncements in widely differing ways, ranging from pure altruism to the shared benefits of economic development in poor countries and further on to the political ideology, foreign policy, and commercial interests of the donor country. Few would dispute that humanitarian sentiments have also motivated donors. Action following severe natural calamities, which continue to be endemic in poor countries, is an example. Food and emergency relief also remains an important form of aid. In addition, existing data and analyses confirm that donors allocate relatively more ODA to the poorest countries.
Emphasis on the needs of poor countries was a particularly prominent characteristic—and the underlying economic rationale—in much of the policy literature on foreign aid in the 1950s and 1960s. Here focus was on estimating aid requirements in the tradition of the two-gap model. While still influential in practice, the two-gap model has been subjected to a variety of criticisms, and in parallel, the role of aid has changed to a much more multidimensional set of concerns. Economic return is by no means the only goal of aid. Nevertheless, growth and economic development in aid-receiving countries have continued as a yardstick for the effectiveness of aid both in their own right and as necessary conditions for the realization of other development aims.
It is not new that selfish motives are critical in bilateral donor decisions. Moreover, bilateral donors do indeed behave very differently among themselves. Up to about 1990, the Cold War was used as a powerful justification for providing aid to developing countries to stem the spread of communism. Similarly, aid from socialist governments was motivated to promote socialist political and economic systems. Other strategic interests play a role as well. The United States has over the years earmarked substantial amounts of aid to Egypt and Israel; being a former colony is an important determinant in getting access to French aid; and voting behavior in the UN can affect aid allocation both bilaterally and through the multilateral system. The same goes for how bilateral donors are influenced in aid allocations by their own strategic and commercial interest versus the development motives of aid recipients.
It is widely accepted that not all donors behave the same; but the donor community has as a whole failed to meet the established international target of contributing 0.7% of their national income as ODA. This is so in spite of widespread endorsement of the recommendations for a large scaling up in the context of the Millennium Development Goals. Only the group of Scandinavian countries and the Netherlands (according to OECD/DAC statistics) have consistently met the 0.7% target since the mid-1970s, while the United States contributed around 0.2% of its GNI in 2009.
To measure the effect of aid properly, the analyst must in principle be able to compare the value of a chosen indicator (such as growth or poverty reduction) in two strictly independent situations—with and without aid. To establish the “true” measure of aid impact, the importance of all other circum-stances that have affected a given country over time needs to be properly accounted for. Comparing what actually happened with an appropriate counterfactual is the fundamental evaluation challenge. Yet there is in social science no way of addressing this problem (i.e., the challenge of establishing an appropriate counterfactual) in a broadly acceptable way without making assumptions that are bound to be debatable, in theory and in practice.
Accordingly, the past decades have witnessed a massive outpouring of studies on the effectiveness of foreign aid. This topic has been a central and recurring theme with which many development experts, subscribing to the different paradigms of development thinking, have grappled, and methodologies have varied. More specifically, (a) the impact of aid has been evaluated at the micro- and macroeconomic level, (b) cross-country comparisons as well as single-country case studies have been relied on, and (c) aid effectiveness research includes broad surveys of a qualitative and interdisciplinary nature as well as more hard-core quantitative work.
One key point on which there is at least some agreement in the literature is that aid has in many cases been highly successful at the microeconomic level. The most rigorous project evaluations in this area are done by the World Bank, and reports from the Independent Evaluation Group of the World Bank are generally encouraging. Average rates of return are generally above 20%, and decent project rates of return have been reported regularly over the years in one survey after the other. Overall, a mass of project-based evidence has been collected, and few dispute that aid interventions have worked in helping improve social outcomes through better health and in helping promote and develop appropriate technology (i.e., the green revolution) and so on. Yet it remains less clear what works in more concrete terms and what does not work, and doubts about aid’s overall impact on growth and development linger on. The question is regularly raised whether all this adds up at the macrolevel.
It is easy to arrive at a negative association between aid and growth in simple aid-growth correlation analysis. There is, however, no logical inconsistency in development terms between little growth and aid inflows of the size experienced in the past. Donors allocate more aid to poorer countries, which are subject to difficulties and shocks of many kinds, including natural and man-made calamities. When countries have done well for a while average income has gone up, donors tend to transfer less aid, and eventually they withdraw. While such “graduation” may take a while, simple correlations are on this background likely to show a negative relationship; but they do not reveal the “true” impact of aid. Aid allocation matters, as do the major changes that have taken place in the global economy and affected the environment in which aid is implemented. Targets for aid have also been changing from one decade to the next. Thus, simple correlation analysis or storytelling cannot—and should not—be allowed to settle the causality debate about aid’s potential impact on development.
It is, however, never straightforward to generalize from case studies, and this helps explain why macroeconomic cross-country (panel data) studies of the aid-growth link became so popular from around 1995. Such an approach makes it possible in principle to move beyond simplistic aid-growth correlation analysis, where the analysis of causal effects is rather primitive. Much of the modern empirical aid effectiveness literature has focused on whether the impact of aid is conditional on policy or whether aid can be expected to have a separate and positive impact, independent of policy. This has involved a mixture of concerns. They range from technically demanding econometric modeling issues to fundamentally different approaches to the design and implementation of development strategy and policy.
Overall, it has become clear that coming up with the “true” aid-growth relationship is far from easy, and aid is in any case of much too limited a size to turn the wheels of history. Yet, while aid is controversial, few reject aid as a potentially useful instrument in the fight against poverty. Careful, nuanced, and subtle assessments are advisable with the empirical evidence in hand; and the single most common result in the modern aid-growth literature is that aid seems to have had a positive impact on per capita growth. No excessive claims about aid impact on development should be made on this basis, and the empirical evidence remains an area of dispute, leaving the door open for conflicting interpretations and policy recommendations.
Foreign aid has been associated with development successes and failures, and the fundamental analytical problem in assessing its impact is that nobody has to date successfully identified the underlying development model. Analysts therefore continue to work with reduced-form models, which are bound to be debatable. In parallel, existing data suggest that foreign aid is far from equally effective everywhere. The necessary and sufficient conditions for aid to have a positive contribution on the development process remain elusive. In other words, how to come to grips better with what actually drives existing differences in the impact of foreign aid is a challenge in theory and practice. This is so, for example, in relation to potential interaction with economic policy, but the same goes for deeper structural characteristics.
The lack of generalized understanding of the complex links in particular country circumstances between aid, growth, and development objectives, such as poverty reduction, means that selectivity in aid allocation, based on simple macroeconomic criteria, is hard to defend. Few would argue that old-fashioned conditionality should be brought back to rule the way; but a better understanding of the intricacies of the donor-recipient relationship in theory and in practice would be valuable. This would as key elements include addressing issues such as (a) the best way to channel resources to the poor, when national governments are not capable and/or willing to take on this task; (b) how to ensure that aid delivered directly to national governments does not undermine local accountability; and (c) establishing the appropriate balance between aid going to the government vis-a-vis individuals and others in the private sector. Accordingly, how best to strengthen incentives in support of genuine domestic policy leadership is a challenge. The same goes for the fundamental task of furthering accountability and transparency visa-vis local populations.
Recent years have seen a drive to scale up aid. In this context, it is critically important to avoid making the mistake of the past of promising too much—that is, of contributing to the misconception that aid can on its own turn history. It would, based on history, appear that aid has much to offer, but managing expectations is far from easy. It is demanding to determine how best to make sure that promises made are kept. There are many unresolved issues here, including deciding how best to design incentives in aid agencies to meet this challenge alongside topics such as the role of independent evaluation, of coordination among multiple donors, and of the need to consider political economy issues, including the need to sharpen the incentives for recipients to use aid effectively in promoting development.
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