Development Aid

Does Aid Work?

We often hear: Aid does not work. It is squandered away by corrupt officials, it does not reach the poorest, and there are many white elephants and failed projects. And worse, as argued by some economists, aid leads to Dutch disease, as the inflow of foreign exchange increase the value of the local currency making it more difficult for export companies to compete in the international market, with the result that growth is inhibited.

At the heart of the Dutch disease discussion is the absorptive capacity of aid: Inflow of aid increases demand for consumer and investment goods, and if this is not met by a raise in supply, the price level will increase. Increasing prices is a problem for the import competing sector as well as the export sector, which will face a hard time. Inflow of foreign exchange from aid will impact the real exchange rate, increasing its value.

There are several problems with this analysis. First, it assumes that aid does not have an impact on the productive capacity in the economy, enabling it to increase supply. But aid used for providing educational services, health system improvements, improved infrastructure like roads and electricity and for increasing the productive capacity in e.g. the agricultural sector through irrigation investments, just to mention a few examples, all have positive effects on the supply side of the economy.

Secondly, inflationary pressures due to inflow of aid have to, can be and are being managed by Central Banks. This requires careful macroeconomic management through monetary policies to influence aggregate demand and its impact on the real exchange rate. Where the exchange rate is fixed (pegged, e.g. to the USD) it entails sterilisation measures (issuing of bonds to mop up excess cash in the economy), and where the exchange rate is floating it results in reserve accumulation. Contrary to what the proponents of Dutch disease believe, Dutch disease is not inevitable, but can be managed. Third, Dutch disease can arise from any large inflow of foreign exchange. E.g. through incomes from exploration of minerals or fossil fuels, or from inflows of remittances. The proponents of Dutch disease assume that this phenomenon is always present and uses this to argue that aid therefore should not be provided. But they do not argue that remittances should be stopped. Or that private debt and portfolio equity should be blocked. Even though both remittances and private debt and portfolio equity are several times higher than aid, and the risk of Dutch disease hence is much greater.

But the sceptics have a point. For aid to reach its maximum effect, a conducive macroeconomic policy has to be in place. What this entails for the individual country cannot be determined a priori. Is an inflation rate of 2% needed? Or can the economy manage if the rate is 8%? Or 15%? The issue is that it is not possible to tell if investment will be discouraged because of an inflation of 5% or 15%. Many other factors influence such decisions. One of the valuable criticisms of aid is that it often is provided under a blanket one-size-fits-all approach without paying sufficient attention to the unique circumstances of individual countries.

An alternative way to look at the postulate “aid does not work” is to see what happen, if aid is not provided. The case of the Ebola epidemic provides an example. Could one imagine that an Ebola epidemic, started from a few infected bats, and spread through people who must touch a dead person before the burial, could happen in the USA or Germany? The answer is no. First, there would after the first outbreak in such a country be a hunt for bats and they would be eradicated. Second, traditional burial customs would be stopped, both through the law and public education. Third, the general educational level in the USA and Germany is so high that at the moment such a contagious disease was discovered all people would comprehend how dangerous it would be and they would understand the messages given by the public health authorities. Fourth, the health system in both the USA and Germany would be able to cope with the cases that had slipped through the net, and ensure that the disease would not spread.

But this is not the case in Guinea, Liberia or Sierra Leone. Many years of neglect, both by the governments in the respective countries and the international community, has left these countries with poor educational and defunct health systems, unable to cope with the threat of Ebola. It is only because the spread of Ebola was a threat to people living in the USA and Europe, symbolised by the young American doctor who contracted the disease (and fortunately survived), that the international community came into gear. The Ebola epidemic started in 2014 has claiming many thousands lives during the first year of the present outbreak. Deaths, which could have been avoided if responsible governments, supported by aid, had build well functioning health and education systems in the three most affected countries.

Photo by Bjarne Larsen Kron.

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