Econ 461: Economic Development Lecture 22: April 4 Aid

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Econ 461 Economic DevelopmentLecture 22 April
4Aid
Sandra Poncet Lorch Hall, room 207 Email
sponcet_at_umich.edu Office Hours Mondays 1630-18
Wednesdays 1030-12
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Introduction
Development assistance ("aid") has been a central
part of the development policy landscape
throughout the post-war era.
After a decline in the 1990s, aid is up again.
Sachs asks for a doubling in aid to meet the MDG.
There is a pledge by northern governments to give
their contribution.
Public perceptions reflect support for higher
levels of aid. When asked what percentage of
the federal budget they think goes to foreign
aid, Americans' median estimate in of the
budget is
25, more than 25 times the actual level.
Only 2 of Americans give a correct estimate of
1 of the budget or less.
When asked how much of the budget should go to
foreign aid, the median response is
10. Only 13 of Americans believe that the
percentage should be 1 or less.
Over 60 of Americans believe that contributing
0.7 of national income to meet the Millennium
Development Goals is the right thing to do.
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Introduction
Evidently Better aid is needed, not just more
aid. Both the quantity and the quality of
development assistance need to increase.
This lecture about aid stylized facts,
theoretical arguments and practicalities Lecture
23 aid effectiveness.
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Lecture Outline
Introduction I-Stylized facts about aid
A-Definition B-Level, allocation and
evolution C-Economic Rationale for aid
flows II-Growing disappointment with aid
A-Theoretical arguments B-Problems lack of
accountability and incentives Conclusion
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I-Stylized facts about Aid
A-Definition of Official development aid (ODA)

• Grants or Loans to developing countries which
  are
• undertaken by the official sector
• with promotion of economic development and
  welfare as the main objective (not military aid)
  
• at concessional financial terms if a loan,
  having a Grant Element of at least 25 per cent.

Remark 1 ODA can be managed individually
(bilateral aid) by the countries or united and
managed by multilateral agencies World Bank, EU,
regional development banks.
Remark 2 most statistics only cover the 22 DAC
(Development Assistance Committee) countries
Non DAC countries include other OECDC countries
(Czech Republic, Hungary, Iceland, Korea, Poland,
Slovak Republic, Turkey) And other countries such
as OPEP countries and China
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I-Stylized facts about Aid
B-Level, allocation and evolution of Official
development aid (ODA)
Total official development assistance (ODA) from
DAC members rose by 32 in 2005 to USD 106.8
billion a record high. This represents 0.33
of members combined Gross National Income in
2005, up from 0.26 in 2004, and the highest
ratio since 1992.
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I-Stylized facts about Aid
B-Level, allocation and evolution of Official
development aid (ODA)
Fact 1 Core development programs rose by 8.6
between 2004 and 2005, but most of this increase
was accounted for by only two countries,
Afghanistan and Iraq. If these two countries are
excluded, core development programs increased by
2.9.
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I-Stylized facts about Aid
B-Level, allocation and evolution of Official
development aid (ODA)
Fact 2 The lions share of the aid increase in
2005 came from debt relief grants (to Iraq (14b)
and Nigeria (6b)), which more than tripled,
while humanitarian aid rose by 15.8
True enough debt relief helps to reduce the debt
overhang problem but does not correspond to fresh
money (in fact no change if the country was not
reimbursing)
Fact 3 Level falls short of the promises. At
the Monterrey Financing for Development
Conference in 2002, world leaders pledged to
make concrete efforts towards the target of 0.7
of their national income in international aid.
In todays dollars, that would amount to almost
200 billion each year (double the current level).
Only Five countries have already met or surpassed
the 0.7 target Denmark, Luxembourg,
Netherlands, Norway and Sweden. Five other
countries have committed themselves to a timeline
to reach this target before 2015 Belgium,
Finland, France, Ireland and the UK. 
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I-Stylized facts about Aid
B-Level, allocation and evolution of Official
development aid (ODA)
On average, the worlds richest countries
provided just 0.33 of their GNP in official
development assistance (ODA).
The United States provided just 0.22.
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Out of the 73 billions of development programs, a
small fraction is financial disbursed to the
developing countries.
1/5 covers administrative costs, student costs
and refegees in donor countries
Around 50 is tied either on trade, projects or
technical assistance (experts service from the
developed world)
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Tied aid Tied aid is aid given on the condition
that the recipient will use it to purchase goods
and services from suppliers based in the donor
country.
In low-income countries, only about 24 of
bilateral aid actually finances investments on
the ground.
Moreover, potentially up to 75 calls for
reimbursement.
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C-Economic Rationale for aid flows
1-Development models (Easterly, AFD 2004)
a-Financing gap b-Poverty gap c-The expenditure
to outcomes model in health and education
2-Critics of these development models
Simplistic hypotheses -aid converts entirely
into investment (no leakages through consumption
or corruption) -investment converts entirely into
growth (cf. limits of Harrod Domar model)
Empirical data reject the validity of the
poverty trap model
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C-Economic Rationale for aid flows
3-Less rosy picture on why donors give aid
political motivations (Todaro and Smith ch. 15,
2006)
Donor-country governments give aid primarily
because it is in their political, strategic, or
economic self-interest to do so.
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II-Growing disappointment with aid
A-Theoretical arguments
1-Ressources are not everything Aid may finance
schools and required textbooks, but education
will not improve unless teachers and students
show up regularly (refer to the problem of
complementarity inputs and incentives covered in
lecture 12).
2-Weakening of institutions
a-induces laxism on raising taxes for receiving
country
Illustration political economy model of Adam and
OConnell (1999) discussed in Gunning AFD (2004)
Framework Government has two sources of revenue
R aid and taxes and uses R to ensure two types
of spending -minimum social services to
population to prevent rebellion -transfers to
favored group
Case 1 aid is used entirely for tax cuts
higher growth since reduction of tax induced
distortion but no improvement in social services
This provides an incentive for CONDITIONALITY
(but inefficient)
Case 2 aid is used entirely for additional
transfers to favored group (even if targeted to
social services as gvt resources are released and
can be used for transfers context of FUNGIBILITY)
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II-Growing disappointment with aid
A-Theoretical arguments
2-Weakening of institutions
b-counter-intuitive results that aid may reduce
social services
The social services are paid to compensate for
the tax burden and thus to prevent unrest. Aid
allows to pay the transfers to favored group
without requiring taxes. The gvt can reduce taxes
and social services without launching unrest.
c-relaxes countries need to explain their
actions to citizens
By expanding a governments resource envelope,
aid relaxes their need to explain their actions
to citizens, which may have a corrupting
influence even on the best intentioned of
governments in the long run.
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II-Growing disappointment with aid
A-Theoretical arguments
3-Adverse effects on competitiveness
Macroeconomic effect on a countrys
competitiveness of large windfalls and their
associated spending ( Dutch Disease). The
problem is limited absorption capacity. Two
channels
a-Aid inflows could push up the price of some
critical (scarce) resources Rise in input costs
of engineers, doctors, teachers, civil servants,
and aid administrators. Sectors for which
prices are fixed by foreign competition
(tradables) will lose competitiveness and
profitability.
b-In a flexible exchange regime aid inflows may
also push up the nominal exchange rate, rendering
the traded goods sector uncompetitive if wages in
that sector do not adjust downwards.
Consequences
Effect of a real exchange rate appreciation the
traded sector becomes uncompetitive and
shrinks. All the more detrimental as traded
sector is often modern, characterized with
learning by doing effect (refer to lecture 14)
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4-Costs associated with aid flows real value of
the aid is much lower
a-Administrative costs Planning nightmare
(Easterly, 2005) Multiplicity of donors/projects
is demanding for limited administrative
capacities of states meetings, proposals
b-Substantial debt repayment burdens Aid is a
mix of grant and debt.
c-Tied aid by source (loans or grants have to
be spent on the purchase of donor-country goods
and services) or by project (funds can only be
used for a specific project, such as a road or a
steel mill).
Consequences
Costs as the specified source is likely to be an
expensive supplier or the project is not of the
highest priority (otherwise, there would be no
need to tie the aid).
Aid may be tied to the importation of
capital-intensive equipment, which may impose an
additional real resource cost, in the form of
higher unemployment, on the recipient nation.
A former British minister of overseas
development once noted that "about two-thirds of
our aid is spent on goods and services from
Britain.... Trade follows aid. We equip a factory
overseas and later on we get orders for spare
parts and replacements. Aid is in our long-term
interest."
d-Volatility of aid flows lack of
predictability entails investment risks
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II-Growing disappointment with aid
B-Problems lack of accountability and incentives
1-Lack of accountability of donors (Easterly,
2005)
No sanction in case of failures (no improvement
in LDCs, MDGs failures) -goals too optimistic?
(insufficient financing as argued by
Sachs) -plan misconception, model
inappropriateness? -were benefits of aid more
than compensated by costs? -was improvement the
donors objective in the first place?
Crucial questions (so far not enough empirical
evidence) but sofar not addressed calls for
further aid expansion coexist with litany of
failures
a-is failure caused by adverse external factors
or by program failures?
b-if inherent program failure who is to blame?
Donors or recipients?
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Two different cases
a-Unrestricted Aid is simply a lump-sum transfer
to the government of the recipient country, who
has complete discretion over its allocation
Drawbacks might be used to finance politicians
private consumption misalignment between donor
and recipients preferences (e.g. aid used to buy
weapons instead of medical supplies)
The recipient is to blame (bad governance) except
if failure is due to negative external shocks
(bad luck).
b-Conditional Aid is effectively a contract
between donor and recipient, by which funds are
disbursed only if recipient picks the "right"
policies
Drawbacks -Issues about how perfect the
contract can be due to observability and
enforcement problems principal-agent (especially
multiple principals)
-Also, not clear whether it is desirable that
the beneficiaries preferences have no role (local
knowledge, lack of ownership)
-Finally, conditionality can create distortions
on other domestic policies or outright cheating
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II-Growing disappointment with aid
B-Problems lack of accountability and incentives
2-Bad incentives (for donors and recipients)
In this latter case blame may be shared between
recipient and donor merry-go-round of
aid-failure (similar arguments as for debt
lecture 19)
Lenders face incentives that cause them to aid
even when the conditions of aid are not met. So
that recipients face incentives that cause them
not to abide to conditions. Add to that the issue
of fungibility.
1-Solicitude of donors for the poor makes their
threat of cutting off lending if conditions go
unmet not very credible
Perverse incentive to recipients stay poor!!
2-Disbursement incentives Larger budgets are
associated with more prestige and more
advancement. If not disbursed cut the next
year. So incentive to lend every time positive
change is identified.
Perverse incentive to recipients zigzagging
policies
3-Political embarrassment as failure may harm
managing reputation and thus threaten the
lenders budget allocation (public support for
aid)
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CONCLUSION

• End of the 1980s, development aid went through a
  crisis of legitimacy without precedent, due to
  various factors and the disappointments about aid

International environment change (end of the
Cold War) transformed political foundations of
bilateral aid, long considered as an instrument
for promoting the political and geostrategic
interests of donor countries.
Economic crisis and strong budgetary constraints
weighing on several donor countries, notably
European countries in the Euro zonehas, since
1992, led to a brutal fall in aid flows to
developing countries.
Problems of increasing debt in recipient
countries and successive financial crises opened
a broad debate over the reform of international
financial architecture and the role given to
multilateral institutions.
Economic foundations and the justification of
development aid were attacked by numerous very
critical studies emphasized the absence of
macro-economic effectiveness, and the failure of
conditionalities.
World Bank reopened the debate on aid and
allocation effectiveness, with the release of its
1998 report entitled Assessing Aid based on
work from Burnside and Dollar. (next lecture)
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APPENDIX
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Recall Various types of creditors
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Sub-Saharan Africa home of 35 of the absolute
poor (420 millions) receives 30 of ODA.
The rise in 2005 of Bilateral Net ODA to
sub-Saharan Africa from DAC members is mainly due
to Nigerias exceptional debt relief
rose.Excluding Nigeria (home of 70 millions
absolute poor), total ODA to the region fell 2.1
to USD 24.9 billion.
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Need to relativize the figure of USD 106.8
billion
Food for thought (data in 2004)
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