Foreign Aid: Does it promote growth or is it ineffective in promoting growth - Essay Example

Foreign Aid: Does it promote growth or is it ineffective in promoting growth? Introduction This paper examines whether foreign aid promotes socio-economic growth and development. It presents both sides of the debate, i.e. the argument that it does promote growth as well as the argument that it is ineffective in promoting growth. It also includes a short case study of Pakistan to illustrate the points raised. The writer upholds the side in favour of giving aid, but highlights the issues involved, and also explains the need for better indicators for measuring effectiveness. The donors are usually wealthy countries or multilateral institutions such as the International Development Association and the World Bank and NGOs, and the recipients are usually less developed countries that need external help for supporting their growth. A significant and influential study that showed foreign aid to have a positive impact on growth in LDCs was conducted by Burnside & Dollar (2000). However, they also mentioned the need for good fiscal, monetary and trade policies for the impact to be effective. On the other hand, its inability to impact positively on growth is usually given as the main reason for not recommending the practice. Rationale for giving foreign aid The traditional rationale behind giving foreign aid has been that it helps to close the ‘finance gap’. This gap is the difference between the amount of investment required for a specific economic growth rate, and the amount of domestic resources available from savings and private financing (Rao, 2003: 102), or put simply, between planned investment and available savings. The situation in which a finance gap exists is created when there is a lack of physical and human capital. The finance has therefore mainly been directed at large-scale infrastructural projects, as recommended in the Harrod-Domar model for promoting economic development (Picard et al., 2007: 10). Furthermore, the assumption made is that the aid takes the place of the gaps in investment the magnitude of which is directly proportional to economic growth (Rao, 2003: 102), which is questionable. The giving of foreign aid also promotes social interaction between nations. It is a useful means for the redistribution of wealth so the practice has an ethical dimension too. The surplus generated by richer economies can be used to help the poorer economies as a moral responsibility. For the latter, it could be a very important source of finance “to tide over financial crises, enhance economic development, [and] promote economic integration with the global economy” (Rao, 2003: 97). Foreign aid therefore deals with the problem of poverty with the aim of helping to generate growth in struggling economies. The Millennium Development Goals announced by the U.N. in 2000 had this specific objective of overcoming poverty to encourage foreign aid flows (Isard, 2006: 219). The idea is therefore benevolent but it only works if the aid is firstly channelled properly and secondly only if it is utilised efficiently. The alternative to foreign aid for recipient countries would normally be to acquire foreign debt or else linger with the financial deficiencies. Foreign aid can therefore prevent or alleviate the long-term problems associated with debt financing. Countries with lack of finance can thus continue to engage in developmental projects without the worry over affording the costs. At the same time, the giving of foreign aid could also benefit the donors as a means for marketing their products and services. It can therefore be a mutually beneficial practice to promote growth in both the donor and recipient countries. Objections and complications with giving foreign aid On the other hand, others view the giving of foreign aid negatively. Although they state that foreign aid has little impact in terms of supporting economic growth and is therefore ineffective, some of them actually view the giving of aid as diminishing the resources available for satisfying their own requirements, hence the concern. Foreign aid continuously granted by a particular country and/or directed at a particular country also results in the ‘aid fatigue’ syndrome. In this situation, “the resource-rich countries look upon potential borrowers as endemic deficit entities” (Rao, 2003: 97). Moreover, some studies have also shown foreign aid to be ineffective in reducing poverty (Picard et al., 2007; Nakamura & McPherson, 2005), thus demonstrating the ineffectiveness of universal growth models to work well (Easterly, 2001: 28). The failure of foreign aid is largely attributed to problems related to incentives and information (Williamson, 2009). The granting of aid is not necessarily an impartial decision. It is often closely tied to political and military considerations. In such cases, the primary aim is not of promoting socio-economic development but for strategic reasons. Thus, the strategic self-interest is another rationale behind foreign aid in practice. The foreign assistance provided by the U.S. to another nations is a perfect example of this close link with foreign policies (Tarnoff & Nowells, 2005). Hence, in the case of the U.S. the aid does not really promote growth in the recipient country as much as it does its own interests. Expert views on both sides of the debate In ‘Debates in International Political Economy: Foreign aid promotes development v. foreign aid is ineffective’, both sides of the argument are presented from the viewpoint of leading advocates. The argument in favour is presented by David Dollar, a World Bank official (Dollar, 2003), and the argument against is presented by William Easterly (2002), a professor of Economics at New York University. In the argument that it does promote development, it is mentioned that most advocates suggest it can only work “if it targets the right things” (Oatley: 267). Thus, where the aid has been shown to be ineffective, it is usually because it is not targeted properly. Instead of directing aid at creating new capital therefore, it should be used to develop high-quality institutions, particularly those that are able to implement state programmes effectively. In this way, the foreign aid helps to strengthen the existing infrastructure or create new infrastructure that would be better able to promote economic development. The chances of the aid being directed effectively are also increased if the governance is strong and provides the essential public services because otherwise it is more likely to be misdirected or consumed by corrupt individuals. Property rights also need to be protected. In the argument that foreign aid is ineffective, it is mentioned that it is not so much the targeting issue but the structure that matters. The effectiveness of the aid is also dependent on the multilateral organisations that manage the provision of aid. The problem with bureaucratic organisations is that is that they are only accountable to the politicians in the wealthy donor countries. This makes them concentrate only on those projects that satisfy their constituents instead of those that would give a higher return in terms of development. Hence, foreign aid can only be made more effective if a fundamental reform takes place of international organisations involved in foreign aid. There is a need for them to be held more accountable in order to ensure the proper distribution of the aid and that development thereby takes place effectively. Such accountability can be ensured if the distribution is made more competitive. High quality institutions are important because they are better able to support the distribution of the aid and target precisely those people and places where it is most needed. If the quality of the institution is weak, then the both the distribution and the targeting is less than satisfactory, and in worst cases suffer from the problem of corruption. Case study: Pakistan The case of Pakistan illustrates some of the points made in this paper. Following the demolition of the World Trade Centre in New York in 2001, Pakistan has been in the frontline of the hyped war against terror by siding with the U.S. However, Pakistan has suffered significantly in terms of falling exports and reduced business optimism (Khan, 2001). Its economic growth had therefore been hampered significantly due to the war (CBP, 2003). Consequently, Pakistan has also been a major recipient of foreign aid, particularly from the U.S as it did also during the Russian-Afghan War during the 1980s, both of which brought about turning points in economic growth. The three graphs below show the rates of net bilateral aid flows, net foreign direct investment and GDP for Pakistan. During the period 1980 to 2001, the average proportion of aid as a percentage of GDP was 2.49%, which is above the average for low and middle-income countries (World Bank, 2003). After this period, the first graph shows the aid flows have generally increased sharply, to higher peaks than in the 1980s. During this same decade (2000s), a sharp rise in investment is also evident from the second graph. A corresponding rise in economic growth is also evident from the third graph, which took place mainly during the Musharraf era, until the period of the global recession in the latter part of the decade where the GDP has been declining. Net bilateral aid flows to Pakistan from DAC donors, 1968-2008 in US dollars Foreign Direct Investment in Pakistan (net inflows as % of GDP) 1967-2009 Economic Growth (GDP) in Pakistan 2002-2010 Source: TradingEconomics.com The figures generally support the thinking that aid promotes economic growth. However, a few additional points are worth noting in the context of Pakistan. Firstly, the U.S. is by far the largest contributor of the aid to Pakistan, and the aid is closely linked with its strategic interests in the region and globally, publicly stated to be the War on Terror. Nonetheless, this does not appear to have impeded translating into growth. Secondly, the issues of effective targeting, allocation, distribution, corruption, etc. discussed previously are very much relevant to Pakistan. The recent decline or inability to sustain the growth also needs explaining, given that aid to Pakistan has actually been increasing. For example, the US contribution was tripled following a bill passed in the Senate (Jeewanjee, 2009). The decline is due to various reasons but they are all related to ineffective allocation, poor policies, but also due to natural calamities, which together have been increasing the finance gap. Pakistan still has infrastructural deficiencies, which are now inhibiting its continued growth, and which raise the question of why the aid has not been directed at infrastructural investment. In particular, it is due to power shortages and flawed economic policies (EconomyWatch, N.d.). Again, the point about foreign strategic interests getting in the way of purely humanitarian foreign aid to support socio-economic growth is valid in the context of Pakistan and is now having the opposite effect. The problem of debt servicing is also exacerbating the situation (Nazar, 2011). In addition, as after the earthquake in 2005, the devastating floods in 2010 have also had a major negative economic impact that explains the decline in growth (Mufti, 2011). All these factors show that simply giving aid alone is not always sufficient and promoting economic growth requires a complex package of measures. Still, this does not mean the aid is ineffective; rather, it needs to better directed and managed. Concluding discussion In conclusion, it has been shown that foreign aid is justified on the grounds of being a means for dealing with the finance gap and promoting economic growth, especially through investment. As shown in a study by Moreira (2005), foreign aid does promote economic growth, but it has more effect in the longer term than it does in the shorter term. This assumes that the targeting and utilisation are effective. On the other hand, as the case of Pakistan showed, serious deficiencies in the economy can bring about temporary benefits but impedes long-term growth. However, it is questionable whether macroeconomic variables such as the GDP should even be used as the primary measure to determine the effectiveness of aid. This gives the erroneous impression to those against giving foreign aid because they do not see any immediate impact on economic growth. “Assuming a short-run proportional relationship between investment and growth” has no empirical basis (WB, N.d.: 25). The example of Pakistan does seem to show a proportional relationship between aid, investment and growth, but the situation is complicated by a host of strategic and other problematic factors. As far as measuring the effectiveness of aid is concerned, human Development Indicators (HDIs) such as literacy and infant mortality should be used instead, which could give a better indication of short-term effects. If poverty reduction is the main aim of giving aid, examining growth figures is not the only way of assessing the impact, and another important factor is the way in which the poverty-efficient allocation is made. Collier & Dollar (2002) showed that more people can be taken out of poverty if a more efficient allocation system is used compared to the present allocations. A study by Masud & Yontcheva (2005) for example, showed that in the case of infant mortality, NGO aid was able to reduce this more effectively than bilateral aid, although the same was not the case for illiteracy. Nonetheless, HDIs can serve as a more direct measure for effectiveness than growth figures. References Burnside, Craig & Dollar, David. 2000. Aid, policies and growth. American Economic Review, Vol. 90, No. 4, pp. 847-868. CBP. 2003. Third quarterly report. In Mullick, 2004. Collier, Paul & Dollar, David. 2002. Aid allocation and poverty reduction. European Economic Review, Vol. 46, Issue 8, pp. 1475-1500. Dollar, David. 2003. Eyes wide open: on the targeted use of foreign aid. Harvard International Review, 25: 48-52. In Oatley, 2009. Easterly, William. 2002. The cartel of good intentions. Foreign Policy, 40-44. In Oatley, 2009. Isard, Peter. 2006. The macroeconomic management of foreign aid: opportunities and pitfalls. International Monetary Fund. Jeewanjee, Zainab. 2009. Defeating terrorism with development. Foreign Policy Blogs Network. Available at http://pakistan.foreignpolicyblogs.com/tag/foreign-aid-in-pakistan/ [Accessed April 2011]. Khan, Ashfaque H. 2001. Recent economic performance, impact of September 11 and short-term economic outlook of Pakistan. Islamabad, Pakistan. In Mullick, 2004. Masud, Nadia & Yontcheva, Boriana. Does foreign aid reduce poverty?: empirical evidence from nongovernmental and bilateral aid. International Monetary Fund. Moreira, Sandrina Berthault. 2005. Evaluating the impact of foreign aid on economic growth: a cross-country study. Journal of Economic Development, Vol. 30, No. 2, pp. 25-49. Mufti, Irfan. 2011. Economic cost of flood in Pakistan. Available at http://www.sappk.org/publications/articles/Article_Irfan_Mufti.pdf [Accessed April 2-11]. Mullick, Haider. 2004. US foreign aid and economic growth: a post-9/11 case study of Pakistan as a key ally in the war against terrorism. Published in the Proceedings to the Pennsylvania Economic Association Conference, Summer 2004. Nakamura, Tohru & McPherson, Malcolm F. 2005. Is foreign aid effective in reducing poverty? Available at http://www.eb.kobegakuin.ac.jp/~ntohru/poverty.pdf [Accessed April 2011]. Nazar, Yousaf. 2011. Net foreign aid flow turns negative. Dawn (newspaper), 21 March 2011. Oatley, Thomas. 2009. Debates in International Political Economy. Longman. Picard, Louis A., Groelsema, Robert & Buss, Terry F. 2007. Foreign aid and foreign policy: lessons for the next half-century. M. E. Sharpe. Rao, P. K. 2003. Development finance. Springer. Tarnoff, Curt & Nowels, Larry. 2005. Foreign aid: An introductory overview of U.S. programs and policy. CRS Report for Congress. Available at http://www.dtic.mil/cgi-bin/GetTRDoc?AD=ADA457380&Location=U2&doc=GetTRDoc.pdf [Accessed April 2011]. WB. N.d. The ghost of financing gap. World Bank Publications. Williamson, Claudia R. 2009. Exploring the failure of foreign aid: the role of incentives and information. Review of Austrian Economics. Available at http://dri.fas.nyu.edu/docs/IO/12361/WilliamsonRAEAid.pdf [Accessed April 2011]. World Bank. 2003. World Development Indicators. World Bank. Additional Bibliography Riddell, Roger. 2007. Does foreign aid really work? Oxford University Press. Additional Websites EconomyWatch. http://www.economywatch.com/economic-growth/pakistan.html Trading Economics. http://tradingeconomics.com/pakistan Read More