Saturday, January 29, 2011

Foreign aid and development economics

The aim of main research agenda of development economics in the last century was to provide an evolving approach to curing the persistence of poverty and underdevelopment in world's least developed and developing countries. High economic growth in developing countries in the last decades has changed many developing nations into middle-income countries. For instance, real economic growth rate in China and India from 1960 onwards averaged 6.67 percent and 3.49 percent, respectively. In 2010, China and India were already classified as lower middle-income countries, belonging to the same income group as El Salvador, Armenia and Philippines. In the recent year, China's GDP per capita was higher than GDP per capita of many high-growing developing nations such as Ukraine, Nambia, Armenia and Bosnia and Herzegovina, and roughly at the same level as Algeria. Over the last decade, the economic growth in developing countries accelerated, driven by an increase in global commodity prices, robust investment rates, expansionary monetary policy and a growing domestic consumption. The economic growth in a majority of African states stagnated, consequently leading to a decrease in the overall standard of living. Between 1960 and 2009, average real GDP growth was negative in countries such as Congo, Democratic Republic (-2.26 percent), Liberia (-1.51 percent), Niger (-1.02 percent), Zambia (-0.52 percent) and Zimbabwe (-0.02 percent) with many other African countries with little or no growth in the second half of the 20th century. The stagnation of income per capita in countries such as Sierra Leone is largely the result of civil war and severe political instability, creating domestic violence and the persistence of poverty, malnutrition and AIDS/HIV prevalence. From the second half of the 20th century onwards, international aid donors have contributed significant amounts of foreign developmental assistance in various forms such as medical care and vaccination against polio, AIDS/HIV, measles and malaria, direct cash transfers and physical infrastructure. Despite significant official and unofficial developmental assitance from international aid donors, dispersion of real income per capita, measuring the level of cross-country convergence or divergence of income per capita, the gap in economic development widened in the course of the last century. In 2010, the percentage of countries with the level of real GDP per capita $1,500 or below equaled almost 20 percent (link).

The rise of development economics in the 20th century was a natural response to growing disparities in income per capita between rich and poor countries. In the framework of neoclassical theory, development economics emerged from a neoclassical growth theory, pioneered by the famous Solow-Swan model. In the simplest possible form, the growth of output per capita depends on the capital per worker and the initial level of output under stable rate of national saving and capital depreciation. Assuming diminishing returns to scale and constant rate of population growth, the increase in capital per worker would increase the output per worker that would, hence, approach its steady-state equilibrium. Theoretical notions of the Solow-Swan model were tested against the empirical data on economic growth. The key assumption of the neoclassical growth model is that poor countries would tend to catch-up rich countries, assuming higher output growth in poor countries. The convergence of income per capita would imply a neg relationship between the initial level of output per capita and output growth over time. Thus, countries with lower levels of output per capita in the initial period would experience faster rates of output growth. Consequently, the output per capita and the standard of living would approach to the level in rich countries. The empirical tests of the Solow-Swan model failed to confirm the theoretical hypothesis since economic growth rates in 20th century in developed countries were higher compared to developing countries. The divergence of income per capita led to the subsequent modifications of the Solow-Swan model. In fact, the main criticism of the model points out that the model itself failed to capture the role of technological progress in determining the level of output per worker. The mysterious growth episode in Japan and other East Asian nations posed a difficult question. How can a country with low initial level of output per worker at the end of the WW2, exceed the productivity level in rich countries? The obvious answer is that Solow-Swan growth model failed to capture the role of technology shocks which violate the assumption of diminishing capital returns, what could explain why initially poor countries subsequently converged to the level of productivity in rich countries and then exceeded the level. The phenomenon, known as growth residual, has subsequently reduced the predictive power of the Solow-Swan model since a considerable share of economic growth was not ascribed to capital and labor inputs but rather to the persistent role of technological change.

Policy implications from Solow-Swan model imply that the essential requirement to boost economic growth in a country with low initial level of output per capita is to increase the amount of capital per worker, namely by boosting public and private investment in infrastructure. From 1950s onwards, World Bank had repeatedly boosted the growth of infrastructure by facilitating developmental assistance into world's least developed countries. According to the neoclassical growth theory, higher capital-labor ratio would provide additional investment stimulus, thereby increasing the employment-to-population ratio. Proponents of the foreign aid provided the rationale for higher foreign aid spending by the analogy of post-WW2 Europe when Marshall Plan provided $13 billion, or roughly $100 billion in today's prices, to Western European economies to recover the physical infrastructure which had been destroyed during WW2. Marshall Plan intervention was rather short, quick and finite. The efficacy of foreign aid in Africa is questionable since little or no growth occured in many African states such as Burundi, Benin, Zimbabwe and Congo. Official forecasts from the United Nations from 1950s onwards, based on the famous Harrod-Domar growth model (link), often assumed a rapid increase in the level of GDP per capita in response to the increase in investment rates. The forecasts, based on the theoretical assumption of diminishing capital returns, predicted a persistent convergence of GDP per capita to the level sustained in richer countries. The fact that the launch of extensive investment in infrastructure resulted in further economic stagnation of many African states, has questioned both the validity and quality of prescriptions laid by the mainstream development economics.

The philosophy of the mainstream development economics was sharply criticized in the light of the fact that foreign aid failed to alleviate poverty and made the growth of African economies slower. The efforts by the World Bank have been diverted from correct diagnosis of the developmental issues in African states to repeated initiatives such as the commitment of the international community to increase the share of foreign aid to least-developed countries to at least 1 percent of the GDP. The criticism of the mainstream development economics was already formulated in 1958 when Mont Pelerin Society organized the 9th meeting and development economics seminar where professor Herbert Frankel of the Nuttfield College put forth the criticism of foreign aid and the failure of development economics:

"The lesson that flows from it is that it does pay to go to these remote areas and find out what the problem is, instead of assuming that one knows the problem before one begins. Until recent years, people have simply assumed in many of these territories in Africa, that there were no real, positive signs of enterprise among the indigenous population, which was supposed to be so uninstructed or inert that it was not able to fend for itself, experiment for itself, or improve itself. It was not realised that a reason why there was this apparent lack of initiative in the population was that there were serious customary or legal obstacles to the exercise of ordinary enterprise, even on a small scale."
Given the lack of the comprehensive diagnosis of the causes of underdevelopment in African countries, the mainstream development economics failed to capture the appropriate assumptions in the theoretical models of economic development, upon which developmental assistance was justified. A more reasonable theoretical solution to the economic stagnation and social conflict in Africa has been put forth by the human capital theory. In its broadest and most general form, the theory stated that the economic stagnation of African countries is a consequence of the lack of skills and investment in education that could provide the necessary input to increase the economic growth and, subsequently, alleviate the issues of AIDS/HIV, malaria, child malnutrition and domestic violence. There is no doubt that the growth of education initiatives in Africa has sent many children to school. In addition, many universities in Western Europe and the United States have expanded the initiative and offered students from African states preferential admission criteria in various forms such as graduate fellowships, student grants and lower required standardized test scores, to boost admission rates of African nationals at U.S. universities. The efforts of developed countries to bring educational initiatives to Africa encouraged school participation as well as international opportunities of African citizens to study abroad, even at world's most prestigious and highly-ranked universities. Notwithstanding the importance of education in creating the stock of human capital for the wealth of nations, educational initiatives should address the essential obstacles that creates the failure of African expatriates to return to home countries, hence, bring skills, knowledge and various other forms of human capital, which are essential to the process of long-run growth, the issues of labor market distortions in African countries. These distortions crucially impede the ability of young African graduates to matching jobs in regional labor market.

What the mainstream development economics failed to take into account is the institutional paralysis which prevails in a majority of African countries, plagued by the destructive tribal institutions based on widespread corruption, bribes and domestic violence as means of achieving political power. The prevalence of hybrid institutions, marred by the complete absence of the rule of law and judicial institutions that could facilitate efficient contract enforcement and the protection of private property rights, is not only a severe obstacle to higher economic growth but also the apparent mechanism that captures the set of explanatory features that could possibly account for what caused the misdiagnosis of the African development dilemma. Back in 2002, African Union estimated that each year, corruption costs African economies more than $148 billion or 25 percent of Africa's GDP. The significance of corruption in state structures in Africa manifests itself in poor quality and provision of public services, the absence of judicial independence from political regimes, cumbersome contract enforcement and unprotected private property rights. Such distortions impede the level of trust and provide evolving incentives to subvert the institutional independence into political cronyism, in which corruption substitutes the tax system through bribes and extortion as methods of lowering transaction costs in overcoming the malfunctioning of the judicial system. In 1978, Erwin Blumenthal of the central bank of the Federal Republic of Germany, warned the international community that "Zaire's political system is so corrupt that there's no prospect for Zaire's creditors to get their money back." (link)

The advancement of country's economic prospects requires not only transparent, sound and efficient regulations but, more importantly, highly efficient civil service. In 2010, Transparency International published Corruption Perception Index (link) by measuring the persistence of corruption in public sectors across the world. The findings showed that the vast majority of poor African countries were plagued by extensive and extortionate corruption and ranked in the bottom 20 percent of the distribution. Comparing the level bureaucracy against GDP per capita reveals the amplified evidence of the negative correlation between the efficiency of civil service and the GDP per capita. The ease of doing business in Africa in countries such as Botswana, Ghana, Mauritius and South Africa is remarkably easier with predictable, stable and efficient regulation, compared to countries such as Burundi, Burkina Faso, Côte d'Ivoire etc. where highly burdensome administrative procedures in doing business hamper capital formation and restrain productive investment in health-care, education and private-sector infrastructure that could provide the impetus to economic growth.

The relationship between the amount of foreign aid, received by the least-developed countries, and the scope of corruption as a rough approximation of the institutional quality in the least-developed states, could provide the answer to the question whether international donors consider the scope and significance of corruption in allocating the amount of foreign aid. The experience from the last century of development policy, suggest that international donors actually allocated more foreign aid to the countries, suffering from severe state failure, widespread corruption, government failure and the complete absence of judicial independence that could provide a system of checks and balances and the necessary restraint on the violiation of private property rights, extortion and violence by the political elites. In 1999, Alberto Alesina and Beatrice Weder (see "Do Corrupt Governments Receive Less Foreign Aid," American Economic Review, 92(4), pp. 1126-1137) found that, contrary to arguments of aid supporters, foreign aid is not used to reward good governments since more corrupt governments received more foreign aid and official development assistance from international donors. The most striking evidence, presented by Alesina and Weder, suggests that U.S donors seem to neglect the persistence of corruption in allocating foreign aid to poor countries while, on the other hand, Scandinavian donors deem the persistence of corruption as highly important, hence, rewarding governments with lower extent of corruption.

In the following graph, I estimated the impact of corruption on official development assitance in the sample of 41 least-developed countries in 2008. In the model, I set the official development assitance to be determined by the scope of corruption in least-developed countries. The official development assitance is expressed as a share of representative country's gross national income (GNI) for it provides a better measure of aid dependence than foreign aid per capita since the size of population is controlled by the main assumptions of the model. The data on official development assistance were download from World Bank's World Development Indicators (link). The data on the extent of corruption in least-developed countries were provided by Transparency International's 2008 Corruption Perception Index (link). The extent of corruption varies from 1 to 10, where lower values indicate more persistent corruption. I estimated whether countries with more corrupt governments receive a higher share of foreign aid from international donors. On the basis of 41 least-developed countries, sample estimates suggest that a 1 point improvment in corruption perception index tends to decrease, on average, the share of foreign aid in gross national income, on average, by 2.37 percentage points. Sample estimate of the slope coefficient is statistically significant at 5 percent level. Even though, the variation in corruption perception index accounts for 5.51 percent of the variation in official development assitance, the influence of the extent of corruption on the share of foreign aid in gross national income is not spurious but systematic and persistent.

Corruption and official development assistance
Source: World Bank, World Development Indicators, 2010. Transparency International, Corruption Perception Index, 2008.

The estimate suggests that international donors indeed reward more corrupt governments by increasing the share of official development assitance. In 2002, African Union estimated that corruption was costing the African continent $150 billion per year. The estimates of the total cost of corruption provide an ample evidence that, over the last century, international donors consistently allocated foreign aid to more corrupt governments, creating aid-dependent economies, prone to bloated bureaucracies and extractive institutions which subsequently led to the stagnation of income per capita in the last decades. An ample criticism of foreign aid initiative was put forth by Dambisa Moyo (link) in the WSJ two years ago: "The most obvious criticism of aid is its links to rampant corruption. Aid flows destined to help the average African end up supporting bloated bureaucracies in the form of the poor-country governments and donor-funded non-governmental organizations."

The consequence of rootedness of corruption and extractive political institutions in African tribal cultures can be, in a considerable part, drawn upon the colonial heritage that spread throughout the African continent from 19th century onwards. The colonial experience across the African continent (link) served not only as a conquest of newly discovered areas but, moreover, also as an experiment of developing political and economic institutions on the basis of European influence. The colonial heritage in Africa was mainly derived from the European occupation of African lands. Hereto, the presence of European colonisers in Africa provided a long-lasting foundation of the institutional lessons from which the African states went forth.

Given the heterogenity of the European perspectives on institutional development, the colonial period in Africa left a long-lasting impact on the economic and political development in Africa. Africa's richest countries, namely Botswana, South Africa and Mauritius, were influenced tremendously by the colonial heritage. In Botswana and South Africa, the colonial influence of English and Dutch on further economic development was mainly derived from setting strong institutional foundations of economic development such as the rule of law, judicial independence and limited government compared to other African states. Apart from the setting of formal institutions, fostering contract enforcement and the integrity of the political institutions, English and Dutch colonizers provided the establishment of cultural setting not prone to fraud, extortion and extractive institutions. Favorable institutional conditions furthered the advertance of trust and institutional efficiency, which are deemed essential in fostering the development of financial markets. Even the German presence in Namibia from 1884 to 1915 during Deutsch-Südwestafrika (link) fostered, to a certain extent, independent judiciary, relatively sound institutions and cohesive framework of the rule of law. As a result, Nambia retained the status of one of the least corrupt countries in Africa, known for relatively high degree of economic freedom in a regional comparison with other African states.

While the influence of German, English and Dutch colonizers was largely beneficial to African countries from the perspective of economic growth and development over the last century, the presence of French, Italian and Belgian colonizers arises serious concerns over the prospects of economic development across the African continent. The myraid of violence, in countries such as Congo Dem. Rep. and Somalia, which ultimately led to civil wars and the settlement of extractive institutions, largely reflects the innate ability of the colonial policies to provide the necessary conditions for the institutional integrity, the rule of law and stringent property rights that could underline the basis of economic development by restraining the power and domination of political elites and their ability to expropriate private property rights in pursuit of extractive monopoly rents from natural resources. That easily explains why countries such as Congo, Zambia, Nigeria and Zimbabwe, in spite of vast reserves of natural resources, were seized by the state capture of political elites. The colonial presence largely determined the size and scope of aid dependency in African states. The most plausible and persuasive explanation of the impact of European colonial policies in African countries was presented by Daron Acemoglu, Simon Johnson and David Robinson (see "Disease and Development" Journal of European Economic Association, 1(2/3), pp. 397-405):
"European colonists were much more likely to develop institutions of private property, encouraging economic and social development, in places where they settled. In contrast, in places where they did not settle, they were more likely to opt for extractive institutions, designed to extract resources without investing in institutional development. In these places, institutions were highly centralized, with political power concentrated in the hands of small elites and with almost no checks on this elite. The property rights and more general rights of the majority of the population were not protected."

The political and economic circumstances of the European institutional legacy in African states imparted aid dependency on those countries where the combination of tribal institutions, hostile to free enterprise and judicial restraint of political dictatorships, and unequivocally detrimental colonial policies dominated the development of political and economic institutions, setting the rules of the game. Therefore, the inability of many African societies to establish sensible and effective institutions resulted in the political capture of the state by the elites. The monopoly power of the political elites, enforcing anti-growth public policies, led to consistently poor economic outcomes, plagued by high rates of poverty and infectious diseases such as polio, malaria and measles.

The challenge of development economics is not to design aid schemes, which inevitably lead to aid dependency, marred by persistent corruption and political fraud, but to ascertain correct diagnosis of why foreign aid repeatedly resulted in the poor economic outcomes and the consequent stagnation of income per capita in many African states in 20th century. The failure of African societies to establish a rigorous system of incentives, which could significantly improve economic outcomes, is not a response to market failures (which deemed highly of early development economics) but a result of severe government failure to establish effective institutions of the rule of law, contract enforcement and stringent property rights. These institutions are the broadest foundations of economic development and the only viable alternative to political nepotism and the power of elites which, as poor development outcomes in Africa show, ultimately impose extractive institutions, causing the persistence of poverty and underdevelopment.