New IPN study shows foreign aid does more harm than good

This weekend (Friday and Saturday), the G-7 finance ministers are meeting in London to conduct further negotiations on next month’s G8 agenda. High profile campaigns are pressuring the countries to commit themselves to doubling aid to African countries, suggesting that Africa needs an extra US $25 billion a year until 2015.

A new study* from International Policy Network concludes that aid has failed to achieve its goals in the past 50 years. Worse, in many cases aid has been counterproductive – crowding out private sector investment, undermining democracy and perpetuating poverty.

Commenting on the new study and high profile campaigns to lobby for increased aid, including the upcoming Live8 concert, Julian Morris, Executive Director of International Policy Network, said:

“Rock star economists see the world through rose-tinted spectacles (both literally and figuratively in many cases). Their belief that aid will help the poor is misguided. The reality is that aid rewards failure and bolsters regimes that would otherwise have been thrown out.”

The author of the report, Swedish economist Fredrik Erixon, points out that aid is based on fundamentally flawed assumptions which undermine rather than enhance economic development. Erixon warns against increasing aid spending, saying:

“If G8 countries commit to increasing spending on aid, the consequences could be devastating for most Africans. Too often aid has done more harm than good, especially in Africa. It has aggrandised the political elite and disempowered the common man.”

Erixon explained the flawed assumptions that underlie the theory of aid:

“Countries are not poor because they lack roads, schools or health clinics. They lack these things because they are poor – and they are poor because they lack the institutions of the free society, which create the underlying conditions for economic development. Aid has it upside down.”

He continued by contrasting the plight of most African countries with that of Botswana:

“Botswana chose to empower its people with inclusive economic institutions instead of pursuing socialism like many of its African counterparts. As a result, it has experienced the world’s highest rates of economic growth in the past 30 years, and its people are far better off – with per capita incomes of around $8000 per year, compared with less than $1000 in many African countries.”

Africa received over $400 billion in aid between 1970 and 2000. Yet, the evidence presented in the study shows an inverse relationship between aid and economic growth – when aid rises, growth falls. In part this is because aid supplants private sector investment and undermines savings: there is also an inverse relationship between savings and aid -- when aid increases, saving decreases.

Although bad governance is not the only explanation for Africa’s woes, the vast majority of countries in Africa are badly governed and bad policy is the most important factor to explain their continuing poverty.

For instance, Kenya and Tanzania were both recipients of large amounts of aid from 1970-1996. Both countries pursued flawed economic policies, such as price controls, marketing boards and import substitution. Their extreme poverty was entirely due to those policies, and reforms have not been forthcoming in recent years because of entrenched economic interests.

In contrast, millions of the poorest people in the world live in China and India, whose economies are growing rapidly despite receiving trivial amounts of aid.

An example of a country that has received aid and pursued the right policies is Uganda, which liberalised trade, opened its economy to foreign investors and privatised state-owned enterprises.

In this case, aid helped to lock in reforms that were already in place, and donors have not interfered with Uganda’s domestic political agenda. Although this is positive, Uganda’s economy is fragile because it is far too dependent on aid and its production is unsustainable.

The study concludes that economic growth depends not on the level of foreign aid given to a country, but on underlying, qualitative factors such as

• the structure of property rights
• the extent to which courts of law apply and enforce abstract, clear rules inexpensively and quickly
• the size of government and its effectiveness in delivering public goods
• the openness of the economy to trade and investment with the outside world.

The study also concludes that it would be more sensible to scale back levels of aid, provide aid only to governments that are already reforming, and make aid available for a strictly limited period of time. Other reforms, such as eliminating trade-distorting agricultural subsidies, would yield far more benefits than increasing aid.