EFFECTIVENESS OF FOREIGN AID: What Matters?

by:NIROJ BHATTARAI
MacroEconomics P.H.D candidate Colorado State Universtiy



Foreign aid can be an effective tool for a third world country’s growth because it provides them with the much-needed fund for investments and other socio-economic activities. However, there have been a lot of disagreements among economists on the question of the effectiveness of foreign aid. Boone (1996) found that aid had no effect on the growth or investment for some developing countries. Is foreign aid really helping the ones it intends to help or is it fueling the corruption bug in developing countries?Some studies show that “there are quite a few countries that have received large amounts of aid for long periods of time and have little to show for it in terms of growth or poverty reduction.” (Burnside and, Dollar, 2002). Burnside and Dollar (2002) also find that “aid has a positive impact on growth in developing countries with good fiscal, monetary, and trade policies”. Easterly, Levine and Roodman (2003) argue that the findings of Burnside and Dollar are not that robust. Nonetheless, critics recognize that fiscal surplus, inflation, and trade openness have a large effect on growth. However, the impact of aid on growth is also influenced by its relationship with economic policies, corruption and other practices put in place by the government. So is handing money to corrupt governments of developing countries to improve their per capita growth a lost cause? Literature suggests that if a country has good economic policies then aid will fuel growth. Svensson (1999) finds that “aid has a positive impact on growth in countries with an institutionalized check on governmental power; i.e. in more democratic countries”. I believe that policies, both economical and social, depend on the type of government and various institutions that a country has.Previous studies have focused mostly on the contribution of aid towards growth and the effect on it by various economic policies. In this paper I attempt to answer whether countries with better-established political institutions and older democracies/autocracies (or governments in general) benefit from aid more than the ones that have fragile, corrupt and young political system. I analyze the interactions between foreign aid, institutions and political system in place in the developing economies, and explore the effectiveness of foreign aid in helping the growth of the per capita income in various settings.To empirically analyze the effect of political systems and institutions on the contribution of aid towards growth, I use the data used by Easterly in his paper “New Data, New Doubts: Aid, Policies and Growth revisited” for the Center for Global Development. I have added the political data from the ‘Polity IV’ data, recently put out by the University of Maryland to the ‘Easterly’ data. This allowed me to create interaction terms between foreign aid, the variables for political systems, and various policies of developing countries. Hence, I was able to isolate the effects of the various political systems, regime duration, aid, and their interactions, towards per capita growth of these countries. I find that the impact of foreign aid on GDP growth in a developing country to be inconclusive. Aid, duration, democracy, and autocracy did not have a significant impact on growth by themselves; however, their interactions with each other were significant in some cases. The interaction between aid and duration was positive and significant when the political system was not specified. The interaction of aid with the squared of duration was negative and significant. In other words, the effectiveness of foreign aid increased at a decreasing rate as the regime duration increased, with the maximum effect when duration was 20 years. I find parallel effect of duration in a democracy, but the results in an autocracy though similar, were not significant.PLEASE PROVIDE WITH YOUR THOUGHTS (POSITIVE AND NEGATIVE) SO THAT I CAN IMPROVE>>>>> CHEERS>>>>ReferencesBoone, P. (1996) . Politics and the effectiveness of foreign aid. European Economic Review, 40, 289-329. Burnside, C., & Dollar, D., (2002) Aid, policies and growth. American Economic Review, 90, 847-868. Center for Global Development. (www.cgdev.org).Chauvet, L., & Guillaumont, P. (2002). Aid and growth revisited: Policy, economic vulnerability and political instability. Paper presented at the Annual Bank Conference on Development Economics. Oslo.Clague, C. (Ed.) . (1997) Institutions and economic development: Growth and governance in less-developed and post-socialist countries. Baltimore: The Johns Hopkins University Press.Clague, C., Keefer, P., Knack, S., & Olson, M. (1997) Democracy, autocracy, and the institutions supportive of economic growth. Baltimore: The Johns Hopkins University Press.Easterly, Levine and Roodman (2003). New data, new doubts: Revisiting “Aid, policies, and growth”. Center for Global Development working paper number 26. Easterly, W. (2003) . Can foreign aid buy growth? Journal of Economic Perspectives, 17 (3) , 23-48.Olson, M. (1997). The new institutional economics: The collective choice approach to economic development. Baltimore: The Johns Hopkins University Press.Polity IV dataset. (www.cidcm.umd.edu/inscr/polity/)Svensson, J. (1999) . Aid, growth and democracy. Economics and Politics, 11 (3) , 275-297.US AID 2007. (http://www.usaid.gov/)