International Development Aid

1. International Development Aid Xavier Sala-i-Martin Columbia University April 2008

2. Heated Debate • Aid has some positive effects on growth (Jeffrey Sachs 2004) and needs to be multiplied. • Aid has effect on growth, only under some circumstances (conditional aid) • Conditional on Policies (Craig, Burnside and Dollar (2000), Dalgaard and Tarp (2004)) • Conditional on type: • Infrastructures [Clemens, Radelet, and Bhavnani (2004)] • Education [Michaelova and Weber (2006) and Dreher, Nunnenkamp and Thiele (2007)] • Health [Mishra and Newhouse (2007)] • Aid has NO effect on growth or may even undermine it (Peter Bauer (1972), Bill Easterly (2006))

3. Evidence: Caution with Simple Figures

6. Source: Easterly (2003), JEP

7. Causality • Aid could systematically go to countries that are in trouble (like a natural disaster): if natural disasters tend to generate low (or negative) growth, this will tend to generate a negative association between growth and aid. • Aid could systematically go to “reward” countries that did things well in the past. If growth persists, then there will be a positive association even though aid does not really cause positive growth. • In order to solve this problem, econometricians use “instrumental variables”. IV estimates are supposed to see the correlation between exogenous aid and growth

8. Empirical Evidence • Early studies found positive correlations (Papeneck 1973, Levy 1988). • But then came Peter Boone (1994): Aid and growth are not correlated, period.

9. Empirical Evidence • Then a very Influential paper was written by Burnside and Dollar (2000): • They find α2 close to zero and α3>0. That is, AID has a positive effect on growth ONLY if the country at the receiving end conduct good policies. • After this paper was published, IFIs and the whole world demanded more international aid and conditionality on good policies.

10. Empirical Evidence • Problems with the paper: it is NOT robust to the definition of “aid”, “growth”, or “good policy” (Easterly, Levine and Roodman (2003)). • Roodman (2007, “The Anarchy of Numbers”) also adds that it is not robust to time period changes

11. Empirical Evidence • Definition of Aid: • Burnside and Dollar use “Grant Aid” (excluding subsidized loans and debt rescheduling). • Normal definition (called ODA) includes subsidized loans and debt rescheduling. • The two measures are highly correlated (0.933) • But when Easterly et all use this second measure, α3 becomes insignificantly different from zero.

12. Empirical Evidence • Definition of Good Policy: • Burnside and Dollar construct a measure which is an average of inflation, fiscal deficit and a measure of openness (originally proposed by Sachs and Warner 1995) • Easterly et al use TRADE/GDP instead of Sachs-Warner qualitative measure, they add “Black market premium” and “financial depth” (ratio of M2/GDP which is a measure of financial development) and… • … the coefficient α3 becomes insignificantly different from zero.

13. Empirical Evidence • Definition of growth • Burnside and Dollar use 4 year averages • Easterly et al criticize this because it contains business cycle noise. • If use 10-year averages… α3 becomes insignificantly different from zero • Roodman (2007) also shows that the paper is not robust to changes in the sample period of analysis.

16. Instrumental Variables • Burnside and Dollar (2000) use instruments that are based on “policy quality”. • The problem is that these variables may be correlated with aid (as they good policies attract more aid) but may also affect growth directly (so they are not good instruments) • Rajan and Subramanian (2005) criticize these instruments and use “colonial origin” variables and “language” variables as instruments (France and UK tend to give more aid to their colonies; if the fact that you have had one colonial power rather than another does not affect growth, then these are good instruments) • Problem: Shleifer et al (various papers) argue that the legal origin (partly inherited from colonial powers) DOES have an effect on growth • Rajan and Subramanian main result: holding constant a number of RHS variables, the IV correlation between aid and growth is zero.

17. Source: Rajan and Subramanian (2005)

18. Source: Rajan and Subramanian (2005)

19. Other papers arguing that aid matters “conditionally” • Svensson (1999), aid works for democracies only. • Collier and Dehn (2001), and Guillaumont and Chauvet (2001), aid is helpful in countries experiencing sharp price drops for key commodity exports • Collier and Hoeffler (2004), aid works only in countries that are emerging from civil war and have good policies • Dalgaard, Hansen, and Tarp (2004), aid works only outside the tropics (because countries outside the tropics have good institutions): • Note on this paper: outside the paper, there were 4 countries: Botswana, Jordan, Egypt and Syria. Do we think Botswana has grown because of aid? Do we think Jordan has grown because of aid (Jordan received a lot of aid during the previous oil boom, from oil producers in the region; AT THE SAME TIME, it opened up the economy for these nice neighbors? Was growth caused by aid or by the opening? • Roodman (2007) shows that all these papers suffer from the same problems Burnside and Dollar does: not robust to simple specification changes.

20. Final point about Evidence • Clemens, Radelet, and Bhavnani (2004) argue that if separate aggregate aid into • (i) emergency and humanitarian aid, • (ii) growth that affects growth only in the long run (e.g. aid that supports democracy, health, environment or education) • (iii) aid that may increase growth over the short run [ie, 4 years] (infrastructures and aid for productive sectors and agriculture and aid that helps deal with balance of payments problems), • then there is a positive association between aid and growth. • Problem: not clear that development process is to help economies out of 4 year recessions (balance of payments problems) o agriculture…

21. Despite the evidence that Aid does not work (or may hurt) • Some people ask for more aid: Sachs, Gordon Brown, etc • How can they argue that more aid is necessary if the evidence is that aid does not work? • POVERTY TRAPS.

22. Poverty Traps: Theory • Start with Fundamental Equation of “Solow-Swan”: • Δk=sf(k) - (δ+n) k or • Δk/k=sf(k)/k - (δ+n) • If s and n are constant, and f(.) is neoclassical (concave with inada conditions), then UNIQUE AND STABLE STEADY STATE • Poverty Trap Theory: instead of unique and stable steady state, THREE STEADY STATES and Lower and Upper steady states stable and middle one unstable

23. Poverty Traps: Theory • Savings trap (savings rate is close to zero for poor countries for subsistence reasons and then shuts up as income increases) • Nonconvexity in the production function (there are increasing returns for some range of k)

24. Savings and Non-Convexities Traps Stable Stable δ+n Unstable s(k)f(k)/k

25. Poverty Traps: Theory • Demographic trap (impoverished families choose to have lots of children) - www.gapminder.org

26. Demographic Trap Stable Unstable s(k)f(k)/k Stable δ+n k

27. Poverty Traps: Implications • The main implication is that a country that is “stuck” in a poverty trap (the low income steady state) that receives aid in the form of capital that is less than the distance between its initial position and the next steady state, converges back to the low steady state. • Hence, the fact that aid has not worked in the past does not prove that it is ineffective. • In fact, the poverty trap implies that the total amount of aid must be increased enough to put countries over the unstable steady state • IMPORTANT NOTE: this is different from having two savings lines (if we have two savings lines with two steady states, then NO amount of aid will work!)

28. Problem 1: Savings Trap • Need to have THREE steady states: • For savings line to cross three times the depreciation line, you need the savings rate have to behave in “s” shape: • First low and constant (the savings line declines so it crosses de depreciation line from above and describes a stable steady state) • Then s should be raising for intermediate levels of k (so that the product s(k)*f(k)/k is upward sloping) • Then it should stay constant at a higher level (so that s(k)*f(k)/k becomes downward sloping again • In sum, it is NOT enough to argue that “poor people save less”. • There is NO evidence that saving rates accelerate sufficiently rapidly to justify the savings poverty trap (Kraay and Raddatz (2005))

29. Problem 2: Savings Trap • If there is technological progress, the savings trap automatically disappears!

30. Problem 3: Demographic Trap • If there is technological progress, the savings trap automatically disappears!

31. Problem 3: Fertility Behavior • True that fertility declines as income increases... but population growth is the sum of fertility, minus mortality, plus net migration • Mortality also declines with capital (and income) • And net migration increases with capital • Hence, need to argue that fertility declines MORE THAN OFFSET mortality declines, migration reversals and the diminishing returns to capital so that the savings and depreciation lines cross three times • This is empirically unlikely

32. Problem 4: Non-Convexities Trap • Normally, non-convexities can be easily convexified (for example, by using an average of the two technologies) • Thus, not only you need to argue that non-convexities exist, but need to argue that non-convexities cannot be “convexified” by averaging production from below the convex and above area • This is a lot harder

33. Problem 5: Poor Countries did not grow less than others

34. Problem 5 (cont): Poor Countries did not grow less than others Defenders of Poverty Trap theory show that poor countries have grown less after 1975. But how do we explain positive growth (1.9% per year) between 1950 and 1970?

35. Problem 6: Evidence of Conditional Convergence suggests that “fundamentals” explain low income • Holding constant conditioning variables, the partial correlation between initial income and growth is negative • Again: To have poverty traps, we should have multiple steady states with same savings and depreciation lines (not that there are multiple savings lines). • If there are multiple savings lines, there is no reason to have increased aid

36. Problem 7: Little Evidence of “Take Offs” • Define take off as a period of large sustained growth (more than 1.5%) following a long period of zero growth (defined as -0.5% to +0.5%)

37. Source: Easterly 2005

39. Problem 8: And take offs are not related to Aid

40. Problem 9: Accelerations are more likely to occur poorest countries • Haussman, Pritchett and Rodrik (2004) • Theory suggest that accelerations should be less likely to occur among poorest countries.

41. Problem 10: Growth is NOT persistent across decades • Easterly, Kremer, Pritchett, and Summers (1993)

42. Problem 11: Quah (1996): Seems Evidence in favor of Traps

43. Forecasting the future of the WDI (by country) • Quah’sMethology: Based on historical experience • Пpp=probability of poor in 1960 staying poor in 2000 • П pr=probability of poor becoming rich • П rp=probability of rich becoming poor • П rr=probability of rich staying rich

44. Forecasting the future of the WDI (by country) • Npoor(2040)=Npoor(2000)* П pp+ Nrich(2000)* П rp • Nrich(2040)=Npoor(2000)* П pr+ Nrich(2000)* П rr • Repeat the procedure infinite many times to get the ergodic (steady-state) distribution • Conclusion: depends on Venezuela and Trinidad-Tobago

45. Problem • Not very robust (Kremer, Onatski and Stock show that it depends on one or two data points)

46. Additional Problems • There is capital in the developing world but it is not invested in the developing world • Correlation between Aid and Growth is zero (more on this later). • Is it Poverty Traps or Corruption? • Countries with low scores on “corruption” tend to grow 1.3% less than other countries (Easterly 2006) • Multiple regression: holding constant “corruption”, the “level of poverty” does not matter (Easterly 2006)

47. Interesting questions: • If it is “corruption” but we increase aid (we double in the next five years, and double it again five years later) because we think “poverty traps”, could we possibly induce more corruption? • Why doesn’t aid work?

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