Does Foreign Aid Make the Poor Poorer?

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The UK government has decided to increase rapidly its foreign aid budget to nearly £13 billion by 2015. This policy has been promoted by the Prime Minister as a moral obligation. Economists, as economists, may wish to hold fire on the moral debate, but they can shed light on whether government aid actually helps development. And surely, if government aid makes poor people worse off, the moral justification is flimsy.

In A-level economics, various 1960s models are used to make the case for aid. Those models suggest, for example, that aid can fill the ‘savings gap’ and help countries accumulate capital to raise growth. In the context of these models, the actual historical record of foreign aid is something of a puzzle.

Aid has not worked

Many South and East Asian countries have increased national income very rapidly with negligible foreign aid. On the other hand, Africa has received nearly $600bn of aid and its economic growth rate has been very slow. Indeed, as Figure 1 shows, there is no relationship between overseas development aid (ODA) and economic growth and there is no analysis of the data that tends to find a positive relationship.

Figure 1.

Aid and growth – 1975 to 20001

There is a solution to this puzzle, but the solution lies outside the field of technical micro- or macro-economics.

Good governance

It is very difficult for economic activity to develop if the basic principles of good governance do not exist. These principles include peace; the rule of law; the absence of corruption; freedom of contract; the enforcement of contracts through efficient court systems; sound money; and the ability to register legal title in businesses and property. For example, if a business is not legally recognised, it becomes impossible for it to expand – as the business will then come to the attention of the authorities; the business cannot make contracts with employees as they will not be enforceable; it cannot advertise or borrow money; and so on. If people are not sure that contracts can be enforced in the courts – because of either corruption or inefficiency – proper business activity may grind to a halt.

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Countries that have grown rapidly in recent years have been those that have nurtured improved conditions for business and put in place the basics for good governance. A study by the Fraser Institute showed that the world's top 24 countries ranked by the quality of their legal systems had an average GDP per capita of $25,716 at the end of the period (2000) and average economic growth of 2.5 per cent during the period studied (1980 to 2000). The bottom 21 countries had an average income of $3,094 per capita and average economic growth of 0.33 per cent. The criteria used to rank legal systems were effectively the good governance principles listed above.

Indeed, basic economic and political reforms in countries such as India and Vietnam have led growth to rise dramatically. And it is the poor who tend to benefit most when this happens – though this can depend on the sequencing of reforms. In India, for example, the eight poorest states all currently have economic growth rates above the average and the proportion of the population that describes itself as hungry has fallen by 90% since the 1991 reform programme (see The Elephant that became a Tiger, published by the Cato Institute, 2010 and available from http://www.cato.org). Belatedly, many African countries are now growing and the continent has some of the top reforming governments as well as a marked reduction in civil conflict. None of this has any relationship to the provision of foreign aid.

Unfortunately, the provision of aid can undermine good governance by providing more opportunities for preferment and corruption by the elites and it can exacerbate ethnic conflicts. The world's worst dictators have received over $100 billion in official development aid and so it is not surprising that one study suggests that 40% of all arms in Africa have been financed by foreign aid. Those same systems of poor governance often lead to huge amounts of aid being diverted so that little reaches the people for whom it is intended.

Adam Smith got there first

The simple lesson for budding economists is that we should not forget to study the political institutions within which economic activity takes place. And we need to look at what happens if the provision of foreign aid undermines the framework within which economic activity takes place. Or, as Adam Smith once put it in a lecture in 1755: ‘Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.’

1. With thanks to Julian Morris for compiling the figure.

Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs and Professor of Insurance and Risk Management at Cass Business School.

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