Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Foreign Aid: Good or Bad?

September 9, 2010

  • Supporters tout positive health, investment outcomes from aid
  • No link between aid and growth, say opponents
  • Efficiently invested aid provides benefits to population, suggest supporters

One of the thorniest issues in developmental economics is about the benefits or not, of foreign aid.

Foreign Aid: Good or Bad?

Waiting for transport after receiving relief aid in Afghanistan. Opponents say aid deters investment in more productive sectors (Photo: S.Sabawoon/Corbis)


Some call for a massive stepping up of overseas assistance; while opponents say it does more harm than good. In this podcast, two economists pit their radically different views against eachother on this hotly contested subject.

Just 10 short years ago, the 189 member states of the United Nations signed a declaration in which they said “we will spare no effort to free our fellow men, women, and children from the abject and dehumanizing conditions of extreme poverty to which more than a billion of them are currently subjected.” In that same document they promised “to grant more generous development assistance, especially to countries that are genuinely making an effort to apply their resources to poverty reduction.”

Underlying that commitment is the assumption that foreign aid is a positive thing, that aid promotes economic development and from that many good things will follow. But are the benefits of aid so positive and straightforward?

IMF Survey Online: To unpick this question I’m joined by two economists: Andrew Berg is with the IMF’s Research Department and has been doing work on the likely results of scaling up aid to Africa; and we welcome back our second contributor, Arvind Subramanian, formerly with the Fund and now with the Peterson Institute in Washington, D.C., and the Center for Global Development.

Let me start with you, Mr. Subramanian. It would seem intuitive that if you pour money into an economy, let’s say in the form of foreign aid; that you’re going to have an increase in output and growth. Is that not the case?

Subramanian: As you say, it’s very intuitive. More resources means more money for investment and, therefore, more growth. But it turns out that you cannot find strong evidence that aid promotes growth. There’s a whole debate on this. Some claim that it works under some conditions; some like me claim that it doesn’t produce positive results under any conditions. So that’s contested. But I think certainly one can say that there is no compelling evidence that aid actually does promote growth.

IMF Survey Online: Mr. Berg, let me turn to you now. You’ve come to a slightly different conclusion. You’ve done some research at the request of the Group of Eight leading industrial economies. They asked you to look at what would happen if the richest nations were to double their aid to Africa. What did your findings discover?

Berg: We have basically a kind of a two-handed conclusion. Our first conclusion is this doubling of aid could have very strong positive effects on growth, but it clearly depends on what the aid is used for, how efficiently it’s invested, and what the policy response is.

IMF Survey Online: You say it “could have positive effects on growth.” Are we talking about a dramatic increase in GDP?

Berg: We didn’t start from the assumption that that would be transformative; that it would change the whole society, or that it would change the institutions, or that it would change the whole direction of the country. But we do think it would make a big difference, a substantial difference. It would save a lot of lives and it would take a lot of poor people out of poverty.

IMF Survey Online: Okay. Let me cut to you, Mr. Subramanian, because you were just about to add a comment.

Subramanian: Yeah. I think there are two really compelling reasons to question the commonsense wisdom that you put forth, and Andy just listed. One is that we know that countries, in the long run, do well when they build domestic institutions.

Historically it’s true that you need the glue of taxation to create good institutions, because it’s taxation that binds the governed and the government. It creates a kind of two-way link. If you have taxes, governments are held accountable because they have to deliver services. And if you have taxation, governments have to make sure that they don’t do things that kill the incentives to invest. What aid can potentially do is to undermine that link between the people and the government because it severs that link and, therefore, it retards institutional development.

Now, donors come back and say “No, no, no. We can ensure against that. We don’t want to undermine it,” which I believe. [They say] “We have ways of ensuring that that undermining doesn’t happen, for example, by imposing conditions.” So they say, “If it undermines the incentive to invest we can say, ‘well, direct your aid here, direct your aid there, create good governance.’”

But the fact is it doesn’t happen because there is an organic built-in thing which prevents the incentives being right for institutional development.

IMF Survey Online: That’s a point that you’ve discovered in your research, Mr. Berg, isn’t it? The characteristics of the countries, which are the recipients of aid, are very important as to whether that aid is effective or not.

Berg: Absolutely. I have not taken the position that aid is a magic bullet, that in and of itself will transform societies. It can help often, I think. But, of course, countries need to do all sorts of other things.

Subramanian: But, Andy, here’s a question for you. I believe what you just said about finding the right conditions to give aid. But the fact of the matter is, the international community actually is pretty kind of undiscriminating—or at least has been for a long time—in systematically pushing aid. So when you say, well, let’s find the right places to give the aid and for the right reasons and for the right objectives, where in practice are the incentives in place to accomplish that?

Berg: But I think there’s been some degree of improvement in the last 10 or 15 years. In fact, donors like to give aid to the “aid darlings,” the countries that have been making some institutional improvements—say, the Tanzanias, Mozambiques of sub-Saharan Africa—and they get quite a lot of aid compared to some other countries that have more difficulty, maybe more trouble, using the aid well.

IMF Survey Online: Two of the benefits that you identified in your research on foreign aid is, one, it frees up resources and, two, it produces “learning by doing”. Could you explain?

Berg: Arvind didn’t get the chance to talk about his second reason why aid can be problematic, but that’s what you’re alluding to there, I think. Aid allows the country to devote its scarce resources to producing stuff for home, for its own citizens.

So where they—a country—might be in desperate need of medicines, say, or food; without the aid, its skilled workers, its capital would have to be devoted to exporting stuff to get that medicine and food. The aid allows some of the medicine and food to come in anyway, and those skilled workers can be used at home, for example, to help cure AIDS. Now, what some people worry about is that the pressure for countries to export may be taken away.

Subramanian: Incentive rather than pressure.

Berg: Well, why don’t I turn to Arvind since it’s his argument?

Subramanian: There are two effects at work. One is what Andy just described: you free up resources, so you can do other things. You can invest and so on. But the downside is the incentives that it creates for exporting get dented and that’s because when you get a lot of foreign money, there’s upward pressure on the exchange rate, your economy becomes less competitive. One way of thinking about it is that if you have some skilled people in the country, they should be exporting. Instead the incentive is for them to move to, and be part of delivering services for AIDS, for example.

So certainly my research tends to suggest that the more countries get aid, the less they export. And then another assumption is that countries that export more, grow more in the long run. So if you get a lot of aid and the incentives are against exporting, then that could diminish the ability of a country to grow sustainably in the long run.

So I feel that in terms of creating the sustainable conditions for growth, which includes investing in tradable sectors and exports, that gets really hurt. And I really worry about that for the long run.

IMF Survey Online: Andrew Berg, do you agree that pouring aid into a country diverts from the trading sector?

Berg: When we were doing some of these scenarios, we sort of discovered something that’s obvious when you think about it, which is that this effect about exporting can go both ways. People talk about “Dutch disease.” The view was the Dutch had discovered oil and they would have this problem that Arvind just described, that they would become uncompetitive in other things besides oil and become dependent only on oil exports and sort of become less vigorous in the economy. So it was called “Dutch disease.”

But one thing that we realized as we played with our models and our scenarios is that there are two sides to that coin. If the aid is used, for example, to build ports and roads and to educate people and to cure them of sickness and maybe even to reduce infant mortality so they can begin to invest more in each kid and so on. You can get more exports in the long run because of the aid.

Subramanian: The evidence shows that government-to-government aid is probably the most problematic or the least compelling, right? But there are other forms of help that the international community has done in the past, and can do, which have actually been very successful.

Now, the best example is the green revolution. The international community financed the technology revolution. So I would like the debate to move from can government-to-government assistance work, to the bigger question of what are the other non-aid ways in which the international community can help.

IMF Survey Online: What are the forms you’re thinking about?

Subramanian: So let me give you three or four examples. One is financing international public goods, like R&D for health, research, et cetera.

Second, I think the international community can do a lot by way of reducing the ability, say, of dictators to park their money in their jurisdictions. So if you want to improve governance in these countries, one of the things we might do is to say that all foreign banks should disclose the illicit money they get from dictators because then there would be less of an incentive for these guys to park it in the first place.

I think we can do more by way of providing market access to some of these countries. But I think the debate surely has to move beyond government-to-government financial assistance to broader ways of helping.