Aid, Policies, and Growth: Bauer Was Right

The late Peter Bauer was a giant in development economics. By the end of his life he had convinced many in the economics profession that it is simply untrue that developing countries can break out of the poverty trap only by receiving foreign aid from the more prosperous industrial nations. In fact, Bauer (2000: 46) went one step further: Development aid is . not necessary to rescue poor societies from a vicious circle of poverty. Indeed it is far more likely to keep them in that state [italics added]. It promotes dependence on others. It encourages the idea that emergence from poverty depends on external donations rather than on people's own efforts, motivation, arrangements, and institutions. Although Bauer's influence has been powerful, it has not been pervasive. There appear to be some in the economic development community on whom his message seems not to have made even a dent. A case in point is the much-acclaimed study by two World Bank economists, Craig Burnside and David Dollar (2000, henceforth BD). Relying on a panel data set of 56 countries over six 4-year periods (beginning with 1970-73 and ending with 1990-93), the authors use regression analysis techniques to examine the relationship between national economic growth, national economic policy, and foreign aid received. More precisely, they regress the growth rate of real GDP per capita on various combinations of regressors, with the basic specification including an index of the quality of national economic policy, a measure of foreign aid, and an aid-policy interaction term. Their two principal findings are (1) the estimated coefficient of aid is negative but not statistically significant, and (2) the estimated coefficient of the aid-policy interaction term is positive and significantly different from zero. From these two results, BD (2000: 847) conclude: "We find that aid has a positive impact on growth in developing countries with good fiscal, monetary, and trade policies, but has little effect in the presence of poor policies. " William Easterly (2003: 24) reports that BD's study has been extraordinarily influential: "Their general finding was passed on from one media report to another and was cited by international agencies advocating an increase in foreign aid. " In all the folderol over BD's study, the trenchant insights of Bauer appear to have been lost. The purpose of this study is to reaffirm empirically Bauer's position on the relationship between foreign aid and economic growth. Sober Second Thoughts BD's conclusion has been challenged by William Easterly, Ross Levine, and David Roodman (2003, henceforth ELR). They use the exact same regression specification as BD, but expand BD's set of observations to include data that were not available to BD. ELR were able to augment BD's 56-country sample with 6 additional countries and one additional 4-year period (1994-97). (1) Using their expanded data set, ELR find that the aid-policy interaction term is not significantly different from zero, indicating no support for BD's conclusion that in a good policy environment foreign aid has a positive effect on economic growth. This study goes one step further: empirical evidence presented below suggests that foreign aid has a negative growth effect even where economic policy is sound. The first two columns in Table 1 provide a comparison of BD's and ELR's ordinary least squares (OLS) results (ELR 2003: 7). The regressand is the average real per capita GDP growth rate (GDPG) over the six 4-year periods 1970-73 through 1990-93. The regressors are the natural logarithm of real GDP per capita (LGDP) in the last year preceding the period for which the growth rate is calculated; the extent of ethnolinguistic fractionalization (ETHNF), whether assassinations occurred (ASSAS), and their interaction (ETHNF*ASSAS); regional dummies for sub-Saharan Africa (SSA) and East Asia (ESIA); a measure of national institutional quality (ICRGE); a measure of the quality of national financial markets (M2); foreign aid (AID), defined as the sum of grants and the grant equivalents of official loans; a measure of the quality of national economic policy (POLICY), an index covering measures of fiscal, monetary, and trade policies; and the interaction between aid and policy (AID*POLICY). …