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The Future of Foreign Aid

Creating the Conditions for Economic Growth in the Developing World

by Mark DeYoung

For more than four decades, the U.S. has funneled billions of dollars into foreign aid, hoping to forge economic and human development in the poorest countries of the world. Such aid has been a staple of American foreign policy since the Marshall Plan (European recovery following WWII), and last year, President Obama proposed to double foreign aid spending. Considering the new economic challenges and constraints now facing the West, it is worth analyzing whether aid dollars generate true economic growth.

Sub-Saharan Africa is a major recipient of foreign aid. For the last forty years, the continent has received over $1 trillion in aid from Western countries. According to Harvard-educated Zambian economist Dambisa Moyo (who wrote a controversial book on the effectiveness of foreign aid), “No nation has ever attained economic development by aid.” Prominent economist William Easterly concurs, citing the fact that decades-long aid to Africa resulted in zero growth in per capita income.

One study that followed 22 African countries over a 25-year period found no increase in production per person, and two International Monetary Fund researchers even suggest that “aid inflows have systematic adverse effects on a country’s competitiveness.” Data for the last two decades show that the highest per capita growth countries received tiny amounts of foreign aid, while the lowest per capita growth countries received massive foreign aid, possibly suggesting an inverse relationship. In fact, the countries that have battled poverty most effectively received very little aid (China, Singapore, Malaysia and other Asian countries).

Why such an outrageous failure?

Peter Boone of the London School of Economics offers one compelling explanation. He studied how aid was used in over 95 countries and found that “virtually all aid goes to consumption.” Because of this, he suggests that aid does not increase private investment and growth nor does it positively affect human development indicators. It simply increases the size of government (97% of the total government budgets in both Ethiopia and Gambia came from foreign aid in recent years).

Another explanation for foreign aid failure is the basic inefficiency of bureaucracy-to-bureaucracy operations. In 2006, for every dollar that was given to Africa in foreign aid, less than 44 cents actually reached the ground.

According to one USAID report, aid also tends to create a greater level of dependence on the part of borrowers, with little incentive to make necessary domestic policy reforms. They cite this problem in the Philippines after the fall of the Marcos dictatorship:

As large amounts of aid flowed to the Aquino government from the United States and other donors, the urgency for reform dissipated. Economic aid became a cushion for postponing difficult internal decisions on reform. A central policy focus of the Aquino government became that of obtaining more and more aid rather than prompt implementation of the reform program.

The president of post-genocide Rwanda, Paul Kagame, put it well in a recent interview. “No country can depend on development aid forever, he said. “Such dependency dehumanizes us and robs us of our dignity.”

So what is effective?

Strangely enough, the elimination or suspension of foreign aid seems to prompt growth. South Korea and Taiwan are two countries cited as USAID success stories, but their economies only started to grow dramatically after aid was cut off. Even the World Bank acknowledges that “reform is more likely to be preceded by a decline in aid than an increase in aid.” For example, private investment in India took off following the sanctions imposed by Western nations in the late ‘90s. The government approved 50 new foreign investment projects to make up for the loss of aid from Japan and the U.S. It seems that countries make lasting economic reforms despite foreign aid, not because of it.

Another primary contributor to true market growth is the liberalization of domestic economic policy. Those countries with the highest levels of growth (such as Chile and Taiwan) have done so because of extensive reforms.

President Bush took this concept to heart, spearheading new foreign aid rules that based spending levels on the political and economic environment of the recipient countries. While this has seen some success, experts are skeptical that countries can be compelled to make such reforms.

In the end, it seems there are two major factors that contribute most to economic growth in developing nations, apart from foreign aid. Countries must liberalize domestic economic policy (eliminating such things as harsh trade protectionism, complicated licensing schemes, nationalized industries, restrictions on investment, etc.) and encourage private investment to truly see lasting growth.

On our end, we should be encouraging private investment in foreign countries by offering generous tax breaks and continuing Bush’s legacy of encouraging domestic policy reform. Likewise, we can be supporting the work of micro-credit agencies like Grameen Bank and Kiva.org, who have had great success offering small business loans to the third world.

Not all foreign aid should be cut off. It plays an important role in improving certain quality of life indicators and infrastructure. The role of foreign aid has been especially important in improving life expectancy. Development programs have saved countless lives by providing access to clean drinking water, fighting malaria, decreasing maternal mortality, improving agricultural methods, and so on. Its importance should not be discounted, but it is clear that aid has largely failed to produce market reforms and economic growth.

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(The views expressed in this column are those of the author and do not necessarily reflect the positions of Headline Bistro or the Knights of Columbus.)