November 18, 2019

Does foreign aid really help poor countries? New paper explores that question

European coins
The intricacies of foreign aid: New research from the Claremont Institute for Economic Policy Studies takes on the issue.

In seeking to eradicate world poverty as set out in the UN’s Sustainable Development Goals (SDGs), it is important to assess the impact of international capital flowing into poor countries. Do these inflows lead to faster rates of economic growth?

Professor of Economic Sciences Graham Bird and graduate student Yongseok Choi attempt to answer this question in a forthcoming paper in the Review of Development Economics.

Bird, who serves as the deputy director of the Claremont Institute for Economic Policy Studies (CIEPS), explained that they produced this paper because “what is needed is hard evidence that is presented without the subjective biases that often encroach into discussions of issues such as foreign aid.”

In their paper, Bird and Choi use an econometric model to investigate the effects on economic growth of three types of international capital: remittances, foreign direct investment, and foreign aid. They use a sample of 51 developing economies over the period 1976-2015.

What are their results?

Overall they discover that FDI has a significant positive effect, that the effects of aid are largely insignificant, and that remittances have a generally small but significant negative effect. But, Bird added, “our results need to be interpreted with caution. It is easy to draw the wrong conclusions.”

Graham Bird, deputy director of the Claremont Institute for Economic Policy Studies.

The principal impact of remittances is almost certainly on contemporary well-being, supporting higher levels of consumption. They are also used to finance investment in education, health and housing. The effects may take years before showing up in the form of faster economic growth. In the short term remittances may stoke up inflation that weakens competitiveness and may reduce the incentive to work—it may be these effects that adversely affect short-term growth.

Similar caution is needed when assessing the impact of foreign aid.

“Foreign aid,” Bird said, “takes various forms and its impact depends on contingent circumstances and the way in which it is used.” When Bird and Choi break down their data, they find plenty of examples in which aid seems to have significantly helped economic growth.

Research based at CIEPS has a long tradition of involving graduate students in work, particularly in the field of international money and finance, that contributes to resolving important global problems. Bird highlights the need to extend current research to discover the mechanisms through which remittances and aid exert their impact. In collaboration with future generations of doctoral students, these will be issues that CIEPS continues to explore.