The history and development of international aid

In exploring the history and development of the notion of international aid I will draw largely on the account offered by Roger Riddell in his 2007 text Does Foreign Aid Really Work? ‘Modern aid”, or aid as it is understood today, is traditionally considered to be rooted in the Marshall Plan for post war recovery and reconstruction in a war-torn Europe post-1945. Designed by George Marshall as Secretary of State for the US, the plan offered financial assistance to European states to rebuild infrastructure, economies and societies. Following the Marshall Plan, in 1949 US President Truman explained that those countries that were able must work to aid states in need of assistance for development.

Development aid

In defining development aid, we face an essential problem: A major part of the literature written on the subject does not describe what exactly should be understood by development aid. Accordingly, we will begin by introducing the most widely used concept, official development assistance, and discuss its shortcomings as a definition for development aid. Thereafter we will look at two other definitions used in research literature.

Official Development Assistance (ODA)

The OECD‟s Development Assistance Committee (DAC) uses Official Development Assistance (ODA) as “the standard definition of aid” (Easterly 2003: 28). According to the DAC

“Official Development Assistance (ODA) is defined as those flows to developing countries and multilateral institutions provided by official agencies, including state and local governments, or by their executive agencies, each transaction of which meets the following tests: i) it is administered with the promotion of the economic development and welfare of developing countries as its main objective; and ii) it is concessional in character and conveys a grant element of at least 25 per cent.”

It consists of grants or loans to developing countries that are:

“(a) Undertaken by the official sector; (b) with promotion of economic development and welfare as the main objective; (c) at concessional financial terms (if a loan, having a grant element of at least 25 per cent). In addition to financial flows, technical co-operation is included in aid. Grants, loans and credits for military purposes are excluded. Transfer payments to private individuals (e.g. pensions, reparations or insurance payouts) are in general not counted.” (DAC – DCD)

There are several noteworthy issues in this definition. First, it excludes private aid which might be spent on the promotion of development. This becomes even more problematic since “To this day, there remains no commonly agreed definition of the aid that is provided by non-governmental development and humanitarian agencies”. (Riddell 2007: 20) Second, ODA includes both concessional loans and debt forgiveness. According to Riddell “the issue of precisely what debt forgiveness figures do, or ought to, count as ODA still remains unclear and open to differing interpretation.” (Riddell 2007: 19) Besides, “concessional loans entail repayment obligations, and, therefore, the aid they involve, i.e. the net financial cost to the donor, is only a fraction of their face value” meaning that the aid content is overestimated. (Chang et al. 1998: 4)

Third, the ODA‟s objective according to the DAC is not only the promotion of economic development, but also the promotion of welfare.

Riddell points out that “confusion arises because „development aid‟ and the technical term „official development assistance‟ are […] used interchangeably to describe concessional transfers which contribute to both development and humanitarian and emergency objectives.” (Riddell 2007: 19 – 20) notes that “one consequence of donors channelling more “development” aid (ODA) to conflict countries is that the distinction between development and emergency aid has become even more blurred.” (Riddell 2007: 47) Also, even whilst looking only at flows intended to advance development, the problem remains what part of these flows actually reaches the recipient countries, and which parts are spent on overhead costs, administrative expenses, etc.

Effective Development Assistance (EDA)

A measure that has become frequently used within the recent decade is Effective Development Assistance (EDA). EDA differs somewhat from ODA in that it excludes the loan component of the concessional loans, which are included in ODA in their entirety. Chang, Fernandez-Arias and Serven (1998) constructed this new measure to solve the shortcomings of ODA. Effective Development Assistance is defined as “the sum of the grant equivalents of all development flows disbursed in a given period”. (Chang et al. 1998: 7) However, we should indicate that Boone notes for the period 1970 to 1991 that also ODA “in practise is virtually all grants”, with the average grant component amounting to 93 per cent. (Boone 1996: 304)

Developmental aid (DA) and non-developmental aid (NDA)

Addressing the problem of which aid in fact targets development Minoiu and Reddy distinguish between developmental aid (DA) and non-developmental aid (NDA). DA is defined as “aid expended in a manner that is anticipated to promote development, whether achieved through economic growth or other means”, while NDA describes “all other kinds” of aid. (Minoiu and Reddy 2010: 29) At the same time, though, they note that “Limitations on data limit us from directly identifying development-promoting aid expenditures – the ideal proxy for DA”. (Minoiu and Reddy 2010: 29) Riddell also addresses the same problem arguing that “A key problem with purpose-based definitions is that purpose is not a fully graspable concept, the meaning of which is open to a wider variety of interpretations”. In addition he asks: “Who is to judge whether any particular form of aid is intended to contribute to development, and what criteria should be used to judge whether the purpose-based criteria are met?” (Riddell 2007: 20) Minoiu and Reddy look at a “second best solution” and identify development-friendly donor countries based on the aid allocation literature, whose aggregate aid is supposed to constitute DA.

Millennium Development Goals (MDGs)

The Millennium Development Goals are a global commitment target by countries, both developed and developing. Faced with rising world poverty levels, many donors and recipient countries gathered to set eight goals for the year 2015. These eight goals break down into 18 quantifiable targets that are measured by 48 indicators. The MDGs therefore represent broad agreement on the goal of poverty reduction. Setting key objectives for aid, they help focus aid delivery. The overall MDGs include the following:

Goal 1 is to eradicate extreme poverty and hunger by setting a target in halving proportion of people living on less than a dollar a day and those who suffer from hunger.

Goal 2 is to achieve universal primary education by setting high target to ensure that all boys and girls complete primary schools.

Goal 3 is to promote gender equality and empower women. The target set is to eliminate gender disparities in primary and secondary education preferably by 2005, and at all levels by 2015.

Goal 4 is to reduce child mortality by setting a target to reduce by two thirds the mortality rate among children under five.

Goal 5 is to improve maternal health targeting to reduce by three quarters the maternal mortality ratio.

Goal 6 is to combat HIV/AIDS, malaria and other diseases, the target halt and begin to reverse the spread of HIV/AIDS by halting and beginning to reverse the incidence of malaria and other major diseases.

Goal 7 is to ensure environmental sustainability with very intense targets. This target aims is to integrate the principles of sustainable development into country policies and programmes and reverse loss of environmental resources. In addition, the target is to reduce by half the proportion of people without sustainable access to safe drinking water, as well as achieve significant improvement in lives of at least 100 million slum dwellers, by 2020.

The last Goal 8, is to develop a Global Partnership for Development.

This is a donor driven approach to development set by many developed countries. The idea is ambitious to reduce world poverty significantly. Accordingly, with targets set for the year 2015, the MDGs have been set as a priority for many countries. The importance of these goals requires an abundance of financial support and many developed country’s donors have pooled their aid in the hope that poverty will be alleviated. Since the year 2000 it has been noted that there has been an enormous increase in the amount of ODA in order to meet the coming deadline. For many countries, 2015 seems a distant future that is difficult to reach. Many reasons came to be involved in the lack of government capacity in developing countries, lacking the natural resources, limited financial supports, war, natural disaster, etc.

Aid effectiveness is essential for the development of poor countries. Since the MDGs have been signed by many countries, more effort needs to be made so that the deadline of 2015 is to be met. The MDGs reflects how aid effectiveness is important so that the distribution of funds can be achieved those Millennium Goals. However, since the adoption of the MDGs many development institutions and donors still operate their aid programmes in their original forms inhibiting the coordination effort of the local government.

Historic review of foreign aid

Foreign aid as we know it today began with the Marshall Plan to rebuild Europe after the Second World War. The US government provided technical assistance and food, and other things, for an amount of around $13bn in just a few years. (Riddell 2007) However, already earlier in history assistance from one government to another had been given. For example in 1812, the US government agreed on the Act for Relief of the Citizen of Venezuela, and the UK assisted their colonies with the Colonial Development Act in 1929, which meant that the colonies could obtain loans or grants for infrastructural projects. Nevertheless, these early acts of aid were primarily agreed upon because of economic or political self interest by the donors (Hjertholm and White 2000).

Under, and especially after the Second World War, institutions emerged to deal with the disastrous conditions in which the war had left Europe. In 1945, the UN – and shortly after the United Nations International Children‟s Emergency Fund (UNICEF) – was formed. Also, the Oxford Committee for Famine Relief (Oxfam), and the Cooperative for Assistance and Relief Everywhere (CARE) came into life. Further, the World Bank began to provide loans for reconstruction. (Hjertholm and White 2000)

Whilst the focus in the 1940s and into the 1950s had been almost entirely on the reconstruction of Europe, through the mid-end 1950s the focus shifted towards Asia and Sub-Saharan Africa. In 1951, the UN Secretary General assembled experts to discuss how the developing countries could best be helped. It was recommended to raise and transfer up to $5bn to facilitate the developing countries‟ growth. Aid was mainly provided as technical assistance and co-operation, food aid and some financial support (loans and grants). (Riddell 2007) One of the basic ideas of development aid became founded upon the Universal Declaration of Human Rights, stating that “Everyone has the right to a standard of living adequate for the health and well-being of himself and of his family, including food, closing, housing and medical care […]”. (UN 1948: Article 25)

During that period (and until the end of 1950s), the United States was the major donor, providing more than half of all development aid. The World Bank, on the other hand, was emerging as one of the largest sources of development financing. In 1960, the World Bank established the International Development Association (IDA), which soon became the “largest single channel for concessional aid to poor countries.” (Riddell 2007: 27) At the same time, the UN‟s Food and Agricultural Organisation (FAO) was the main supplier of emergency aid, while aid from Non-Governmental Organisations (NGOs) for development and emergencies was still comparatively small.

In the 1950s, economists had come to identify some problem areas and shortcomings in developing countries which had to be resolved if those countries were to achieve reasonable growth: Arthur Lewis (1954) described the lack of capital to make structural transformations as the main problem of developing countries. M. F. Millikan and Walt Rostow (1957) regarded financial capital and technical assistance as the two main ways for aid to promote growth. (Riddell 2007) An earlier contribution in a similar line had come from Rosenstein-Rodan (1943), who was one of the first to formulate the idea of the “big push”. Here, the basic idea is that through huge amounts of capital a country could even out all its limiting constraints, and could then achieve growth through larger amounts of investments. (Riddell 2007) Some years later, Hollis Chenery and Alan Strout (1966) presented what became known as the two-gap model. The essential idea of the model is that if we through aid could compensate for the savings gap and the foreign exchange gap it would promote growth (Easterly 2003)

Milton Friedman argued that aid did more harm than good, suggesting instead an abolishment of barriers to trade. Friedman notes that, aid to developing countries was channelled to unproductive uses, and the idea of a central government planning the development of its country was contrary with everything known about development i.e. namely that development originates from free, capitalistic markets. (Friedman 1958)

Further, Chenery and Strout, and Rosenstein-Rodan emphasized the importance of the differences in the various developing countries‟ economies, and that no economy works exactly like another. Additionally, Rosenstein-Rodan identified the effort of the recipient country and the improvement of human skills as very important factors for aid to be efficient. These important insights somehow got lost in the following decades and first re-surfaced about 40 years later. (Riddell 2007)

In the 1960s, aid levels had gone up, and one could see positive growth in many developing countries, including Sub-Saharan Africa. By all means, development aid really had established itself as a part of international relations between developed and developing countries. Many new bilateral and multilateral institutions were founded to administer the rapidly increasing amounts of ODA given. One of the most important organizations to be founded was OECD‟s Development Co-operation Directorate (the later DAC). However, as the 1970s began, the support for development aid vanished and ODA had gone from 0.5 per cent of donors GNI to 0.33 per cent on average. The US played a huge role in this decrease of ODA. Together with the rest of the world, America’s attention had shifted towards South-East Asia and specifically for the US towards the costs of the war in Vietnam that had become a lot higher than anticipated. (Riddell 2007; Tarp 2006)

In order to reverse this downward trend of development aid, the newly appointed World Bank President Robert McNamara tried to increase attention towards poverty reduction once again. In a speech given in 1973, McNamara pointed at the importance of poverty reduction, which resulted in a redistribution of aid. The share of aid funds going to the poorest countries, e.g. Sub-Saharan Africa, increased. This increased amount going to the poorest countries came at the expense of other low-income countries like Ghana, Kenya and India. A similar development became apparent with the movement of more aid going to lower-middle-income countries like Morocco, Indonesia and most of Latin America, at the expense of upper-middle-income countries like Mexico and Turkey. (Easterly and Pfutze 2008) Another trend of the 1970s was the shift in attention away from growth and towards “basic human needs”, and the addressing of the poorest directly. In short, the focus changed from development and growth in the 1950s and 1960s to poverty reduction in the 1970s. (Riddell 2007)

It was also McNamara in 1973, established the Commission on International Development with the former Prime Minister of Canada, Lester Pearson, as the head. The task of this commission was to summarize the previous 20 years of development aid. As the name of the consequent report, Partners in Development, indicates, one of the messages of the report was that donors and recipients had to work together to achieve development. Other important issues outlined in the report were that: 1) growth had to come from inside the developing country, 2) a doubling of foreign aid (0.7 per cent of the donors GNI) should be reached by 1975, 3) increased effectiveness was necessary, 4) non-interference from donors in the recipient countries was required, 5) technical assistance should be fitted exactly to the recipient’s needs, and finally, the report warned against too many donors and the ineffectiveness following therefrom. Some of the Pearson Report’s findings still remain relevant today, as we will see later in this paper. (Riddell 2007)

While general aid was not increasing, the number of NGOs and their income levels did. From the beginning to the end of the 1970s the charitable income of NGOs had gone up from $860mn to $2.3bn. This trend continued steadily until the beginning of the 1990s, where NGO charitable income reached around $6bn.

The 1980s got underway with the aftermath of the oil crisis (1979) – which meant that most donor countries had cut their budgets for development aid. To get out of the crisis the developed countries followed a very tight economic policy of stabilization. The situation in many (and in particular in the African) countries deteriorated drastically – with slow global growth, high inflation and macroeconomic imbalance leading to import compression and limited export opportunities for the developing countries. (Tarp 2006; Riddell 2007) Several conflicts – both political and military – arose, which worsened the countries‟ economies even further. Donor countries found that as a basis for new development strategies, a stable macroeconomic and a safe political environment would be required. As a result, many donors attached stability-promoting conditions to their aid, emphasizing balanced budgets; the conditions required that the state and direct government spending should be reduced (including the health and the education sector), and open market forces should be predominant. Thus, the 1980s became known as the decades of Structural Adjustments. (Hjertholm and White 2000; Riddell 2007)

In the late 1980s and the beginning of the 1990s some began to criticize these structural adjustment policies. Amongst others, UNICEF argued in their report State of the World’s Children that these policies disregarded the poor. Further, some bilateral donors, namely the Scandinavian countries, Canada and the Netherlands had realized that these policies were not working. Also, due to the pressure of the rising awareness of the failure of these adjustment policies, the World Bank adjusted their stand and switched focus back to poverty with the report in 1990, New Poverty Agenda, – and most other bilateral donors followed step. (Hjertholm and White 2000; Riddell 2007)

Beside economic concerns, political motives played a significant role in aid giving from the 1950s to the 1990s. The US, for example, used large amounts of aid for preventing countries from becoming communistic regimes, and even for supporting developing countries‟ military. The UK and France allocated the major part of development aid to their former colonies.

The 1990s began at the end of the Cold War, which meant that instead of the Soviet Union being a donor, the former Soviet States became receivers of development aid. What also became apparent was that aid now to a greater extent was given to states with “good governance”, i.e. governments who were less corrupt and actually were committed to use received aid on growth enhancing projects. Further, “aid” tied to political concerns became less significant.

While donor’s self-interests in development aid decreased, a disturbing issue remaining unresolved till this day is that the DAC, which as mentioned controls huge amounts of aid, still does not have any representatives from the developing countries. Also, there is no African representative in the Special Programme of Assistance for Africa (SPA) which coordinates donors‟ adjustments support. Thus, it seems that donors today to a certain degree still follow their own interests. (Tarp 2006; Hjertholm and White 2000; Minoiu and Reddy 2010)

From 1992 and onwards, economic development aid decreased; some literature even proclaimed the end of development aid. While researchers discussed the current and future role of development aid, official emergency aid doubled. Including non-governmental emergency aid it even quadrupled during the 1990s. This was due to a growing number of local military conflicts and natural disasters, but also because of the increasing media coverage of these conflict and disasters. However, the level of development aid provided remained very low through the 1990s, much of which can be explained by the conclusions of the literature that development aid does not work.

After a decade of aid fatigue, development aid began to increase again. The fraction of ODA given of donor GNI increased from close to 0.2 per cent back to around 0.35 per cent, but was thus still far away from the mark of 0.7 per cent outlined several times since 1969 in the Pearson Report and others. Many DAC member countries have improved their ratio since then, but to which degree DAC members may include debt relief accruing from non-concessional funds in their ratio of ODA (cf. Section 2.1.1. and 2.1.2.). The forgiveness of debt earned much attention in the new millennium, because Bono (Sir Paul David Hewson), the front singer of the rock band U2, and the former Pope (John Paul II) advertised and pushed for debt relief for developing countries. (Bjørnskov 2007; Easterly 2001b and 2003; Riddell 2007)

Today, the focus has shifted to good institutions and policies, as mentioned above, but also on human rights, security, development (growth) and peace. (Riddell 2007)

NGO‟s have increased significantly since the 1970s. It is remarkable that NGOs have not been affected by the downturn of development aid in the 1990s. The income of the NGOs has steadily increased, and private donations from individuals and foundations reached $10bn around the first years of 2000. Furthermore, where NGOs in the past focused on the defence of the poor and tried to give them a political voice, they now are getting involved with direct campaigning activities, criticising official donors and governments. (Riddell 2007)

The adverse effects of aid

Contrary to its literal meaning, development aid has been shown to have some unfavourable effects on the recipient countries and their economies. Partly these effects are connected to the nature of aid being a kind of windfall revenue, but to a great part these effects are caused by human choices about how to deal with the aid and its consequences. In this section, we will examine the actual negative effects of aid on the recipient countries’ development, and we will look at how the issue of fungibility makes some of these negative effects possible in the first place.

Fungibility

Much of development aid is given aiming at some specific objectives. After a while, projects are evaluated and rates of return are calculated. However, there is a concrete problem with this approach – namely, aid is fungible. According to Devarajan and Swaroop, “research shows that aid intended for crucial social and economic sectors often merely substitutes for spending that recipient governments would have undertaken anyway; the funds freed are spent for other purposes.” (Devarajan and Swaroop 1998) More specifically, when aid is fungible this means, that although aid may be intended to support or realize a concrete project, it may in reality finance something completely different. When a donor considers supporting a project, there are several different possibilities with respect to the intentions of the recipient country’s government. Either, the domestic government would have carried out the project even in absence of aid, or it would not. Further, if the domestic government would have supported the project, it may now choose either to still do so, combining its resources with the aid for implementing the project, or it may choose to “treat the entire aid amount as a pure supplement to its domestic resources”. (Devarajan and Swaroop 1998: 4) In the latter case, the aid is said to be fungible. By financing projects under this condition, donors free domestic government’s resources, which now can be used in a different way. These resources could obviously be spent in accordance with the donor’s intentions – for example on similar project, or at least according to objectives the donor would agree upon. But of course, these resources may be spent in a very different manner as well.

Pack and Pack argue that “Critics across the political spectrum have concluded that recipient governments can easily circumvent the intentions of aid donors by altering their overall expenditure patterns”. (Pack and Pack 1993: 258) Since it, especially with many donor‟s involved in one country can be extremely difficult to assess what the recipient would have spent the resources on in absence of aid. (Devarajan and Swaroop: 1998)

Further, Devarajan and Swaroop note that donors have been “increasingly concerned that aid development assistance earmarked for critical social and economic sectors is being used directly or indirectly to fund unproductive expenditures including those on defense.” (Devarajan and Swaroop 1998: 1) Neither Devarajan and Swaroop, nor Pack and Pack, investigating how changes in aid affect public expenditures in the Dominican Republic, do cite any evidence of fungible aid being spent on defence. However, their conclusions “are consistent with the most negative views” on the question of fungibility. (Pack and Pack 1993: 264) Although their findings on one country cannot be generalized, they do give rise to some concern: Amongst others, the aid is used – directly or indirectly – on deficit reduction and repaying debts, but not on development-enhancing objectives. Devarajan and Swaroop, on the other hand, note that partial fungibility may involve the “flypaper effect”. The flypaper effect was found on intergovernmental aid in federal systems, where resources transferred by a central governing authority to local authorities were more likely to increase the public expenditure of the latter, than regular income would. (Devarajan and Swaroop 1998: 7) Indeed, they cite Khilji and Zampelli (1994) and others for having found fungible aid to stimulate public expenditure – either through tax reliefs or by other means. The same is true for Pack and Pack‟s findings on Indonesia, which – contrary to the Dominican Republic – spent the additional resources on development expenditures, in accordance with donor‟s intentions, and the aid, most likely, was not fungible in this case. Pack and Pack explain the differences in fungibility by the importance of aid to the recipient. More precisely, they argue that “the more important foreign aid as a source of public revenues, the greater the ability of donors to monitor changes in expenditure and, therefore, the more likely are the recipient‟s expenditures to reflect donor intentions.” (Pack and Pack 1993: 264) The findings on Africa, however point in the same direction as Pack and Pack‟s findings on the Dominican Republic: Aid is highly fungible, and is partly spent on debt servicing, but partly also increases government spending. (Devarajan et al. 1998 cited in Devarajan and Swaroop 1998)

In summary, we see that fungibility is a problem – in both African and other developing countries, mostly directing aid to not intended purposes. “Even advocates of foreign aid often agree that [aid] is highly fungible”, Pack and Pack (1998: 258) note. This further renders the evaluation of concrete projects very difficult, often implying much lower rates of return than calculated. (Devarajan and Swaroop 1998)

Undermining institutions

While there is no connection between investment and aid in the short run, private investment may very well be necessary in the long run (Easterly 1999; Knack 2009). Further, in the literature, there is a broad consensus that good governance, including well-designed policies and institutions are required for sustained growth. (Knack 2001, Easterly 2003) However, with the fungibility of aid presumably playing an important role in this connection, we have seen that conditionality in aid giving does not promote these goals. (Bjørnskov 2007, see section 4.2.1.) Here, an important aspect of aid may exacerbate this problem. While it seems that aid not only does not contribute to better institutions, more and more research finds that aid possibly undermines recipient countries‟ governance and institutions. Although there may or may not be a direct link, good governance and well-functioning institutions are important for countries‟ growth in various respects, including encouragement of private investments and providing required environment for manufacturing and trade. (Knack 2009; Rajan and Subramanian 2007) Thus, in the following we will investigate the effects of aid on governance and institutions, including the tax system.

Aid and governance

Rajan and Subramanian (2007) suggest that aid may have an adverse impact on the quality of governance in a country, which becomes apparent in the relation between the aid a country receives and the relative growth of those of the countries‟ industries that depend on good governance. Testing this hypothesis, they indeed find that in countries with good governance, the industries depending on governance grow relatively fast. Further, they find that the level of aid predicts the growth of those governance-dependent industries. More specifically, the annual growth rate of more governance-dependent industries is 2.8 per cent lower for countries that receive one more standard deviation of aid. Rajan and Subramanian argue that “manufacturing is likely to be more dependent on a good-governance environment that can foster multiple transactions.” (Rajan and Subramanian 2007: 322) Therefore, this finding obviously is problematic for those parts of the manufacturing sector whose business involves trade and high levels of interaction with other companies. If the government does not ensure a relatively safe business environment, i.e. promoting the rule of law and contract enforcement, limiting corruption, etc., it will hamper the growth and prosperity of those industries most dependent on it. (Rajan and Subramanian 2007)

The explanation for the influence of aid on good governance and thus the manufacturing sector may, according to Rajan and Subramanian, be that aid “By expanding a government‟s resource envelope, […] reduces the need for governments to explain their actions to citizens, which may reduce its need to govern well”. (Rajan and Subramanian 2007: 322)

Investigating the influence of aid on governance in general, Knack (2001) supports these arguments. Citing Keefer and Knack (1997), he argues that “Good governance-in the form of institutions that establish a predictable, impartial, and consistently enforced set of rules for investors-is crucial for the sustained and rapid growth in per capita incomes of poor countries”. (Knack 2001: 311) Intuitively, it makes sense that aid could play a facilitating role in this connection. Through aid, poor governments may be able to build a well-functioning public sector, which they could not before, due to financing constraints. However, Knack‟s findings suggest the opposite. In line with Rajan and Subramanian (2007), aid to governments seems to rather encourage rent seeking and other non-productive behaviours, undermining the quality of public institutions and governance. Knack tests the connection between the ODA to GNP ratio and governance, represented by the index of the International Country Risk Guide (ICRG), including government corruption, bureaucratic quality and the rule of law on an 18-point scale. Depending on the method, he finds that ICRG is reduced by up to 3 points with a 20 percentage increase of aid to GNP. When disaggregating ODA into technical assistance and aid exclusive of technical assistance, he finds that the former has an even more negative impact on the quality of governance. This supports Knack‟s assumption that aid also undermines the government‟s ability to establish administrative capacity and to attract qualified personnel, which instead will seek employment by the donors at a higher wage. (Knack 2001) As we have seen above, this situation may be aggravated by a high level of donor fragmentation. (Bjørnskov 2007)

Although Knack notes, that there have been some donor projects which succeeded in building up institutional capacity in developing countries, in general aid seems to have the opposite effect, worsening the quality of governance and undermining existing institutions. His findings as such do not provide an explanation of this effect, but he theorizes that “Perhaps most importantly, foreign aid represents a potential source of rents, with adverse effects on the quality of the public sector and on the incidence of corruption” and that aid “commonly [is] used for patronage purposes, by subsidizing employment in the public sector, or in state owned-enterprises”. (Knack 2001: 313) Opposite to studies such as Burnside and Dollar (2000), arguing that aid can have a positive impact on growth in developing countries with good governance and policies, Knack shows that aid itself affects the quality of institutions negatively, increasing “the size of the institutional gap”. (Knack 2001)

One important problem connected to a low quality of governance and institutions is corruption. Knack (2001) includes corruption when testing for the effect of aid on the quality of governance. Although his results are somewhat ambiguous with respect to the aid – corruption relationship, and there may not be a direct connection between aid and corruption, there is at least an indirect one. According to Easterly, there is a strong link between the quality of institutions and corruption, which is “at least consistent with the view that institutions can influence corruption.” (Easterly 2001a: 251) The International Country Risk Guide (ICRG) estimates institutional quality by rule of law, quality of bureaucracy, freedom from government repudiation of contracts, and freedom from expropriation; and corruption is connected to either one of these measures. (Easterly 2001a) According to Transparency International corruption “is where temptation meets permissiveness”, or more specifically where “administration and political institutions are […] weak and pay scales are […] very low, tempting officials to “supplement” their income.” (Transparency International) This description coincides with what Easterly defines as decentralized (as opposed to – centralized10) corruption, which “creates the worst incentives for growth.” (Easterly 2001a: 247) Thus, if aid has an adverse effect on the quality of governance and institutions, which may bring along higher levels of corruption, this in turn may affect growth additionally.

Aid and tax

Mainly, development aid has been given from donors directly to developing countries‟ governments, often to support public expenditure. (Devarajan 1998; Knack 2001; DAC – DCD) This fact, together with the fungibility of aid, may lead to yet another unintended effect of development aid. In general, governments collect their revenues through taxation for which they in return should be held accountable in terms of the rights they give to their citizens and the public services they provide. Aid however, as a source of revenue to developing countries‟ governments may weaken the link between governments and its citizens – accountability and taxation. Like with other windfall revenues, such as revenues from natural resources like oil, aid seems to make the government much less dependent on its citizens; it does not depend on taxes anymore, and thus can “afford” being less accountable towards its citizens. (Knack 2009)

As a consequence, the government‟s reduced accountability towards its citizens may lead, as we saw above, to bad governance and for example result in a weakened manufacturing sector. (Rajan and Subramanian 2007) Another consequence is, however, that governments‟ need to rely on taxes as revenue is reduced – which in turn renders possible a negligence of the tax system. Indeed, the findings seem to validate this concern. For example Boone, distinguishing between three different types of political regimes, finds that the “laissez-faire” regime acts according to the above hypothesis – lowering taxes by the same amount as aid received11. (Boone 1996: 298) Furthermore, Knack (2009) tests whether aid flows or windfall revenues flows from natural resources influence the quality of a country‟s tax system. While the latter lies outside the scope of our paper, both flows seem to have a somewhat similar effect on the tax system, reminding us of the circumstances under which Dutch disease originates (see section 4.1.3. below). Knack tests ODA against Efficiency of Revenue Mobilization (ERM), a World Bank measure of both tax policy and tax administration. He finds that a 14 percentage increase of aid in relation to GNI deteriorates the ERM measure by half a point (in Knack 2009 on a scale from 2.5 to 6). Thus, Knack concludes that “high aid levels tend to undermine the quality of tax policy and administration, potentially aggravating long-run dependence on foreign aid to finance public expenditures.” (Knack 2009: 368) In summary, if Knack‟s observations reflect the situation accurately, development aid affects growth negatively through another channel, in that “inefficient tax systems can reduce the level and productivity of private investment, slowing growth in incomes”. (Knack 2009: 368)

If growth indeed depends on the quality of policies, institutions and governance – including the formulation and protection of property rights and the abatement of corruption – as the current consensus indicates (Bjørnskov 2007), the above discussed consequences of aid provide a very sound explanation to why we have seen no results to the trillions of aid dollars over the years. As Friedman already argued in 1958, “government-to-government grants are likely to be adverse to economic development.” (Friedman 1958: 7) Dutch disease

Another problem connected to aid is that it may evoke the Dutch disease effect. Originally referring to the effects caused by a large discovery of natural gas in the Netherlands, the Dutch disease describes the problems arising from a massive inflow of foreign currency into a country. There are two effects related to this scenario, the spending effect and the resource movement effect. The former refers to an increase of the real exchange rate, which can happen in two ways: If the country‟s nominal exchange rate is flexible, it will appreciate through the massive inflow of foreign currency and thus lead to a real appreciation. However, if the country‟s nominal exchange rate is fixed, the increased money supply will lead to a surge in demand, increasing domestic prices and in this way lead to an increase of the real exchange rate (Bjerg et al. 2007). At the same time, the resource movement effect means that production factors are redirected from other sectors the booming sector(s), i.e. the sector attempting to satisfy domestic demand (and – if the foreign currency inflow was caused by a specific tradable sector – to the booming tradable sector). These two consequences leave the traditional tradable sector with deindustrialization, due to the shift of resources, and decreased international competitiveness, due to the increase in the real exchange rate. (Ebrahim-zadeh 2003)

There is some discussion as to in how far Dutch disease actually is damaging the economy or whether it just represents an adjustment period, shifting from traditional tradable sectors to others. This may depend on whether the financial inflows are permanent or temporary. (Ebrahim-zadeh 2003) Aid, by definition, should be temporary, however looking back at the history of development aid, as we have seen aid could be categorized as rather permanent. (Younger 1992) Nevertheless, even a permanent shift towards the service- and other non-tradable sectors may involve considerable disadvantages for developing countries, as we will see later.

Rajan and Subramanian investigate the possible effects of Dutch disease on the manufacturing sector in developing countries. They hypothesize that “the inflow of aid leads to a relative shrinkage of the tradable manufacturing sectors of the economy and that this shrinkage occurs through the appreciation of the recipient country‟s real exchange rate.” (Rajan and Subramanian 2009: 3) Indeed, their findings indicate just that. First, they find that in countries that receive more aid, the exportable sector grows more slowly than other sectors. According to their definitions they find that the exportable sectors grew between 0.5 and 1 per cent more slowly than others with one more per cent of aid. Further, they find a similar effect of a real appreciation on the exportable sector. (Rajan and Subramanian 2009)

Adjusting for reverse causality, and also testing for whether excess real appreciation may rather be caused by for example trade or macroeconomic policies, Rajan and Subramanian conclude that the increase in the real exchange rate is most likely due to aid. In summary, their results suggest that “there may indeed be an adverse impact of aid on the relative growth of exportable sectors, and that the channel through which these effects are felt is the exchange rate overvaluation induced by aid.” (Rajan and Subramanian 2009: 18) Finally, Rajan and Subramanian argue that although the manufacturing sector currently only may be a minor part of many developing countries‟ economy, causing it to lag behind may have important implications for the future of those countries. Returning to the above mentioned argument that the Dutch disease may just signal a transition period, Rajan and Subramanian cite studies that have shown that “the traded goods sector is the channel through which an economy absorbs best practices from abroad”, and that “The absence of these learning-by-doing spillovers, which may be critical to long run productivity growth, could be one constraint on growth.” (Rajan and Subramanian 2009: 3) This is in accordance with the Solow‟s and Lucas‟ models, proposing, as we have seen above, that technological progress and human capital (especially through learning-by-doing) is critical to long run growth. Supporting the above argument, Rajan and Subramanian note that basically all countries that have had healthy growth since World War II “have seen a large increase in their share of manufacturing and manufacturing exports.” (Rajan and Subramanian 2009)

The implications of these results for development aid raise the questions, why Dutch disease is discussed so infrequently in connection with aid effectiveness. Indeed, Doucouliagos and Paldam remark that they “have found very little exploration of the links between the AEL [Aid Effectiveness Literature] and the Dutch disease literature.” (Doucouliagos and Paldam 2009: 455, brackets added) One paper, however, that addresses the issue, is by Younger (1992). Younger looks at Ghana, which experienced a major inflow of foreign capital, mostly in the form of aid, from 1986 and onwards, due to the implementation of very positively perceived macroeconomic reforms. As predicted from what we know about Dutch disease, this resulted in some serious problems for Ghana. Although Younger does not specifically mention manufacturing, he indicates that the most important result of the governments‟ attempts to deal with the inflow of foreign currency was a crowding out of the private sector. In order to avoid increasing prices the government pursued a tight monetary policy, increasing interest rates and thereby discouraging private investments, while at the same time increasing public expenditure. “Thus, [Younger concludes,] the increased size of the government has come largely at the expense of private investment […which] is exactly the part of GDP that Ghana needs to provide self-sustaining growth in the future.” (Younger 1992: 1593)

In summary, we see that aid due to the effects of the Dutch disease damages growth. With respect to Ghana, Younger concludes that in the end “the aid flowing toward Ghana has worked at cross purposes with some of the reforms in recent years by driving up aggregate demand and by making foreign exchange relatively abundant.” (Younger 1992: 1595) More generally, Doucouliagos and Paldam indicate that “while a transfer certainly does increase the income level of the recipient, it is „paid for‟ by a compensating decrease in the growth rate.” (Doucouliagos and Paldam 2009: 455) Rajan and Subramanian‟s results indicate that aid in this way also negatively affects future growth through a crowding out of the private sector, or more specifically through deindustrialization and through a reduction of the competitiveness of tradable sectors.