Sunday, July 22, 2007


I recently noticed a report in Washington Post about the link between between foreign aid, poverty reduction and GDP growth respectively.

There has been much discussion about reducing global poverty and one of the most mistaken beliefs is that foreign financial aid moves poor nations onto accelerated growth path. Such foolish beliefs emerge from the lack of knowledge about dynamic behavior developed by the course of economic theory.

One of the most sufficient evidence about the zero link between foreign aid and economic growth is that there is no empirical and robust positive correlation between aid and growth. First, foreign aid transactions do not target the supposed goals but rather help to fight fiscal crisis by reducing budget deficits and intensifying the pace of public spending in poor countries.

Empirically, there is a huge negative correlation between high public spending and GDP growth performance. Simply, if policymakers in any poor country want to impose an expansionary fiscal code, they implicitly undermine economic performance of that country as there will be more tax wedge pressures as well as the output volatility to transitory shocks could possibly pop in.

Second, in a dynamic general equilibrium that is capable of generating large sustained income gaps between rich and poor countries, there are at least three sources of poverty, (1) the lack of access to international capital, (2) low value index of human capital and (3) a domestic fiscal policy based on anti-growth actions.

The lack of access to international capital is a sign that economic policy in a sample poor country prefers protectionism of domestic elites and therefore increases the cost of foreign investment penetration in the country which could in turn increase the productivity output. Another deadly consequence of the lack of accessing international capital is that domestic economy in a poor country is unable to sufficiently generate capital formation which is essential to GDP growth while there has been numerous empirical and practical evidence that foreign direct investment supports growth as it helps to boost and engine the industrial restructuring of the economy. After the collapse of central planning, Estonia significantly benefited from the access to international capital which transformed its financial sector into one of the most competitive in Eastern Europe with a high degree of foreign investment penetration.

Low value index of human capital means a decreased availibility of disposable resources which could generate economic growth and sizzle domestic economies in poor countries onto higher growth trajectory. Going through the data, we can see that there is a low share of educational participation on nearly every level, especially on tertiary level which tops the competitive needs in accelerating capital formation and growth resources. Therefore, the lack of access to education, is a key consequence of poverty as the separate human capital profiles can't sufficiently combat the challenges in global economy.

Anti-growth domestic fiscal policy emerges from wrongly set fiscal targets and high public spending and government consumption. It is not surprising, that poor countries face painful anti-growth tax codes nailed through high tax rates on capital and individual income. There is numerous empirical evidence that expansionary fiscal policy undermines GDP growth simply because positive correlations between low spending and high growth disappear as the incentives to work, save and invest are hampered by tax pressure, increased compliance costs and red-tape regulation. Also, anti-growth tax system set by fiscal policymakers, slashes the price of tax avoidance and abuses through complex deducations, exemptions and tax preferences set as fiscal incentives but because of the lack of information, fiscal policymakers can't sufficiently manage the information output simply because there is no such thing as "responsibility edge" through which the wrong assumption of risk management and allocation could be launched to meet pro-growth fiscal targets. In case of rigid and expansionary welfare and fiscal policy, its engine turns into anti-growth system which hampers both, investment and savings, whose multiplication is possibly downgraded by high and unstable inflation rate.

One of the very reasons why poor countries lack GDP growth performance, is also a very weak rule of law and the lack of property rights which is an essential fundamental framework in which the economic performance and society work.

Also, high tariff rates and staunch quotas push-up the price of imports which could reverse the anti-growth performance into pro-growth path by importing the investment products needed to converge the GDP towards growth. Empirically, there is also a sense of cautiousness in analyzing the effects of aid to poor nations, because immediate unusual situations such as hurricanes abd earthquakes can skew the data, as they nevertheless stunt economic growth.

Handling out more and more money to poor nations, will not reduce poverty. Foreign aid programs are not based on decision-making assumptions and thorough analysis and therefore cause more harm than good as there is no clear evidence between aid and growth. To reduce poverty, pro-growth policies and economic liberalization are the best possible tools to fight the spiral of poverty and the lack of economic development.

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