Can foreign aid buy growth?

Introduction:
This post will be an examination of an application of economic trend analysis using economic growth, investment, and foreign aid data.  In the article, Can Foreign Aid Buy Growth?,  William Easterly discusses the effectiveness that foreign aid has on influencing economic growth in developing countries.

Summary:
The standard model used to justify aid is called the “two gap” model.  It was developed by Chenery and Strout in the mid-1960s.  The first gap in the model addresses the difference between the amount of investment in an economy that is necessary to attain a certain rate of growth and the available domestic savings.  Essentially the gap exists when the public does not save enough and thus there is not enough capital to invest.  The second gap is between import requirements for a given level of production and foreign exchange earnings.  In the article the author primarily focuses on the first gap.

The first gap, the “financing gap”, makes two assumptions.  The first is a stable linear relationship between investment and growth exists.   That is to say, that for every dollar invested in an economy, the economy sees a corresponding dollar in growth.   The second is that aid intended to fill the financing gap will actually finance investment rather than consumption.  Easterly says that if the causes of low investment in an economy are because of poor incentives to invest, then aid will not increase investment.  In fact, the author claims, aid could actually worsen incentives to invest which could lead to economic contraction.  Aid in this case will then finance consumption, the author cites the work of Boone in 2006 as an example.  

Easterly tested the “financing gap” to determine how many of the 88 aid recipient countries showed a significant and positive result from having received foreign aid.  The test covered the period of 1965 to 1995.  Only six of the 88 countries showed results that indicate aid was able to increase investment in the economy.  Hong Kong, China, Tunisia, Morocco, Malta, and Sri Lanka were the six countries.  The next step in the Easterly’s analysis was to look at the growth rate of the economy and rate of investment in the economy.  Using the same 88 countries the author found only four countries had a significant relationship between growth and investment.  Israel, Liberia, Reunion (a French colony) and Tunisia were the four countries.  Easterly concluded that only one country, Tunisia, passed the “financing gap” test.  Of course, the author said that Tunisia was more likely to have passed due to chance.  

The following graph shows a 10-year moving average of aid as a percentage of GDP and growth per capita in Africa from 1970 through 2000.

Easterly reports that the current theme in foreign aid is that aid should be directed to where it can do the most good.  Specifically, to nations that have good fiscal, monetary, and trade policies.  There is, however, some debate on what constitutes “good” policy.  The article concludes with the author stating that in no other field of economics do economists and policymakers promise such large benefits for modest proposals.  Easterly says the macroeconomic evidence simply does not support the claims.  He suggest the goals should be more modest in that the aid should simply provide benefit to some of the poor some of the time.  However, Easterly also says the quality of aid should come before an increase in quantity.

Source:
Easterly , W. (2003). Can foreign aid buy growth?. Journal of Economic Perspectives, 17(3), 23-48.