It is widely assumed that to be effective foreign aid should be linked to a needy country's adopting sound institutions and policies. That belief lies behind the Bush administration's decision to set up the New Millennium Challenge Account, intended to increase aid by 50 percent over the next several years. However, in a new study in the Cato Journal, Harold Brumm, an economist with the federal government, finds that "foreign aid has a negative growth effect even where economic policy is sound."
Brumm examines data for 53 underdeveloped countries and finds a statistically significant but negative relationship between aid to countries with good policies and growth of real gross domestic product per capita. His results cast doubt on a much-cited study by World Bank economists Craig Burnside and David Dollar, who concluded in "Aid, Policies, and Growth" (American Economic Review, 2000): "We find that aid has a positive impact on growth in developing countries with good fiscal, monetary, and trade policies, but has little effect in the presence of poor policies."
In 2003, William Easterly, a former World Bank economist, along with Ross Levine and David Roodman, wrote a study for the National Bureau of Economic Research casting doubt on the Burnside-Dollar good governance argument for foreign aid. Using additional data, but the same model as Burnside and Dollar, they found that aid, even when conditioned on good governance, had no impact on growth.
Brumm goes one step further. He corrects for measurement error in the policy variable used in the earlier studies and employs a different model specification. His conclusion -- that using "selective" aid to reward developing countries with good policies may actually reduce growth, rather than simply have no impact -- strengthens the doubts expressed in the NBER study regarding the usefulness of foreign aid in promoting development.
Indeed, Brumm notes that his study lends credence to the view expressed by the late Peter (Lord) Bauer, a pioneer in development economics. According to Bauer, "Development aid is ... not necessary to rescue poor societies from a vicious circle of poverty. Indeed it is far more likely to keep them in that state."
Aid has perpetuated poverty in Africa, Latin America, and elsewhere. There is no reason to believe that "selective" aid will be the elixir for poverty in the 21st century. Rather, what we now know is that the best way to move from poverty to prosperity is to increase economic freedom. Official development assistance, in the form of grants and concessional loans that have a grant component, is neither necessary nor sufficient to increase economic freedom and prosperity. Hong Kong received virtually no aid but found that its free trade policies, limited government, and protection of property rights were the key to wealth creation.
Hong Kong and other economically free countries have higher living standards than those countries that lack the institutional infrastructure conducive to a vibrant market system. That conclusion is well documented in the economic freedom indexes published annually by the Fraser Institute and by the Heritage Foundation in conjunction with the Wall Street Journal. Leaders in developing countries have access to those indexes and are beginning to recognize the importance of economic freedom. They do not need more aid, they simply need to trade and eliminate interventionist policies that politicize economic life and lead to corruption. India, for example, is finding out that trade liberalization, lower marginal tax rates, and elimination of red tape are positive steps toward prosperity compared to state-led development planning and foreign aid.
It is tempting to think that aid can be targeted to countries with good policies and have a positive impact. However, once we recognize that all aid is political, since it is government-to-government assistance, we should not be surprised that it has either no effect on development or a negative effect. Moreover, the World Bank continues to give substantial aid to countries with poor policies.
The First World would do the Third World a favor by ending all but humanitarian aid and opening markets so that poor nations can trade according to their comparative advantage. Protecting special interests in the United States and Europe while preaching free trade to developing countries is hypocritical and harmful to the future of freedom.
Free private capital markets, not the World Bank or the International Monetary Fund, can judge whether policies are good or bad. Those countries that walk the walk of the free market will find the capital they need for development. Private lenders, in the absence of bailouts by the IMF, will have an incentive to direct capital to where it has the highest risk-adjusted return, and that will be to countries following good policies. Hong Kong's development path of free trade is far superior to the dead end of aid.