Executive summary
For fifty years, proponents of ‘aid’ have argued that poor countries are poor because they lack the funds to invest
in the infrastructure that would enable economic activity to take place, which in turn means that they are unable to attract investment. Originally used to justify mega-projects, such as roads and dams, these arguments continue today in modified form, ostensibly justifying investments in schools and hospitals.
Donors have justified aid with various theories and political motivations, but its core justification, the ‘gap
theory’, is fundamentally flawed. This theory assumes that poor countries are trapped in a vicious cycle of poverty because they are unable to save and hence have insufficient capital to invest in growth-promoting, productivity-enhancing activities. But there simply is no evidence that this savings/investment ‘gap’ exists in practice.
As a result, aid has failed to ‘fill the gap’. Instead, it has, over the past fifty years, largely been counterproductive:
it has crowded out private sector investments, undermined democracy, and enabled despots to continue with oppressive policies, perpetuating poverty.
‘Gap theory’ premise fundamentally flawed
The reason countries are poor is not that they lack infrastructure – be it roads, railways, dams, pylons, schools or health clinics. Rather, it is because they lack the institutions of the free society: property rights, the rule of law, free markets, and limited government.
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In a majority of poor countries, the average poor person is typically unable to own and transfer property. Courts of law are slow, expensive and corrupt.
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Government plays a large role in the economy and government policies undermine incentives to engage in mutually beneficent economic activities.
A review of the evidence suggests that when money is given to the governments of countries that do not have these institutions, it is not spent wisely.
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Very often, aid is spent on projects that benefit the political leaders at the expense of the citizens.
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Almost always, the money crowds out investment by the private sector and – because government is not good at making investment decisions – it undermines economic development.
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Often it has bolstered corrupt regimes that would otherwise have been thrown out.
Aid fails to fill the gap – in Africa and elsewhere
Africa received approximately $400 billion of aid from 1970 to 2000.
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Aid as a percentage of Gross National Income (GNI) grew continuously in Africa between 1970 and 1995, starting at around 5 per cent in 1970 and peaking at around 18 per cent.
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There appears to be an inverse relationship between aid and growth (see Figure 1, page 8), and this is not unique to Africa. Growth is higher in periods when the aid-to-Gross National Income ratio falls.
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Aid does not finance additional investment for which the recipient countries failed to marshal domestic resources. It simply frees central government resources for spending on current consumption – which in turn fuels corruption.
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Paul Rosenstein-Rodan, a former deputy director at the World Bank Economics department, observed: “When the World Bank thinks it is financing an electric power station, it is really financing a brothel.” (page 10)
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Meanwhile, the savings ratio (savings in relation to national income) has actually fallen when aid has increased. Research clearly demonstrates a negative effect of increased aid on savings in Sub-Saharan Africa.
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If the governments of the World’s richest countries do increase spending on aid to Africa by $25 billion, the consequences could be devastating.
In contrast, Aid to Asian countries has generally been small (below one per cent of GNI). Nevertheless, the aid that was received may have crowded out projects that would have resulted in long-term growth – and thus may have had a negative impact there also.
Overall in Asia, aid has not had a significant and positive effect on economic development. Millions of poor people live in India and China, but their economies are growing despite the insignificant role that aid plays in their investments. (see Figure 4, page 10)
Case study: Tanzania and Kenya
Aid played a significant role in Tanzania’s and Kenya’s economies – each received approximately US$ 16 billion between 1970 and 1996.
Following their independence, Tanzania and Kenya pursued a variety of unsound economic policies which led to economic stagnation and extreme poverty.
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Kenya pursued ‘import substitution’ through restrictions on imports, price controls, the establishment of marketing boards and nationalisation of industry – all of which led to economic stagnation and had a devastating effect on the country’s citizens.
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Tanzania pursued ujamaa, or ‘African socialism’, which involved the nationalisation of trade, absolute price controls, and the abolition of private ownership. As a result, Tanzanians were even poorer than Kenyans.
The countries exemplify two failed development models, one more extreme than the other, but both heinous. While a few reforms have occurred in recent years, entrenched economic and political interests prevent truly meaningful reforms. In Kenya and Tanzania, aid effectively aggrandised the political elite and disempowered the common man.
Reforms in Africa: Uganda
Some have suggested that aid could act as ‘a midwife of reforms’ in countries that are already pursuing the right policies and/or where the government is dedicated to a reform agenda. Uganda may be one such country.
Uganda’s economy was destroyed by tyrant Idi Amin in the 1970s. Between 1971-95, its GDP per capita fell by 40 per cent, leaving many Ugandans in extreme poverty.
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In 1987, President Yoweri Museveni embarked on a liberalisation programme, which opened the economy to foreign investors, liberalised trade and financial sectors and privatised state-owned enterprises.
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Uganda’s average real GDP growth during the 1990s was 6.9 per cent. It’s per capita growth was around 3.5 per cent.
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Uganda’s reforms were assisted and at times led by donors – but Uganda has owned the process and reforms have been accomplished through a domestic political agenda, without significant interference from donors.
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Aid helped to lock in reforms once they had already occurred, and financed investments with good returns.
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However, a significant proportion of Uganda’s economy is still fuelled by aid, so if aid were to decrease in the near future, its GDP will fall significantly.
In a few cases and for brief periods, aid has provided impetus and support for governments to improve their governance – to liberalise, privatise and deregulate their economy. Yet even in those cases, growth that depends on aid is intrinsically fragile and reforms may be reversed.
Governance in Africa and the case of Botswana
Bad governance alone does not explain poverty in Africa, but the vast majority of countries in Africa are badly governed and bad policy is the most important factor to explain their continuing poverty.
Botswana experienced the exact opposite development of Africa in general.
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After independence, Botswana generally pursued a path of sound, market friendly economic policy rather than the socialism of its African counterparts.
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Property rights and a reasonably well-established system of law were instituted and enforced.
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The country has had less external interference in its economy.
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People have an interest in stable political development because inclusive economic institutions (such as property rights) have enabled them to participate in economic activity. Wealth from natural resources (diamonds) has thereby benefited the country as a whole rather than only benefiting the political elite.
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As a result, Botswana achieved the highest rates of real economic growth in the world in the last 30 years – with GDP per capita rising from around $1600 in 1975 to around $8000 in 2004 (in purchasing power parity terms).
Conclusions
Fundamentally, economic growth depends on qualitative, not quantitative, factors: 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, and the openness of the economy to trade and investment with the outside
world.
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 removing trade barriers and eliminating trade-distorting agricultural subsidies, would yield far more benefits than increasing aid.
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