Development aid works over time, but must adapt to 21st-century needs

Most of the world’s poorest people now reside in middle-income as opposed to low-income countries. Reuters/James Akena

In academic discourse, it has become almost ritualistic to begin a piece on foreign aid by highlighting the sharp controversies over its effectiveness as a tool to promote social and economic progress in developing countries. This has happened even though evaluations of development aid at project and sector levels have consistently pointed to the positive impact they have.

Instead, controversy has centred on the ability of aid to promote overall economic growth. In this domain, conclusions have varied from positive to perverse.

We argue that the balance of evidence has tilted notably towards the positive impact of development aid on growth. But, partly due to this very success, most of the world’s absolutely poor people now reside in middle-income as opposed to low-income countries. Unfortunately, the aid architecture is adapting only slowly to this new reality.

The aid growth controversy recedes

Though some dissonance remains, the large majority of recent empirical studies find positive impacts with broadly comparable results for the effect of aid on growth.

These studies suggest that receipt of foreign aid equal to 10% of GDP over a sustained period is expected to boost growth by approximately one percentage point on average.

These studies also emphasise that the effect on growth takes a long time to materialise. Development assistance can also have limited or even negative impact on growth in the short run.

For example, a successful drive to increase school enrolments may reduce the size of the labour force with negative implications for output. Similarly, successful programs to reduce infant and child mortality initially have little effect on output while increasing population.

The mathematical result is a relative decline in GDP per capita due to a larger population (denominator). In both cases, a better educated and healthier workforce will over time contribute to higher economic growth.

The positive impact, on average, of development assistance on growth is consistent with findings for other important socioeconomic indicators. Over the long run, foreign aid has:

  • reduced consumption poverty;

  • contributed to more rapid expansion of “modern” sectors (industry) alongside a relative decline of agriculture’s share in GDP;

  • enhanced aggregate investment; and

  • increased government spending with generally positive implications for a range of social outcomes.

Why did it take so long to figure this out?

The volume of aid to a country and its effects are not always large enough to be identified in macroeconomic data. And the not-so-large impacts often take a long time to be realised.

Large fluctuations in growth – something that nearly all developing countries experience – have also complicated the way aid contribution is detected.

On top of this, observations of both the flow of aid funds to developing countries and the outcomes achieved (such as economic growth) are known to be imperfect. For these reasons, it is not surprising that the economics profession is only recently converging on broadly similar results.

The reality is that the development process is long and arduous, even when supported by effective aid inflows. The role of assistance in fomenting development has not been as potent as early advocates had hoped.

Rather, development assistance has played a role in growth and development consistent with modern growth theory. This means it has served as a material contributor to the graduation of many countries from low- to middle-income status.

Wanted: an international institutional architecture for this century

That is the good news. The architecture of international development assistance can build on a record of success. The bad news is that this international architecture is – at best – adapting slowly to the new world it has helped bring about.

In 1970, half or more of the world’s population could be categorised as deeply deprived with the very large majority of these living in poor countries. Today, about 10% of the world’s population live in extreme poverty. Of those, the large majority live in middle income countries.

The World Bank now categorises only 31 countries as low income. Most have relatively small populations. Ethiopia, with about 95 million people, is an exception. But development assistance remains targeted mainly at low-income countries. This means that the existing system pays relatively scant attention to the bulk of the world’s absolutely poor people in middle-income countries.

This is just one of the more obvious manifestations of the mismatch between the 20th century institutional designs of development assistance and the needs of the 21st century.

Another manifestation is the persistence of operational structures predicated on country conditions characterised by:

  • very low human capital;

  • weak institutions;

  • high aid dependency; and

  • limited information circulation.

Substantial advances in these areas – even in countries still categorised as low income – creates a mismatch between the services donors provide, particularly knowledge services, and country needs.

Finally, shareholding structures in important international institutions, such as the World Bank and International Monetary Fund, reflect outdated mid-20th-century power structures. Partly as a result of this, the response to new challenges is institutionally dispersed. Climate change is a good example. Many players prefer to invent new institutions for even traditional development tasks, as in the New Development Bank.

Meanwhile, very large development challenges remain. Despite unprecedented global prosperity, more than 700 million people remain absolutely poor. Thirty-one countries remain mired in low-income status. Relative poverty has been increasing in many countries.

At the climate change conference in Paris in December 2015 developing countries pledged to make serious contributions to the mitigation of climate change. But to do so they are seeking, quite reasonably, assistance in creating clean energy systems and in coping with the higher temperatures.

Now is a good time to rethink the international assistance architecture, building on lessons of success from the past while focusing on meeting the challenges of the future.